Wrong again - on AIG

There is only one piece of AIG that is still highly valuable – which is the core American P&C business (including some auto businesses).  AIG has for instance merged AIG Direct into its fully owned 21st Century – a California Insurance Company.  That business is still a very effective competitor – but their website no longer mentions those three letters (AIG) – I guess to protect the value of that business.

Life companies (ALICO etc) are not anything like as valuable as they were.

I posited in this post that the Feds were taking their interest in direct ownership of the valuable bits of AIG – so that they could let the mothership go.

I was wrong.  The Treasury announcement contains this phrase:

The Revolving Credit Facility will be reduced in exchange for preferred interests in two special purpose vehicles created to hold all of the outstanding common stock of American Life Insurance Company (ALICO) and American International Assurance Company Ltd. (AIA), two life insurance holding company subsidiaries of AIG. AIG will retain control of ALICO and AIA, though the New York Fed will have certain governance rights to protect its interests. The valuation for the New York Fed’s preferred stock interests, which may be up to approximately $26 billion, will be a percentage of the fair market value of ALICO and AIA based on valuations acceptable to the New York Fed.

If the government wanted to protect taxpayers it would take control of the really valuable bits of AIG through this sort of structure.

They are not doing so.  

Taxpayer protection bought to you by Geithner, Obama and Moral Hazard’s other friends.

As for investment theses - I have gone through a few iterations thinking AIG debt might be worth par to my recent view that it might be worth zero to my current view that it is worth whatever Mr Geithner will make available for you.  

John

HSBC are to blame

Of all the ways to lose money – one of the most painful is to be right and lose money.

It doesn’t happen to unlevered longs.  If you have no leverage (financial and operational) you can buy a share – and if it goes down on the way back up you will be fine.  If you are a trader (who almost always operate with some leverage) that won’t help you.

But on the short side you can be in a stock which goes from 10 to zero via 20.  That is what happened to me with Conseco.  I held on – but it was painful.  Very painful.  In some instances (notably Calpine) I did not do much of a job of holding on.

But even worse is when some bozo idiot (in my case the idiot was often Sir Fred Goodwin) comes in and buys the company out at a massive premium when you are short it because of looming disaster.  Then you can’t recover (except perhaps by shorting the bozo idiot acquirer).

My story

I once shorted Household International from 50 to 20 via the mid 60s.  It took a long time to play out and for a long time I was losing money.  

I covered – not for any particularly good reason but that I wanted my capacity for other shorts.  

HSBC came in and bid for Household subject to due diligence.  I thought that they would find enough on due diligence to make them run (and run and run).  So I reverse arbitraged the takeover – going long HSBC and short Household in the hope that HSBC would come to its senses.  In this case if I was wrong the deal would close and I would lose the spread.

If I was right Household would probably have failed right then.  If HSBC thought Household was not worth buying then its doubtful anyone else would have financed it.  

So if HSBC had come to its senses then I would have made a little over 100% on my position.  Fantastic really.  

But HSBC were bozo idiots and they completed the trade.  I lost the spread.

HSBC are now forced to raise huge amounts at a highly dilutive rights issue to make good the losses.  But their pain does not refund my clients.  Intellectual satisfaction is nice – but I really would prefer that refund.

A counterfactual

Had HSBC done a proper due diligence on Household and understood what they were purchasing they would never have done the deal.  I would have made out like a bandit.

Household – then the biggest subprime mortgage company in the world - would have failed in 2002.  

People would have (correctly) understood that subprime mortgages and securities backed by subprime mortgages were dangerous.  The capital markets would have been (far) less open for dodgy mortgage paper.

And the mess we are in today would thus be far less intense.

The real purveyors of moral hazard

People deride governments and central banks for bailing out bad banks.  The critics argue (fairly) that those bailouts encourage risky behaviour (by failing to punish it) and hence make the next crisis far worse.

All true enough – but by far the biggest bailout last cycle was the bailout of Household – the world’s biggest subprime mortgage company – by the respectable HSBC.  

By contrast the US Government let Ameresco, Conti Financial and a few other mortgage companies fail.  Compared to Household however these companies were tiny.

HSBC are the villains here.  They provided the assurance that got this subprime mortgage thing really rocking.  They are who you should blame.

The shorts

There is a lot of nasty things said about short sellers.  And short sellers say a lot of nasty things about the companies that they are short.

I said nasty things about Household to anyone that would listen.  I had a bet with a UK analyst that HSBC would close or let Household (which was not guaranteed) fail before 2007.  I lost.

But sometimes – just sometimes – the world would be better off if short-sellers were taken more seriously.

John 

Restructuring AIG – letting the mothership go

The rumoured AIG restructure should make the hardline – hit-em-where-it-hurts-and-get-rid-of-adverse-selection crowd happy.

The government is going to swap its debt in the parent company into an interest in each of the subsidiaries.

As a result it is subordinating all parent obligations to the Government’s claim.  

Once you do that you can let the AIG parent company go.  The parent company debt is trading above 50c in at least some maturities.

I once thought the AIG parent company debt was probably money good.  I suspect it is now probably zero.

Not too bad a thing either – because the AIG parent company is not systemically important.

Four times slaughtering a dead horse

Editors note

This is the fourth post on a quarterly set of numbers from Bank of America.  That post sent my in-box on fire.  The disagreement was absolutely vehement.  Even when I mention global warming I do not stir up passions like this.

If you want to follow the saga read the posts in reverse order.  Start with this post, then this and then this.  Finally get to this current post.  However if you are willing to accept my assertion that bank margins are rising regardless of subsidies then just ignore all but the first post.

I fully agree that – if at the moment – the FDIC guarantee were removed then Bank of America would fail.  That failure would happen regardless of whether Bank of America is actually capital adequate or not.

However if the guarantee were removed the few banks around that were considered solvent would be flooded with money from people who wanted to put it there.  

They would get those deposits very cheaply.  Really cheaply.  Free in fact.

The lending situation would be truly diabolical though.  The rate customers would pay would go up sharply.  

Bank margins would be truly spectacular.  The problem would be survival to take advantage of those margins.

There is only one reason at all you are paid interest on bank deposits.  It is that they are guaranteed.  

Go to Bankrate.com.  Look up the highest rate you can find.  It is usually Corus Bank – which as noted here – is truly diabolical.

If you want to attract deposits you have to compete with Corus Bank.  Corus Bank has those deposits and has the ability to attract them purely because it is guaranteed.

Note this.  The guarantee raises the number of serious competitors in the deposit market.  It raises the cost of deposits and it hence lowers bank margins.

Yes I stand by the assertion that if the guarantee were removed bank margins would rise – and deposit costs would fall.

Access to funds at all would be the issue.  Not their price.  Offering to pay for funds would not help (see the Akerlof Paper on the Market for Lemons for a good theoretical explanation).  

Now when is it that my readers - usually with good economics training - stopped believing that the main determinant of margins is competition - and that subsidies given widely do not increase the income of the receiving industry - but just get competed away?

Trying to thrice slaughter a dead horse

Bank of America’s stock price in July last year was still $25.  It was above 30 for most the first quarter.  

In those days nobody seriously talked about a Geithner put on Bank of America.  Certainly the average Bank of America depositor did not think about the FDIC guarantee.

Both those quarters were record revenue quarters (other than trading revenue).  

The Geithner put does not explain the rising margin of Bank of America in those quarters.  

Bank revenue has been rising fast across the board since the first glimmers of the subprime crisis.  It has happened even in parts of the bank that are not guaranteed.  

It is a global phenomenon.  Well except in Japan.

It is not surprising at all.  The margin collapsed when money was freely available and banks were grovelling to lend money.

Now banks are able to (a) tighten credit standards, (b) raise rates and (c) have customers come begging.

Banks have the upper hand when dealing with loan customers and it shows in their numbers.  

Once banks wined and dined potential customers.  Now potential customers wine and dine bankers.

Bank revenue is rising.  It is rising faster when governments guarantee their funding – but it is nonetheless rising pretty well across the board.  The explanation for that rise is at best in part taxpayer subsidies.  But that is not the only explanation.  The competitive dynamics are far more important in explaining why revenue should rise.

Why is it that people have given up believing that competition is the main determinant of margins?

John

Ideology over numbers

Simple observation required here.  Almost every comment on my post about widening interest margins argued that they were only widening because of guaranteed funding by the Federal Government.

It is simply not true.  Look at the numbers and the interest margin was widening sharply until the third quarter of 2008.  Indeed interest revenue was a record every single quarter of last year – and that was the case at most banks.

Bank of America did not get any guarantees until that point.  You can do the maths on the guarantee and they cannot explain the massive surge in the fourth quarter (too little money, too late).  In the Bank of America case most of the guarantees were backstop after they purchased Merrills.   They happened this year and hence outside the fourth quarter.  

Revenue is rising at pretty well every bank I look at.  Doesn’t matter if it is in America or not.  It doesn’t matter whether it got a lot of government assistance or not.

Just accept it – for franchise banks – those that have good access to deposits or other sources of funds – revenue for a bank is rising.

It rises faster if the government will lend you wholesale money at government interest rates.  But it is rising regardless.

This should not surprise people but there is resistance.  In the boom there was no government assistance – and yet interest margins went down and down and down and down.

The banks levered themselves up further and further to get what they deemed acceptable ROEs.  

At the moment the reverse is happening.  Margins are going up and up and banks can’t de-lever themselves fast enough to survive.  

 

John

PS.  Just to further rub in the numbers - a liquidity trap means people save cash rather than spend.  That is the macro problem.

So deposit balances are growing sharply.  Bank of America deposits were up from 492 to 583 billion over the past year.  I think that is good news for Bank of America.  The cost of those deposits on average was down sharply.

Further - the non-interest bearing deposits were up by 25 billion.  The bank gets to lend those new deposits at marginal loan rates slightly above their average loan rate of 560bps.  One and a half billion dollars of the rise (annualy) is explained just by those numbers.  The vast increase in the extra low-rate deposits explains a good proportion of the rest.

If you think that bank revenue is rising simply because of the government guarantees then you are letting ideology get in the way of the numbers.  Bank deposits are rising.  The cost of those deposits is falling.  Banks with good franchises are finding that they don't need to chase to get zero rate deposits.

The opportunties in banking are wonderful - provided you can survive to take advantage of them.

A series of quarterly numbers

Here is a series of quarterly numbers

Quarterly  

   

12/2008 13,106 

09/2008 11,642 

06/2008 10,621 

03/2008 9,991 

12/2007 9,164 

09/2007 8,615 

06/2007 8,386 

03/2007 8,268 

12/2006 8,599 

09/2006 8,586 

06/2006 8,630 

03/2006 8,776 

Obviously this number has been getting bigger over time – and very dramatically bigger this year and particularly in the fourth quarter.

So what is it?  The credit loss series for a bank?  No – but it is a bank.

It is – wait for it – the quarterly net interest income for bank of America measured in millions of dollars.  

It’s a good number to be big – and it is getting bigger rapidly now.

The fee income is also growing but only if you net out trading losses.

Felix Salmon objected (quite strenuously) to my pre-tax provision number in the long post.  His objection is here.

Well here is the oddity.  Other than for banks with substantial trading income (or losses) the fourth quarter has been an absolute record at just about every bank I am looking at.  Sure if your losses are huge then your net interest income could be going backwards (as per Corus bank).  But that is the exception.  If this trend continues (and I think it will) then my pre-tax, pre-provision estimate in the long note is dramatically low whereas Felix was sure it was high.

Saying something nice about banking is certainly not the common parlance in the blogosphere.  Yves at Naked Capitalism for instance commented on this section – quoting from a WSJ article:

From the Wall Street Journal:  Citigroup executives are attempting to strike a seemingly impossible balance: Run the business in a way that will please their new federal masters, but also help the bank rebound from $28 billion in losses over the past five quarters.

Yves: That is another company-serving bit of spin. Does anyone think, with pretty much all advanced economies contracting and deleveraging likely to continue, that there are great profit opportunities out there? 

Well yes Yves.  Even with pretty much all advanced economies contracting there are opportunities in banking.  

Indeed provided you can maintain access to funding the opportunities in banking are the best that they have ever been in my life.  The margins are massive.  Many people want (even need) to borrow money – and if you have money to lend you can select on the absolutely best credits.  Your risk is much lower than it was on the average loan in the boom.  The implied return on equity is much higher.

Happy days.

Of course they are happy days only if can maintain your funding (far from being a given) and you do not have losses so big from the boom that you will be wiped out (also far from being a given).

But in the past most banks that have got into trouble have been recapitalised by pre-tax, pre-provision earnings.  And at the moment pre-tax, pre-provision earnings are going up.

For the record this is very different to Japan.  In Japan bank spreads collapsed to 30bps.  They did this because of the vast excess deposit bases at zero interest rates.  But I cannot find another banking crisis in which bank spreads have fallen.  Does anyone else know one?

John 

Memories of the bull market

Citigroup (once Salomon Smith Barney) in Sydney used to have the biggest and best Christmas parties.  

Picture this: a balmy Sydney night and the investment banking clients and the whole 30ish Sydney investment banking crowd converge on a warehouse on the docks.  Girls in bikinis serve champagne to blokes in suits with no ties and that dishevelled look you get when you have drunk too much.

There is always a band.  A big name band – but the identity is kept secret until about 10.30pm when the act comes on.

One year it was Jimmy Barnes.  That might not mean anything to an American – but he is the iconic aging rock-and-roller here.  His original band (Cold Chisel) sang the Vietnam song that still gets everyone singing around a party (Khe Sanh).  But in his solo career his biggest hit was a song called "Working Class Man".

My single most enduring memory of the bull market is a thousand drunk investment bankers howling at that song and the top of their voice:

"well I’m a working class man

oh ma ma . . . . . . . I tell you I'm a working class man".

You can enjoy Barnsey belting it all out again courtesy of You Tube.

Wrong again - on AIG

This blog aims to admit its mistakes.  This is an admission that this post was spectacularly wrong.

The main reason why the that post was wrong was that I assigned a very large value to AIG's life insurance businesses - and in the meantime pretty well every life insurance company in the world has imploded.  (See Hartford for a good example.) 

With the written down value of life insurance companies (and AIG is fundamentally a life insurance conglomerate) there is no hope that core bits of AIG can be sold in any reasonable time frame.  Hartford might come back as Peter Eavis posited in the WSJ - but I am not holding my breath.  Likewise there is some hope that the life insurance bits of AIG can find a bid one day.  But not today.

AIG was about 50% life insurance, 40% property and casualty and 10% the rest which included some very bad bits (mortgage insurance in the US) and some truly unbelieveably bad bits (AIG Financial Products).  

Even if it had not been for AIG Financial Products a company as dependent on life insurance as AIG would be in deep trouble now.  It would - for instance - almost certainly be trying to raise capital in the same manner as Manulife.  

J

Corus bank

FDIC taking over WaMu and forcing Wachovia to the altar were unusual events not because the banks were large but rather because the banks were arguably viable when the FDIC acted. WaMu was capital adequate when taken over. My view is that it would – if left to its own devices – have survived – though it was touch and go. Without implicit FDIC support it was done for. Wachovia actually found a buyer without government support.

The FDIC usually waits until very late in the piece to take over a bank. With very few exceptions banks are shockingly insolvent by the time the government acts.

Lets do a comparison. WaMu still had 8 billion of pre-tax, pre-provision income – and that was enough to deal with what I thought were likely losses (30 billion or so – when WaMu was predicting 20 billion).

By contrast Corus bank - not yet taken over - is truly unremittingly awful. The the pre-tax, pre-provision income has disappeared. Banks should probably be confiscated before that event – but whatever – when that happens no amount of “voodoo maths” will save you.

So if you want to see what a truly insolvent bank looks like look at Corus Bank. I am not telling you anything new – they have signed written agreements as to how they will manage themselves and they have paid their senior staff retention bonuses so that they can manage. Here is an extract from their annual results.

Nonaccrual loans have grown to $1.5 billion, more than one-third of total loan balances outstanding at December 31, 2008. Combined with other real estate owned (“OREO”) of over $400 million at year end, most of which was foreclosed on during the last quarter of 2008, Corus’ nonperforming assets at December 31, 2008 totaled $2.0 billion. This extraordinary level of nonperforming assets put such negative pressure on Corus’ net interest income that it fell below zero for the quarter ended December 31, 2008. Empasis added.

To get an idea of how bad this is, non-performers were five times capital. Negative net interest income and there is no future – none, nada, zip. There is no income to bail you out.

In the words of Monty Python, this one is “pushing up daisies”.

Anyway what is strange is that some banks in America look like this – and others have non-performers of well under 1 percent. The system may be solvent (and I think it is) but there will be a few more Corus banks out there.

John

PS. This is a personal disgrace. I read Corus’s accounts in 2006 and never shorted them. That was despite a stated business model of being a specialist lender to the developers of condo projects.

PPS. The retention bonuses for the staff – critical staff in keeping this thing run – are – wait for it – 125 thousand dollars. When you see multi-million dollar retention bonuses to the people who failed what you see is theft. Whether the 125 thousand is theft is a matter of taste – but it is almost certainly a practical payment to keep people around at a bank with no future.