The past few weeks have yielded some very strange behaviors, some of which reflect a lack of understanding of what needs to be accomplished while others display the sheer fear and panic felt by many in the financial markets. This will make for good entertainment at some point in the future, though right now there is nothing funny about the recent turn of events.
Here are just a few items that raised eyebrows, though why they happened is perfectly understandable in light of the current financial crisis.
- Treasury Secretary Paulson argues for the need to pay above-market prices for illiquid assets
- The SEC proposes relaxing FAS 157 (mark-to-market accounting rules)
- The SEC's selective ban on short selling
- GE sells $3 billion in 10% preferred stock plus warrants to Berkshire Hathaway
- 2-year swap spreads exceed 160 bps
Paulson and mark-to-market: I understand the arguments for why Secretary Paulson, and many others in Congress, think the only way to save the banks is to buy their illiquid inventories and carrying value: there is no true "market" for their asset portfolios. Dramatic write-downs arising from sales at "market" relative to carrying value would render them insolvent.
This gives the U.S. Government the ability to pay arbitrary prices for the illiquid assets as they are the only game in town, etc. I understand the arguments: I just find them specious.
As I've stated previously, it has to be a two-part plan:
Step 1: Buy busted asset portfolios at market. The U.S. Government is only one bidder. If they come up with prices that are too low, private equity firms, distressed hedge funds with long lock-ups and sovereign wealth funds will come in and bid.
There is over a trillion dollars of liquidity on the sidelines, easy, plenty to create a rich market in illiquid assets with intrinsic value if they can be held for an extended period. The U.S. Government is only one potential bidder; the others keep them honest and create a true market.
Step 2: Determine what the seller's capital gap is, after the asset sale. Here the U.S. Government will buy either debt + warrants or a variant that provides the regulatory capital necessary to bring the bank into compliance, and provides the U.S. taxpayer with a senior claim and equity upside when the market stabilizes.
I really don't get why Paulson and his buddies are at odds with me on this. I think what I am proposing is pretty straightforward and fair. Then again, this is why the issue made my top 5 list of eyebrow-raisers.
SEC and FAS 157: This is related to the points above. What is to be gained by more hiding-the-ball and providing other avenues for obfuscating reality? Have we not yet learned that transparency has to be the guiding principle of all aspects of the recovery?
The fact that this is still up for debate is why the market craters even after the Senate resoundingly passed the bill. There is such a profound lack of trust in the markets that nobody believes any company's numbers any more, particularly those that are either in or related to financial services.
A market can't function this way, and the SEC's step to provide even more latitude for financial reporting is an incomprehensibly stupid move when financial service companies, mutual funds, money market funds and the markets overall are on trial.
Transparency and clarity has to be Job #1 -- let investors make their own determinations as to what is short-term impairment and what is permanent. But when you guard access to this information, investors will vote with their feet, and the vote will invariably be to run away. Fast.
Short selling is evil?: The notion that short-sellers are at the root of the decline in financial services share prices is a bunch of bull. Those in the market who aren't also media personalities or have an axe to grind know that.
For politicians, however, it is a great photo op: "Damn those hedge funds and short-sellers; they are screwing the American people." This could not be further from the truth. In fact, by virtue of the SEC changing the rules of the game in the middle, they have essentially screwed, yes, the American people.
Let's think about this... Who dominates the investment in hedge funds? Wealthy individuals? Nope, not any more; it's pension funds and endowments. And who are these funds and endowments? They invest money on behalf of lots of ordinary people and institutions that are important to such people, like those who depend on their companies' pension plans to provide for their retirement and resources for the colleges to which they might want to send their children.
Bashing hedge funds, even if justified (which it is not in this case), really hurts the average American first and foremost, not the rich people for whom a sharp drop in value is annoying but not life-changing. So pandering politicians, short-sighted members of the SEC and Congressional idiots, WAKE UP! Because once your constituencies do, they are going to be really, really pi%&ed off.
GE's stock sale: So this is what it has come to -- General Electric (NYSE:GE), a AAA-rated corporate, sells $3 billion of preferred stock yielding 10% , plus receives a $3 billion notional, 5-year warrant struck at today's preferred sale price. Oh, and this is in conjunction with a $12 billion common stock sale which further bolsters the security of Berkshire's (NYSE:BRK.A) investment.
The IRR of Mr. Buffett's piece of paper is mind-boggling. It is almost as if he got shares in a AAA-rated company for a BB price. What this purchase says to me is less about Mr. Buffett's confidence in GE, or that the market is turning, but more about the unvarnished fear and panic GE is feeling to have agreed to such a transaction.
Does GE really perceive themselves to be AAA if they are motivated to raise money on the terms proposed by Mr. Buffett? Something is grossly wrong with this picture.
Either GE is stupid (doubtful), they think having Mr. Buffett associated with GE will be helpful for market perception (sure, but how much is this really worth?), or they are scared out of their minds by the uncertainty of today's and tomorrow's financial landscape (ding ding ding ding!).
This is one of the most disturbing deals I've seen announced in a long time, because it shows just how scared one of the best and most diversified global corporations feels right now. And they are feeling pretty, pretty bad.
2-year swap spreads: I remember the days when these were in the 20s. Now they are in the 160s. From an implied AA-rated bank credit to probably an implied BB/BBB.
The fear and paranoia evidenced by GE is clearly resident among those in the dealer community. Nobody wants to lend to anybody. Everybody is suspicious of everybody else. Nobody is truly safe.
This does not bode well for commerce, because if the banking system lacks the basic elements of trust it is hard to get business done. Money flows grind to a halt. Lending ceases. Banks hoard cash like they are protecting against a bank run. This is the point we are rapidly approaching.
The 2-year swap rate is generally a good indicator of two things: Fed Funds policy or bank stability. Clearly the Fed isn't in a tightening mode, so virtually all of the aberration in the swap rate is due to the spread, a sad comment on how banks perceive each other right now. And as I am writing this, I don't see a clear path to the spread coming in any time soon.
I find it hard to believe that things have reached this point but they have. A generation's worth of restructuring an industry in two weeks.
Bulge bracket investment banking is dead. Thousands of other banks are on death watch. Lending has come to a screeching halt.
But as it was in the 1930s, the U.S. Government is making some very, very poor decisions, and the market is speaking out. We need to get a deal done - now - but we absolutely need transparency, we need a clear and unwavering set of rules for financial market participants that don't change at the whim of the SEC, we need to create a competitive market for distressed assets and we need to address those who are creditworthy with badly structured mortgages.
This is a big job but a doable job, and it requires bipartisan support with a minimum of BS. And if our current leaders can't do it, let's get some people who can. Because we, the GLOBAL WE, can't take much more dickering around before it is too late.