An uncomfortable observation for GE common

One of the cases for GE is that GE does not guarantee GE Capital Services (GECS).  GE has less than 40 billion in debt outside the GECS structure – and if you buy GE and they let GECS go you get

1. The industrials business which – as GE points out – makes about 17 billion in cash a year and requires only 3 of capital expenditures, and
   
   
2. NBC Universal – which happens to own a few nifty (and well watched on Wall Street) cable channels.
   

This sounds like nice downside protection – except that the FDIC tied General Electric up.  Not that I am used to saying anything nice about Sheila Bair – but the FDIC guaranteed debt that GE Capital issued has a guarantee from the parent company – at least as per this disclosure in the GE Capital Services form 10K.

At December 31, 2008, GE Capital had issued and outstanding, $21,823 million of senior, unsecured debt that was guaranteed by the Federal Deposit Insurance Corporation (FDIC) under the Temporary Liquidity Guarantee Program. GE Capital and GE entered into an Eligible Entity Designation Agreement and GE Capital is subject to the terms of a Master Agreement, each entered into with the FDIC.  The terms of these agreements include, among other things, a requirement that GE and GE Capital reimburse the FDIC for any amounts that the FDIC pays to holders of debt that is guaranteed by the FDIC.

Sheila Bair protected the taxpayer – but at the expense of crisis residual value in GE.  

Of course this is only operational if GECS fails.  And whilst I have worked quite hard on that - and my prima-facie view is that it does not - I will admit I just do not know.

John

Hey guys – you can make a much better investment than Warren Buffett

Warren purchased some GE converts a while ago.  Got what looked like a sweet deal at the time – a big yield and a nice conversion.

With where GE and GE debt is trading now you can – by buying debt and equity – produce a hybrid instrument that is (a) senior to Warren, (b) has a higher yield than Warren and (c) has better effective conversion terms than Warren.

Warren has stuffed up before.  He purchased Irish banks last year.  He purchased oil companies when the oil price was high.

But GE – wow.  Maybe his ability to analyse it is no better than any of ours.

From the wonderful vaults of General Electric

You need to do something special to get into the GE Annual report.  Ordinary revenue producers do not get a photo.  You need to be special.

And so – with a sense of foreboding – I give you an image from the 2005 GE annual report.  I do not have a soft copy because this report was restated and GE does not keep a soft copy on the web.  

So I scanned it.

The image I think is Ortakoy Mosque and the Bosphorus Bridge.  Turkey.  I have never been there so I stand to be corrected.

Snow on the Bosphorus was a memorable image and I doubt I would have remembered the photo without the snow.

The likely lads in the photo are Charles Alexander, President of GE Capital Europe, Ergun Ozen, Chief Executive Officer of Garanti Bank, Ferit Sahenk, Chairman of the same bank and Dmitri Stockton, Chief Executive Officer of GE Consumer Finance, Central and Eastern Europe.  

Central and Eastern Europe - and Charles Alexander's UK mortgage business are amongst the main areas of concern of people shorting General Electric.

The last guy (Stockton) at least is still in his position.  This is either a darn good sign (he hasn’t blown up and was really clever avoiding a freight train) or a darn bad one (he has blown up – but the powers that be haven’t worked that out yet).  

Informed comment wanted.

Memo to Jeffrey Immelt – if you are going to lie you have to do it more convincingly than this

• GE sold its mortgage insurance business before the crisis broke.  That was high quality risk aversion.

• They sold their bond insurer (FGIC) to a combination of private equity and PMI Inc.  I figure the private equity buyers are hurting – PMI trading at less than a dollar surely is.  Again this is the mark of superlative judgement.

• I know the guys who run the Australian mortgage business.  They started cutting back risk very early.  The staff who used to get paid on volume are very unhappy indeed because – well – as credit standards tightened volume dropped.  Another mark of superlative judgement.

• They sold their life reinsurance business to Swiss Re.  I suspect Swiss Re is hurting - and indeed Swissy had to sell a big stake in itself to Warren Buffett - I suspect to partly cover those losses.

• They sold their P&C reinsurance business as well.  That is probably doing OK – but it carries a long tail risk.

• They sold their long term care insurance business.  That player – now part of Genworth – is the best company in the world in one of the worst businesses in the world.  The risks were high.
  

GE Finance in other words cut back on risk.  A lot of risk.  Mostly the right risks.  And they cut back on risk early – before the crisis hit – when they got good prices for rubbery assets.

I have argued at times that Immelt is the best CEO in the world for that. I even owned the stock for some of the fall in the price (though I have not owned it for a while). 

It was an article of faith for me that when you see consistent bad behaviour by a bank or an insurance company in one area it is usually rife.  You can’t know everything in a bank balance sheet.  Not even the CEO and CFO have a hope of that.  

Symmetrically if you see consistent good behaviour then you can guess that the good behaviour pervades the book.

When analysing a financial all you can judge is the culture – and if the culture was cleverly cutting risk in areas you knew really well it was probably cutting risk everywhere else.  

GE looked pretty good to me.  The behaviour exhibited was smart and consistent.

The problem

In finance you make profits in normal times by carrying risk.  The more risk you carry generally the higher your "normal time" profits are.

If you cut risk – as GE did – then your "normal time" profits will fall.  GE Capital profits did not fall as they cut all that risk.  That was very strange.

There is no question that GE fudged its results a little bit in order to keep reported profit momentum when actual profits were falling.  Gradient Analytics did a solid report on GE showing how they had systematically stripped reserves in many businesses.  

The bears travelled from the analysis of fudged accounts to guessing (and it can only be a guess) that GE must be full of toxic assets.  

I thought the negative reports were overly bearish.  I watched what they did more than I watched the accounts and what they did told me they were very good.  

The summary was that they were doing the right thing and their profits were falling for good reasons – and they were lying about the profit fall.  

Normally I have the view that a company that lies about its earnings in small ways has a lot to hide – there never been only one cockroach – but I was desperately impressed at the big-picture things that GE was doing.  To the accounting junkies GE was diabolical – because they lied.  To them sanctity of accounts is the true mark of quality of a business.  I am a little less pure than that – but maybe I should listen more.  I went long GE in the thirties.

Now my buy case for GE depended on them being a capital equipment exporter with costs in US dollars and with Asia growing like crazy.  This was the decoupling fantasy that cost a lot of investors (including me in this instance) some pretty coin.  As the world now knows China fell into the economic abyss sometime in the third or fourth quarter of last year and the upside case for GE (capital equipment sales) collapsed.  I sold for a bad loss – but it would have been a worse loss had I held.  

Anyway it is not true that GE kept cutting back risk.  They took a few too many risks in commercial property and even Immelt admits problems in UK mortgages.  The risk de-jour though is that they tied themselves up in Eastern Europe – and until very recently they were boasting about as a presentation show made in September last year shows.  (That presentation seems to have disappeared from their website).

Still according to Immelt’s letter GE Capital made $9 billion last year.

Sorry – I do not believe it.  Indeed the claim is comical.  Here from GE’s recently released annual report is a table of non performers and reserves.

In almost every financial company reserves have had to rise faster than non-performers over the past year.  Why?  Well consider how a non-performer becomes loss.  We will do it in the case of a mortgage:

1. The customer stops paying full interest.  They do this because they have had a hiccup in their business or life that is temporary or semi-permanent.  If they are an electrician and fell of a ladder you can bet that once their broken leg is healed the non-performing loan will again perform.  But if they are an auto worker who loses their job they might not get another one for a year or two.  You are probably going to foreclose.  The chance of a non performer defaulting goes up with unemployment.
   
   
2. Then once the loan defaults you need to sell the property.  If you haven’t noticed the loss given default has gone up sharply.  

In summary the chance of a non-performer turning into a loss has increased sharply so the ratio of reserves to non-performers should go up sharply.

What if I told you that the reverse was true at GE.   In many of the lines of business reserve coverage went down – often down sharply.  Not great.  Not even plausible.

Real GE profits

The funny thing is that it never needed to be this way.  GE was still – even on my adjusted numbers – profitable last year.  I have seen some bear-case estimates of the loss on the ground in various GE businesses and they look high to me.  These are guys who estimate losses by looking at accounts – and the losses GE will take are – in my view – substantially less than market because – on the ground – I have seen them operating in a lower-risk manner than their competitors.  

The problem of course is you do not know.  Summary: mostly good behaviour – bad accounts.  Sure I have heard some instances of bad behaviour – but they are thinner on the ground than the good things.  

Jeffrey Immelt in his letter says that he takes responsibility for the loss of reputation of GE.  If that were an operational responsibility he would resign.

And on the basis of his accouting he should.  

But I am not calling for his resignation.  On the risk management described at the top of this blog post he remains possibly the best CEO in the space - and he is way better than any obvious replacement.

GE as a parallel for America

Speaking as an outsider I have to agree - America at its best is a wonderful place.  It is amazingly productive.  The degree of specialisation of people and the cities they live in is wondrous.  The innovation is jaw-dropping and it has changed the world.  

Silicon Valley is a wonder of the modern world.  But so are half a dozen fecund places in America.

So is General Electric.

America has plenty to recommend it - and if I did not love Australia so much you would see me on the plane yesterday.

But the accounting sucks.  It sucked when the broker certified the taxi driver's income at $350 thousand for the purpose of the no-doc loan and it sucks when Immelt certifies the reserves in GE's accounts.  

It sucked when the Bush administration regularly and systemically misestimated the US budget deficit and it sucked when the SEC went after truth-telling short sellers rather than easily provable frauds by powerful people.  

But beyond all that accounting when the mess is cleaned up the good stuff about America will probably still be there.  

Will GE will still be there?  Well I think it will probably will - but without a huge run through the accounts and without your lie-detector running full blast - well it is very difficult to know.

I am trying to do the work.  But hell - this one is really hard.  Six Sigma precision - that I cannot deliver.

John

Disclosure: no position but leaning long.

They read me in Washington!

The latest leak from the WSJ about the details of the Geithner plan should sound very familiar to readers of the "long post".  Even the numbers are the same as the long post.  To quote:

These private investment managers would run the funds, deciding which assets to buy and what prices to pay. The government would contribute money from the $700 billion bailout, with additional financing likely coming from the Federal Reserve and by selling government-backed debt. Other investors, such as pension funds, could also participate. To encourage participation, the government would try to minimize risk for private investors, possibly by offering non-recourse loans.

The public-private partnership grew out of the "bad bank" concept, an idea popular among some economists that would have required the government alone to buy up the troubled assets.

Maybe they read me in Washington - even if it is only briefly.  

Calculated Risk thinks its a bad idea - but say 100 billion of private money lying in front of public losses is a real capital injection into the banking system.  Big money too.

That seems better to me than all the capital coming from the goverment.  If you are ideologically hooked to the nationalisation solution then private money is bad.

Calculated Risk's objection is that the money is non-recourse.  But all banking capital is non-recourse with the taxpayers - through the FDIC bearing the downside.  As long as a fair bit of capital is required (as it should be required for banks) this is not dissimilar to new private money starting banks.  

I doubt Calculated Risk would have an objection to that.  The issue is not non-recourse - it is the ratio of private to public money because if only a slither of private money is required there is little real risk transfer to the private sector.  If a lot of private money is required there is real risk transfer and this plan is the real-deal, but would reduce the chance that the private money could be found.

I gave ratios of 6.5 to one or 7 to 1 because those were about a third where banks were allowed to operate and these funds will hold what on average will be riskier assets.  Numbers - not the concept - should be the realm of debate.

John

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.

We are not close to being Swedish yet

Nouriel Roubini has a newspaper article that says we are all Swedish now. I wish it were true. We are nowhere near being Swedish.

This is an investment blog – so – in tradition of investment blogs I am going to start with a stock chart.

This is a chart of a bank – I have removed the currency and the name of the bank.

The bank could be any bank that (nearly) collapsed in 1992 and recovered. It could be Citigroup or a small property exposed regional (such as North Fork). But it isn’t.

It is Skandinaviska Enskilda Banken, a Swedish bank which – at least in those days – was more upmarket and had a large corporate loan exposure.

It was in deep trouble. It was involved in a government support process which – had they failed various tests – would have wound up in nationalisation. The market truly believed that it would be nationalised. The only thing that kept it liquid was the implicit support that if it failed certain capital tests (weak tests because buffers were reasonably used by that time) then it would be nationalised.

It didn’t fail the tests. It got some private money. And the stock went to the races. The stock was a 20 bagger in 18 months. The bank however was implicitly supported by a process that could end in nationalisation. (That is it was solvent and would have been illiquid if not for implicit government support. It was a crisis - but a crisis alone was not enough reason to nationalise a Swedish bank.)

Here is another chart – this one is Svenska Handelsbanken – one of the better managed banks in the world. It too was loss making at the height of the crisis – and it had elevated losses for several years.

This bank did not even apply to be enrolled in the government support program (though it did consider it). It decided (with some justification) that it would get by fine. However the bank sure looked done for.

Swedish bank nationalisation wasn’t done by a traditional Swedish semi-socialist government. It was done by a centre-right reformist government for whom nationalisation was anathema.

They developed processes which were certain and which some adventurous money could recapitalise the banks under clear rules. The process respected private capital.

Banks that were deemed to require capital had to raise it – if they couldn’t they were fed capital by government. If they required too much capital the government wound up owning them. But there were defined rules and a process.

This is how it is – with certain rules and a process not every American bank is going to die - and possibly some or most of the big six will survive. Some will live – and they will prosper. Nationalisation with process leads to 20 baggers. Oh, and zeros - 100 percent losses.

But we are here in limbo. The nationalisation meme has taken hold – and nationalisation of some banks will happen. America is a current account deficit country – and almost all American banks need wholesale funding. There is none of that since the Lehman/WaMu week – and there will not be substantial wholesale funding until the rules are clear. All banks will fail in that environment.

The faster we come out with a good process – one which has nationalisation as one (but not the only) possible outcome then banks will continue to fail. And ad-hoc decisions will be made to bail them out or confiscate them. And we will be no wiser. And no closer to a solution.

Investing and nationalisation

Equity investors should not fear the nationalisation meme. It happened in Sweden and two of the banks were 20 baggers. Svenska Handlesbanken was a 50 bagger to peak (and it still trading well above 100 kroner).

The “all banks are insolvent” idea is simply not true – and it is not going to help you make money forever (though it will work until a process is found). But – hey – while there are no rules – it all a crap shoot. We own no American bank common equities at Bronte. Short a few.

Waiting, hoping… hoping we really can become Swedish. You make the real money on the long side...

John

A post script is required. SEB – which was an OK – but not great bank – got itself entangled in the Baltic mess. It is not quite as exposed as Swedbank – but it is not pretty. The stock is down from 250 to 50.

SvenskaHandelsbank has operations in the Baltic. Here is their Estonian page. But the exposures are substantially less large and the stock is one of the better performing European banks. Hey – best bank last cycle – best bank this cycle. A solid culture is the only way to run a bank.

A second postcript - in the comments it is noted that (a) the Swedish Kroner devalued sharply giving Sweden a strong competitive edge, and (b) the rest of the world could buy the Swedish product. It is much harder with a synchronised world downturn. No argument from me there.

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?