Monday, August 31, 2009

The perverse impact of Value at Risk

Since we are on the topic of banks, let's take a quick look at Value at Risk (VAR). It's a dollar measure used by banks to allocate trading limits as well as a tool regulators use for capital requirements on banks' trading activities (under the Basel Accord). In principal it is meant to measure the level of risk (potential losses) in a portfolio.

In practice however it a simply function of historical volatility that an existing portfolio would have experienced if one held it intact over some historical period (such as 2 years). There has been debate and academic literature on the topic (see references) ad nauseam, particularly on what type of VAR constitutes a more "accurate" measurement. In fact some sadly refer to the VAR calculation process as "risk management". But in the end it just comes down to one thing: VAR is very much linked to some form of historical volatility.

Under the BIS requirement, most use a 2-year historical period (or some other fixed time period). And therein lies the problem. The historical period deployed may be capturing a time of relatively low volatility, resulting in a risk measure that is considerably lower than the actual risk in the portfolio. And as long as the business understands the limitation of such a measure, there is no issue. But when banks allocate capital and set limits based on VAR, it can have all sorts of unintended consequences.

Below is a VAR measure over time on a $10 MM position in S&P500 based on a two-year rolling window (for each day it looks back to what the volatility was in the previous two years). If the period happens to be over a mild volatility range, the VAR measure becomes skewed to the low side.



In the middle of 2007, this chart shows VAR on the position that is over three times lower than the VAR on the same position now. That is for the same VAR limit a trader could have over three times as much in S&P500 as she can now. It is truly a perverse way of thinking about risk, as it lulled banks in 2007 into increasingly large positions. A $10 MM position in S&P 500 is probably no more or less risky now than it was in 2007 (many would argue that in 2007 it was more risky, rather than a third the current risk).

As historical volatility became lower, the capital requirements to hold the same trading positions gradually dropped, allowing banks to take on more risk. Now a two year period includes 2008 and everything looks extremely risky. But here is the kicker. As the second half of 2008 moves out of the two-year window (which will happen in the fall of 2010), the VAR measure will drop again assuming volatility stays mild (as it has been recently). And bank capital usage will drop allowing them to take on more trading risk.

It is mind-boggling to see regulators so committed to such capital requirement techniques. In effect this approach is a path to building asset bubbles. Banks increase risk (inflate the bubble) when volatility is low because they have excess capital. But they are forced to rapidly reduce risk (pop the bubble) when volatility increases because their capital requirements go up. But it's exactly during those periods of high volatility when banks don't have enough capital, forcing rapid unwinds and increasing volatility even more.

Sunday, August 30, 2009

The gap in the US banking system

We recently received a comment related to bank failures from someone pointing out that in Germany, with a population of some 82 million, there are only about 5 banks (there are actually more - but let's stay with this line of thinking). The question was why does the US need that many banks?

For one thing, banks in the US used to be quite profitable in the real estate boom days. They were also relatively easy to set up (particularly relative to Europe). The 2008 crisis however may have taken care of that, pushing the US closer to the German banking system, dominated by large national banks. The chart below shows the 2001 US banks sorted by total assets. It's a fairly continuous chart that may resemble other sectors with a relatively open competition.



But the crisis changed all that. The 2009 picture looks quite different, showing a large gap between the fourth (Wells) and the fifth (PNC) largest bank (when comparing total assets). The ratio of assets between these two is over 4.5, showing that the top four banks are massively ahead of the rest of the industry.



Large banks have tremendous advantages - from regulatory support to cheaper cost of funds and less reliance on deposits (ability to borrow interbank or in the capital markets). That advantage will continue propelling the larger banks ahead of the rest.

The gap some may argue is filled by institutions that have just become bank holding companies, such as Goldman and Morgan Stanley or non-banking firms such as MetLife and Amex (both of which have a bank holding status). But these firms don't significantly impact the consumer landscape, where the big three banks are beginning to completely dominate (it's unclear if the investment banks have any plans to get into retail banking). The chart below from the Washington Post illustrates the deposit growth at large banks (mostly driven by government arranged acquisitions, but also attracting nervous depositors leaving smaller banks.)



And here is a comparison to the deposits various institutions controlled in 2007 (from the Washington Post):



Unlike Germany, where regulators are quite happy with the large few (Landesbanks, Commerzbank, Deutsche Bank, DZ Bank, etc.) dominate the landscape, the US regulators are quite nervous. From the Washington Post:
Regulators' concerns are twofold: that consumers will wind up with fewer choices for services and that big banks will assume they always have the government's backing if things go wrong. That presumed guarantee means large companies could return to the risky behavior that led to the crisis if they figure federal officials will clean up their mess.

One solution the regulators are proposing is to increase capital requirement on the larger banks.

That [Obama administration's proposed] plan would impose higher capital standards on large institutions and empower the government to take over a wide range of troubled financial firms to wind down their businesses in an orderly way.

But capital increases will negatively impact lending, as banks would rather focus on fee businesses that require little balance sheet usage. Reduced lending is the last thing this economy needs. But that seems to be the direction large banks are taking as they continue to probe for weaknesses in the wall of regulatory rules to come up with solutions that require less capital (whether it's rating agency shopping or TRS).

On the retail side however, foreign institutions are starting to make inroads, trying to fill the gap. From HSBC to ING, foreign banks are trying to grab share of US deposits. Some are trying to get in by acquiring failed US banks. From the WSJ:
The sale of the operations of failed Guaranty Bank in Texas on Friday to the U.S. division of a Spanish bank signals that foreign banks can succeed in the auctions for collapsed U.S. lenders.

Banco Bilbao Vizcaya Argentaria SA on Friday became the first foreign company to buy a failed U.S. bank in this crisis; on Friday, federal regulators shut down Guaranty.

Other foreign banks with a U.S. presence interested in gobbling up failing U.S. banks include French bank BNP Paribas SA through its San Francisco subsidiary, Bank of the West; Toronto-Dominion Bank, through its Portland, Maine, subsidiary, TD Bank; and Rabobank, the El Centro, Calif., subsidiary of Rabobank Group of Utrecht, Netherlands.

With competition still in place in the US (for now), it's unlikely the US banking system will converge to look exactly like the one in Germany going forward (it's much harder for a new bank to make inroads in Germany). However the landscape, shocked by the financial crisis, will be changing rapidly, becoming almost unrecognizable in years to come.

The harsh realities of the federal budget deficit

As a quick follow-up to Krugman's comments on the escalating federal budget deficit, here is the updated report from the Congressional Budget Office. The recent spike in budget deficit (chart below) is only the beginning.




CBO is forecasting a continuing budget deficit with no possible way to close the gap. It's a truly sobering projection. From CBO:
CBO estimates that, as the economy recovers, if current laws and policies remained in place, the deficit would shrink but remain above $500 billion per year, or more than 3 percent of GDP, throughout the 2010–2019 period. As a result, debt held by the public would continue to grow as a percentage of GDP during that time. That debt, which was as low as 33 percent of GDP in 2001, would reach an estimated 54 percent of GDP this year and grow to 68 percent of GDP by 2019.




And this projection hinges on a steady GDP growth in the next ten years. Without such GDP growth, the budget gap will look significantly worse. Here is their latest GDP projection. It could turn out to be much too optimistic.



See the full CBO report below:



State budgets continue to pose major risks to recovery

One of the biggest risks to sustainable economic recovery is often overlooked. It is the unprecedented budget shortfall faced by the majority of US states. Here is an updated map from the Center on Budget and Policy Priorities (CBPP) showing states that are or expected to be facing budget shortfalls.



Unlike the federal government however, most states' constitution prohibits them from running a deficit or borrowing to cover their operating expenses. States are faced with the following choices:

1. Draw down existing reserves,
2. Cut spending,
3. Raise taxes.

Those who can are now drawing on reserves, creating a temporary cushion. However the reality for 2010 and beyond is grim. Spending cuts across the board will negate some of the federal stimulus programs in place. But a larger risk to the economy will come from state tax increases. As we discussed before, the tax multiplier on the GDP is roughly 3. That means for every dollar in tax increases, the GDP is expected to contract by $3. And states have a great deal of ground to cover with a budget shortfall of $165 billion in 2010 and an estimated shortfall (from CBPP) of $180 billion in 2011. Below is the updated report from CBPP:



Saturday, August 29, 2009

The warning signs in the US equity markets

The US stock market indicators pointing to a frothy market are now showing up everywhere. The danger signals are flashing. Here are just a few of them (not in any particular order):

1. The chart below shows short interest on SPY (SPDR S&P500), the most liquid equity security traded. It has been used as the instrument of choice to short the overall market by institutions and individuals alike. SPY short interest has fallen dramatically.



2. Insider selling has spiked, both on an absolute level as well as relative to insider buying:
TrimTabs Investment Research reported that selling by corporate insiders in August has surged to $6.1 billion, the highest amount since May 2008. The ratio of insider selling to insider buying hit 30.6, the highest level since TrimTabs began tracking the data in 2004. (prnewswire)


3. The Arms Index (TRIN) a technical indicator, defined as follows,

source: Investopedia

has hit about 0.75, the lowest level in the last 9 years. That means that the bulk of the trading volume is chasing advancing stocks. The rally is increasingly driven by speculative momentum traders - a sign of a frothy market.

4. The percentage of bullish stock advisers has spiked. From the WSJ:
The Investors Intelligence Advisors Sentiment index, which gauges the stock advice of about 150 newsletters and other paid market-advice outlets, on Wednesday said the portion of bullish stock advisers jumped to 51.6% in the past week, the highest since December 2007.



Bears fell to 19.8%, the first time since October 2007 that the percentage fell below 20%.


5. Projected PE ratio based on analyst estimates (from Bloomberg survey) is hitting new highs. With an optimistic projection of about $60 in 2009 earnings for the S&P500, the PE ratio is over 17. But taking a more realistic projection of $40, we are looking at a PE ratio of close to 26.

These are just some of the indicators warning of an impending correction. There are still others painting a similar picture.

Please note that this is not any sort of investment advice, but merely 5 observations.

Restructuring allows some hedge funds to survive the crisis

Market illiquidity and hedge fund redemptions tend to coincide. That combination of events, together with poor performance, was bringing the hedge fund industry to its knees in late 2008. Many funds had the cash or enough liquid instruments to meet these redemptions, but many chose not to. Here is the reason: if a fund uses its cash or liquid securities to let those investors who want out to redeem, the remainder of the fund becomes increasingly less liquid. The redemption disadvantegas those who either chose to stay in the fund or whose lockup periods have not yet ended. It also forces the manager to sell securities at liquidation prices, forcing the remaining investors to realize losses too early. Thus all the "loyal" investors end up holding the illiquid portion of the portfolio, with all the cash going to those who got out.

The hedge fund community came up with two types of restructuring solutions to address these conflicts.

Solution I: The approach was to create what amounts to be a side pocket (or an illiquid fund) and a liquid fund. Everyone gets their pro rata share of the two funds. Anyone wishing to redeem from the liquid fund can do so at any time (or at least when lockups permit them to do so). The illiquid fund however operates like a private equity fund (or has a long lock-up), with payments to investors only upon monetization of the illiquid investments.

Here is an example of this type of restructuring:
Tudor Investment Corp., the firm run by Paul Tudor Jones, temporarily suspended client redemptions from the $10 billion BVI Global Fund Ltd. as it plans to split the hedge fund into two.

Tudor is proposing to put hard-to-sell investments, mostly corporate bonds and loans from emerging markets, into a new fund called Legacy...


Solution II: After suspending redemptions (or putting up gates) the manager splits up the portfolio into two separate but identical funds with pro rata holdings. One would hold the portfolio belonging to those who stay in (sometimes called the continuation portfolio), the other would belong to the liquidating investors (sometimes called the realization portfolio). Then the "liquidating" fund would sell all it can and return most of it's cash to the investors. This way the illiquid investments are shared pro rata between those who redeem and those who don't. The redeeming investors would then need to wait (possibly for years) until their illiquid holdings get sold. The manager would charge a minimal fee (say 50 bp) to oversee a gradual liquidation. In the mean time those who chose to stay, still have their share of the cash and liquid securities in the fund. The bulk of the managers' own funds would get moved into the continuation portfolio to align their interests with investors who stay (although some of the manager's money may go into the "realization" fund to assure those who get out that they will get the best value from the liquidation.)

These two funds would therefore start with identical holdings, but quickly diverge to meet the needs of the various investors without creating a conflict. Those who stay in the fund are asked to agree to a lockup (maybe 2 years) in return for reduced fees (something like 1.5% management fee and 15% incentive fee).

Here is an example:
Indochina Capital published information last month on a possible division of the company’s portfolio into a continuation portfolio and a realisation portfolio.


The problem with Solution-II comes in when those who had to stay in the fund because of previous lockups decide to get out when their lockups end. The manager then needs to split the fund again, creating a separate "liquidation fund". The process becomes a management nightmare. The manager would have to manage the main fund plus two or more liquidation funds with divergent interests and holdings.

But such restructuring doesn't work when investors completely lose faith in a fund's future. Cerberus recently attempted solution #2: From the WSJ

...the main hedge fund run by the firm, called Cerberus Partners, lost 24.5% in 2008. It is up about 3% in 2009. Since December, Cerberus has faced a wave of withdrawal requests by investors spooked by the markets and Cerberus's own losses. Cerberus refused to return cash, saying that weak market conditions would mean low prices if it sold holdings.



Responding to the clamor from its investors, Cerberus last month began a restructuring plan that opened a window for investors who wanted to leave the funds. Cerberus hoped it could persuade them to move their assets to a new fund with longer asset "lockups" but lower fees [this is the continuation portfolio]. At the time, the Cerberus bosses expected to retain more than half the assets of the funds, known as Cerberus Partners, in the new vehicle. Mr. Feinberg has personally called Cerberus clients over the past two weeks to discuss his firm's plans to retool the Cerberus Partners hedge funds, according to investors in the funds.

Investors' response was an overwhelming "we want out":

Clients are withdrawing more than $5.5 billion, or nearly 71% of the hedge fund assets, in response to big investment losses and their own need for cash, according to people familiar with the matter.

At this stage, with 71% redemptions and a 3% return for the year, their options are limited. Cerberus may end up scrapping the proposal to restructure, forcing investors to stay in by keeping redemptions suspended. If they choose to do so, their hedge fund business is finished. In fact managing illiquid assets in a hedge fund (vs. private equity type fund) may be the thing of the past for the whole industry.

But for those funds that still have an ongoing business, these restructuring solutions allowed a more fair treatment of redeeming and continuing investors, who would normally be at conflict within the same fund vehicle.

Friday, August 28, 2009

Rating agency shopping from the inside


Here is a great BNN interview with Ed Grebeck discussing bank capitalization and the rating agencies. Of particular interest is the discussion on rating agencies' methodologies and the resulting ratings that vary across the various departments within a single agency. Here are some highlights:

1. Basle-II convention treats a company (such as GE) debt "AAA" and a structured credit "AAA" (such as a CDO) in the same manner, allowing banks to hold minimal capital against both. Thus by pooling risky assets and selling the junior tranches of these pools, banks retained (and still sometimes do) the senior most tranches (which have much higher notionals than the junior tranches) with minimal capital requirements. That allowed banks to run excessive leverage, getting to 30:1.

2. "AAA" tranches used to trade with such tight spreads that the yields and the implied levels of risk were approaching treasuries. And a number of institutions were buying paper based entirely on agency rating. Many have learned their lessons.

3. Mr. Grebeck discusses the issue of rating agency "shopping". In addition to banks' ability to "shop" the various agencies for the best rating, an even bigger ratings arbitrage exists among the various departments within a single agency. Rating agencies' internal departments covering various products or in different geographic locations operate in silos from one another.

A bank familiar with the agencies' internal workings can pick them off to obtain a reduced capital charge - depending on how they structure a security and which department/location does the rating. In effect to get a desired rating a bank can find a department within an agency that would require the least amount of subordination, thus increasing permitted leverage.






Hat tip Ed!

Krugman's deficit madness

It is sometimes sad to see some brilliant thinkers of our time advocate what amounts to be madness. That is exactly what Paul Krugman is pushing for in his latest NY Times OP-ED column
... we would be better off if governments were willing to run even larger deficits over the next year or two. The official White House forecast shows a nation stuck in purgatory for a prolonged period, with high unemployment persisting for years. If that’s at all correct — and I fear that it will be — we should be doing more, not less, to support the economy.
Once a government incurs significant incremental debt, it will never go back to to the levels of indebtedness it had earlier - it's a political impossibility. The debt levels become permanent and even if a government runs a surplus, it is unlikely the politicians will use much of that surplus to bring down debt.

What Mr. Krugman is proposing to the nations of the world is a bet on GDP growth. Go ahead and incur huge additional debt in hopes that the GDP growth will catch up to the new levels of debt, making debt to GDP ratio (the government leverage) tolerable. But that is an absolutely dangerous bet to make and is what got the private sector into trouble. A great example is Japan. They effectively followed Paul Krugman's way of thinking and this is where their debt to GDP ratio is now:



Japan's GDP growth has been lagging their government deficits. Now the government is increasingly concerned about placing paper and is nervously looking for additional buyers. From Bloomberg:
Japan is expanding efforts to attract buyers to the nation’s growing debt load, flooding the backs of taxi cabs for the first time with pamphlets in the hopes of getting retirees to invest more money in bonds.

“Government bonds are worth another look,” the Ministry of Finance says in its latest advertisement, which features a picture of 37-year-old Junko Kubo, a former anchor on Japan’s public broadcaster NHK
Besides the issue of pushing current problems onto the next generation (who may end up with much lower GDP growth), there is a more dangerous precedent being set. It's a form of moral hazard at the national and even international levels, as financially reckless behavior is rewarded. It's OK to leverage up and borrow too much. Let's make more money now, let's buy what we can't afford, let's fight another war that may stretch us to the limit. Let's transfer debt from the private sector to the government the way Japan did. In the end the government can just issue more debt to rescue us.
Here is a good response to Krugman's proposal

Thursday, August 27, 2009

Falling emerging markets risk premium

A number of emerging markets sovereign CDS spreads have tightened to the pre-crisis levels. The recession has been discounted completely. Part of the reason is that numerous investors bought sovereign protection in late 08/early 09. Recently they have all been getting out, forcing a sharp tightening. Here is Brazil and Colombia (some of the stronger EMG names):



Philippines, Indonesia, and Turkey:



The oil producing nations Mexico and Russia are still at elevated levels relative to the pre-crisis period, although Mexico is barely above. A jump in oil prices may tighten these some more.



Argentina and the Ukraine continue to trade at distressed levels.



As a comparison here is the US sovereign CDS spread - protection agains the default in Treasury bonds. Interestingly enough it still trades above the pre-crisis levels.



Misreading the tea leaves of the money supply

An article written by Irwin Kellner (MarketWatch) proclaims that the Fed is actively taking liquidity out of the market.
Guess what? The Federal Reserve has not only stopped depositing copious amounts of liquidity into the economy -- it now appears to be in the process of making a sizable withdrawal.

Mr. Kellner argues that the evidence for such sudden action can be seen in the measures of money supply.

For example, the monetary base -- the raw material for the money supply -- has fallen at a seasonally adjusted annual rate of 8% from early April of this year through mid-August, after soaring at a 187% pace during the previous eight months.

A picture is worth a thousand words. Let's take a look at the monetary base:



There is no clear downward trend here. But even if there was a decline, the reality is that the Fed has little control these days over the monetary base. The bulk of this measure is represented by cash that banks deposit with the Fed. In the past the Fed did not pay interest on these deposits and banks only kept the minimum required amount there. The Fed could increase and decrease these requirements, thus controlling the money supply. But last year the Fed started paying interest on such deposits and the banks flooded the Fed with funds - depositing orders of magnitude more than was required. The banks were petrified of depositing funds at other banks, so a riskless deposit with the Fed was the best option. Now the banks use their Fed account as their piggy bank - they put money in and take it out as part of their cash management needs.

And even if this measure were to drop, it would just mean that banks are doing a little more lending. Sorry to disappoint Mr. Kellner, but the Fed has not been "making a sizable withdrawal", because the central bank has no control of the monetary base in this environment. The only way the Fed could influence what the banks hold with them is to set the rate they pay on deposits back to zero.

Mr. Kellner continues:

As a result, the Fed's two measures of the money supply, M2 and MZM, have begun to contract. M2 has shrunk at a 3% pace since the middle of June, while MZM, the St. Louis Fed's measure of liquid money, is down by 2% over the same period.

OK. Here is the M2 money supply trend broken into the M1 and the "non-M1" components. M1, which is physical cash and checkable deposits, has not moved down. The non-M1 component of M2 represents household savings deposits, time deposits (CDs), and retail money market funds. That component has dropped slightly.

>

Again, does the Fed have anything to do with the amount of household savings decreasing slightly? Maybe the Fed tells Mr. Kellner when to spend some of his savings, but the rest of us (at least for now) have control of what we do with our money. In fact the simplest explanation of the slight drop in retail deposits may have to do with Cash for Clunkers. People with some savings simply saw this as an opportunity to buy a car. And maybe (as controvercial as it may be) some people with savings are starting to buy homes.

Reading the money supply tea leaves and interpreting it as some sort of action by the Fed in this environment is pointless. Of course it is possible that Mr. Kellner has been adding something else to his tea.

Real estate exposure - revisited

We received a thoughtful comment from EPEON (on Seeking Alpha) on the recent post called Small bank, big bank - the difference is real estate exposure
I have reviewed a lot of small banks and I have to say that your analysis is true but entirely misleading. Small banks (and credit unions) do, indeed, have a higher exposure to real estate loans. However, the exposure is usually to their own depositers and or members. The banks and credit unions have relationships with these people and they know, quite well, the credit worthiness of these people.

Their default rate is usually far lower then it was on the subprime crap. So, the problem is not real estate. Rather, the problem is loaning money to people that are not credit worthy.

This is an excellent point, and is indeed part of the problem. Smaller and regional banks lend within their community, often to clients they know well. However just as their clients were stretching on their real estate purchases, so did the banks on their lending practices. Part of the issue is that regional banks have been poorly diversified, with tremendous exposure to real estate in their communities. And as the communities came under pressure in the recession, so did the banks.

Here is a map showing housing price to income ratio. No surprises here - the overheated markets are all showing up in yellow and orange.


Source: CreativeClass.com

And here is a map of bank closings. Again, it shouldn't be a surprise given banks' exposure to real estate in their communities. The overheated real estate areas tend to get hit with more bank closings. There are obviously idiosyncratic local factors affecting bank closings, but the pattern is clearly there.



Regional banks' real estate exposure will continue to pressure their balance sheets, making it harder to lend, compressing their earnings, and forcing some to close. And at this stage it's not the sub-prime that is causing the problem, it's the prime lending into what was an overheated real estate market as well as commercial property and construction loans.

Increasing FDIC fees (which the FDIC will eventually have to do) on secured deposits will make the situation even worse.

The market definitely recognizes this. The chart below compares year-to-date performance of KRE - the regional banks ETF (down 24.7%), and VFH - the Vanguard financials ETF (up 18.8%). Regional banks are clearly struggling.



The small and regional banks excessive real estate exposure and lack of diversification has been a major factor in bank closings and is likely to continue pressuring these institutions going forward. From Bloomberg:

The U.S. added 111 lenders to its list of “problem banks” in the second quarter, a 36 percent increase that pushed the group to a 15-year high.

A total of 416 banks with combined assets of $299.8 billion failed the Federal Deposit Insurance Corp.’s grading system for asset quality, liquidity and earnings, the most since June 1994, the Washington-based FDIC said in a report today.




Wednesday, August 26, 2009

Lehman's $130 billion went out with the market

A recent article in Naked Capitalism called "So Where, Exactly, Did Lehman's $130 Billion Go?" again suggests that Alvarez & Marsal have mishandled the Lehman's bankruptcy.
It has come out that the losses appear likely to be $130 billion on what was a roughly $660 billion balance sheet. That is an insanely high level.
The author argues that increased haircuts on Lehman's portfolio do not account for the losses.
Let us make generous assumptions, that Lehman was using 40% structured credits as collateral. And remember, thanks to the 2005 bankruptcy laws, the counterparties can grab collateral. They don't have to go into the bankruptcy queue.

But even with a 20% spike in repo haircuts, we get only to $26 billionish. Even if the Lehman counterparties were jerks and upped the haircuts by 30%, it still only gets you to around $40 billion.


Therefore there must be a conspiracy (or at least some juicy fraud or accounting "irregularities"). That should get people's attention.

It is no surprise that unwinding Lehman has been a mess. Just consider the size and the complexity of the institution. It is also clear that if the filing were more orderly, more funds would have been recovered. But consider the timing of the event.

Increased haircuts and refusal to roll repo financing may have contributed to Lehman running out of liquidity, but it was not the cause of major losses in recovery. The losses have to do with asset valuations and liquidation levels after the collapse. Lehman was concentrated in a couple of asset classes that contributed to these losses. One was exposure to structured product, particularly CMBS. Here is what happened to "AAA" CMBS spreads last year:



Depending on maturity this shock corresponds to some 30% - 50% loss in value. When liquidated in distress, the losses could be higher.

The other large exposure Lehman had (and still has) is commercial real estate. Below is the Moodys commercial real estate index.



These assets took longer to liquidate/value as the property market continued to deteriorate. Thus on a $660 billion balance sheet, a $130 billion liquidation loss should not seem so strange considering the circumstances - in fact it's surprising it wasn't higher. But of course looking for a conspiracy creates some good hype, and that's what ultimately gets the advertising clicks.

M&A is about to pick up steam

The data says that mergers and acquisitions activity has come to a halt. Here is the latest chart from Thomson Reuters showing M&A activity for the US at a fraction of that for recent years.



But all that is about to change. M&A will be making a rapid comeback shortly, at least for a short period. Here are some reasons:

1. The equity rally created a more valuable "currency" for stronger companies, who will use their newly appreciated shares to make purchases. Many firms don't believe this rally is going to last and will view the next few months as a window of opportunity.

2. The credit rally provides a relatively inexpensive financing for corporations to fund acquisitions. In particular the rally in the leveraged loan market makes it possible to obtain LIBOR based bank financing that could be appealing to some firms. Some firms view this demand for credit as a window of opportunity as well.

3. As many firms prepare for slow economic growth, cost cutting becomes a priority. Many firms have gutted their staff and cut expenses to the bone. The next step in cost cutting will be consolidation of companies with the goal to use economies of scale and a common infrastructure to wring out additional savings. For some, acquisitions may be the only way to grow.

4. Some firms are trying to refocus and raise cash (to recapitalize or rebuild). That means selling businesses. Here is an example:
General Electric Co. is seeking to sell its security unit, which builds surveillance cameras and alarms, and may fetch about $2 billion, three people with knowledge of the matter said.

GE hired JPMorgan Chase & Co. to find a buyer for most of GE Security, said the people, who declined to be identified because the talks are confidential. Fairfield, Connecticut-based GE asked potential buyers to submit preliminary bids about a month ago, the people said.

We should expect to see more of these types of transactions before year-end.

Tuesday, August 25, 2009

Goldman's $4 trillion projection is wrong

From Bloomberg:
Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc., said the Federal Reserve could double the size of the central bank’s balance sheet again if needed to support economic growth.

A rise in the balance sheet to $4 trillion is a “possibility,” Hatzius said in an interview on Bloomberg Radio in New York. “It is going to depend on not just what inflation does, but also on whether the economy does move back to a slower growth pace.”

This scenario is truly scary (and may also be great for Goldman because there would be that much more paper Goldman can sell to the Fed), but such a massive balance sheet buildup is increasingly unlikely. The Fed will continue it's securities purchases, but the lending facility usage will collapse, resulting in a much slower balance sheet growth. Here is the reason (from Bloomberg):
The Federal Reserve must for the first time identify the companies in its emergency lending programs after losing a Freedom of Information Act lawsuit.

Manhattan Chief U.S. District Judge Loretta Preska ruled against the central bank yesterday, rejecting the argument that loan records aren’t covered by the law because their disclosure would harm borrowers’ competitive positions.

This suit, filed by Bloomberg under the Freedom of Information Act, will force the Fed to release the names of the banking institutions who are borrowers under the various liquidity facilities. And there is nothing that banks hate more than being perceived as weak, which is what would happen upon disclosure that they had to borrow from the Fed. Institutions who are using these facilities will now simply stop, unless they absolutely need the Fed's support to survive.

An example of this is Bank of America's refusal to participate in the TALF program because it's credit card portfolio would be classified as sub-prime. TALF provides financing on sub-prime cards as well as auto, with leverage that's a bit lower than the prime equivalent. Economically BofA could and should be using the sub-prime TALF financing, but because TALF is a high profile program and the media would learn that BofA is the only large bank doing a sub-prime deal, they stayed away. From Bloomberg:

JPMorgan Chase & Co., Citigroup Inc. and American Express Co. are among issuers that sold $21 billion of card-backed debt this year through the Term Asset-Backed Securities Loan Facility, a Federal Reserve lending program to spur bond sales. Bank of America, the only major card-issuer that didn’t sell any, lacks enough quality loans in its credit-card trust to sell TALF bonds without being labeled a subprime issuer.

So Goldman's projection on the Fed's balance sheet doubling is just wrong. The securities purchasing may continue for a while (although some in the Fed are getting increasingly nervous about it), but the purchases will be offset by reductions in bank liquidity facilities.

Paul Volcker's beef with money market funds

Paul Volcker is obsessed with protecting banks from "unregulated competition". In his view this competition comes from money market funds who offer a product that competes with bank deposits.

"In my vision of the new financial system, you obviously want to protect banks and have strong banks, and I don't think they should be put at a competitive disadvantage vis-a-vis money-market funds," (from Reuters)


In some ways this proposal is equivalent to suggesting that UPS and FedEx should be regulated (or federally owned) because they present competition to the USPS. Sounds like socialism, doesn't it?

It is not clear just how much competition money market funds actually pose to banks. Money markets are restricted on the average (and maximum) maturity of their assets. As an example let's take a look at SPRXX, the Fidelity's money market fund. It's assets' average maturity is now 74 days and the current yield is 0.33% - annualized. Banks on the other hand don't have significant maturity restrictions and can take advantage of the steep yield curve. If they are lending at 5-6% longer term, they can afford to pay higher rates to depositors.

The chart below compares yield on average bank money market deposit rates (national average) with the yield on the Fidelity money market fund.




As the yield curve gets steeper the differential gets worse for money market mutual funds. Even bank checking account rates are higher than money fund rates. The table below shows current (national average) rates banks are paying on retail deposits of different types:



An individual who wants a safe place to deposit cash will generally choose an FDIC insured account yielding 1.17% rather than an unsecured account yielding 0.33%. One of the reasons people hold cash with money market funds is to get convenient access to their brokerage or mutual fund accounts (such as Fidelity). Another reason (as is sometimes the case with institutional investors), they just don't trust the stability of banks. Money funds therefore serve an extremely useful purpose. Without a money market product for example cash in a brokerage account would have to be moved into a bank account and back to facilitate securities trading.

In addition, money funds purchase commercial paper that gives corporations (and banks) access to inexpensive short-term financing - some of which translates into better financing and lower costs for consumers.

To the extent money funds present some competition to banks because of the their niche role, it would be counterproductive to eliminate this competition. The approach Mr. Volcker is suggesting is to regulate money funds the way banks are regulated. That means the following:

1. Insuring money market funds via the FDIC program
2. Giving funds access to the Fed's emergency facilities
3. Requiring them to hold capital

FDIC insurance will force a fee on money funds, that combined with more stringent maturity restrictions (that are definitely coming), will squeeze the return on funds and their ability to charge fees, making the business completely unprofitable. This will also have a potential to put additional pressure on the FDIC deposit insurance fund. Giving money market funds access to the Fed's emergency liquidity facilities would help the funds, but will put the taxpayer at an increased risk. Requiring money funds to hold capital is an impossibility, because unlike banks, mutual funds can't raise separate equity.

Mr. Volcker's need to protect the banking system from money market fund competition is misguided. From Bloomberg:

His proposals “would eliminate money funds as we know them,” Paul Schott Stevens, head of the Investment Company Institute ...
Which is exactly how far Mr. Volcker wants to take this in order to help the banks.

Sunday, August 23, 2009

The Fed's balance sheet - latest trends

A few days ago the Fed published it's monthly report on the bank's balance sheet trends and the various credit facilities (the full report is included below). Here are a few takeaways:

1. The total assets on the balance sheet have been stable at about $2 trillion. It's hard to imagine how it is possible to avoid balance sheet growth with all the quantitative easing. However the purchases of securities have been entirely offset by reductions in the various liquidity facilities.




2. Liquidity facilities usage continues to drop. We've discussed reductions in the usage of TAF as well as CPFF. The Central Bank Liquidity Swaps represent transactions that allow other central banks to get access to dollars in exchange for their currency at market FX rate, while committing to return the dollars in exchange for currency at a contracted rate. The Swiss used this faculity as part of their bail-out of UBS, since UBS needed dollars. Other central banks needed the facility as well because for a number of foreign banks dollar financing had been cut off. Now with the reduced needs for dollars by other central banks, this facility usage has been on a decline.

The one liquidity program that continues to grow, though tapidly, is TALF. However in the bigger scheme of things, TALF is not a significant contributor to Fed's balance sheet.




3. The securities component of the balance sheet has been growing quickly, with MBS purchases outpacing everything else. Quantitative easing continues to move in full force. For those interested in getting a new mortgage, now is the time. Once the MBS purchase program is over, mortgage rates are sure to go up. The Fed's position in MBS and agency paper combined is now about the same as their holdings of Treasuries.




4. One of the items that stands out in the report is the Maiden Lane portfolio, the facilities set up for Bear Stearns and AIG. In particular the Maiden Lane - II (ML-II) has deteriorated. Unlike ML-III (the other AIG facility which is diversified), ML-II is backed by mortgage linked paper, and with mortgage delinquencies continuing to rise, this is not a surprise. The idea was that it will generate enough cash flow to pay down the facility faster than the decline in collateral value, which is not happening. ML-II will be the facility to watch closely going forward.

The table shows how much "under water" the facilities are (asset value less what's due to the Fed):










The escalating Afghan violence and the opium trade

As strange as it may seem, troubles in Afghanistan are very much linked to the downturn in the global economy and the drug wars raging in the Western world.

The West is flooded with cheap opium, the bulk of which (93 - 97%) is now coming from Afghanistan. The drug trade accounts for half of Afghan's GDP (according to National Security Network). The chart below (from the UN's World Drug Report 2009 - see embedded below) shows Afghanistan's dominance in opium production.



Even though most heroin sold in the US is cultivated in Mexico and South America, one fact remains - the street cost of heroin in the US has dropped to $250 an ounce (in 2009), compared with roughly $800 some ten years ago. Sadly that price drop is destroying the Afghan economy and spurring violence.

Before 9/11, the so-called Northern Alliance fought the Taliban for years, ultimately losing most of the territory they used to control. With the US support, they were able to overcome the Taliban and regain power. But their war wasn't about Afghanistan's liberty or some other ideals. The Northern Alliance war lords that ultimately became Karzai's regional leaders, wanted one thing - to regain the control of the poppy fields and distribution channels for opium. It all fell into place for them after 2001. The US provided stability, Karzai looked the other way to maintain control, while Tajikistan, Uzbekistan, and particularly the friendly Kyrgyzstan (ex-Soviet republics to the north), as well as Russia provided excellent distribution routes into northern Europe and the Far East.

By the way if you are an attorney looking for work, here is your opportunity to become a Resident Legal Advisor in Kyrgyzstan working for the US Justice Department. You would be assisting the local authorities to fight drug trafficking from Afghanistan as well as local production. But be careful because Kyrgyzstan may legalize opium and you will be out of a job.

Pakistan and Iran were also there to move inventory into Western Europe and Africa - some ultimately headed for the US. Ironically it is rumored that some ex-Taliban who resettled in Pakistan were and still are providing distribution support. This industry became a well-oiled machine.


source: PBS

According to the UN:
The Report shows a downward trend in major drug markets. Opium cultivation in Afghanistan, where 93 per cent of the world's opium is produced, decreased by 19 per cent in 2008.


With prices collapsing, driven by the global recession, and production down, there is no longer "enough to go around". Margins are thinner and those participating are not getting paid the way the used to. Th economy is in perils as nearly half the GDP is impacted directly. And that is leading to the rapidly escalating violence in Afghanistan.



What's striking about the chart above it the cyclical nature of the casualties, spiking each summer. The Taliban don't exactly become more anti-Western or more motivated in the summer. The violence escalates during the poppy harvest period when more trafficking takes place and when the US attempts to destroy some crops. Thus contrary to popular belief, Afghanistan violence is more about the opium crops and trafficking than it is about ideology, making this war that much tougher and more expensive. The Taliban is actively engaged in the drug trade, becoming more critical to the welfare of the Afghan people, gaining their support. They are seen as the protectors of the crops which are now threatened by the US. The video below from CNN zeros in on the issue:



As important as stability of Afghanistan is, it will be nearly impossible for NATO to generate stability without replacing the revenues from opium. The Afghan conflict is becoming increasingly more expensive for the US in part due to the global slowdown and drop in prices. Ironically the economic downturn is also the reason the US and NATO can ill afford to wage this war. Since this is effectively a "war on drugs", maybe it's time of others who are impacted by opium (and have the resources) to step up and help with the conflict.





Saturday, August 22, 2009

CMBS TALF is starting to ramp up

In our previous discussion on CMBS called CMBS balloon risk looming, we covered the refinancing risk for commercial mortgages. These mortgages form the collateral pools for CMBS bonds, creating significant risk that these securities will default on part or all of their principal. That risk however varies dramatically based on the seniority of CMBS tranches.

Here we refer to CMBS securities in terms of ratings, which represent the level of seniority (the actual ratings themselves are fairly meaningless for CMBS at this point). The chart below shows spreads (from Morgan Stanley) for the highest seniority tranche (super-senior AAA) and a junior tranche (BBB).

Super-senior AAA and BBB spreads over US Treasuries (spreads are on two different scales - see left and right y-axis)


Since the start of the financial crisis, the spreads have blown out on these securities in part because of increasing delinquencies, but mostly due to refinancing risk. However as the credit markets stated rallying, the senor tranche spread has narrowed, while the junior tranche stayed at distressed levels. The junior tranche is priced based on coupons it may pay, assuming that it will not pay any of it's principal. In fact in some instances these tranches are expected to pay only a portion of their expected coupons.

The super-senior AAA is different. Even in an environment of highly depressed real estate values, the tranche (for many CMBS deals) is expected to pay a significant portion of it's principal due to substantial subordination "beneath" the tranche. When properties are liquidated (because mortgages can not be refinanced), there may be enough to pay down the AAA, but the market does not expect there to be much left to pay the junior tranches. The diagram below illustrates how the market views the risk on these bonds:



Some view the most senior tranches of CMBS as a potential investment opportunity. Even if not all the principal will be recovered (though some market participants think many of the senior tranches are money good), the discount (or effective spread) may justify the investment. But 500 basis points over Treasuries for securities that are 5-10 years in maturity is not a great return for many investors who are taking this risk.

But the Fed came to the rescue to bump up the return, by providing leverage on the senior CMBS tranches via TALF. This is the riskiest component of the TALF program for the Fed (and that's why the leverage on CMBS is lower) Thus CMBS TALF has started doing some volume.



However, this is still a drop in the bucket, given the $700 billion CMBS market. Also these TALF transactions are secondary CMBS only. The big question remains, is whether TALF will stimulate any private financing of new properties. So far new CMBS activity is nearly non-existent, but there are some deals in the works to take advantage of TALF. From the WSJ:
Vornado Realty Trust, one of the U.S.'s largest real-estate investment trusts, is planning on raising between $550 million and $600 million through a bond sale that would qualify for a key government program aimed at resuscitating the commercial-property market, according to people familiar with the matter.

Participants are banking on a larger TALF operation in September to move some of the massive existing inventory and possibly do some primary deals.

Small bank, big bank - the difference is real estate exposure

As a follow-up to our previous post, on failures of small banks, here is an interesting fact: small banks had significantly higher exposure to real estate than large banks.

There is a general misconception out there that the large banking institutions have been responsible this financial crisis by taking excessive risks, while the "main street" banks have been relatively prudent. This assumption turns out to be completely wrong.

Using data from the Fed, we looked at the ratio of real estate loans to total assets for large and small domestically chartered US banks (for reference: FRB data code H8/H8/B1026NLGAM over H8/H8/B1151NLGAM). For large banks we also included mortgage-backed securities (code H8/H8/B1303NLGAM). The result is actually quite shocking:


Source: Federal Reserve Board

At the peak, almost 50% of small banks' balance sheets was in real estate loans. Large banks never got close to those levels. Furthermore small banks' real estate related portfolios have not decreased significantly - still over 45%. It's no surprise therefore that small banks are not lending and Meredith Whitney is predicting 300 additional small bank failures.

Small banks used depositors' money and the taxpayer's guarantee to lend against real estate without much consideration for diversification. This is indeed bad news for the FDIC and the taxpayer. What's ironic about this situation is that TARP funds will likely be repaid - it is even entirely possible that the Treasury will end up making money on TARP (with dividends and warrants). However the bulk of taxpayers' money to bail out the FDIC deposit insurance fund (FDIC is asking Congress for a half a trillion credit line) will probably never be recovered.

Friday, August 21, 2009

Meredith Whitney: 300 more bank failures

Meredith Whitney is predicting 300 additional bank failures, putting continuing pressure on the FDIC. The FDIC insurance fund, which may already be in the red is going to require more taxpayer funds.




Many of the smaller banks played the same game that the Wall Street firms have, chasing more spread and loading up on real estate related assets. The chart below shows rapidly expanding real estate loan balances at small US banks.



source: the Federal Reserve Board


In fact in some ways many of the smaller banks have been more aggressive on their portfolios than the large ones due to limited devirsification. Now it's the taxpayer's problem.



Fed's CPFF winding down due to pricing

One of the reasons the declines in the commercial paper markets have been gradual rather than falling off the cliff in October of 08, was the Fed's program called Commercial Paper Funding Facility (CPFF).

Here is part of the announcement form the Fed at the time of the CPFF launch:
The CPFF will provide a liquidity backstop to U.S. issuers of commercial paper through a special purpose vehicle (SPV) that will purchase three-month unsecured and asset-backed commercial paper directly from eligible issuers. The Federal Reserve will provide financing to the SPV under the CPFF and will be secured by all of the assets of the SPV and, in the case of commercial paper that is not asset-backed commercial paper, by the retention of up-front fees paid by the issuers or by other forms of security acceptable to the Federal Reserve in consultation with market participants. The Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the Federal Reserve Bank of New York in support of this facility.

For those who were unable to sell commercial paper in the market could go to the Fed and place the paper with CPFF. Even GE Capital ended up using the facility last fall, as it became clear it would have trouble rolling it's paper. The stronger issuers like GE stopped using the program as soon as they could find private buyers. Many weaker issuers however continued to rely on CPFF.

At the time of it's creation, the costs to use the program were reasonable. Here are the terms:



These costs dropped somewhat a month after the program was launched, but remained almost constant since then.

CPFF historical rates:


Given that the assets financed with commercial paper tend to have a floating coupon, CPFF created a mismatch between assets that are yielding increasingly less and the financing that's almost fixed.

The market based commercial paper rate however, continued to fall (with LIBOR). Those who are able to issue paper privately are getting increasing cheaper financing.

90-day (A1/P1) CP rates for corporate CP as well as ABCP:


Thus on a relative basis CPFF is becoming increasingly expensive, and participants are desperately trying to find other sources of funds (including getting out of the CP market altogether). That's why the volume on CPFF continues to fall:



Overall the program kept corporations (including GE) and bank facilities from a complete liquidity crisis, creating gradual wind-downs or a migration to private sources. Ironically the Fed has made a bundle on the program. There haven't been any defaults and with the 300 bp spread on ABCP and 100 bp upfront for unsecured CP, it's has been a good deal for the Fed.

Thursday, August 20, 2009

On the way to euphoria

As the US equity market rally continues, many point out that the S&P500 is still 21% below last year's level. We still have ways to go just to get to last year's levels. Stocks are still cheap. Right.

The chart below shows the S&P500 level as well as the PE ratio, both the trailing ratio and the estimated PE (based on Bloomberg survey). Both PE ratios are at multi-year highs. The projected PE number of nearly 17 times earnings is particularly troubling because it's a forward looking measure. These levels indicate that equities are really expensive.



So why are people buying stocks with such enthusiasm? A few possible reasons here:
1. analysts are completely underestimating next year's projected earnings,
2. earnings growth in the next few years will significantly exceed historical growth,
3. stock market euphoria is back.

According to Credit Suisse, number 3 is more likely, or at least on the way there. The following chart shows the levels of risk appetite in the system, and we may be on our way from "panic" to "euphoria" in a matter of a few months.



Euphoria has been known to carry asset levels way beyond fundamental valuation, and that's exactly what may be happening here.

China's "massive offload" of US treasuries is insignificant

The People's Daily (the government sponsored newspaper) published a blurb a couple days ago called "China massively offloads U.S. debt holdings first time in 2009". Readers around the world particularly focused on the word "massively". Given that this publication is censored, there must be a message there. Some in China heralded this as a sign of China's new strength. Is China retaliating for the recent US trade victory in WTO ruling? Some believe it's a form of intimidation - trying to spook the Obama administration into compliance on trade issues.

The following day the paper published another article on the topic entitled "Cut in holdings of US debt may help diversify China's reserves".
Yin Zhongli, a senior researcher with the financial research institution of the Chinese Academy of Social Sciences, believes that the share of US dollar-dominated assets in China's foreign exchange reserves is too large.

"So, we have to diversify our portfolio for risk aversion," Yin said, adding that the country might buy more assets denominated in other foreign currencies, such as the euro, the Japanese yen and the Australian dollar.

One would think in order to diversify reserves, China can simply sell their dollar cash holdings and buy some Yen, Euro, or AUD instead of selling notes. But there is no evidence that China is in a hurry to do much of that. What's really going on?

The reality is that it simply doesn't matter. So they sold some notes and let some bills mature without reinvesting them. This change and even a larger sale by China will have a very modest effect on the treasury market. The chart below shows just how immaterial the "China massively offloads" action really was in the larger scheme of things. The foreign holdings of US Treasuries continues to grow even as China is moderating it's holdings.



China simply has little choice in the matter. Allocating $2.13 of China's foreign reserves will roughly get them to the same place every time - they have to keep a significant part of it in dollars (currently estimated to be at 70% of the reserves) and they have to hold US debt. The rapidly growing supply of US debt is clearly an issue, but the alternatives for them are no better. Many of the markets that have some depth to them such as UK gilts or JGBs carry as much or more risk than the US government debt.

The significance of this reduction in China's holdings is simply overblown.

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