October 13th, 2008 Alex Jurshevski
Dateline Washington, DC, Columbus Day Weekend, IBRD/IMF Meetings
The markets were up sharply overnight and today on news that 15 European countries are taking moves to shore up stresses in their banking systems. However, volume was thin as it was a holiday Monday in parts of Asia and all of North America. This impressive relief rally belies significant unease in the investment markets and does nothing to dispel fears of the now generally acknowledged wider recession that is on the way and the fears that yet more stresses are in store.
How Times Change
In years past the IBRD/IMF meetings represented the “Gotta be There” Schmoozefest for A-List Investment Bankers, Lawyers, Fund Mangers and a variety of other hangers-on in the game of international finance. To say that this year’s affair was subdued would be a vast understatement. In fact at times it appeared that the host institutions and the various politicians in attendance would have welcomed news of a massive asteroid on a collision course with Earth or an outbreak of a new virulent flu bug as a welcome diversion from what is turning into a quagmire of thorny and seemingly intractable issues.
The non-party got going late last week when the Treasury announced that it was going to substantially rework the TARP Plan as it did not meet the requirements of the situation (See our last month’s post on this topic). The G20 communiqué then announced that officials endorsed the idea of a coordinated response to the financial crisis, but offered no specifics on what this coordination might entail. The proceedings really started to fall apart when the Managing Director of the IMF, former French Finance Minister Dominique Strauss-Kahn declared that, rapidly growing “…… solvency concerns about a number of the largest U.S.-based and European financial institutions have pushed the global financial system to the brink of systemic meltdown.” Our readers might well imagine how pumped up the audience was after that pronouncement.
As an interesting counterpoint, an ANIME (Japanese Cartoon) conference was being held in the hotel adjacent to mine coincident with the IBRD / IMF meetings. Wild wigs, brassy makeup and other getups were the order of the day. Taking a cue from this event, I was given to wonder whether any of the IBRD/IMF delegates were tempted to join the cartoon celebrations in place of the sombre proceedings taking place within the Perimeter.
And the Second Angel Blew his Trumpet
Sunday afternoon we learned that the lip service given to a coordinated a response among the G-7 and G-20 has resulted in European countries announcing plans to inject “billions of dollars into their banks.” This needs to be viewed in the context of UK Prime Minister Gordon Brown declaring that he plans to sue Iceland over the failure of its banking system and consequent impact on British depositors; while Russia is being looked to as a saviour by the Icelanders – ahead of the IMF – as it is bearing a possible EUR 4.0 Bn rescue loan package.
Rather than reinforcing confidence, the general lack of coordination up until last night’s announcement, the paucity of answers and surplus of buck-passing that appear to be the hallmarks of this year’s set of meetings, will likely significantly worsen the already very gloomy market sentiment, despite today’s uptick.
The bottom line is World Leaders, with the US at the forefront, seem to have squandered a major opportunity at these meetings to draw a line in the sand and calm market fears about the spread of the liquidity crisis and the seeming resistance of this credit virus to the policy tonics that have so far been applied .
As the realization that this crisis is far from over watch for the fear and loathing to spread:
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Banks have already tightened lending conditions significantly. Expect further credit rationing as opposed to price-driven activity. This means that some well-capitalized borrowers will likely fail. No one is immune. (Note to the Unbelievers: When Lehman went to ground its leverage ratio was 10.5:1 , Hugely conservative for an I-bank and much less than Goldman’s contemporaneous 22:1);
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Consequently, 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.
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Global Stock Markets will remain weak and IPO activity will continue at a low ebb, sapping banks of fee and spread income and foreclosing deal entry and exit points for private equity funds and corporations.
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Expect a further strain on Government resources in the affected countries, with consequent implications for employment, profits, inflation and growth. In this connection it is worth noting that, on our count, the Fed has already blown its wad and exhausted its Balance Sheet. Thankfully, cooler heads are tempering the Treasury’s initial planned reliance on fixed income financings as a way out of the mortgage quagmire. In part this strategy would have caused a predictable spike in bond yields (no doubt a reason why the TARP is being reconsidered along the lines we first suggested). So watch for additional money creation…..and a more immediate reaction on global markets once they realize that the wheels were never even on the TARP or any other plan in the first place;
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The witch hunt is only starting. This week we saw Dick Fuld, the former CEO of Lehman Brothers, being grilled by the House Oversight and Government Reform Committee. At the close of the sessions, Committee Chairman Henry Waxman ominously stated “Mr. Fuld, You say you will be haunted by the collapse of your firm until the end of your days, but you don’t seem to think that you did anything wrong. And that is troubling to me! (sic)” Will they call Fuld back to the Hill and then on to a courtroom for a slow “perp roast”, to be aired on C-SPAN? Maybe, maybe not. But you should expect a slew of corporate executives in a number of countries, but particularly the US, to be indicted, tried, convicted and led to the gibbet before the dust settles on this debacle.
The larger questions about this crisis still remain. The IMF’s resources at around USD 200 billion are woefully short of the amounts needed to make a dent in the problem. In fact the IMF appears to be holding its resources in reserve for a kind of “reverse triage” in case any of the emerging economies run into trouble. The G7 and G20 do not appear to be equipped or inclined to solve these problems. Therefore, questions must legitimately be asked as to whether the IBRD, the IMF and other global institutions are effective or even relevant any more, and moreover, whether the economic policy-making machinery and risk management systems in all of the major economies, should be in line for a major overhaul.
Don’t get sucked into today’s rally. It is primarily a technical bounce that will fade once the markets realize the scale and number all of the risks and obstacles that lie ahead.
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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 “problem” 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 the voters in the history of the Republic.
In our view a rescue plan must satisfy several basic criteria if it is to be successful and contribute to a lasting betterment of the situation:
• The Plan must recognize that the first step in any troubled asset remediation – if one’s objective is to avoid bankruptcy and liquidation – is first and foremost, to Stabilize the situation and then to Triage the zombies.
• The Plan must conserve precious financial resources.
• The Plan must be transparent and allow for performance benchmarking and accountability.
• The Plan must recognize that the process of remediation will take a long time and that not all problems are presently fully in view.
• 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 – 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 funded “carpet bombing” 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 country’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: “Decisions 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.” It goes on further to state…..”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.” 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, and 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 – 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 “Get Out of Jail for Free” 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 – 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 and 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 this 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 needn’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 “cost” 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 “Loss Given Default” of the liabilities, the size of the contingent liability at this stage is probably in the range of USD200 billion at most, and would not need to be financed. This is vastly more financially efficient than the TARP.
The Reality
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 market’s political assessment of the legislative situation as outlined above. The package will pass.
Therefore we believe that ultimately this will all end in more 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 “Bond Aid” response is setting the stage for even worse problems yet to come.
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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 not 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. [“Zombies” 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 “Notable Zombies” 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 AIG has now been nationalized backed by an initial USD 85 Bn. of public funds. Our long-held views that the GSE’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 wasn’t a crisis at all; six months ago they were touting the GSE’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 and 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 unstabilized 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 that are also 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 implemented 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 – 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 – 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 represent 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 world’s largest free market economy nationalize some of its most sizable companies, the heavy reliance of the Government’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.
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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 the 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 characteristics seem to be 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’s 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) …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 the Proverb.
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August 22nd, 2008 Alex Jurshevski
It is rather remarkable to note that every time we visit the Fed’s statistical database we increasingly encounter a “SERIES DISCONTINUED” 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:”What are they trying to hide?”). The disappering data notwithstanding, 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 Fed’s website .
In March we informed our clients and service providers about the unprecedented developments on the Fed’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 because over the entire history of the Federal Reserve System, Discount Window borrowings were usually maintained at extremely low, frictional, levels – certainly never much more than USD 1-2 Billion from week to week, whether the economy was weakening or not (see Chart 1). Since our March report the level of net borrowing has skyrocketed further, into the area of 170 BN, indicating that the pace of increase in the markets’ reliance on the Fed displays no sign of slackening.
Chart 1
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 ARS’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.
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 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 Rogoff’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.
Chart 2
Don’t Count on the Curve to Bail 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 1990’s and 2000’s. The income statement response was fast and predictable.
Chart 3
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.
We’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 Fed’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 Paulson’s varied mumblings as regards the viability of the GSE’s and Bernanke’s recent inflation outlook commentaries, then the markets may punish them by sharply lowering the credibility they attach to such guidance (When I was trading rates we called this the “BS Coeffiicient”; or otherwise, 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 speculative activities dependant on friendly markets and gullible investors with deep pockets 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 confidence 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 the US 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?
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July 23rd, 2008 Alex Jurshevski
In the early 1990’s I was managing the Capital Markets desk of a Canadian Broker/Dealer in Tokyo Japan. In the wake of the “Triple Yazu” – precipitous drops in Stocks, Bonds and the Yen – 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 – for a time. Chief among these was the “Rescue Bond”. 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 – 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 portfolio….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 – The Lost Decade – 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:
“….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 – mark to market – 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 – and thus showing in the balance sheet a smaller write-down – 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. “
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. Don’t get sucked in.
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July 8th, 2008 Alex Jurshevski
While we generally do not like to boast, we will point out that at Recovery Partners we have been informing our clients, colleagues and friends since 2006 that the credit cycle is turning. For some quarters now, the credit markets have provided unmistakable signals that the party is over and that additional, significant, stresses clearly lie ahead.
We note that a market report from the Bridgewater Associates was leaked over the weekend that estimates losses from the credit crunch at US1.6 Trn. That is a far bigger number that the USD 1.2 Trn. estimated by Goldmans only two months ago. It is also more than three times the amount of losses announced by banks and brokers to date. As far as we can tell this number does not include the destruction of shareholder wealth caused by tumbling sharemarket and real estate prices. The relevant questions are: (1) If the estimate is in the ballpark, have the markets already discounted this, and if not, are they prepared for the red ink when the wounded and dying financial sector firms begin to own up to the scale of their losses? And (2), whither the economy in the face of such unprecedented negative wealth effects?
Read the rest of this entry »
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April 14th, 2008 Alex Jurshevski
The markets continue to whistle past the graveyard. Most commentators are in fact suggesting that the worst is behind us and that the Fed’s rescue actions have saved the day yet again.
We couldn’t disagree more.
In her seminal work “On Death and Dying” Swiss Doctor Elizabeth Kübler Ross postulated that there were seven stages of coming to terms with reaity upon being told that one has a terminal illness. Denial is but the second stage following Shock. There are four more stages before Acceptance is reached and the stricken individual can again find his or her forward. We are obviously past the Shock stage. We suggest that markets are now experiencing Denial.
Anger and Depression lie ahead for investors who do not yet understand that the Bull is DYING and will soon be DEAD.
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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 that 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.
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March 24th, 2008 Alex Jurshevski
The markets seem to have shrugged off some of the fears on the back of the Feds recent unprecedented policy changes: the granting of access for non-banks and primary dealers to the Feds lender of last resort borrowing window and last weeks announcement of a swap of up to USD 400 Bn of Treasuries for illiquid and sharply marked down MBS securities and other non-bankable structured product.
In addition the policy measures also include the ultimate hypocrisy of announcing that the GSE’s (Fannie Mae, Freddie Mac etc) will soak up another USD 200 Bn or so of mortgage risk through a relaxation of capital requirements on these institutions. Nothing illustrates more clearly that Fed is running out of rabbits than the fact that these institutions are now viewed as part of the solution to the mortgage mess in spite of their widely publicized risk management and accounting problems and their reluctance to so far recognize their mark to market losses on their mortgage portfolios. A proper investigation of this situation may one day reveal that senior US policymakers and the management of these organisations knowingly allowed these firms to “trade while insolvent” in the vain hope that they could contribute to the bailout “plan”.
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