"Trust" and "Confidence", or the lack thereof, are being blamed for the current credit crunch. The lack of credit is forcing banks all over the Western world to fail, and states like California and Massachusetts to ask the US Treasury for loans to keep running. Since the Federal Government (the Fed) will be playing a key role in stabilizing the financial markets, it is important that the markets trust the Fed. Trust here does not imply the Fed's ability to fix the problem overnight; but that they will follow systematic procedures and above all stand by the deals they facilitate.
Lehman Brothers Bankruptcy
The bankruptcy of Lehman Brothers is an interesting study. Lehman Brothers was allowed to fail when the Treasury made a political decision not to provide support in spite of the NY Fed's request to intervene. Worse, the bankruptcy filing failed to take into account the global nature of Lehman's operations and the worldwide cascading effect it will have. Things got to the point where the Prime Minister of England, Gordon Brown, had to make statements requesting the United States to return some $8B which had been transferred to the US from UK, but not sent back after the bankruptcy.
This had the direct effect of leaving many hedge funds in London without access to their money; money Lehman Brothers was in possession of as custodians of their brokerage accounts. This led to the run on the prime-brokerage business of Morgan Stanley (MS) and Goldman Sachs (GS) who as a result were forced to become commercial banks from investment banks. Another fallout of the Lehman bankruptcy was the run on Money Market funds as investors lost confidence in financial firms, who often rely on short term financing in the commercial paper market; the debt which is purchased by the Money Market funds.
The TARP and The Federal Government
It is quite clear that the Treasury did not realize the implications of letting Lehman file for bankruptcy. They quickly reversed course; the refusal to bail out Lehman (which needed $10B or less) stands in contrast with the $85B in loan guarantees provided to AIG, which of course was followed by the $700B Paulson rescue plan. The inability of the Fed and the Treasury to sell the plan to the House of Representatives mitigated any salubrious effect it would have to calm the markets. When the markets are in a state of anxiety, there is nothing worse than to dangle a carrot and then take it away. The failure of the vote on Monday not only triggered a massive equity sell-off in the US, but led to cascading sell-offs all over the world.Market participants feared Armageddon, credit markets froze, and "trust", including any in the Federal Government evaporated.
FDIC and Wachovia
The FDIC's role in the takeover drama for Wachovia (WB) is also not inspiring any form of trust. The affidavit filed by Bob Steele, Wachovia's CEO raises certain fundamental questions about the sanctity of contracts, even contracts initiated and brokered by Federal Agencies. According to Mr. Steele, Wachovia was close to going bankrupt and the Federal regulators like the FDIC and the Federal Reserve were aware of the precarious situation. They invited Wells-Fargo (WFC), to make a bid for Wachovia. The FDIC did not want another takeover like Washington Mutual to roil the market, and wanted some other bank to take over Wachovia's operations.
Wells-Fargo, which counts Warren Buffett as one of its biggest share-holders, decided to walk out at 6:00PM on Sunday. Wells argued that it did not have enough time to analyze Wachovia's books though the argument is specious; Bill Gross of PIMCO has said that he can analyze a portfolio of mortgages in 15 minutes! My best guess is that Wells was hoping that FDIC will take over Wachovia (like WaMu) and it will be able to get the deposits of Wachovia for peanuts. The FDIC, left high and dry by Wells, and with very little time to find another suitor, called Citi (C) to take over Wachovia.
In a matter of hours, Citi stepped in as a buyer of last resort and struck an agreement which was approved by the Boards of both companies. Under the terms of the deal, Citi agreed to take the first $42B of losses on $312B of Wachovia's loan portfolio. It further agreed to pay the FDIC $10B in warrants to insure Citi against any loss beyond $42B on Wachovia's portfolio. Citi paid $1/share for Wachovia's commercial banking while leaving the Securities (A.G. Edwards) and Investment Management (Evergreen) in the holding company.
Later that week, an IRS ruling changed the way in which companies acquiring other banking companies as a whole could write off debt-related losses of the acquired companies; the losses could be written an order of magnitude faster than before (years versus decades). With the Senate passing the TARP bill on Wednesday, Wells Fargo, the same firm which on Sunday had condemned Wachovia to bankruptcy, leaving the FDIC high and dry, made a $7/share offer for all of Wachovia, without requiring any Federal Assistance. Citi had been providing liquidity to Wachovia since the agreement, and hammering out the details of the takeover, including a potentially higher offer, till Wells stepped in with its offer which incidentally included a $225M golden parachute for Wachovia's executives.
What bothered me the most is the role played by FDIC chief, Sheila Bair, in encouraging Wachovia's CEO to consider Wells' offer. One could argue that Ms. Bair was looking out for the taxpayers' interest since the Wells offer is not backed by the FDIC. But as this article from the Washington Post highlights, Wells could shelter $74B in profits from taxation, which would have been taxed at the corporate tax rate of 35%. In the Citi deal, FDIC would take losses only when principal losses exceed 17% which translates to every third mortgage defaulting and the house under default being sold for 50c on the dollar. The Wells deal is virtually guaranteed to cost the Treasury revenue; the Citi deal will not cost a penny except under a doomsday scenario!
Incidentally the new IRS ruling would not apply to Citi since it was buying a part of Wachovia and not the whole. In fact, Bill Ackman suggested that the remaining assets of Wachovia would be a valuable takeover target (and worth $8/share) since the acquirer would reap huge tax benefits. (Bill purchased 7% of Wachovia's shares after the Citi merger was announced.) So it also was not clear that the Wells offer is that much better for the shareholders than the Citi offer.
Another side-effect often overlooked is the damage to TARP. Wells, with its strong capital position, has the capability to tolerate large losses. With a Wachovia buyout, it will also have the incentive to take the losses to offset profits. Wells has the potential to saturate TARP with bad assets from Wachovia, while selling them at low prices. This not only will limit the Treasury's ability to recapitalize other struggling banks, but continue the deflationary spiral in asset prices.
When Is a Deal a Deal?
The FDIC's behavior in the Wachovia's case raises serious questions about when is a deal a deal? In these times of crisis, it is understandable that the rules will be changed in an attempt to achieve stability. However, changing rules and applying them to the past is clearly delving into an unpalatable, uncharted territory. The FDIC went as far as inserting a clause in the TARP bill which would protect potential suitors (like Wells) from being held in violation of an exclusivity agreement (like Wachovia signed with Citi), if the original deal was backed by the FDIC!
I am sure Lehman shareholders who bet on the long term future of the firm would like to get their money back if they had known that the bailout-fairy was going to take a vacation over that fateful weekend, before rediscovering her benevolent ways and showering AIG with $85B three days later. Similarly investors who bought Citibank stock after the FDIC blessed Citi's purchase of Wachovia, are stuck with a big loss, since it is no longer clear whether C belongs to the chosen group blessed by the Feds as the winner's in this crisis.
In case you are wondering, my current list of of the chosen few consists of GS, MS, JPM, BAC & WFC. C will be on this list if it can come away with a good portion of Wachovia. If a contract brokered, blessed and announced by the Feds cannot be trusted, how do the Feds plan to restore trust and confidence in the marketplace?
How about Investments?
Coming back to investments, the equity markets are in a tail-spin. In a news-driven market there are going to be a lot of ups and downs. My strategy is to buy the chosen companies on a large dip (8% intra-day) and simultaneously write covered calls, earning a good premium due to high volatility.
I am also looking at preferred shares of financial firms via the diversified ETF PGF. The strategy again is to buy whenever there is a 5% intra-day dip. These shares have the potential of significant long term capital growth while offering a juicy yield during the current turmoil.