The cooler - better looking Hempton

Gratuitous advertisement:

The Nick Hempton Band is having its album launch in the Zinc Bar.  You can hear a little of his music on his my-space page.  

My cousin got the talent and the looks.  I just got a pile of nearly incomprehensible bank balance sheets.

Anyway the last newspaper review said he looked like a movie star and can play like Charlie Parker.  I wish I was there.

J

Do they read in Washington?

I got a lot of comments on the “big post” – many are smart, some are just plain wrong, many however taught me stuff.  

I should find the time to answer them – but for the moment I was just keen to see how many readers I had found in Washington DC.  

I did find a few.  Google Anlaytics allows you to track some user data (region, frequency, time on site etc.)  Google tells me that I received my all time record Washington readers (about 200).  Almost 80 percent of those had never visited Bronte Capital before.

Great – I am having an impact I thought.

But then I was pegged back a little.  The average time on the site was one minute and thirty two seconds for a 5000 word essay.  

As said - I received a lot of quality comments.  I doubt I received any from people who read for less than 2 minutes.

John

Postcript... I know its just an average, and I know people cut and paste - but the New York crowd read twice as long...

Bank solvency and the "Geithner Plan"

Warning – a very long and wonky post - and possibly a little self indulgent. Don’t bother reading it unless you are really interested in banks and the crisis. More an essay than a blog post. If you are going to read it give me the courtesy of reading it to the end. If you are a direct report of Mr Geithner please read it now (the stuff you want is at the end).

It wasn’t the intention of this blog to become a public policy forum. It was just going to be a conventional investment blog. I used to be an (Australian and New Zealand) Treasury official and thought I gave up policy analysis when I ceased being a bureaucrat.

But the analysis of banks got intertwined with the analysis of politics. You can’t possibly decide what bank to invest (or for that matter short) without an understanding of where the politics is. If the government is going to keep giving money to banks (as per the Citigroup bailout) then you just have to own them. If the government is going to be harsh (as per the AIG bailout) then you want to run a mile. And they could be harsher than that. There are lots of possible outcomes – and the outcomes seem uncorrelated to the solvency of the institution. WaMu was probably solvent (subject to definitions below) and was confiscated – certainly – according to the FDIC – it had enough capital when it was confiscated. Wachovia was forced to sell itself when solvent (and when Wells happily purchased them later proving the point). AIG was shockingly insolvent and the shareholders were 80% diluted. Citigroup was in much bigger trouble than WaMu (it was actually illiquid) and the shareholders were given a big kiss (lots of very cheap government money and guarantees) and told to go on their way.

The government policy is very hard to determine. Under the Bush administration there was no policy. Each financial institution in crisis was handled a different way – think Bear, Lehman, AIG, Fannie and Freddie, WaMu, Wachovia, Citigroup. No two deals were even close to similar. Ad-hoc – thy name is Hank Paulson.

We have gone from an administration which demonstrated that it had no plan to the “Geithner Plan”. The “scare quotes” around “Geithner Plan” are because it is unfair to even call the “Geithner Plan” a “Plan”. As far as I can see there is no detail – and if you don’t have detail you don’t have a plan. I will remove the scare quotes when I think the Obama administration has a plan.

That said – lets put some framework around “the plan” – such as it is

First – let’s diagnose the problem – because I don’t even think the problem is well diagnosed.

We have a lot of pools of bank assets (pools of loans) which have the following properties:

• The assets sit on the bank’s balance sheet with a value of 90 – meaning they have either being marked down to 90 (say mark to mythical market or model) or they have 10 in provisions for losses against them.
  

• The same assets when they run off might actually make 75 – meaning if you run them to maturity or default the bank will – discounted at a low rate – recover 75 cents in the dollar on value.
  

• The same assets if sold in the market (which does exist if you wish to discover the price) trade at 50 cents in the dollar.
  

The banks are thus under-reserved on an “held to maturity” basis. Heavily under-reserved. If you were to take correct provisions – many banks – not all but many – would have negative net worth. Few banks would meet capital adequacy standards. Given the penalty for even appearing as if there was a chance that you would not meet capital adequacy standards is death (see WaMu and Wachovia) and this is a self-assessed exam, banks can be expected not to tell the truth.*

Before you go any further you might wonder why it is possible that loans that will recover 75 trade at 50? Well its sort of obvious – in that I said that they recover 75 if the recoveries are discounted at a low rate. If I am going to buy such a loan I probably want 15% per annum return on equity.

The loan initially yielded say 5%. If I buy it at 50 I get a running yield of 10% - but say 15% of the loans are not actually paying that yield – so my running yield is 8.5%. I will get 75-80c on them in the end – and so there is another 25cents to be made – but that will be booked with an average duration of 5 years – so another 5% per year. At 50 cents in the dollar the yield to maturity on those bad assets is about 15% even though the assets are “bought cheap”. That is not enough for a hedge fund to be really interested – though if they could borrow to buy those assets they might be fun. The only problem is that the funding to buy the assets is either unavailable or if available with nasty covenants and a high price. Essentially the 75/50 difference is an artefact of the crisis and the unavailability of funding.

The problem with new loans

The difference between the yield to maturity value of a loan and its market value is extremely wide. The difference arises because you can’t eaily borrow to fund the loans – and my yield to maturity value is measured using traditional (low) costs of funds and market values loans based on their actual cost of funds (very high because of the crisis).

The spread between the origination value of a loan and its secondary value is huge. It simply makes no sense to originate new loans when you can buy old loans so cheap. Because it makes no sense to originate loans banks will not do it unless they are driven by an “institutional imperative” (they don’t know what else to do) or they are forced to by regulators or they are trying to prove their solvency by using capital (something I have accused Barclays of).

The irrationality of lending has dire economic consequences. At worst business just stops because they can’t get trade finance, working capital funding or any of the other basic services of modern banking.

Some reasonable numbers for the United States

Reasonable numbers are that:

• The system starting capital (ie pre-crisis) was 1.4 trillion dollars,
  

• Banks have raised about $500 billion along the way
  

• Financial institutions have passed say 300-700 billion in losses outside the banking system (such as to defaulted bonds on Lehman or to hedge funds that have blown up) or to non bank holders of junky CDS (such as Norwegian local government authorities), indeed the whole point of securitisation was that it took the loans and losses out of the banking system,
  

• That end cumulative losses (the 25 cents in the dollar not recoverable in the above illustration) total maybe $1.5 to 2 trillion and
  

• That mark-to-market losses (where the assets are marked down to what the market price for those assets) is about 3 to 4 trillion dollars. The current Nouriel Roubini number is 3.4 trillion.
  

The hardest of these numbers to determine is the end cumulative losses. The reason is that it is a prediction.** You can’t possibly know the end losses until the loans have run their course. Moreover the government response to the system will – to a large part – determine this number. If the government handles it very poorly then end losses will be larger.

The starting capital, capital raised along the way, losses outside the financial system are all just hard facts (though my quantification is not fantastic and there are serious quantitative difficulties such as double counting). The mark-to-market loss is able to be estimated because the market prices are observable – but banks are not happy to tell you what is on their books – and – more importantly – they don’t want to find out the price for those assets because they know above all that this is a self assessed exam for which the penalty for failure is death. For what it is worth I suspect the end cumulative losses will be at the low end of my range and that the mark-to-market losses will be at the high end of my range (ie that Roubini is an optimist on mark-to-market losses).

The other observation is that the starting capital for the US banks was high. The regulators in the US by-and-large forced banks to have a lot of capital. They were more lax in Europe and totally lax in the UK. The UK problems arise in part because the banks started the cycle massively capital deficient.

Are the banks solvent?

It has been the blogosphere (and now commentator) meme-of-the-day that the US banking system is not solvent. See Paul Krugman, Yves Smith or Felix Salmon for examples. But I am not sure that anyone even defines solvent appropriately. So let's think about different definitions of solvency – and whether the banks meet them.

There are several definitions of solvency here – and it is not clear which definition people are using. Here is a list:

• Definition 1: Regulatory Solvency. Does the bank have adequate capital to meet the solvency tests imposed by regulators?
  

• Definition 2: Positive net worth under GAAP. Does the bank have positive net worth under GAAP accounting (ie yield to maturity with appropriate provisions when YTM is required or mark to market otherwise)?
  

• Definition 3: Positive economic value of an operating entity. If the bank is allowed to continue to operate it will be able to pay all its debt and replace its capital?
  

• Definition 4: Positive liquidation value. If you liquidated it today at current market prices it would have positive value.
  

• Definition 5: Liquidity. Does the bank have adequate liquidity to operate on a day to day basis?
  

Let’s look at the banking system against each of these definitions of solvency. That should clear the woolly thinking up on solvency.

Solvency against definition 1: does the banking system currently contain adequate regulatory capital.

To this definition the answer is not likely – and though if you ran for three or four years you might get there. The US banking system started with 1.4 trillion – which was quite near regulatory limits. In the great boom it was just assumed you wanted to run with as little capital as required because that got your return on equity up. So the starting capital was somewhere near required capital. As say 1.5-2 trillion has been lost (on the yield-to-maturity-definition) and only 500 billion or so raised so collectively the banks are likely to be short. Pre-tax, pre-provision operating profits (probably greater than 300 billion per annum with normalised funding costs) would not cover the difference.

There will be disparity amongst banks and some will actually have gone negative regulatory capital (including probably WaMu had it been left). The regulatory insolvency is far greater if you were to mark the assets to market but outside the brokerage area most banks don’t have to mark assets to market – and inside the brokerage area they really want the mark-to-market rules suspended.

Trading books (or loans originated for sale) are by accounting standard mark-to-market. This is a big problem because the market price is substantially lower than the yield to maturity value. If a bank did a lot of trading (eg Citigroup) or originated a lot of loans for sale but was stuck with them at the end (eg Royal Bank of Scotland on its private equity loan book) then it is likely to be deeply insolvent on a regulatory standard because it needs to mark those loans down to a the very low market price. These institutions are squealing for a suspension of mark-to-market rules – and I would have some sympathy if I could get them to account for it on a reasonable yield to maturity basis with reasonable reserves. I don’t trust them – after all – they are bankers and they lie.***

Nonetheless regulatory capital is not where it is at. The whole point of regulatory capital is to ensure buffers in case of a really bad downturn. When the really bad downturn happens the buffers will be (naturally) be used. It’s perfectly normal (and in my view acceptable) to have inadequate regulatory midway through a nasty downturn. Dividends should be cut, profit should be retained, even growth curtailed – all of which are how banks get back to normal regulatory capital – but confiscation or nationalisation of banks because the regulatory buffers have been removed is harsh – and unreasonable behaviour.

Solvency against definition 2: do the banks have positive net worth under GAAP?

This is a much less strict test than the regulatory capital test. It’s a test of whether there is capital there – not whether there are buffers there. You would not expect there to be broad buffers at this point in the cycle (after all the point of a buffer is that you use it when you have a crash) but soundness requires some buffer.

My view – and it is open to debate – is that a reasonable sort of regulatory buffer is that a bank – properly provisioned when the disaster happens – should be forced to have about a third required regulatory capital – and should be restricted from reducing that capital (dividends, buybacks etc) until the buffers are fully restored. Forbearance is right at this point of the cycle – unlimited forbearance is not. And Test 2 here is too weak for most policy application.

Nonetheless on Test 2 the banks almost certainly collectively pass. The losses (yield to maturity basis) are unlikely to be more than 2 trillion. We started with 1.4 trillion of capital – will have made probably 400 billion on pre-tax-pre-provision profits and having raised more than 500 billion. Moreover – the whole point of securitisation and the “shadow banking system” was that it moved considerable losses outside the banking system. As losses were moved elsewhere – whether that be to dumb hedge funds (of which HF-Implode has a large list) or to Norwegian local government.

Now I have a metaphor for how you might think of Test 2. In the centre of the road are double lines. You are not allowed to cross them. Crossing them is dangerous (you might crash and you might cause injury to others). When you cross them you should get back to your own side of the road quickly. However there are times of driving stress when you would cross them and that crossing is considered normal and acceptable. A child runs out on the road – and under stress you swerve over the double lines. Nobody will confiscate your car and lock you up for that. However if you stayed over the double lines you would expect the government to come down on you. Breaching regulatory capital buffers is normal in times of stress – but staying at very low to zero levels of negative capital – that is suicidal.

If we consider a modified Test 2 – whether the banks have collecting a third of required regulatory capital right now (say 500 billion) then it is harder to determine collective pass or failure – but my guess is pass. The losses in the system are indeterminate – but on a yield to maturity system 1.5 to 2 trillion seems about right. Now there may be 500 billion losses outside the banks (that is the shadow banking system). We started with 1.4 trillion and have raised a bit along the way. If losses are 2 trillion total – 500 billion outside the system and you have some operating profits along the way you get a bare pass.

The situation of trading books under Test 2 however is much more dire. Trading books under GAAP are mark to market – and as noted above the market values of assets are considerably less than the yield to maturity values. (The Roubini number of 3.4 trillion in mark-to-market losses comes to mind.) If these insitutions are forced to account honestly according to GAAP – that is to mark their own book appropriately – then they are likely very insolvent indeed. The mark to market losses (which are in excess of yield to maturity losses) however are offset to some extent by the phoney mark-to-market gain resulting from reducing the value of their own liabilities because of reduced credit worthiness. The banks that are in this situation (insolvent under mark to market) include Citigroup, JP Morgan, possibly Bank of America now that it has swallowed Merrill, and possibly Goldman Sachs.

Solvency against test 3: positive economic value of the banking entity.

This test requires adequate ability to repay the debts of the banking system and have some value provided the banking system is able to function. Before I go any further I should mention the proviso is critical. At the moment the banking system (indeed anyone) has a hard time getting cheap funding. This test presumes that the banks can fund themselves more-or-less-normally (either because times are normal or because governments have guaranteed the funding making the funding problems go away).

Here I am counted as a radical. The system in my view clearly has positive economic value. I did that calculation in my voodoo maths post. To me the issue is unequivocal. The pre-tax, pre-provision income of the banking system normally funded is probably 300 billion. It is probably much larger if the funding costs were reduced to near Treasury levels. If you haven’t noticed interest rate spreads and hence pre-tax, pre-provision profits of the banking system should (presuming normalised funding) be way way up. 300 billion is an underestimate. So if there are 2 trillion of losses and 1.4 trillion of starting capital then four or five years and we are back to fully capitalised. We would get back there faster than that – because the banks have raised considerable capital on the way down and not all the 2 trillion of end losses are born within the banking system. Indeed against "Test 3" I think the system is brimming with solvency. Individual banks are possibly insolvent against this test – but the system is not and anyone that tells you otherwise is just not doing maths.

The usefulness of this test however is problematic. It presumes the system can continue to operate (a test falsified by the facts on the ground). It is however an indication of what would happen if the system were nationalised – the government would make a profit. It is also the test of what would happen if the system had credible government guarantees and were sensibly run. (If you are going to give it government guarantees then – in my view – you might as well nationalise it. However at the very minimum you need to control it to an enormous extent because government guarantees cause nasty moral hazard problems.)

Test 4: do the banks have positive liquidation value?

This one is easy – no way. There is nothing wrong with the Nouriel Roubini number about 3.4 trillion in total losses if all assets on bank balance sheets are marked-to-market. Indeed if anything Roubini’s number is light. Bluntly speaking if you liquidated the banks now the losses would be huge – and they would be huge for almost all banks including those that met regulatory tests in "Test 1". The losses would be huge for the same reason that the banks are having trouble – nobody could lever up to buy the assets at anything that looks like a reasonable “yield to maturity” value. Incidentally it should be noticed that a bank which has adequate regulatory capital and has been well run will be profitable in run-off but have negative liquidation value. It is rough in the extreme to use liquidation value as the test - though in the event of widespread confiscation liquidation value is the test that will wind up being used.

Test 5: do the banks have enough liquidity?

Well this is hard – and critically dependent on government policy. Solvent banks (even "Test 1 Solvent Banks") will be "liquidity insolvent" if there is a run. And when people who provide funding lose in a run then any thought of runs will be self-fulfilling. So far several banks have failed "Test 5" – notably various brokers and Citigroup (which is a broker). The ability to pass or fail "Test 5" however comes mostly from the faith that people have that you will pass "Test 5". If you pass "Test 3" above (and the US banking system does) and people have sufficient faith then you should continuously pass Test 5.

Government policy however has been arbitrary and capricious. The Hank Paulson plan was no plan. It was ad-hoc. The “Geithner plan” is so vague as to be meaningless. WaMu which was adequately capitalised but had a minor run (induced by leaked rumours of a government takeover) was confiscated. Citigroup – which – being a broker – is almost certainly insolvent from a GAAP perspective – and which had a major liquidity squeeze was given a big-fat-sloppy-kiss (lots of cheap government capital). In the WaMu case the intermediate funders had any rights confiscated. That I thought at the time was reckless and irresponsible. I still think that.

If the government doesn’t get a consistent plan – and that consistent plan does not appease intermediate creditors of banks (as argued in the “reckless and irresponsible” post) then we might as well nationalise the entire US banking system now – because almost all banks are dependent on intermediate funding – and that funding has fear-of-government.

An observation

If you believe these numbers – and I do – then there is no need to nationalise the banking system in the US provided that you can get confidence back into the system. Now that is a big proviso – I have some methods of getting confidence back into the system – but they are harsh. Mostly it can’t be done with the current tier of executive management (who are utterly discredited). It also can’t be done unless government policy becomes consistent and appears to be consistent. A strong plan is necessary.

Nationalisation will work though as a way of bringing confidence back. I first mentioned nationalisation (as something that would work) in June 2008. One big name Wall Street journalist (who now thinks I was prescient) thought that I was mad then. I thought nationalisation might happen if government policy were badly executed. So far government policy has been badly executed - and the takeover of WaMu (which kicked the intermediate debt holders and hence put the fear-of-government into people that fund banks) is exhibit A. (I thought the end consequence of Sheila Bair’s action would be the nationalisation of the whole US banking system though I still harboured hope for better. I hoped that Hank Paulson – and later the Obama administration would be better than that. So far I am very disappointed.)

Anyway – there would not be a crisis if people trusted – even if the banks were marginally insolvent. However banks have told lies – blatant lies – for so long that nobody believes them. Certainly the blogosphere has decided that banks are insolvent no matter what they say – though the evidence for insolvency (other than mark-to-market insolvency as per Nouriel Roubini) is thin to non-existent. Mark-to-market insolvency is the norm.

Nationalisation, insolvency and process

Now when a blogger or an analyst tells you a bank or the system is insolvent then ask them what definition of insolvency they are using and test them against that definition. Then test them against others – and work out – in the context given – whether the institution is solvent against the definition appropriate for the circumstances. People who do not think clearly as to definition of insolvent are being sloppy – and that includes most the bloggers I most admire including Paul Krugman. The context in which the banking system is insolvent is that (a) it is illiquid because people don’t trust it and (b) it can’t get enough liquidity because it has to sell assets into a market in which they are trading considerably below their “yield to maturity or GAAP price” and if you sell it at that price you reveal “mark-to-market” insolvency as per Roubini. However provided the banking system could remain liquid it is unlikely it will actually be insolvent though individual banks might be. [I should note that this is a US conclusion. The UK banks started much more thinly capitalised and I think they are insolvent.]

This is what the stakes are in the (so far incompetent) government policy as to how the banking crisis is to be dealt with. What is a marginal solvency crisis (and that is all it is on a yield to maturity basis) is being turned into the mother-of-all-liquidity-and-solvency crises. Sure the banks bought in on themselves by telling so many lies in the good times (so they are never believed now). But now the problem is beyond their ability to control.

Anyway wholesale nationalisation is not the right policy per-se. It will the inevitable result of following the wrong policies. The right policies will involve selective nationalisation – what I have described in other posts as “nationalisation after due process”.

The “Geithner Plan”: module 1 – stress testing

The first element of the “Geithner Plan” is a stress testing of banks. This is so vague as to defy description. That hasn’t stopped Calculated Risk from thinking that this should start quickly and will be quick – though Yves at Naked Capitalism has it right.

Fannie Mae (according to its 2006 10K) spent almost a billion dollars in 2006 alone trying to remedy its accounting from its 2004 accounting scandal. Hey – that was just Fannie Mae. If you want to do a proper stress testing with qualified people across the banking system then your accounting bills will be in excess of $3 billion dollars. At the end of one post I jokingly called this “stimulus” – but it is – lots of work for underemployed business accountants.

At Fannie Mae I do not need to remind my readers the money wasn’t well spent.

Anyway the words “stress testing” in Geithner’s speech do not constitute a plan. Not close.

There is one stress test that it doesn’t cost a billion in accounting bills to do – and that is to say – hey – you got only 8 percent reserves against that pool of loans – why don’t you test that in the market. If you can sell those loans – even a few of them – at 92 cents in the dollar then we will think your reserves are sensible. Having done that we can believe your assumptions and stress test using the bank’s existing assumptions. The only problem – and it is a big problem – is that the secondary market price of the loans is way below the yield to maturity price – and if that is the test that you are going to have then you will reveal Nouriel Roubini type insolvency – because the whole system is grotesquely insolvent on a mark-to-market basis. A market based stress test can’t be done unless you fix the secondary market up.

The “Geithner Plan”: module 2 – private money involvement in purchasing assets from banks

Again the word “plan” is a misnomer here. More a statement of hopeful intent. I jokingly put some figures around it with a blog post that suggests that Geithner get the US Treasury to lend Bronte Capital a trillion dollars under favourable terms. I figured with such a loan that I could start making substantial money.

But the idea deserves more consideration than I gave it. If instead of one fund with 150 billion of private money and say 1050 billion of public money you established ten funds of one thirtieth that size then you could produce a functioning secondary market for the dross that banks are taking off their balance sheet. And this leads to what I think is the obvious meld of “module 1 and module 2”. That is (a) establish the funds – but with a rule that they are expected to – and only allowed to bid on the assets sold by banks on their stress test, and (b) having established the market for the secondary assets (admittedly supported by cheap money) you can get the banks to redo their reserves by selling sample assets into that market. This allows you a market redo of the accounts – and hence to avoid the problems that caused Fannie Mae to waste a billion dollars redoing their accounts.

If they have inadequate capital after testing in that market then you have the basis for forcing them to raise more capital or putting them into receivership – you have a functioning due process.

When the banks are illiquid rather than offer guarantees you beef up the secondary market by establishing more funds (with private money at risk in those funds). You have the banks sell their assets to gain liquidity.

This is a workable plan along Geithner lines. It won’t necessarily result in wholesale nationalisation – and I hope that I have convinced you that nationalisation is the end result of failure of policy rather than a policy goal in itself.

At worst it gets maybe a hundred billion of private money into the fray. It has all the requirements of due process. It should be a good plan.

Thanks for reading this far.

John Hempton

*It was Warren Buffett who first – at least to my hearing – described financial accounts as a self-assessed exam for which the penalty for failure is death. I think he was talking about insurance companies – but the idea is the same. Truth is not expected.

**Estimating the end losses for loans is always problematic. The modal outcome is near to zero (most loans pay) but the tails are fat. We live in a time of fat tails – and getting a handle on this number requires that we pretend we as much about the future as we do about the present. (And we know the present fairly poorly because – as I have pointed out – bankers almost always lie.)

***Note also it was acceptable to pay bonuses to traders based on mark-to-market profits. Now they want those rules suspended. Cynical comments are allowed…

Shark attack

Regular readers will know that I am a surf lifesaver at North Bondi and later at Bronte Beach.

I am stunned as anyone by the shark attack. 

I was not at Bondi yesterday evening - but I was the evening before - but at the North end - teaching my son to surf.  The conditions were very similar - dusk, extremely low tide, overcast, weeds washing into the beach.

John

Tapes and films – the data-point from hell

Think of Nitto Denko as Japanese 3M.  Indeed it is the company in the world that most resembles 3M.  It does tapes, films, laminates – the usual 3M product set.  Like 3M a large part of sales winds up in automotive uses.

Now just how bad are their sales?  Here is the monthly sales report:

Compared with January 2008 , Nitto Denko's total consolidated sales revenue was down 51% (Y-o-Y) and decreased 9% from December 2008. LCD-related product sales was also down 57%(Y-o-Y) and decreased 1% from December 2008.

Ok – is it a recession or a depression?  

Private equity involvement in the bailout and leverage

I don’t know what Mr Geithner’s plan is. The stuff out there is so vague you can drive a truck through it.

But the smarties all seem to have one trade on – which is long distressed loans short financial institutions.

That is at least the broad position in the Paulson letter.

And far from me to encourage you onto a crowded trade – the position makes sense.

There are plenty of assets trading at 60-70c on the dollar that sit on bank balance sheets at much higher prices. If you force the banks to recognise the assets at 70c on the dollar they are amazingly insolvent.

So either

(a) the assets are underpriced, or

(b) the banks are overpriced or

(c) both.

Long junky loans short financial institutions is just an old fashioned arbitrage – and the few unimpaired arb funds (eg Paulson) are making hay...

Are the junky assets really underpriced in the market?

There are plenty of assets trading at 60 cents on the dollar. Diversified pools of mortgages (admittedly less-than-prime pools) often seem to trade at this level.  AAA strips against those pools are often 70c in the dollar and where 12 percent of the assets need to go bad before you bear any loss. Implicitly there needs to be 40 percent losses before you lose money on these investments.

I know it is bad out there – but 40 percent losses imply worse than 60 percent defaults with 60 percent loss given default. It is simply not going to happen on a widespread basis (though I can show you individual securitisations that are worse than this).

So why don’t people bid up the price of the junky assets? Well some are – see the Paulson letter – and he has made good money doing things like that.

But there is a return problem. Some of these assets are quite long dated – you might get paid over ten years. And meanwhile you get say 10/7 times the AAA yield (the stuff is trading at 70c in the dollar) and it might pay 85 cents in another 10 years – so you get nearly another 2% per annum in carry.

Well 10/7 times treasuries isn’t very much – less than 4% and nearly 2% carry – and whoa you have an asset on which you won’t lose money indeed on which you probably will make five percent.

That really excites me. Asset prices are way down – this crash might be the investment opportunity of a lifetime – and I have a smorgasboard of assets to chose from on which I will not lose money over the long term – indeed on which I might make 5% per annum.

I am just thrilled.

So how are those assets really?  Underpriced but hardly exciting. To be exciting they have to be insanely underpriced. There are a few insanely underpriced assets out there, but John Paulson (Paulson funds) won’t tell you what they are. And even then they are not that exciting.

No – to be exciting you need to borrow against them. You need to be able to use leverage. Cheap leverage. Lots of leverage. And it can’t be margin loans or the like – because the asset prices are so volatile that your funding might go away.

But – with permanent cheap funding at government rates it should be profitable to buy those assets. Seven to one levered at government rates (which are a couple of percent) the returns will be spectacular.

So if the Geithner plan is to attract say one hundred and fifty billion of private risk capital and allow it permanent and secure access to say a trillion dollars of government money at a government rates then hey – I am in. (I would require the interest rate risk be matched too.)

It would be a pretty big gift from the government – as nobody – a good bank or a bad bank – can borrow at the same (extraordinarily low) rate as the US Treasury. But as a plan it might just work. And because 150 billion of real private spondulicks is at risk there are some pretty strong incentives for the private sector manager to get it right.

Well who should be the private sector manager?

I don’t know. Most of them won’t work for a $500 thousand dollar salary. And that is problematic.

But – hey its my civic duty. I will do it.

Yes – you heard me, I would do it for a $500K salary. And no base fees – and a very small performance fee. Admittedly the very small performance fee will be on a very large amount of money – and with all that cheap government leverage it might leave me as rich as Croesus – say Bob Rubin rich. Indeed as the underpriced assets are common and the only problem is the inability to lever them – I should make an absolute killing if Mr Geithner will give me enough cheap, matched and permanent funding.

Indeed I would never bother with this fund I am setting up. I would get my original clients together and raise a few hundred million of private money to start the bail out fund. I will even put in most my own net worth.

Oh, and I wouldn't hide the motive either.  Its greed.     

How about it Tim? You game?

Don’t believe what they say

Calculated Risk points us towards a slide in the presentation that JP Morgan made when it purchased Washington Mutual.  Calculated risk (falsely I think) indicates that it is relatively easy to quickly put up a stress test scenario as to end losses for various types of loan.

Anyway – back to the slide which you can find here.  It presented three scenarios up to and including a “severe recession”.  It is now clear that the unemployment rate will exceed the severe recession scenario in the slide.  However home price appreciation (well really depreciation) from peak to trough is still considerably less than the severe recession scenario in the slide and it is still not clear we will get outcomes that bad.

When that slide was presented I thought it overly – indeed insanely bearish on housing losses – and I still do.  WaMu had loan balances of 176 billion and JPM was predicting a loss over the history of those loans of 54 billion in its severe recession scenario. 

To get that loss more than half the loans WaMu made had to default.  If you assume any reasonable recovery the default rate probably had to be north of sixty percent.  

Even in a severe recession that seemed unlikely to me.  I know a few WaMu customers (middle class, northern California, financially stressed) and whilst some might default it seemed unlikely that half would.

There is – in America – a core group of people who believe that you should pay your home loan.  It is bad out there – but WaMu did have some old loans in its book – which even with 40 percent house price depreciation were going to have positive equity.  Also WaMu’s book was at least in part diversified by states.

If you believed in $54 billion in losses (and I don’t) then it is right that WaMu equity was worthless or near worthless even if Sheila Bair had granted some forebearance.

Why financial institutions lie

Most the time problematic banks have an incentive to spin their position as better than it is.  Banks lie about the quality of the assets on their book.  They do it all the time because if their capital appears adequate their cost of funds will be lower and the availability of funds will be higher.  Having funds available at low cost is central to bank profitability.

Most banks have huge and responsive investor relations functions – because continuously convincing the market of their credit worthiness is a core operating function.  The guys staffing these IR departments are usually nice enough – but unless you can piece together their statements over a period of years then you are probably best advised not to believe much they tell you.

Bank IR and financial management are very practiced at spin.  

They will really get to lying if the Government chooses to buy bad assets from them.  I can just imagine the scene – lying bankers (there is no other kind) on one side – and suckers – also known as taxpayers – on the other.  

There are exceptions to the rule that financial institutions spin the positive.  Ambac (a credit insurance company) is a company that is brutally bearish with you if you go do an investor relations meeting.  I have done that – and you come out wanting to slash your wrists.  Ambac is writing no business.  It is trying to settle old claims presumably for less than the present value of the claims that they will have to pay.  If they can convince people that there is a high probability they will not be around in six years to pay the claim then claimants might settle for 60 cents on the dollar now.  Indeed the only reason why you wouldn’t settle for 60c on the dollar now on an Ambac claim is that you haven’t taken the hit in your own balance sheet.  [Barclays is an offender here.  It will not settle some claims because it does not want to recognise its own losses.  Oh, and there is a high possibility that Ambac will not be around to pay the claims which will be problematic for some...]

Anyway because Ambac is trying to settle claims they have an incentive to make their credit look worse than it really is – that way you get to settle the claims cheaper.  [Funnily MBIA is not playing that game.  My view is that MBIA is worse than Ambac – but is pretending it is better.]

The incentives on JP Morgan

Consider the situation that JP Morgan was in when they were negotiating with Sheila Bair to convince her to confiscate WaMu and to hand it to them.  JP Morgan had previously been willing to buy WaMu for $8 a share.  They had done due diligence on it twice.  But here was the opportunity to buy it for less-than-nothing – if you could get it confiscated first. 

Bluntly JP Morgan had an incentive that few banks actually have – which is to high-ball the loss estimates.  Their job was convince Sheila Bair to confiscate the bank.  How do you do that?  Well you tell bad stories.  You have to make it seem that even in modest recessions (their severe recession case was a modest recession by current standards) that the losses would be enormous.

So – consistent with incentives – they high-balled the losses to Sheila Bair – and then – to be consistent – they highballed the losses in the public presentation.  They were of course doing what bankers do – which is lying when they have the incentive to lie.

Calculated Risk swallowed that lie.  They know better than to swallow overly bullish lies.  They should also know better than to swallow overly bearish ones.

General rule: believe nothing bankers say when their incentive is to lie.  Verify everything you can.  If you can’t verify then discount veracity appropriately.  If they are investment bankers they lie more convincingly than regional bankers – though both are pretty convincing.

John

PS.  This was a situation where a banker (Jamie Dimon) was buying something (WaMu) from the government (Sheila Bair).  The lying banker got the better end of the deal.  

It won't be any different if banks sell things to government.  The lying banker will get the better end of the deal.  If the private sector is in for 10% of the equity it will help but not solve the problem...

PPS.  I suspect I am meant to comment on the plan.  I don't think there is a plan.  Stress test everything is not a plan.  Indeed I think the stress tests have the same lies built into them that everything else does.  Third party assessments is a plan - but it requires an openness that banks are not familiar with - and perhaps a billion dollars in accounting bills (which is I guess stimulus).  

Not ordinary fires

I do not want to say much about the Australian fires - but this photo of molten metal from burnt cars gives you some idea of their intensity.

For the record - apparently these were aluminium alloy wheels.  The melting point is just under 1000 kelvin.   Way hotter than lead (600 kelvin).  Iron melting point is 1800 kelvin - furnace temperature.  There are incidents of iron being serious impaired (eg children swing sets that collapsed with heat damage) but I have not seen plausible photos of iron melting like this...

J

How good is the Wall Street Journal?

Or alternatively how bad is the New York Times?

The Wall Street Journal was the only major American paper to increase its circulation last year.  Given the malaise of newspapers its a miracle that any paper increased circulation.

However they did it after increasing their cover price as this old Seeking Alpha article reminds us.   

It is hard to find any business anywhere (let alone a newspaper) that managed to increase prices and custom last year.  Now part of it was that the financial crisis made financial news interesting.

But at least part of it has to be the demise of the once-great New York Times.  

I guess Ben Stein is the Sulzberger family gift to Rupert Murdoch.

For competitors the failed editorial of the New York Times (Krugman excepted) is the gift that keeps on giving... 

John

Weekend edition: The conspiracy to keep you poor and stupid

First- a brief book review:  Nontechnical Guide to Petroleum Geology, Exploration, Drilling and Production – Norman J Hyne.

This is a good but dull book - a handbook of upstream oil process – how a drill works, all the processes involved in guiding drills, essentially a technical manual aimed at scientists and engineers who want to get up to speed (and hence useful) in the management of upstream oil and gas.  If that is what you want I highly recommend this book.

I do not believe in investing in any industry until you understand it – and this will give you a very good understanding of the oil and gas industry.  If your fund manager doesn’t read stuff like this then find a different fund manager.  (This book is about widening your circle of competence.  I am hardly recommending it for general reading – but we found it useful.)  

The real purpose of this post

Norman Hyne is very matter-of-fact.  For instance – without reference to whether such a thing should exist – or without reference to the vast scientific revolution that was required even to say such a thing – Hyne talks about 14 thousand feet of sediment.  Sometimes he talks about 20 thousand feet of sediment.  And it goes without saying that the world must be very old for this sediment to exist.  The author won’t even bother entertaining the idea that the world is 6000 years old (and that the sediment was all laid down in some biblical flood).  That notion is of no use whatsoever to a field petroleum engineer.  

Likewise there is a chapter on analysing drill core samples.  This is done by analysing micro-fossils – weeds and seeds.  The organising principal of the theory is evolutionary biology.  Creation Science is not entertained.  Norman Hyne is a practical guy – and he wouldn’t mention such “theories” because they are no use in drilling for oil.  Indeed you will find no worthwhile petroleum geologists who view creation science as a useful theory in finding oil.  

We have just had a US President whose fortune was built on oil.  We had a VP who was CEO of Haliburton – a major upstream oil contractor and technology provider.  These people know that Creation Science is useless – that it will not help you find oil or make money.

Yet – admittedly with political considerations at heart – they were active or passive supporters of creation science crap.  They knew it would keep the constituents poor or stupid – and yet – for understandable political reasons they backed it.

One of the more famous conservative blogs is called the Conspiracy to Keep you Poor and Stupid – but I have only once found such a conspiracy.  And that was on the conservative side of politics.

I have said on this blog that conservatives sometimes have a better grasp of reality than liberals.  They tend to have a more realistic view of the human condition than many starry-eyed liberals.  However this is another example of conservatives becoming the anti-science reactionaries of American politics.  Lots of real reform (eg greenhouse) will not be done well until conservatives engage properly with the reality.  This is yet another plea for American conservatism to get back its intellectual strength.  It really is time...  

John Hempton

I have been criticised in the email and in the comments for a political sermon - the belief that creationism is a straw man to beat the political drum on.  

I wish it were true.  Over half the US population in some surveys believe this crap.  I have seen high profiles conservatives describe evolution as "the liberal creation myth".

These are the same conservatives who have anti-science belief elsewhere.  Everytime I mention greenhouse the blog goes wild.   The temperatures of over 120 farenheit that my parents in law (rural southern Australia) experienced on the weekend  may not be driven at all by the greenhouse effect - but my feeling is that the burden of proof is now totally on the climate-change-deniers.  A couple of hundred dead (in the resulting fires) tends to focus the mind - and my mother in law - usually a tough old woman - spent most of Sunday crying...

Once Maggie Thatcher argued (indeed demonstrated) that lots could be achieved if you appealed to individualism.  She was right.  She had a decent understanding of the human condition.  I might not agree with all she aimed for - and ultimately I think there are non-market goals.  But the position had strengths and we should keep the good bits of it.

But the Maggie Thatcher view that financial markets could regulate themselves is now a smouldering ruin called the Royal Bank of Scotland.  

How we get a facts-and-circumstances driven politics is something that regularly makes me ponder.  Its is also the central political question of the next ten years - how we keep the good bits of the Thatcher/Reagan revolution (a general belief in markets and the worth of the individual) whilst tossing the bad bits (lack of environmental responsiveness, failed financial market regulation etc).  

If I sound like I am giving a sermon I apologise in advance.  But my guess is that the same people who believe in creation science are the people who believe that climate is the realm of god - not the realm of human ingenuity and destructiveness...

J

Finally - the real issue with greenhouse for this blog is the notion that it is real and it will effect investments.  For instance if heat-waves of the kind experienced in southern Australia are common then fruit trees in the Goulburn Valley are not worth what they used to be.  (You have a hard time growing peaches when the temperature is 120 farenheit.)  

Likewise governemnts will do things and that will change the value of all sorts of assets (coal, nuclear, hybrid cars and lots of things I can't think of).  All of that is worthy of consideration.