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CIT Group's Bankruptcy Plan: Goodbye Common and Preferred Stock

The CIT bankruptcy is confirmation that the problems in the financial sector were not liquidity based. Mark to market accounting tells the story, the assets are worth less than the liabilities. In this case 30% less, even after the common and preferred equity are wiped out. Apply that lose severity to other lenders and see what you get for equity values. If you don't believe in mark to market accounting or think that the assets are more valuable, the new post reorganization equity is for you.

Fannie and Freddie: Worthless?

While I have thought FNM and FRE are worthless for a while, without a shut down condition there is value to the equity. The value is not in the traditional sense of positive shareholders equity on the balance sheet but option value. If this company is never shut because it lacks capital, eventually the new profitable business that is being written will restore the equity. Right now the movements in the stock are short term speculation since the strike price of the option is so far out of the money.

Banking Sector: Worst Is Yet to Come

This analysis is dead on. One of the reasons bank failures persist is that the banks have been permitted to "play games with their loans". Troubled construction loans in 2008 and early 2009 were extended or the builders were allowed to complete the project with the construction financing still flowing. Look at Corus Bank. It was obvious that the projects financed by their loans were doomed in early 2008 yet they kept sending money out the door. From the bank perspective, their is no hope of recovering money on an incomplete project, better to continue funding the loan and have a completed project to sell in a potentially better economic enivornment when the project is finished. The loan stays current as there is an interest reserve built in so all the statistics the FDIC looks at to determine capitalization levels are not affected. Then once the loan comes due it immediately defaults with a very high loss severity since the economic recovery didn't materialize. Construction loans are very similar to negative amortization mortgages in that respect. Look how fast all those loans went bad and how severe the losses were.

One reason Paulson's current strategy is successful is that the government has removed the risk that many banks will be forced to shut or be seized. First in the too big to fail tier, there is zero chance of failure so the banks are now given time to rebuild the capital base and will eventually earn extraordinary profits by virtue of artificially low cost of capital and by reduced competition. In a normal banking environment when by virtue of idiosincratic risk a bank that falls below the required level of capital it is shut, it is game over with no chance of a future therefore zero equity value. Correspondingly, the only losers should be the equity holders as the assets should be sufficient to pay depositors and creditors. While for smaller regional and local banks, the shut down condition has not been completely removed, it is certainly less likely. The FDIC seems taking out the worst banks first so a relatively better bank, which in normal times would be seized immediately, now has a long time during which it can potentially earn enough to recapitalize.

When Warren Buffet was privately financing the banking system, the cost of capital was over 10% yet the Federal Reserve now provides it at 0.25%. That subsidy is a great stealth transfer of wealth from savers to the banks. The stockholders of the banks that survive are going to be richly rewarded.

Disclosure: No positions. Formerly short FED, CORS, WFC, BOFL.

Why Netflix Is a Short

Churn baby, churn. NetFlix can't keep 'em. After a bad experience who is going to go back and resubscribe.

Why Netflix Is a Short

The larger question is in a video on demand via internet world, why does anyone need NetFlix as an intermediary? They are not a technology company so they lack any potential competitive advantage in whatever consumer device, cable set top box, video game console, internet ready television, may be necessary to access on demand content. They are not a content creator so they have no advantage as a supplier. The best NetFlix can do is to be an aggregator of content, competing directly with cable video on demand service and the content providers themselves. That competition will simply lead to lower prices to consumers and lower margins. Cable companies simply are not going to cede their lucrative content delivery market to the internet. In a world on internet ready televisions, content providers can simply create their own a la carte subscription services either directly with an internet based delivery system or in partnership with cable companies based on the On Demand model. I predict that the core business of the company will die faster than the CEO estimates and NetFlix will be disintermediated in the next phase.

Disclosure: short NFLX for a while

The Leading Cause of Personal Bankruptcy

Academic studies have shown that people misprice extremely unlikely high payoff and high loss events, overpaying for high payouts, e.g. lottery tickets, and underreserving or under insuring for high loss events like catastrophic weather and health events. In the healthcare debate, people ought to separate the questions of who is going to pay for routine care and who is going to pay for catastrophic care. Most healthy Americans would be better off paying for routine care out of pocket rather than relying on a third party payor. All insurance prices in the expected routine care of the pool with the effect of the premium payments of the young and/or healthly subsidizing the care of the unhealthy and/or the old. In a capitalist society, people should save for their expected lifeitme routine care needs and adjust their consumption accordingly. Under the current insurance system there is no incentive for the young and healthy to join the insurance pool since there is no savings mechanism. If health insurance operated more like whole life insurance where the policy builds value over time, young people would be incentivized to "save" for their future healthcare costs and be protected from catastrophic losses. A simplistic version would be the that the premium would be expected healthcare costs and a catastrophic component. If an insured's actual costs were below expectations, a portion of the excess payments would accumulate and be available to pay future period premiums. If an insured's actual claims where higher than expected their future risk premiums would be higher.

The problem with the American system is that an individual is better off not preparing for future or potential healthcare costs. The worst that can happen is that in the unlikely event you suffer a catastrophic illness is that you go bankrupct. If you never have a catastrophic illness, you get to consume more (cars, televisions, homes) than the people who protect the downside by purcashing insurance. The maximum benefit of purchasing insurance is limited to the amount of unprotected assets in bankruptcy. Since most Americans couldn't earn and save enough to self fund the costs of a catastrophic illness anyway it makes no economic sense to purchase insurance.

A Stealth Rally in Commercial Real Estate

The large amount of equity issuance recently by the REITs leads some to conclude that they will be able to meet their mortgage maturities over the short horizon 2009 to 2010 taking some pressure off CMBX.

Reinstate the Uptick Rule?

Traders realize a few things about markets. There are many different types of participants in the equity market, to list a few; short term momentum traders, hedgers, speculators, long term value holders, long term growth (momentum), short sellers, mean reversion traders. Understanding the interaction between and the behaviors of the different types of participants helps the best traders and investors profit. Introducing an asymmetry in the market through an uptick rule simply creates an environment that favors long sellers over short sellers. The tick rule allows long sellers to sell first and at a higher price, compare the hypothetical execution of a long sell market order and a short sell market order in a decling market. The long seller will tap out the first bid and the short seller's trade won't get executed unitl the market stops declining and ticks up.

In capitalism, the main purpose of a stock market is to lower the cost of equity capital by providing liquidity. Anything that reduces liquidity, e.g. restricting short sales through a tick test, raises the cost of capital for companies that raise capital. Short sellers are the only market participants that eventually need to buy. Removing or reducing the participation leads to higher volatility, since short selling has a potential dampening effect as they amplify the effect of mean reversion value investors, buying in big declines and selling on big moves up. All those who are skeptical of the academic work on short selling that led to the removal of the up tick rule by the SEC, should look at the Australian market during the period when short selling was banned.

Finally as a long time arbitrageur, the outcry over naked short selling is completely overblown. For the past 15 years that I have been in the market almost every NYSE and actively traded NASDAQ stock has been available to borrow, albeit some at a steep cost as high -30% rebate. Naked short selling is only a problem in the penny stock and OTCBB arenas where no real investors should be anyway.

New Government Policy: Tax Credit as Mortgage Down Payment

Forget the homebuilders, they are unlikely to benefit as the pull forward of demand will simply help them liquidate their current inventory. While that may be a benefit in terms of cash flow it probably won't do much for earnings as the margins will continue to be weak and future demand will be reduced. The government is desparate to prop up the major banks. The government needs to put a floor under home prices to break the foreclosure induced home price and mortgage security devaluation cycle. The policy also has the additional benefit of giving the banks more time to benefit from the great wealth transfer from creditors to debtors (banks are just conduits) by virtue of the steep yield curve. Once debt capital providers stop being satisfied with essentially zero real yield, mortgage rates will spike and home prices will stagnate. Look to short banks once the yield curve flattens or there is a parallel shift to higher rates.


As policy it is probably better to put some full price buyers (owner/occupiers) into the homes even if the credit risk is high versus having the properties trade at discount valuations to higher credit quality buyers with the government taking the stealth loss through TARP, PPIP, TALF etc. The model would be similar to the credit card company model whereby the high interest rates offset the high default rates. From a societal prospective, the positive externalities of "stabilized prices" and increased homes sales velocity need to be factored into the credit loss equation to determine the true impact to the taxpayer. To make a rationale investment decision, investors need to focus not on what should be and what is fair and right, but on what is. Ultimately we are price takers, which is why the government can set interest rate artificially low. The essense is whether you would you rather earn negative real return by holding cash or an essentially zero after tax return by buying government bonds. Once business risk appetite returns worldwide, the government will lose control of interest rates and will not be able to artificially have credit providers subsidize the mortgage market.

Annihilate the Perverse Effect of CDS on Bondholders

The U.S. system gives a preference to rehabilitating the debtor in bankruptcy whereas other legal systems give preference to ensuring maximum recovery for creditors. As a creditor to a company my duty is to maximize the recovery. That may be accomplished by a liquidation or that may be accomplished by a restructuring of the debt and a continuation of the company as a going concern. The concept of "saving a company" is reaction to retain control usually by the stakeholders (management)who have destroyed it from overleverage and/or from failing to recognize and adapt to the changing business environment. Or from shareholders who failed to do research to understand the true business risk, overpaid and are likely to be wiped out anyway, think AIG, LEH, FED, DSL, Chrysler, GM. As a bondholder and a senior stakeholder, if I can put the approriate capital structure on an otherwise viable business, that would maximize my recovery (through equity ownership in the reorganized company) otherwise the assets need to be liquidated and transfered to others who will make productive use of them. If the assets are employed productively so too will the human capital of the business. The existence of CDS does not change any of this, in fact the a competent writer of CDS, like any option market maker probably hedged the credit exposure as it deteriorated through a short stock or short bond position anyway. The concept that the CDS holder assumes the credit risk and should have a stake is ridiculous. What would happen if the CDS buyer didn't own any bonds? The CDS takes a derivative risk but has no direct effect on the outcome and no influence, much like two friends betting on a sporting event or wagering on a horse race. In other scenarios, a distressed buyer could buy bonds at a steep discount then buy CDS after the credit improved to lock in the profit. Asymetries hurt markets.

Again until the company defaults, there is really nothing a bondholder can do to save the debtor, other than forgiving the debt. The company may make a debt for equity offer, buy back bonds on the open market, negotiate a prepackage plan of reorganization, but still the company controls its own fate.

CDS is a complex knock in option struck at par. As a bondholder, I would have to pay a premium to protect my position, once the credit quality of the issuer deteriorates that option becomes very expensive, so it would be cheaper to sell and realize the loss. The reason for creating the synthetic call is from a belief that the credit will recover. Options are not free. The same is true for equity options, if I have created a zero exposure postion in order to control voting rights, I have paid real money to do that. I have decomposed the value of the equity by separating the voting rights and compensated someone else who has the economic exposure for those rights. My interest as a shareholder or bondholder Seeking Alpha are not necessarily aligned with the other stakeholders of hte company, e.g. management and employees. As a shareholder, I want the company to take on maximum leverage and return capital to me either through buybacks or dividends. Most companies that borrow money to buy back stock are not doing so to insure the survival of the company but to maximize potential returns to share holders and shift risk to bondholders. The key for investors is not to whine and complain but to analyze the game theory to understand who profits and why.

Annihilate the Perverse Effect of CDS on Bondholders

This concept is poorly conceived and based on incorrect premises. First if I am a bond holder with CDS protection, I want the company to pay the coupon as long as possible. Buying a bond and simply getting the principal back doesn't earn me any money. In fact I would lose money since I've paid the CDS premium. Therefore I really have no incentive to push the company into bankruptcy. Second as a bond holder, I have no power to force the company into bankrupcty unless the company defaults on its contractual obligations to pay principal and interest. Once that happens bondholders could file an involuntary bankruptcy petition.
Quite simply companies don't file for bankruptcy because their stock price declines or their bond prices decline. They file for bankruptcy because they cannot pay either their debt!

Limiting CDS purchases to bondholders is a solution proposed by people who do not understand financial markets. Just like any other market there are a variety of different participants, e.g. long term holders, short term traders, speculators, hdegers etc. If potential participants are not allowed to enter the market, the market for that instrument will be less liquid and therefore more expensive either as a result of wider spreads or lack of market depth. Commentators fail to consider the ramifications of that sort of proposal. For example if I bought a bond and CDS protection, what would happen if I sold the bond and the buyer decided that they didn't want to buy the hedge? I would end up long CDS on a bond I no longer own, should I have to sell it back to the bank (I wonder where the bid would be), should I have to keep paying the premium even though I no longer need the protection?

For this writers proposal, the question is why the CDS seller should get some of my recovery? If the CDS settles at 20 cents, my expected recovery in bankruptcy is 20 cents. If my claim is split with the CDS writer I would only get 4 cents (20% of 20 cents).

Will All Be Well at Wells Fargo?

One of the biggest lies being propogated is that companies like Wells Fargo didn't need the TARP funds they received. If they had the ability to return the TARP funds, the Treasury would already have the check. A simple desire to throw off the yoke of government and taxpayer scrutiny does not magically make poor lending decisions and asset price declines disappear. At a minimum, Wells Fargo will struggle with losses in the Wachovia lending book. Wachovia was advertising negative amortization loans on television almost to the end. Take a look at the stock price of some other companies with large neg. am. exposure for a glimpse of WFC's future. FFED (formerly FED), DWNFQ (formerly DSL but the Q tells the whole story), BKUNA.

The other delusion is that the assets are good and it is just market to market accounting that forces banks to take a loss. It doesn't take many back of the envelope calculations to determine that even a prime conforming loan made in 2005 to 2007 is in trouble. At 90% LTV with the value down 25%, the loan is underwater almost 17%. While the loan is still servicable and all is fine until the prime borrower losses his or her job, then the 25% decline in value of the underlying collateral becomes 50% loss in foreclosure. Examine California sales data and a 25% decline is conservative. None of the pundits who spout this unsubstantiated assertion are willing to pay even 80 cents on the dollar for these assets (levels where banks would be happy to sell) or there would be no need for the Treasury's Public Private Investment Plan. Even if the assets were 90 cents on the dollar, the equity in a bank levered 8 to 1 would wiped out. Consider that too when analyzing bank holding companies with off balance sheet liabilities, e.g. GS and JPM.

The Geithner 'Some' Plan

The whole plan is a massive transfer of wealth from the taxpayer to the equity and debt holders of the banks. In return for facilitating that transfer a few large investment firms will be given the opportunity to make incredible returns on equity capital with minimal risk.

If the premise is to save the banks, the best course of action for the American taxpayer is to separate the banking infrastructure (branches, managers, software and systems etc.) from the existing owners and creditors. The FDIC could seize the insolvent banks and the U.S. Treasury could recapitalize the skelton, leaving the losses with the stock and bond holders. The government would end up owning the financial assets as it eventaully will in the Public-Private Plan but it would own less of the loses. As taxpayers we would also own 100% of the potential upside.

In the Public-Private purchase plan the government is bearing substancially all the risk and giving the half the potential profits to a select group of large investment firms. The private partners in the plan are going to earn extraordinary returns on equity. First and foremost the private capital will have a earn a significant interest spread (6%-2.5% for 350 bps) between the cost of the guaranteed debt and the yield on the assets (levered 6x) . Why the government willing to give this away, for what essentially is private capital's advice on setting the price, is incredible. I predict private capital will earn back its investment in 18 month. If the govenment lets them extract those profits prior to the guaranteed debt being repaid, the private partners will have created a free call on the toxic assets with an ongoing income stream. As taxpayers we are giving up potentially half the upside for about 7% downside protection. That is a terrible risk reward ratio for our government and the American taxpayer.

What 'Wipe Out the Stockholders' Really Means

There are no innocents. What has been exposed as the high tide of the S&P 500 recedes, is a multitude of inept money managers. As the weighting of financials in the S&P 500 increased , all the closet indexers (that is a eupehmism for Beta as masquerading as alpha) had to increase the weights in their investment portfolios. There is absolutely no excuse for the poor investment decisions of many pension fund and mutual fund managers. Not only should the investment managers be fired by their pension clients and the capital allocated to skilled managers but the inept capital allocators at the pension funds should be fired too. Bull markets breed complacency. There are plenty of investment managers who foresaw this crisis, they either underweighted financials, underweighted stocks or went short. Anyone who directly or indirectly provided capital to banks is complicit in the failure. The risk of any investment in a limited liability structure such as a corporation is a complete loss of the capital invested no matter where in the capital structure that investment is made. Shareholders shouldn't be surprised that they lost a significant percentage of their investment in banks (they should have been cognizant of the risks the banks were taking). There is really no compelling argument to socialize investment losses (socializing catstrophic losses from unforeseen of infrequently occuring natural disasters is another matter). I don't think I find anyone on this site who'd by for socializing gains.

Things Not All That Bad at General Growth Properties

GGP common stock is simply a call option on a game of chicken between the company and its lenders. The lenders don't want to take back the malls and the company doesn't have the NOI to support a refinancing. As long as the company is a going concern there will be some option value but if and when the lenders declare default the company will file Chap. 11 and the option (equity) value will disappear. The only way the equity has any value is if the current group of lenders agree to extend the current amounts due. If they don't extend, there is no way the lenders will let equity holders keep $167 million (the current market cap.) of value in bankruptcy proceedings. The misperception in one posting is that Chap. 11 means that the company fails and closes, it only means that the control of the company shifts from the current equity holders to the debtholders. No malls will close, no jobs are at risk, so the government has no compelling interest to save the equity holders. While the government may make capital available to banks to suport an extension of the loans, the banks may be loathe to grant credit to GGP at the current LTV ratio.