viewfromnyc

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.

Recent Policy Decisions and a Greater Depression

The economic policies of the Bush administration did not lead the economy into recession. Recessions are a normal part of the business cycle. The excerbation of the negative portion of the cycle is a direct reflection of the excessive non-productive investing in housing which drove the positive phase to extreme. Housing is not a productive asset. The long term government subsidies (mortgage interest deduction, artifically low interest rates) for owner occuppied housing have distorted the capital allocation decision of consumers. Our economy can only achieve optimal levels of growth if capital is allocated away from consumption to productive assets.

In Search of a New Hedge Fund Business Model

It is time to stop worrying about hedge fund fees. The bad funds will close and their managers will make no money. People should be angier at traditional long only money management which charges fees well in excess of any value created and in addition has high costs due to marketing fees and soft dollar arrangements. Oh and they tend to underperform hedge funds.

Why the Hedge Fund Industry Needs to Reinvent Itself

The prospectus for every security or partnership interest from a money market mutual fund to a hedge fund should state. "This investment is risky. Investors could lose all or part of their investment. The only investments that guarantee return of principal are direct U.S. obligations. If you do not understand the risks of this investment or are unwilling to lose all of your money, you should not invest."

Citigroup believes hedge fund short-selling (not position unloading?) has fueled the recent nosedive. "You would think the regulators would want to exercise some leadership and protect the integrity of the financial-services world," a source familiar with Citi's position says. ((WSJ))

If the regulators wanted to protect the integrity of the financial services world, perhaps they would end the farce that ascribes positive value to the equity of most banks, including Citigroup.

disclosure: long C

It Might Be Impossible to Stop the Decline of Housing Prices

It IS impossible to stop the decline in housing prices as the price of homes in most markets is above the market clearing price, Economics 101! The government can introduce distortions to the market to increase the market clearing price, but all that does is reallocate wealth within society and ultimately hurt our country. Market mechanisms are not instantaneous. People who bought overpriced homes, either directly as the purcahser or indirectly as a lender wth weak underwriting need to realize that they in fact have lost money and nothing the government could do will materially change the amount of money lost. Time to adjust the selling price and adapt to the current market.

Bill Gross: Politicking for His Own Bailout

Why bother pontificating about how we got here, who is to blame and why? Why not think about how to make money! The Federal government is poised to take a significant portion of the domestic housing market onto its balance sheet. What are the ramifications? Does anyone think that interest rates are going down because of that action? Anyone want 10 yr U.S. Goverment paper at 3.6%, when the government is going to have to continue to borrow if it wants to maintain the subsisidy, through low cost borrowing, for housing. All the government is doing is interjecting its credit worthworthiness between the American home buyer and the predominately Chinese and Middle Eastern providers of capital. Eventually, the overseas holders of the mighty U.S. dollar will tire of earning negative real rates of return. Investment ideas, short long dated Treasuries,or go long TBT the double short ETF on the Lehman 20+ year bond index.

In the short term, perhaps the hombuiders will rally as market participants believe that liquidity will return to the mortgage market. I would short any strength take your pick of names or use the XHB. The government simply won't have the capacity to reflate the market. All Paulson et. al. are trying to do here is to stabilize home prices. What will probably happen is that home prices will find a bottom but transaction volume will decline and inventories will remain high as the market won't clear due to a wide bid/ask spread and a general lack of creditworthy buyers. After a bailout, I doubt regulators will permit the wide range of "affordability products" to be offered again by banks. Banks will probably be weak too as they continue to be hobbled by a lack of capital and a trouble loan book. It will take some time for potential homebuyers to repair their balances to the point where they can afford 10% down on a Southern California or Northeastern U.S. home.

Asset prices (stocks, bonds, real estate) need to decline for equilibrium to be restored to the market. The government can't keep asset prices at their high water mark through manipulation of short term interest rates. The phantom wealth created by Greenspan is gone! Somebody had to lose the money, it is now just a process of realizing all those unrealized losses. The result will reveal itself in one of two forms, losses at financial institutions as debtors default or long term diminished capacity of debtors/average Americans to consume and invest either because they are debtors who have overpriced assets or they are investors who will never be able to realize the phantom gains. I don't think PIMCO will ever be able to monetize all of its overvalued bonds. Great paper profits and a nice bonus for Bill Gross as the government keeps rates low. Watch out when they lose control.

4 Tidbits from Third Avenue Value Fund's Q3 Letter

Third Ave Funds are likely to continue to be poor performers. From a macro perspective U.S. real estate is going nowhere any time soon, due primarily to the ongoing credit crisis. I don't have an opinion about Hong Kong or Japan but the weightings in cash and troubled U.S. stocks portend underperformance and continued redemptions. If this fund group has to start selling core positions, e.g. the large stakes in relatively small companies, the positive feedback loop will move in a negative direction. (Positive feedback loops amplify or accelerate trends, negative feedback loops dampen or decelerate trends). The managers of this fund have fallen in love with some stocks that are facing tremendous headwinds from macroeconomic conditions. Don't make the same mistakes fund management is making and fall in love with the fund because it has done well in the past. It will be of no consolation when your investment in this fund underperforms, that Mr. Whitman's investment also underperformed.

The Hedge Fund Hustle

This is one of the dumbest posts ever. Lets' see a hedge fund manager (of course it has to be a hedge fund manager, not a prop. trader from an investment bank) manages to make 5% in one month net of fees and commissions and this is a bad thing? How often does prop. capital turnover at investment banks, specialist firms, commodities trading groups? Is it so evil when those who don't charge 2% and 20% do it? And what are the imputed fees paid by shareholders of investment banks and other trading firms to the internal prop. desk traders who get bonuses, car service, expense accounts. Maybe the hedge fund shouldn't have paid any commissions by doing zero trades and made no incremental return for the month.

If trading is so bad, why do we have markets that are open all day and night. Why not just have one price for all trades done on a given day? High frequency traders provide liquidity, to the venerable (sarcasm intended) long only managers, long term investors and all the other constituencies that claim to suffer from excessive trading and volatility. Buy and Hold Long only is a completely mediocore strategy. When you benchmark against annual returns of an index long only is fine. If you were to benchmark against some other measure of maximum potential return in the market, hypothetically say the absolute value of the whole years daily market changes, long only looks pathetic. Theorectically a trader could go long or short the S&P 500 (a popular benchmark) at the end of every day, analogous to betting red or black on roulette. The maximum return if you are right every day dwarfs anything produced by a long only manager. Oh and you can make money in an up market, a down market, and a flat market. The stock market isn't an odds based game like roulette where you can caluculate your expected return. There is information available which allows investors who gather and correctly analyze the information the opportunity to gain an advantage. Market participants who either don't gather the information or don't correctly analyze it and trade/invest accordingly get "fleeced" by those who do. You wouldn't gamble in a casino without knowing the rules of the game, it is no different in trading markets, just that the game is more complex.

No systematic risk comes from trading firms, whether they are hedge funds, prop desks, entering the public markets and providing liquidity. Systematic risk is introduced when someone decides to lend the traders and investors too much money, i.e. LTCM, the mortgage brokers, FNM, FRE etc. The biggest systematic risk in the market right now is derivatives trading. Which is why Bear was bailed out. The large banks seem to think that they should provide nearly limitless capital to investment funds to make bets in the CDS market. The banks and insurance companies also seem to think the counterparties in the CDS market have the creditworthiness to back all the CDS written. This is the same fallacy that lend to the problems with MBIA and Ambac et. al. That is the real potential problem.

Sears Faces Risk If Economy Doesn't Improve

Sears will probably not go bankrupt, but it will trade much lower. The real estate is not worth anywhere near the optimistic values based on assumptions made at the real estate peak. Watch for some data points on pricing coming out of the Mervyn's bankruptcy. Cap rates are headed up and rent per square foot is not going up, particular for locations that show declining sales. Given that Sears is such a poor retailer, none of it's competitors who are the ultimate buyers or end users for the locations are going to step up and pay a premium. Target, Costco, et. al. are going to wait for the fire sale. There is no hurry to buy since few retailers are expanding. What mall REIT is going to pay up for a space that needs to be reformatted or substancial TI to be re-tenanted, to say nothing of the releasing risk? A few quarters more of poor operating performance and the short term financing well will dry up. Then comes the fire sale! What if ESL has some liquidations and needs to sell stock to raise cash, where do you think the price will go? I think you can figure out what position I have in this stock. When your longs go wrong sell!

Senator Schumer's Careless Remarks Result in IndyMac's Early Demise

There is a very simple test to see if Senator Schumer caused the demise rather than just hastened it. When the portfolio of (bad) loans is run off, if the government loses money after the uninsured depositors already took a 50% loss then Schumer had nothing to do with the underlying economics just the timing. The regulators should have shut this pile of crap down long before it cost the American taxpayer any money. If the government makes money and returns some to shareholders then Schumer caused the demise.