bearfund

The Next Shoe to Drop in Banking: An Options Strategy

When money is expensive, only ventures that create a great deal of value get off the ground. When money is free, it's easier to take a big pile of it and just play. If you want more value creation and less financial engineering, you want higher interest rates. Tell Big Ben, don't complain to the traders; we're only doing what the circumstances dictate.


On Aug 25 12:39 AM User 476509 wrote:

> I think all the above creates nothing of substance. These are people
> that assist each other's ego with toxic jargon that plays to a choir
> unified in a culture of meaningless finance driven by greed and self-import.
> They have in the last year unvieled to us a (their) culture of meaningless
> (poisonous) financial products and their unapologetic search for
> the next creative and dangerous wave of financial infection. For
> God's sake, stop it. Invest in support of simple "growth" as it
> should be ... and finance to facilitate growth. Stop the pure gambling
> environment that places bets on companies losing and plays losing
> and growth against each other in the sickness of hedging. Where
> did real, basic and honorable business go? It seems that our masters
> of business feel like they have to find ever new ways to distort
> finance in search of a trade commission or a sense of invention infected
> with layers of complication. They create default swaps and things
> that "derive value" rather than create value. It is sad that our
> financial talent has come to this meaningless sense of occupation.
> Who is teaching this? Their work now hurts the world instead of
> helping it improve, grow and produce real GDP. The MBA has become
> a Master of Bogus Activities seeking the next bonus for smoke and
> mirrors and products that mean nothing real, yet bring poison to
> honest enterprise and are truly an infection behind the weakend muscle
> of honorable work and productivity.

Bank Stress Tests: Is Everybody Confused Yet?

What's confusing about it? A few banks are in deep trouble (don't believe the "adjustments" to Citi's capital shortfall) and a few others are in good shape. It's interesting that most of the banks required to raise capital are facing "more adverse scenario" losses that exceed their market cap, while the banks not required to raise capital aren't. This suggests that the market has correctly identified the weak sisters already; therefore there are no real surprises. USB, STT, and AXP are fine. BAC, C, and GMAC are insolvent. Gee, who knew? Oh, right: everyone.

Yawn.

Bank Liabilities: Why the Discussion Isn't Explicit

There are all kinds of preferred shares out there; some of them are like debt, others are nothing like debt. Probably the most typical type of preferred share is the perpetual non-cumulative fixed-rate share. This is really nothing like debt at all; it's plain old equity with two advantages over common: the dividend is cut last and restored first (income preference) and in a liquidation, preferred shareholders are reimbursed at par before common shareholders get anything. Other than these two forms of preference, these shares are the same as common stock: the dividends can be cut or suspended (and need not be "made up" later) and the shareholder will very likely lose his entire investment in the event of bankruptcy. In exchange for this preference and what is usually a fairly juicy dividend, the shareholder gives up most of the upside, since preferred shares' dividends are rarely if ever increased.

Other preference shares are much more like debt. Cumulative shares require that missed dividends be made up before any dividend can be paid on common or junior preferred shares. Callable (and mandatory call) preferreds are also more debt-like in that they have a maturity date. Citigroup's trust preferreds are senior to all other preferred classes, including the government's. So certainly it is possible to construct preferred shares that are very similar to debt; a trust preferred share with a mandatory call date and cumulative dividends is for all practical purposes subordinated debt. But most of the bank preference shares outstanding are nothing like debt and their holders certainly don't expect to survive bankruptcy. It's worth noting that the trust preferreds weren't forcibly converted into common. This is both unsurprising given their senior position and unhelpful in that converting perpetual non-cumulative preferred equity into common equity does very little if anything to materially improve a bank's capital quality; TCE is being blown way out of proportion as a useful measure of a bank's capital. Suspending or reducing the preferred dividends to preserve cash would have been sufficient and would have had far less adverse impact on banks' ability to raise capital by issuing more preferred shares. This is important since most banks' common shares are now priced too low to make issuing common stock a worthwhile way to raise capital. In any event, forcibly converting run of the mill preferreds to common does very little to improve a bank's capital position. Giving subordinated noteholders a 10% haircut and converting them to noncumulative preferred shareholders would do much more. Ultimately it would probably hasten the recovery and increase the noteholders' total returns. If I held subordinated debt in a troubled bank I would be itching for a mandatory partial conversion; the bank isn't able to operate effectively with such a large debt burden and so little capital, and a bank that cannot operate efficiently is ultimately more likely to go bust, costing me much more of my investment. I would much rather have $9m in subordinated debt and $1m in noncumulative preferreds at par in a bank with 15% tier 1 capital than $10m in subordinated debt in a bank with 6% tier 1 capital. Get that sword of Damocles out from over my head; in the meantime I'll probably be able to collect at least some of the dividend and in a few years it won't be hard to sell the preferreds at par. Much better than watching CDS on my notes head for the moon.

Of course, all of this also presumes that existing common shareholders should be wiped out altogether - as they should, since many of these banks do not have enough equity, common or otherwise, to continue operating. Given that, don't fear the haircut. Embrace it, for it is the way out.

Where's the Bottom? Still Anybody's Guess

The bottom for equities and paper, in dollar terms, will come when people are no longer writing articles asking when the bottom will come, because they are too busy selling.

The bottom for the dollar, however, does not exist. It will continue asymptotically approaching zero until it becomes inconvenient to quote prices in it, at which time it will have zeros lopped off or otherwise be replaced by something else with indistinguishable characteristics, which will itself promptly begin its own asymptotic march toward zero.

Bank of America / Merrill: Shotgun Marriage

Three possibilities:

1. BAC is a conduit for covert Fed money, injected either for "systemic protection" or perhaps to help friends (or well-armed enemies?) get out of precarious positions.

2. BAC has balls of steel and wiles to match and will emerge from the crisis far ahead of all other players.

3. BAC is recklessly building itself up to ensure that it is deemed too big to fail even if its big bets don't pay off.

Is the U.S. Banking System Safe?

prescient11,

I'm very much of two minds about WFC. They are indeed making money, at least so far. But they also have a lot of dodgy exposure, and the HELOCs are coming, too. I agree that it's a much better bank than C or WM or WB. But it's hard to make a case for buying it instead of USB, a similarly-priced bank with a more conservative balance sheet. Both did very well after they announced similar earnings at the short-term bottom. But I have more faith in USB's management and loan book than in WFC's, even though USB's payout ratio is somewhat higher and it's slightly more expensive to book. USB just seems the safer pick here. Unfortunately at $30 both are now fairly valued and I see little upside beyond the dividends. At $21, well, that was a nice day to buy.

Long USB. No position in WFC.

Is the U.S. Banking System Safe?

The FDIC no longer has $53b. Based on published figures from this year's bank failures, I place their current reserves between $44b and $48b. There are 21 weeks left in 2008. If there is another failure each week of the same size as First National of Nevada, almost half those reserves will be gone. Sprinkle on a few more First Priority sized failures and maybe one or two more IndyMacs and the FDIC will be insolvent. What will the next "FDIC Friday" bring? Ready for RTC II?

Can Cities Create "Foreclosure Sanctuaries?" [Housing Tracker]

The way forward for San Diego is to buy all the properties in default, then lease them back to their current occupants along with an option to buy at the short sale price good for as long as they live there. This can be paid for with block grants to cities from the Treasury, which in turn will borrow the money abroad for periods of 7 to 30 years. As someone with 31% of his portfolio in short positions on the back side of the Treasuries curve, I think this would be an outstanding way to keep hardworking American families in their homes. Another good financing option would be for the Fed to reduce interest rates further and open the discount window to cities using the money to prevent foreclosure. They could buy the loans from the banks, put them on indefinite forebearance, then borrow against them at the Fed window to repeat the process. As someone with 29% of his portfolio in gold and silver, I am convinced that this dramatic step is essential to the stabilisation of our housing market and the protection of both the banking system and the ordinary American working man and woman and should be implemented as soon as possible.

Discipline and hard work are unpopular and unpopular things are not done in leaderless political democracies. We will not soon, if ever, return to our founding principles. Instead we will have one bailout after another. The way to profit from this is to make aggressive naked bets against American strength, as shown above, then during a lull between a round of debilitating regulation and the next round of stifling oppression, convert your winnings to gold, put it in a backpack, and GTFO of Dodge.

The Outlook for Financials Failure

It's hard for banks to raise capital when most of what they offer is yield but the yields, fat as they are relative to other stocks, are below the rate of price inflation while real interest rates remain negative, suggesting strong inflation for years to come. The market is asking itself why it should invest in bank stocks when it could have oil instead. Yesterday, at least, the answer was pretty clear.

Paradoxically, if the Fed raised rates to 7%, I'd like the banks a lot better: the weakest would fail quickly and the strong would be available cheaply, becoming attractive homes for capital as their much-reduced dividends would nevertheless exceed the rate of price inflation for years to come, with capital appreciation on the cards when short-term rates later ease. Right now it's just an unattractive and overpriced muddle in which, as you seem to be saying, no one fails but no one succeeds either. Oil it is, then.

Big Ben's Credit Card Moves: The Good, the Bad and the Ugly

There is nothing I can use to predict the future price of V, so there's no way to formulate an exit strategy. Its price is decoupled from its value and there are no technical indicators; it's a new issue and the chart is parabolic. That's not trading, it's gambling. If you need the returns and are comfortable with that, so be it. Good luck to you.

Big Ben's Credit Card Moves: The Good, the Bad and the Ugly

No, Visa is not a credit card issuer. But V trades at 40x earnings and it pays no dividend. That's an automatic fail here at the bearfund. If you want to bet on number 23, go ahead. The casino is over there. V is neither a sound investment nor a reasonable trade; you are doing nothing but betting on the greater fool. I'll give you $15 a share for it; that's a bit above its liquidation value but I'm willing to take a bit of risk that it'll someday pay a dividend.

No position on V. I don't trade the untradeable.

Ten Comments on Housing

“The prudent will have to pay for the profligate.”

I refuse, sorry. Their misbehaviour did me too little good, I'm too young, and the bill is too large; stick me with it now and I'll never recover. If you insist, I'll buy more gold. If you keep insisting, I'll put it in a briefcase and leave the country with it. If you can't handle that, I'll arm myself heavily and smuggle it out. A nation of looters has no chance and I'm not going down with your ship.

Hitting the Reset Button On Home Mortgages

The greatest danger lies not in the handing out money aspect; the government does that all the time. Much worse is the fact that such a bailout actively punishes those of us who (a) didn't feel comfortable gearing up 40x on real estate, (b) recognised that the market was significantly overvalued, and thus (c) preferred to save our money so that we could take advantage of the coming correction. We've already taken it in the shorts from negative real interest rates - our savings not only aren't growing any longer, inflation is eating away at their value. Now you also want to deny us proper pricing? To hell with that; I might as well just quit my job and go live in the park. Why participate in a heavily manipulated economic system that seeks primarily to punish prudence?