October 28th, 2010 Alex Jurshevski
Â ‘Advocates of austerity believe that mystically, as deficits come down, confidence in the economy will be restored and investment will boomâ€Â Â Â Â Â Â Â Â Â Â Â Joseph Stiglitz writing in the Guardian newspaper recentlyÂ
Â No Professor, we donâ€™t believe in Magic. You do.
A couple of days ago, I together with Martin Wolf of the Financial Times was interviewed by Howard Green of BNN on the recent austerity budget passed by the UK Government. The entire interview is viewable by hittingÂ this link or by going direct to our Newsroom page.
For those of you who do not want to watch the entire 21 minute clip; this short note will identify some of the key points that were raised. I was quite glad to participate in this discussion because it exposed a number of deficiencies in the thinking behind opposition to getting government finances under control and implementing sound debt management policies in the UK and elsewhere.
â€œCuts could mean contraction of GDP of 1-2% per yearâ€ Wolf
Mr Wolf cites a recent IMF study that estimated the impact of fiscal tightening on GDP growth in countries that are running ZIRP. According to the boffins on 19th Street, this could shave growth in those economies by a small amount. And according to the Krugman crowd, this must be avoided at all costs by maintaining Government spending.
We say â€œSo whatâ€. This is not a choice between â€œJam today, or Jam tomorrowâ€. There is no more jam. Western economies in many cases need to face up to their fiscal situation by making hard choices on expenditure reduction and debt control. Expenditures need to be managed better and in many cases the size of governments need to shrink in order to â€œright sizeâ€ to a situation where there are more and longer lived retirees draining pension and medical expenditure coffers while fewer taxpayers as a proportion of the population are around to fund these requirements. The UK (and the US and others) is in this boat. The focus on the next few quarters or a couple of years of GDP growth misses the imperative of recalibrating public finances to the reality of the next FIFTY years.
The social contract needs to be re-engineered and there is no time to waste. Mr Wolfâ€™s line of thinking also seems to hold that only if the recovery was well in hand then austerity would be a risk that Britain could afford to take. On the basis of our understanding of history and the proclivities of Postwar developed country governments, the chances are that if Britain was well into recovery there wouldnâ€™t be any debate about cuts at all. There would be none and the orgy of spending would continue until financial collapse became an unavoidable consequence (as is rapidly becoming the case in the US). Austerity now and a re-engineering of the entire basis of Government tax and expenditure policy is a risk that Britain and other developed country Governments cannot afford NOT to take. So far the only large economies that are tilting against this thinking are Japan, which is drowning in debt; and the US which is blindly hoping that it massive monetray and fiscal experiment can turn things around without the need for any real sacrifice or reckoning.
â€œThe government needs to maintain or expand its deficit as long as the private sector is running huge surplusesâ€ Â Wolf
There was broad agreement that we are in a state of affairs where the Western economies will be in a vulnerable, slow-growth mode as they de-leverage from the credit boom. Mr Wolf seems to believe that this obliges the Government to maintain or expand its deficit – for as long as it takes to get out of the slow growth mode. This ignores the history. Expanding your deficit is exactly the wrong policy. Japan is proof enough that all you get from Keynesian deficit spending is more debt. Japan has squandered decades of trade surpluses by paving its countryside and building roads and bridges to nowhere.Â The country’s debt to GDP ratio now stands at over 200% after two decades of following failed policies that are still being peddled in the face of this experience by the likes of Stiglitz, Krugman and Wolf. If interest rates donâ€™t rise first and choke off Japanâ€™s debt servicing capacity, Japanâ€™s fast shrinking working age population guarantees its ultimate demise as a financial power within the next couple of decades.Â (As a sidebar, in all of these debates about deficit spending their proponents never hint at establishing deficit limits, debt to GDP limits or performance metrics being applied to these programs. Their thinking seems to be that Governments can keep writing blank checks and printing money without limit. Why has no one, for example, referenced the Stability Pact limits adopted by the EU â€“ namely the obligation to keep government deficits under 3% and Debt to GDP under 60%. This seemed to make sense in determining admission criteria to the EU â€“ before the Crash.)
â€œDeveloped Countries Have no Difficulty Funding Themselves. There is no risk to the US.â€ Wolf
The observation that because Governments are able to fund today does not mean that they will be able to fund tomorrow.Â Does Mr Wolf seriously believe that if his no-cut policies were followed that in three or four years that the UK would be able to raise funds cheaply in Sterling? Or at all? This view is coming from people like Messrs Wolf, Krugman and Stiglitz who have never sat on a desk and had to fund anything, let alone run a process in unsettled markets. It ignores the reality that debt portfolio management is a game of risk minimization. The debt portfolio manager must always be prepared for the â€œstormâ€ and never become complacent. ZIRP canâ€™t last forever and countries with high debt loads, unwieldy and poorly specified portfolios, badly specified debt policies, or other holes in their game plan and ability to execute will suffer reduced fiscal flexibility up to and including default in the next few years. There is in fact significant risk to the US at the present time precisely because they have engaged in massive debt creation with QE1, Â are now about to unleash QE2; and are on an unsustainable fiscal track with no exit strategy having been communicated to the market. (At the time of writing it appears that Mr Bernanke and the Fed Governors are dithering over the size of the next round of QE.)
â€œIf there are no buyers for the bonds its because you have a wonderful recoveryâ€ Wolf
Actually if you have no buyers for your bonds it could be because you have upset your traditional investors by acting against their interests; if you have a history of issuing too much debt and have run out of headroom; or if the market loses confidence in your ability to manage your financial risks in a prudent way. These are all situations that can befall countries who wear out their welcome in the New Issues Beauty Parade. As this slow growth period wears on, which everyone agrees it will, the markets will undertake a triage of the most financially weak and mismanaged economies . It will pay dividends to those economies who can stay out of this group and contain their vulnerabilities to an adverse financial shock. Constraining deficits and implementing prudent debt management and financial risk management policies and communicating these to the markets as the UK authorities have done is a huge step in the right direction
â€China isnâ€™t Selling Bonds. There is nothing to buy thereâ€ Wolf
Mr Wolf is dead wrong. China has issued sovereign debt on a number of occasions and several Chinese banks and SOEâ€™s also have outstanding yuan-denominated debt issues as do foreign multinationals such as McDonalds. They are not issuing the bonds for financing purposes because they donâ€™t need to. Rather, the opening of this market is a part of China’s attempt to internationalise its currency develop the market for financial products based on the yuan, and develop a doemstic capital market. There are billions and billions of yuan bonds available for purchase. No debt manager with a heavy borrowing calendar (like the US Treasury) nor any fixed income asset manager, should ignore Chinaâ€™sÂ rapid move up the learning curveÂ in this area, nor China’s growing atrractiveness as an investment destination.
â€œThe fundamental assumptions are Neanderthal and Pre-Keynesianâ€ Â Wolf
Mr Wolfâ€™s contention is that the austerity budget is the wrong policy because it risks throwing the economy back into recession or even into a Depression. How can this be argued when at first one trots out the IMF forecast and hangs oneâ€™s hat on it? It shows a potential hit of 1-1.5% of GDP. This is small beer, and certainly not a Depression!
The real risk in this scenario is something that we have said for some time now: The record of governments implementing and maintaining fiscal consolidation initiatives to their proper conclusion is not very good. Out of 140 attempts in the last 30-40 years there have been only a handful of success stories. The real risk therefore is that the UK Coalition Government loses popularity and the stomach to see the plan through, it is then abandoned and Britain again becomes more vulnerable to financial stresses. Failure to act forcefullyÂ now on these matters in the US and elsewhere virtually gurantees another round of turbulence in the not to distant future.Â Acting now, as Britain has done assures some insulation from the finacial shocks that are most probably yet to come.
Although, Mr Wolf expresses hope for its success, he could do much more than hope through his position of influence on the FT pages by actively supporting the Government in this important and right-minded enterprise to get the countryâ€™s finances under control.
July 23rd, 2009 Alex Jurshevski
(The Phony War is a phrase coined to describe the months following the German invasion of Poland in September 1939 and preceding the Battle of France in May 1940. The Great Powers of Europe had declared war on one another, yet neither side had committed to launching a significant attack, and there was relatively little fighting on the ground.)
Â Every so often it is important to reflect on one’s earlier expectations for the market and the quality of the predictions that one has made to support and guide one’s business judgments. Here at Recovery Partners, we have been consistently bearish on events for the past three years – and we have been largely correct.
Â The meltdown in the sub-prime area came as no surprise because, in addition to other factors, we had been flagging the weakened condition of the GSE’s for some time, while Paulson and Bernanke were hailing them as possible saviors of the US housing market.
During a TV interview in October of 2007 we projected that US Speculative Grade Default Rate would reach or exceed 5% before the end of 2008. At the time of the TV spot,Â it stood just a shade above 2%. It ended 2008 just below 8% and it is now over 10%.
In July of 2008 we published our “Zombie List” of the top “walking dead” banks. Of the 14 institutions on the list, fully 10 have either been bankrupted or forcibly merged. The others have all accepted TARP funds.
We have repeatedly warned that the stock market was vulnerable and that defensive-minded investors should avoid it altogether. We first provided a warning in January 2007 and repeated the warning before the avalanche in September 2008. The market is over 25% lower today than when we first piped up on this topic.
In January of this year we warned that the configuration of Bond Yields in the US was unsustainable and that rate rises should be expected in the immediate and medium term ahead. At the time of our call the US Ten Year Treasury Note was trading at a yield of 2.25%. Since then it has risen to yields approaching 4% before settling back somewhat. We continue to be very bearish on US term interest rates in the medium term.
We have for some time also said that the US stimulus package was unlikely to have the intended effect. The general view now is that additional stimulus is likely required and that US unemploymentÂ willÂ most probablyÂ rise yet further, contrary to the jawboning and promises made by various officials prior to the passage of the monster spending program.
With all of the foregoing under our belt, you would think that weÂ would be feeling pretty good. Unfortunately this is not the case. We are disappointed because while making all of the earlier calls, our “sidecar” expectation was that there would be ample opportunities for Recovery Partners and firms like ours to provide advisory services to financial sponsors who were backing now-failing companies; and that this would be accompanied by a large flow of distressed loans into the market, therebyÂ creating additional opportunities for us, our competitors, and our service providers.
Unfortunately, so far the bankruptcy statistics are not telling a tale of undue financial stress, and activity in the distressed M&A market remains at a low ebb. True, in the US the number of business failures is up about 190% from the trough in 2006. However the annualized run rate is only tracking on a par with the experience of the relatively mild recession in the early 1990’s. That said, the number of personal bankruptcies has escalated rapidly in the US, consistent with the scale of job losses. The weakness of consumer finances promises to restrain consumption activity and will further stress the corporate sector.
In Canada we have also seen rapid increases in personal bankruptcies that mirror the weakness in the jobs picture and the cost-cutting efforts of many firms desperate to remain in business. However, on the business side of the coin, the situation in Canada is positively perverse. In the latest twelve months of data, which arguably spans the most severe economic crisis of theÂ Postwar period, the incidence of corporate failures in Canada has actually gone down! The data show that there were 5.7% fewer bankruptcies coast-to-coast in the year to April 2009 than in the twelve month period to April 2008.
Although it might seem unreasonable that the flow of defaulted loans has remained relatively light in the US and that it has actuallyÂ decreased in Canada, there are some very good reasons why this is occurring and Recovery Partners is confident that the avalanche of activity that we along with other market participants have been expecting, is as a consequence, simply late in arriving:
Recovery rates for both bondholders and leveraged-loan investors are hitting historical lows. According to Fitch, loan recovery rates for the first five months of 2009 came in at 57.5%, a full 10 percentage points lower than the 67.5% experienced during the last recession trough in 2002. This weakness in real asset markets has caused bankers to shy away from pulling the plug on weak customers in the hopes of better markets and prices ahead.Â
There were a number of structural issues associated with the boom in loan issuance in the four years that just preceded the recent Crash. Corporate balance sheets had become heavily tilted toward senior bank debt, but protective covenants that were normally embedded in loans were systematically relaxed or removed by market-share hungry bankers as the boom in loan issuance ran its course. This means that the early warning systems that signaled borrower problems in previous cycles do not in many cases exist in the current cycle and it is therefore now more time-consuming and laborious for banks to triage the Zombies in their portfolios.
- Relatedly, banks have in many cases substantially reduced headcount in their Special Loans areas because of new risk-based capital charges that are required under Basel II. These Operational Risk Capital charges have made it much more expensive for banks to maintain a staff of Special Loans professionals. Prior to the recent Crash, and with no apparent storm clouds in view, this supplied a strong incentive for these firms to re-organize their Special Loans Groups into areas featuring much lower headcount and therefore less bandwidth to deal with any surge in insolvencies. These capital charges have also impacted certain US banks subject to Basel II, in similar fashion. The bad loans problems have therefore in many cases not had enough time to emerge in the normal course of business to this point in the cycle.Â
A reduction in market liquidity has not only impacted banks’ recovery prospects, it has also eliminated exit alternatives. In the years preceding the crash there were numerous leveraged loan funds, who, usually oblivious to credit quality, would eagerly pay up for whatever assets the banks happened to be selling. These participants are either out of business or have sharply reduced their activities.
Â Banks have been protective of their loan portfolios because they have wanted to appear as financially strong as possible in order to attract much-needed infusions of private sector capital. These issues were aimed at shoring up balance sheets that had been ravaged by sub-prime and related losses. Announcing large provisions on their loan portfolios would have done little to reassure investors who were being asked to put more money into these firms. This behaviour hasÂ to a greater or lesser extent been condoned by regulators and authorities in North America who have winked and looked the other way. Witness for example, the recent relaxation of mark-to-market rules in the US.
Banks have extended forbearance terms to Zombie borrowers, jacking up spreads and adding on fees and restrictive covenants in the hopes of buying time until the economy improves. Then, one of two hoped for outcomes would allow the Banks to skate away from these problems: either (1) another lender would step in to take the Bank out of their position; or (2) the Borrower’s business would re-float in line with an improving economy generally. This strategy only buys time, it does not solve any problems.
Â Unfortunately for the banks, time is running short. Further cracks are appearing in the banking system and the economy and the authorities cannot stop them from spreading. In fact our views on the Stress Tests reflect the opinion that the problems in the banking system are far from having been properly resolved and that in aggregate, US banks remain significantly undercapitalized. Moreover, numerous US Banks that have earlier qualified for TARP funds now have more toxic (Level 3) assets on their books than before the financial crisis began. Other areas of concern include credit cards, commercial mortgages, and of course the fact that anecdotal and other evidence continues to reflect an anemic US economy whose consumers are tapped out and who are either falling into unemployment or under-employment in vast numbers, where a substantial portion of the housing stock is under water, and whose Government is in a deepening fiscal hole.
Some of the stronger banks have therefore recently begun to aggressively set aside money for future loan losses. Last month Moody’s warned that over $400 billion in charge-offs the U.S. banking industry are expected to occur in 2010. While this number may be vastly understated, as have all of Moody’s and S&P’s recent similar forecasts, it should be expected that whatever the size of the number, a good chunk of the losses are expected to occur in commercial and industrial loans portfolios.
The situation is broadly similar in Canada with the exception that the amounts are rather smaller. Based on the differences in market size, and a reversion to normal default rate relationships between the Canadian and US markets, Recovery Partners estimates that there are at leastt $20 to $30 billion of loan-related charge offs in Canada that are bottled up on balance sheets.
In both countries we forecast that the affected sectors will be Manufacturing (particularly automotive-related), Travel and Hospitality, Forestry and related, Construction, Commercial Real Estate, Media and Newspapers, and Transportation. In terms of timing we observe that this situation is persisting with the encouragement and approval of the authorities and there will not unwind as per cycles in the past. In fact we estimate that Canadian banks, given low nominal rates and profitable operations generally, Â could sustain this state of affairs for some significant amount of time to come.
Â It took a good bit of time for the really serious shooting to start in WWII, and we reckon that we are now in the midst of a broadly similar lull (see last months post entitled “The New Normal”) that is seducing shell-shocked market participants with an array of false hopes as to the future economic picture. The World Economy is not out of the woods, additional, significant, credit-related carnage liesÂ ahead, as does therefore the bulk of the distressed investing and advisory opportunities that this cycle will eventually bring forth. In short:
“You Ain’t Seen Nothing Yet!!”
Randy Bachman,Â Bachman-Turner Overdrive,Â 1974
September 25th, 2008 Alex Jurshevski
Intrade has opened a new market on whether the proposed bill (”TARP”, an acronym for Troubled Asset Relief Program) to bail out financial firms will pass Congress by the end of the month. The contract trades as BAILOUT.APPROVE.SEP08. Open for the past couple of days, the market has already gained significant trading volumes, and an early verdict: the bill looks about as close to a sure thing as you can imagine (90% at the time of writing).
Why, is not hard to fathom: Now that the White House, and the Fed and Treasury are finally owning up to the scale of the issues that need to be dealt with, they are desperate to demonstrate that they are in control and have all of the answers. They have pulled out every stop, including , not surprisingly, the use of scare tactics to strong-arm legislators into swallowing the TARP package whole.
Whereas a few quarters ago there was no â€œproblemâ€ requiring intervention according to the Administration; now the problem is of such a magnitude that unless the TARP gets passed before the end of September the world as we know it will end.
Red Herrings such as the debate on executive compensation are being thrown about to divert attention from the fact that the proposal arguably represents the biggest usurpation of Congressional accountability, oversight and responsibility to theÂ voters in the history of the Republic.
In our view a rescue plan must satisfy several basicÂ criteria if it is to be successful and contribute to a lasting betterment of the situation:
â€¢Â The Plan must recognize that the first step in any troubled asset remediationÂ – if oneâ€™s objective is to avoid bankruptcy and liquidation â€“ is first and foremost, to Stabilize the situation and then to Triage the zombies.
â€¢Â The Plan must conserve precious financial resources.
â€¢Â The Plan must be transparent and allow for performance benchmarking and accountability.
â€¢Â The Plan must recognize that the process of remediation will take a long time and that not all problems are presently fully in view.
â€¢Â The Plan must offer a reasonable probability of success to the American public.
Sadly, the proposed TARP legislation falls short in all of these key respects. Looking at this by the numbers:
There is nothing in this plan that suggests a normal stabilization process to remediate bad assets will feature prominently in the process of buying out the cratered paper. There does not seem to be a triage process defined in the legislation. As a consequence some institutions requiring help may not get it and others may receive more assistance than they need. The proposal leaves the entire process open to bad decisions and misappropriation. Wall Street houses are already now lining up to offer their services in helping to administer various parts of the proposal â€“ to earn fees from problems they or their friends helped to create.
In his remarks to Congressional leaders earlier this week, Paulson signalled that it was time to move away from a case-by-case approach to a taxpayer fundedÂ â€œcarpet bombingâ€ of the problem. The proposal to undertake a bond-financed USD 700 Billion buyout of bad assets could be not more ill-advised, as it is open to fiduciary malfeasance and inefficiency, and it further and unnecessarily encumbers the Government Balance Sheet. Because it is far from clear that this is as big as it is going to get, the strategy furthers pushes the envelope on the countryâ€™s solvency and significantly heightens the risk that the eventual bailout will be financed by printing money.
The draft of the TARP reads in part: â€œDecisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.â€ It goes on further to stateâ€¦..â€The Secretary is authorized to take such actions as the Secretary deems necessary to carry out the authorities in this act without regard to any other provision of law regarding public contracts.â€ No wonder Congressional leaders are rightly up in arms, there is no accountability and no transparency.
There is a real risk that the proposed legislation will prove inadequate because it does not address the other areas of concern that could lead to additional problems for financial institutions, Main Street, and the economy generally. These include now-latent problems in commercial real estate, brewing issues in the derivatives markets, the growing risk of a sell-off in the bond markets, andÂ the impact of rising prices and a slowing economy on corporate profitability and creditworthiness.
As a consequence of the forgoing, the probability of the proposal as announced and being discussed as leading to a durable solution are extremely remote â€“ whether or not some of the features of the plan are amended. It is flawed in its essence. The markets will not buy into this for very long.
A Different Proposal
Here we suggest a solution that starts off with the premise that Stabilization and Triage are key. In order to help ease the gridlock in the credit markets we propose that the Treasury extend a specific guarantee over the liabilities of all US Financial institutions that apply for inclusion in the remediation program. The guarantee would be secured by the equity of the companies and a priority claim on their assets in the event of default. To apply, financial companies need to have assets above a minimum threshold of materiality, own a threshold percentage bad assets out of total assets, and be participants in the interbank markets.
Inclusion in the remediation program will also require that each of these institutions provide an accurate accounting of its financial position and a register of all impaired and defaulted assets on their books to the Treasury; and that each senior officer and the board directors of such applicant institutions provide representations and warranties for the accuracy of those submissions that would be irrevocably secured by a high percentage of their personal assets.
This would be a one time â€œGet Out of Jail for Freeâ€ card for the zombie institutions and their managers.
This strategy also suggests that the holding action to supply adequate liquidity to the markets to keep the credit wheels turning is continued by the Fed and other global central banks. As banks begin to trade with each other in the interbank again â€“ the US Institutions with the benefit the guarantee from the Treasury – the central bank sources of liquidity could be gradually scaled back. The stabilizing actions (and other tactics not herein discussed) will provide the necessary breathing room to properly assess the situation and run a triage exercise.
In this phase, and using the information supplied by the applicant institutions, the Government would conduct a parallel process to assess and value all of the cratered assets in order to evaluate the sick and dying institutions andÂ measure the actual scale of the problem. Valuations should rightly feature a distinction between OLV (Orderly Liquidation Value) and FLV (Forced Liquidation Value) to determine the scale of the buyout funding.
The weaker institutions could then be merged off with stronger players and bad assets would be hived off into a Bad Bank Vehicle (in the Remediation stage of the process). At each stage Treasury managers of thisÂ exercise would report to Congress through a public mechanism. Funding would be doled out on an as needed basis and subject to strict oversight.
As such the legislation to deal with the issues neednâ€™t be rammed through in one go. There could be separate, less overarching, legislation for the Stabilisation operation, and additional legislation to cover offer the Triage and Remediation stages of the plan. This would give Congress and the public time to properly consider the proposals.
Moreover, the immediate Operating and Balance Sheet impact of this proposal would do far more to bolster confidence, buoy the markets and the support value of the US dollar than the idea to appropriate USD 700 billion of bond finance for a quickie buyout. At a minimum, there would be no immediate need to raise this vast sum of money on top of already otherwise ballooning fiscal requirements.
The actual â€œcostâ€ would be limited to the government taking on a contingent liability relating to the solvency of companies that it knows it will rescue with certainty, but only after appropriate due diligence has been conducted and after the size of the problem at the various companies has been soberly determined. As the guarantee would only cover the â€œLoss Given Defaultâ€ of the liabilities, the size of the contingent liability at this stage is probably in the range of USD500 billion at most, and would not need to be financed. This is vastly more financially efficient than the TARP.
Whilst we believe that other solutions such as ours outlined above merit consideration and that this is no time to be making significant decisions under artificial pressure and with still limited information, we also agree with the marketâ€™s political assessment of the legislative situation as outlined above. The package will pass.
Therefore we believe that ultimately this will all end in moreÂ tears. In our view, the combination of bumbling and incompetence represented by the lurch into these financial difficulties, the constraints on future action imposed by previous rescue measures, and now the $700 Billion TARP â€œBond Aidâ€ response is setting the stage for even worse problems yet to come.
September 18th, 2008 Alex Jurshevski
Early this morning key global central banks poured an unprecedented USD180 Billion of temporary liquidity into the global banking system to keep the wheels from coming off. While this will notÂ alleviate the fundamental solvency problems of many institutions, the added liquidity will forestall disaster for a time.
It was about a year ago that we began to make occasional reference to “zombie” financial institutions. [â€œZombiesâ€ are institutions whose equity and debt is trading at levels that make the continued viability of their business models uneconomic (equity too cheap to issue in needed amounts to re-float the business and debt trading at yields that do not allow their asset portfolios to be financed at a positive spread). Unless they are rescued or re-financed by stronger institutions, insolvency is the unavoidable outcome.]
In regards to the list of thirteen â€œNotable Zombiesâ€ that we set out in our last blog entry on September 8th, so far two of the firms on that list have gone out of existence; and AIGÂ has now been nationalizedÂ backedÂ byÂ an initial USD 85 Bn. of public funds. Our long-held views that the GSEâ€™s were insolvent has also been proven out.
There are more bailouts in the pipeline and what is of some concern is that by now it should be clear to everyone that the US authorities have no plan, no roadmap, out of this mess. Recall that a year ago Bernanke and Paulson were reassuring markets that there really wasnâ€™t a crisis at all; six months ago they were touting the GSEâ€™s as part of the solution to the sub-prime mortgage crisis; and as at last Friday, AIG was not going to fail, it was going to be rescued by private sector firms.
Please click here for an extremely useful representation of the value destruction that has occured in the year to date, courtesy of the New York Times.
Through all of this, Paulson has reverted to type as an investment banker, whipping and driving deals, arranging shotgun marriages, doling out dollops of public sector funding for zombies on the verge, and trying to jawbone markets higher, while ignoring the public policy andÂ government finance dimensions and longer term impacts of what he and the rest of the current Administration are doing.
In fact that the practical outcome of the use of public funds so far is far from certain in part because the process of rehabilitating the failed institutions that have been rescued, but remain unstabilizedÂ is going to take a very long time. In addition, in a normal transaction environment it usually takes months and quarters of due diligence before a successful change of control can be valued and implemented. For these and other reasons, success is far from guaranteed if we stay on this risky path.
This, in particular view of the fact that there are perhaps hundreds of smaller institutions thatÂ are alsoÂ now on the zombie list that will eventually fail. Will the arranged marriage approach work; does Wachovia/Morgan Stanley make sense; or will some or a large proportion of these deals come apart and/or end up costing significantly more than the markets are being told?
To us it is very worrying that other means of support and other more comprehensive remedial approaches are not being explored and implementedÂ and why confidence boosting measures that include more stringent regulation and oversight of the financial services industry are not now being signalled as part of the eventual solution to the problem. For example, the imposition of leverage caps for financial services companies â€“ including hedge funds; more stringent and transparent reporting requirements; the more stringent enforcement of existing securities laws, and the rollback of some of the anti-regulation signed into law by Clinton in 1999 should all be on the table for discussion. Unfortunately this thinking goes against the grain of the non-interventionist orthodoxy in DC â€“ in this case to the longer term detriment of the country and the planet, we believe.
Even though they are not saying it, the current behaviour of the Treasury and Fed indicates that the Administration believes that the band-aid remedies are appropriate, that they representÂ durable solutions, and that life can go on as before.
We do not agree. Our belief is that the current course of action has used up valuable public sector financial resources and reduced future options and flexibility for dealing with what is going to be a very long drawn-out crisis. And, as we have seen over the past few days, contagion to other markets has become more than a possibility.
Apart from the irony of having the worldâ€™s largest free market economy nationalize some of its most sizable companies, the heavy reliance of the Governmentâ€™s balance sheet is only a few more bailouts away from exhausting existing resources. The jousting by Obama and McCain regarding tax policy is painful to watch as it describes almost total ignorance of the fact that whoever becomes President, in the very near future he will be faced with an economy saddled with what will prove to be near-Trillion Dollar budget deficits, near-Trillion Dollar external deficits, and no fiscal room to manoeuvre.
In the end, this may leave only the printing press with Helicopter Ben on the button to inflate away the excesses………with all that that implies.
September 10th, 2008 Alex Jurshevski
The answer to this age old African proverb is:
“One bite at a time!!”
And so it has come to pass that the US Government has finally owned up to what many of us have known for several quarters if not years: Fannie and Freddie are bankrupt. (You can check theÂ posts on our blog for our earlier views in this regard.) It appears to us that the timing of this move was heavily influenced by the growing realization within the US Government that these entities, if left to fend for themselves, would shortly face insurmountable refinancing problems stemming from the need to roll over massive maturing term borrowings over the next several months.
The stock market roared ahead in the wake of the nationalization of the two GSE’s, the relief rally sending the Dow Jones index up over 300 points. Unfortunately, it is not immediately apparent that the socialization of the losses associated with these organisations represents a great day either for free markets or democracy.
What has changed we ask? The Fannie, Freddie announcement merely enables a needed liquidation process to commence; it will not speed up the process or make it any less painless.
Several key question marks remain following the announcements on the weekend that include but are not limited to:
- The effect of influences stemming from a worsening economy, a large external deficit that needs to be financed amid the threat of accelerating inflation, and a FED and Treasury that are rapidly running out of ammo to deal with the various problems that beset them;
- The growing risk of a sell-off in Treasuries sparked by heightened inflationary expectations that would bring more pain for mortgagees and borrowers carrying high debt loads.
Following the activities of the last few months and this weekend, what seems to be less questionable at this moment is the US Government’s chosen approach to dealing with the Credit Crunch. Five defining behavioural characteristicsÂ seem to beÂ emerging:
- Buy Time: delay action and deny the existence of problems until the bitter end;
- Shield the Problems: internalize the risk on the FED’s or the US Government’sÂ balance sheet;
- Spend Other People’s Money: aggressively use the public purse to fund and paper over mistakes made in the private sector;
- Jawbone with Style: with the aim of keeping the markets relatively orderly during what will be a very long process of unwinding the excesses, so that the FED and Treasury, and by connection, the USD, will continue to enjoy the confidence of domestic and overseas investors; and finally,
- [Try and] Keep some Powder Dry.
One bite at a time…Hmmmm…..Sounds OK and it Might even be Doable (but not likely)Â …In that case maybe all we need to do is to keep watching the FED……
* We gratefully acknowledge and thank, Ray Williams, Managing Director, Derivatives, National Bank Financial for suggesting the use of theÂ Proverb.
August 22nd, 2008 Alex Jurshevski
It is rather remarkable to note that every time we visit the Fedâ€™s statistical database we increasingly encounter a â€œSERIES DISCONTINUEDâ€ notice in connection with the data that we have come to rely on to analyze the activities of the US Central Bank and the health of the economy (Our friend, Marvin the Paranoid Android, asks:â€What are they trying to hide?â€). The disappering data notwithstanding,Â some inferences are possible using the information they still deign to release. We are therefore pleased to be able to offer the following narrative based on recent information found on the Fedâ€™s website .
In March we informed our clients and service providers about the unprecedented developments on the Fedâ€™s Balance Sheet. Back then we were surprised to find that the level of Reserve Borrowing had risen to USD 100 BN, a level of borrowing suggestive of the “backdoor nationalization” of the US Banking System. We argued that the re-entry issues associated with this state of affairs may prove extremely problematic.This is becauseÂ over the entire history of the Federal Reserve System, Discount Window borrowings were usually maintained at extremely low, frictional,Â levels – certainly never much moreÂ than USD 1-2 Billion from week to week, whether the economy was weakening or not (see Chart 1).Â Since our March report the level of net borrowing has skyrocketed further,Â into the area of 170 BN, indicating that the pace of increase in the marketsâ€™ reliance on the FedÂ displays no sign of slackening.
Clearly, banks are finding it increasingly difficult to find funding in the open market for vast chunks of their asset exposures. This however does not tell the entire picture. The borrowings reported on the Chart above only include discount window loans to depository institutions and not the dollops of financing that have been extended to broker/dealers and other zombie institutions unable to otherwise source liabilities for themselves.
The recent buybacks of Auction Rate Securities (aptly named ARSâ€™s) by the dealers have likely also been underwritten through the backdoor by the Fed. On our estimates, the Fed has now encumbered more that 75-80% of its balance sheet with illiquid, and otherwise unfundable, loss-making paper. There is presently no exit in sight.
Loan Losses Popping
While this has been going on, other statistics published by the Fed show that loan losses have started to accumulate in the Banking System. Chart 2 below shows that net charge offs have doubled in the year to end March 2008.Â
Based on recent projections of system wide losses of USD 1.5 to 2.0 TRN that have been made by the IMF, Goldman Sachs and other market analysts, we can expect reported Â loan losses to climb sharply in coming quarters and to vastly exceed the previous peaks shown on Chart 2 by a factor of 2 to 4. This means we can expect aggregate charge offs to reach some 4 to 6 percent of system assets if the loss projections announced by various analysts as described above come to pass.
This level of loan losses will be unprecedented. At a minimum it suggest that Ken Rogoffâ€™s recent comments about a small number of high profile financial players going to ground is a conservative view. It will likely be much worse, and many, many financial institution failures will occur.
Donâ€™t Count on the Curve to BailÂ Anyone Out
In past crises the Fed lowered rates, the yield curve steepened and the financial sector re-liquified their balance sheets as the spreads between their asset yields and liability costs widened. This is clearly shown on Chart 3, particularly in the spread expansion shown in the periods immediately subsequent to the previous downturns in the early 1990â€™s and 2000â€™s. The income statement response was fast and predictable.
Unfortunately this is not happening this time around. Net spreads have continued plummeting amidst one of the most significant Fed easings in recent memory. In fact net spreads are at an all-time low and still falling, despite the easing. Due to the fact that median asset quality is declining, significant optimism is required to support a view that even a small recovery from these levels is possible within a reasonable timeframe.
Weâ€™re not in Kansas any more Toto!
Thus, it appears that the tonics and potions that the Fed has used in past crises, and the new elixirs brewed up earlier this year are not doing the trick. This means that the Fed is rapidly running out of bullets, and they have to be now betting that things are going to get a LOT better before they get ANY worse.
Our conclusion is that the Fed is in a hole and digging itself deeper.
Since the Fedâ€™s rescue program appears not to be working, expect more jawboning from the US Policymakers. However, if their comments continue to be as ill-advised as Paulsonâ€™s varied mumblings as regards the viability of the GSEâ€™s and Bernankeâ€™s recent inflation outlook commentaries, then the markets may punish them by sharply lowering the credibilityÂ they attach to such guidance (When I was trading rates we called this the “BS Coeffiicient”;Â or otherwise,Â the inverse of credibility) .
Other things to watch for include:
- Banks are going to tighten lending conditions significantly. Expect credit rationing as opposed to price-driven activity.
- There will be a significant spike in corporate bankruptcies both as a result of the credit squeeze but also intimately related to the vast volumes of sub-investment grade debt issuance in the last 5 years.
- Stock Markets will remain weak and IPO activity will continue at a low ebb. M&A, Private Equity Investment and other speculativeÂ activitiesÂ dependant on friendly markets and gullible investors with deep pocketsÂ will decline markedly.
- Growing financial stresses will cause numerous banks to go under. Expect consolidation and a further strain on Fed and US Government Agency resources. In this connection, it is worth noting that the recent Indy Mac bankruptcy alone consumed 10% of the reserves of the FDIC.
- Spreading Contagion. A crisis of confidenceÂ might break out leading to a chain reaction in global financial markets and an ultimate break in confidence in the US dollar. This confidence is not being helped by recent Russian military adventurism, other festering problems in Central Asia and North Korea, commodity price volatility, poor relative inflation performance and the seemingly insatiable requirement for foreign capital inflows needed by theÂ USÂ to keep its game afloat.
Returning to our initial premise, if we can draw these conclusions on the basis of what the US Government is still allowing the markets to see in the way of statistical information, then, we wonder, how much worse is the situation relative to what we have been told and are able to deduce; how much more problematic is it going to get; and are US Policymakers truly able to adequately cope with what is turning into a rapidly deteriorating mess of gargantuan proportions?
July 23rd, 2008 Alex Jurshevski
In the early 1990â€™s I was managing the Capital Markets desk of a Canadian Broker/Dealer in Tokyo Japan. In the wake of the â€œTriple Yazuâ€ â€“ precipitous drops in Stocks, Bonds and the Yen â€“ Japanese banks and investors were groaning under the weight of balance sheets laden with securities that were underwater and incapable of supplying enough future income to avert catastrophe.
With the active encouragement of the authorities there, a variety of sleight of hand transactions and accounting treatments were employed to allow many of these organisations to forestall disaster â€“ for a time. Chief among these was the â€œRescue Bondâ€. The idea was simple: an approach is made to a Japanese institution who is underwater on some bonds, Say their portfolio is worth 80 per cent of par, carries a coupon of 5.00% and has an average life of 3.5 years. The pitch was to buy the portfolio at par and to provide a teaser coupon that would allow large interest accrual gains to be reported in the first 2-3 years- say 9.00%. Unfortunately you do not get something for nothing. The security would be long dated â€“ typically 10 Years and the coupon structure would decline to a negligible level after year 2, say 1-2%. The economics of the restructured bond were in fact inferior to the original portfolioâ€¦.How are investment bankers otherwise expected to earn their bonuses? There were other tricks that relied on the fact that most Japanese investing institutions actively manipulated their books and did not mark-to-market that allowed the merry go round of value destruction to continue twirling without getting the economy and loss making institutions anywhere but dizzyingly bankrupt. It took 10 years â€“ The Lost Decade â€“ before the Japanese economy regained a semblance of health.
It is therefore frightening to see similar accounting tricks and subterfuges now being employed by US banks and investors in a similarly vain attempt to forestall the day of reckoning.. With the SEC and other watchdogs actively looking the other way, many institutions are pre-determining the losses that can reasonably be reported rather than adhering to the mark-to-market discipline. Nouriel Roubeni of the Stern School of Business reports that:
â€œâ€¦.folks dealing with the toxic/illiquid assets come up with totally ad hoc assumptions to make sure that such illiquid assets are valued consistently with the decided-in-advance amount of write-downs and losses. This is not earnings smoothing; this is active manipulation and falsification of financial results aimed at creating even more obfuscation of the true state of financial institutions. This obfuscation is actively abetted by the SEC, the Fed and all other regulators that are now in forbearance crisis management stage where the objective is to avoid at any cost anything that may trigger a financial meltdown. Thus, most of these earnings reports are not worth the paper they are written off. This earnings manipulation occurs in a variety of ways. First, ad hoc assumptions still used to value and write down level 2 and level 3 assets. Second, banks are leaving aside less reserves for loan losses that are much less than necessary; they do that by using ad hoc assumptions about future losses on mortgages, credit cards, auto loans, student loans, home equity loans and other commercial real estate loans and industrial and commercial loans. Reserves for loan losses have been sharply lagging actual and expected losses, thus padding earnings as decided by the financial institutions’ managers. Third, there is disposal of illiquid and toxic assets in ways that misleadingly reduces the amount of actual write-downs. An example is as follows: suppose a bank wants to dump illiquid MBS or leveraged loans that are worth â€“ mark to market â€“ 70 cents on the dollar rather than 100 cents on the dollar. Then, instead of selling these at a price of 70 and showing a 30% write-down these are sold to hedge funds and other investors to a price closer to par â€“ and thus showing in the balance sheet a smaller write-down â€“ by providing a subsidy to the buyer of the security: so a hedge fund will buy such toxic securities at 80 or 90 cents and receive a loan to finance the transaction at an interest well below the borrowing costs for the funds. Thus, write-downs are then shown smaller than the true underlying loss on the asset and the bank finances that fudged transaction with earning less revenues than otherwise on its credit portfolio. This is an accounting scam- bordering on the criminal – that auditors and regulators are abetting on a regular basis. â€œ
This and other facts which we will discuss in subsequent posts convince us that the crisis is far from over. In fact we are not even near the end of the beginning. More likely we are standing on the verge of what will likely be the largest incidence of bankruptcies in the financial services sector in history. Expect a massive wave of restructuring and consolidation. Recovery Partners first provided this outlook in an address to the World Hedge Fund Summit about two years ago.
Our obvious conclusion is that the recent rally in financial shares is a head fake. Donâ€™t get sucked in.
April 3rd, 2008 Alex Jurshevski
In 2007 Recovery Partners became engaged in a $500 million bad loan remediation in Asia. Working for certain Multilateral Financial Institutions, in part our activities determined early on that the Central Bank of this particular country had attempted to shore up financial problems in the agricultural sector by using its balance sheet to support unprofitable borrowings by private sector entities. The game had gone on for a few years but was doomed to crash. Unsurprisingly, the finances of this country and the private sector entities involved are in a now in a shambles.
This morning we heard that the Fed is attempting to shore up liquidity problems in the shadow banking system (i.e. bankruptcy-remote private sector asset backed funding vehicles) by extending its balance sheet further. It has now encumbered more than half of it’s almost $1 TRN in financial resources, by supporting re-purchases of assets thatÂ are either non-financeable or non-priceable in the open market – in short, assets that are unsellable, unprofitable and illiquid.
Time to batten the hatches. This is going to get worse before it gets better.