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.

Wachovia for Free? Citi Still Paid Too Much

I think the author's point wasn't that Wachovia is worth less than nothing but rather that it has no value to Citi specifically. Whether WFC will profit from its offer is a different question altogether.

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.

An Optimist Looks at the Market

1. Expensive oil spurs innovation, providing a competitive advantage to the US and other technological leaders. Cheaper oil spurs pollution and climate change and encourages further investment in inefficient living patterns. The best thing that could possibly happen to America is $500 oil.

2. That number was inflated in several ways and should not be relied upon. Even ignoring the wrong signs on several of the components and the "stimulus checks", one cannot ignore the silly "chained dollars" method of calculating the deflator. GDP growth in real terms has been negative for 5 years and remains so. If you don't believe a chart of nominal GDP priced in gold, ask anyone who works for a living. They'll tell you the same thing. If you happen to ask anyone in California, make that 8 years.

3. Dead cat bounce inspired by weakness elsewhere.

4. There are always once in a lifetime opportunities. Today's involve being short, especially Treasuries, which are at historically overvalued levels. And there are always opportunities for good stock pickers. But how is this optimistic? It's no better than at any other time, and probably worse: even "cheap" stocks have earnings yields no higher than 7-8%, and few pay anywhere near that much in dividends. With the dollar losing 10%+ of its value every year, you won't get much out of them. And those dividends won't look like much once the benchmark interest rates hit 10%.

5. Housing is horribly unaffordable in historical terms. Only with the most myopic view focused solely on the 21st century could anyone conclude otherwise. 20% down? Here in San Francisco, one of America's wealthiest cities, the median household income is $68k. The median house in the City proper costs $790k as of July. Once a frugal household is done paying its crushing tax bill and the rent on a modest rent-controlled apartment, it might save $15k a year. In a mere 11 years (no help from the Fed's 2% interest rates here, eh?), it would have the down payment saved up. Too bad it'll need to put 60% down to qualify for a mortgage it can actually afford. When the median house costs 3x the median income, housing is cheap. When it costs 10x and people call that cheap because 2 years ago it was 14x, those people are silly but housing is still expensive.

Keeping an emergency fund, unless it's in gold, and living within your means are foolish in the extreme. Borrow more, spend lavishly, and declare bankruptcy when when the game is up. The entire system is set up to encourage that, and you would do well to get your piece of the pie while the Chinese are still willing to lend it to us. There are no prizes for prudence; you'll be stuck with a fat tax bill no matter what. Might as well enjoy getting there.

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?

Financial-Dip Buyers Forget To Ask What's Next

Sentiment, sector rotation, and squeezes. Those are all that matter. Earnings? If the market is determined to go up, it will. If it is determined to go down, it will. There's always something in an earnings call that can be spun whichever way the wind is blowing. Just remember, we've seen this movie before.

The Great GSE Meltdown: Market Adding Fuel to Fire?

researcher, investors aren't going to buy. No investor would ever buy debt that yields less than the rate at which the currency in which it is denominated is losing purchasing power. Speculators might buy them, possibly. More likely they'll be bought by sophisticated traders betting on spreads, but that trade will evaporate quickly once the money is made. Most of this paper, though, will end up at big foreign banks and central banks. You know, the ones Paulson's been calling all weekend. I don't know what he's told them, but I'm guessing it went something like this:

"You know, you have $300b in Treasuries. I know it's been a tough year for those dollars, and I'm really sorry about that, but darn it, America is still the greatest country on earth and I'm sure you're thrilled to be holding them. But gee, it sure would be a shame if we had to bail out Freddie and something bad happened to those Treasuries. Well, that's all; I just wanted to get a better understanding of how tomorrow's auction is likely to go. Nice chatting with you."

While a few central banks and SWFs have stopped throwing good money after bad, we have yet to see anyone start dumping this garbage, even slowly. One wonders if it's really Paulson making these calls and not Gates. Either way, though, there's no reason to think anyone will stop now, not over a paltry $3b rollover.

Investors Look to the Fed for Signals on Inflation and Interest Rates

There is no way the Fed will raise rates in June, probably not in August either. There have been several good opportunities to "disappoint" markets when sentiment was positive, and the Fed has taken none of them. Now sentiment is awful. I suppose that if your thesis is that the Fed is acting to reinforce rather than counter the business cycle, presumably through gross incompetence, then you might bet on a small hike. My thesis is that the Fed is simply a galactic inflation engine that cares nothing for savers and will happily sacrifice us all for the benefit of the almighty bankers who founded it. Long gold. Short Treasuries. I'll keep saying it until everyone starts doing it.

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.

Broker Default Risk

No one on this list will ever be allowed to fail. The proper hedge against a long position in one of these IBs is short the dollar. The Fed will print to get these guys out of trouble.

Saving the Economy with IRA Funds

ABF, how is owner-occupied residential real estate an investment at all? It generates no cash flow. It produces nothing. It has maintenance and operations costs, and if you borrow to buy it, it has financing costs (if you don't, it has opportunity cost). In return for those costs, you're taking the risk that the property you buy will be valued more by the market at the time you want or need to sell it. Sounds a lot more like speculation than investment, doesn't it? If you do the math, most people are much better off renting. Leave speculation to those who can afford to lose what they put in.

Citi's Pandit Spams His Customers

I don't much care if my bank admits it's fallible. I just want a rate of interest on my extra cash that exceeds the rate of inflation. So, Mr. Pandit, how about talking your Fed buddies into raising rates? I'll happily lend you $100k for a year at 8%. Get that pitiful capital reserve figure north of 10% and we can talk about bigger numbers. Right now you're a lot closer to insolvency than to a "global financial institution [of] enduring strength". And horribly managed, to boot. Tsk, tsk.