Wednesday, September 24, 2008

Comment deletion policy

I have started getting a wave of comments promoting commercial services in debt consolidation, mortgage workout and the like.

I delete these.

I accidentally deleted a useful comment on the oil short-squeeze - but that was because it was bracketed by spam.  To the author - I am sorry.

I have also received a wave of comments accusing all short-sellers of being criminals.  I know that view is out there.  But it is hardly constructive to repeat it here.  So I deleted them (at least in part because of the aggressiveness of the commentary).  However in fairness in keeping with this blogs policy of encouraging open comment I will at least tell you that the argument covers the full gamut of arguments against short-sellers and you can find them at the Sanity Check and other "anti-short-selling" websites.

My experience is that most people that argue against short sellers are in fact fraudsters - and they don't like that shortsellers profit from the falls in their stock.  But I will listen to other arguments.

The FDIC and WaMu

I have noted that the FDIC seems to take a lot to take over a bank.  It took 42% non performing loans (versus about 4% and WaMu) for the FDIC to take over Ameribank. 

Against that Ameribank had slightly more deposits than loans and so liquidity was not a huge issue.

WaMu’s book is MUCH better than Ameribank – but unfortunately WaMu has much more deposits than loans and hence liquidity is and issue. 

Pretty well my entire email inbox says I am mad buying the preferred of WaMu.  I may well be. 

And here I would love a little birdie to tell me what the FDIC is thinking.  And all I can rely on is my friends from the fourth estate. 

So we go to a little article on WaMu and the FDIC.  This is in that wonderful little journal called “The Deal”, and is really the unsubstantiated gossip from investment bankers who are working on WaMu deals – or people who know investment bankers who are working on WaMu deals.  You can bet that every “source” is talking their book meaning they are trying to lobby government officials, WaMu officials, other investors or whatever to act in a way favourable to themselves.

The sale of troubled thrift Washington Mutual Inc. looks set to come to a head this weekend, according to sources. One source said WaMu could choose a buyer by Thursday, Sept. 25, and announce a deal this weekend.

There are so many sources that say that potential buyers are scouring the books that it’s got to be true.  Things are corroborated by five sources so they are right.  The “choose by Thursday announce this weekend” is insane.  If you chose you announce – and all deals are done on the weekend.  So “one source” in the second sentence is either junior and stupid or being misquoted.  My guess is misquoted.  This sources however doesn’t stick around and the next paragraph quotes another source.

However, another source said the Federal Deposit Insurance Corp. is working in parallel to structure a deal that may allow any buyer to acquire the company without taking on WaMu's toxic portfolio of mortgage securities.

The FDIC would almost certainly be thinking about how they deal with WaMu.  The deal that buys the bank without taking on the mortgage book is called an FDIC takeover.   It is precisely what happened with several deals where the deposit book was sold.  I would lose badly.  However I have never known the FDIC to shop a bank without taking it over first.  There is plenty of evidence that they do these things quickly and on the weekend – surreptitiously coming into town and even booking hotel rooms for their officers in false names.  Besides we know for certain the FDIC is looking because WaMu announced it. 

A WaMu representative declined to comment, but a source close to the situation said that there has been no indication by the FDIC of its intentions.

The FDIC does not show its intentions other than asking for information and business plans from the bank in question.  This source is almost certainly right. 

"If they're running a parallel track, they're doing it without telling the bank," the source said, noting that WaMu's managers do not feel they are operating under a government-imposed deadline to complete a deal. This source added that an auction for the company has been ongoing for five days, and bids have been coming in from multiple parties. The government, the source added, has been watching closely.

Well this has got to be the nub of it.  There is unambiguously an auction.  The bidders have been saying to the government “you guarantee this and we will buy it”.  The FDIC would then (of course) be “watching closely” but would not signal its intentions.  Signalling its intentions would be tantamount to giving government money away – and only Paulson seems to feel entitled to do that. 

"There's no doubt the government is very interested in what happens to WaMu," the source said. An FDIC representative declined to comment, citing agency policy to avoid comment on "open and operating institutions."

Well there is no doubt the FDIC is interested.  WaMu have even confirmed on 8 September when they said:

WaMu also announced that it has entered into a Memorandum of Understanding (MOU) with the Office of Thrift Supervision (OTS) concerning aspects of the bank's operations, principally in several areas of its risk management and compliance functions, including its Bank Secrecy Act compliance program. In addition, WaMu has committed to provide the OTS an updated, multi-year business plan and forecast for its earnings, asset quality, capital and business segment performance. The business plan will not require the company to raise capital, increase liquidity or make changes to the products and services it provides to customers.

Anyway back to the article – I think we can safely conclude that the FDIC is watching, not acting and not signalling its intention.  We can also safely conclude that the FDIC is not insisting that a deal be done this weekend – but would very much relieved if Warren Buffett were to pony up a spare $15 billion.  That is not going to happen – but the deal if it happens this weekend will be a winner for WaMu preferreds because it will NOT involve an FDIC takeover. 

Another sell-side source called the situation fluid, and said the FDIC is not communicating with WaMu or its advisers, which include Goldman, Sachs & Co., Morgan Stanley, and law firm Simpson Thacher & Bartlett LLP. Possible bidders reportedly include Banco Santander SA, Citigroup Inc., J.P. Morgan Chase & Co., Toronto-Dominion Bank and Wells Fargo & Co.

This just confirms what I think is obvious now – which is that the FDIC is not forcing this process – but wants to keep informed.  It is not communicating with WaMu or its advisors – which means that we are not going to get a FORCED sale this weekend.  But the FDIC would love to see a sale. 

A source close to the company said the FDIC is looking at the possibility of selling a stake in the company with an option to buy it later. That could not be confirmed independently.

Well of course they would be looking at this.  They would happily settle for a deal which says “hey you solvent bank, you chip in $5 billion and you have the option to buy the whole thing within twelve months”.  This of course gives WaMu $5 billion now – and that improves the FDIC position.  It also improves the position of the preference shares.  It does NOT improve the position of the common – but then since when has it been the FDIC’s responsibility to care for common shareholders?

Seattle-based WaMu, weighed down by toxic mortgage loans, has been under pressure from federal regulators to raise capital or find a buyer to restore confidence in the bank.

Journalists puzzle me.  I think we got to the point where the Journo clearly believes his source who says that the FDIC has NOT been in contact with WaMu or its advisors.  But he is also saying that they are under pressure from Federal Regulators.  How can they be pressuring you if they are not contacting you?

I don’t doubt the FDIC would like to see things done – and is clearly in touch with business plans – but the Journalist’s sources here are pretty clear – they say the company is for sale and that the FDIC are not day-to-day forcing the process but they are listening to bids which are requesting an FDIC back-stop. 

Concerns about its book of residential mortgages has pushed WaMu's stock to single digits. On Tuesday, it traded at $3.40 a share, down some 92% from $33.54 a share one year ago.

Tell us something that we didn’t know.  But then the stock price does the analysis all the time in this business. 

WaMu this month replaced longtime CEO Kerry Killinger with Alan Fishman, former president and chief operating officer of Philadelphia-based Sovereign Bancorp. WaMu is the country's largest mortgage lender and, although any buyer would benefit from its 2,300 branches and $143 billion in deposits, there are concerns about an expected $19 billion in mortgage losses over the next 2-1/2 years.

Well this journalist does not do numbers.  If losses are “only” 19 billion in the next two and a half years WaMu doesn’t cause anyone any problems.  WaMu as I have pointed out many times has 8 billion in pre-tax, pre-provision earnings.  19 billion gets neatly absorbed over two and a half years and the capital ratios at the end of the period don’t even look stretched.  The problem with WaMu is not 19 billion in losses.  It’s the possibility of 30 or even 40 billion in losses.

But most of all I am sure that the Journo knows nothing when he makes statements like ”WaMu is the nation’s largest mortgage lender”.  I am not sure that there ever was a time that was true.  Certainly most the time the biggest lenders were Fannie and Freddie in that order, and the biggest originator was Countrywide. 

The data for WaMu now is that it has almost stopped originating for its own book.  In the first quarter of 06 it originated $51 billion total – and less than half was GSE conforming loans.  In the second quarter of 08 it originated only $9 billion – and three quarters of this was conforming loans.  For all reasonable purposes Washington Mutual has ceased to be a mortgage lender and most certainly is not now the “country’s largest mortgage lender” as our friendly journalist purports.  The fact that it has ceased being a mortgage lender tells you there really is liquidity issues here...

"We believe WaMu's capital is insufficient to absorb its mortgage losses," Moody's Investors Service senior credit officer Craig Emrick said Monday. Moody's lowered WaMu's financial strength rating to E from D+ and placed the debt ratings on review for possible downgrade on Tuesday, saying the thrift has "severe asset-quality issues."

Moody’s don’t believe the 19 billion either.   

Attempts to either inject capital or sell WaMu received a boost last week, when private equity firm TPG Capital waived an anti-dilution protection for its investment in the thrift. The move appeared to be an acknowledgment that the troubled savings and loan may need to raise more than $500 million of additional capital.

On paper, TPG had lost $1.55 billion of the $2 billion it invested in WaMu in April. Its investment came in equal portions from its fifth and sixth buyout funds and from a $6 billion fund it raised this year to make distressed investments in the financial sector, according to a TPG investor.

Ok, we know the situation is desperate though.  TPG have access to the books.  I don’t.  They waived their anti-dilution clause so they are clearly willing to get diluted to preserve some value in their position.  That is the real indicator of problems here.  The waiving of the anti-dilution clause is however a GOOD thing for the preferred holders.  Extra equity capital (diluting but not wiping out TPG) strengthens, not weakens the position of the preferreds.  However TPG are also saying "get me out of here" and given that they have access to the books I should not be comforted by that.

In a research report, Keefe, Bruyette & Woods Inc. said last week that WaMu might have enough reserves to weather future losses, but that if the losses intensify it would need new capital that it would find increasingly hard to raise.

That is fill.  Its fill however consistent with my thesis.  If the losses are “only 19 billion WaMu has enough capital to survive.  If more – then problems. 

According to one banking source not involved in the sale process, any buyer would face immediate mark-to-market pressures from WaMu's mortgage portfolio. Noting that purchase accounting rules would force a buyer to immediately mark the portfolio to market prices, the banker said that the hole in WaMu's balance sheet upon purchase could be as high as $52 billion. On the other hand, if the bank was not sold, but recapitalized, the hole would be anywhere from $12 billion to $19 billion.

The first sentence gives it away.  WaMu is a “sale process” because this journo is distinguishing between people in the know and people like me who are just interested outside observers.  [Unfortunately the said journo is not in the know.] 

The outside source however has nailed the obvious problem with “buying WaMu” which is that WaMu’s assets are mismarked – and the mismark would be exposed by any purchase.  A purchase at a token sum ($1 a share) would solve many of these problems though because there is a lot of “stated capital” left at WaMu even if there is not much real capital. 

A deal whereby someone injects equity and retains an option to purchase solves the mark-to-market problem described.  That might be the reason that deals are taking the forms stated.  A deal where the FDIC warrants that the assets are not going to be $40 billion bad (even with a fee paid to the FDIC) also solves the marking problem.  I am not sure whether the FDIC has the legislative power to cut such a deal.

The oil price spike

Lots of amazing things have happened in US capitalism in the last ten days. Monday's oil price spike has been lost in the noise. But it looks to have told you something about how hedge funds and oil companies behave.

Global oil consumption is about 87 million barrels per day. US oil consumption is just shy of 21 million barrels per day. At $100 oil that is an 8.7 billion or 2.1 billion dollar per day market.

It would be pretty hard to squeeze the oil market because of its sheer size.

Yet - on contract expiration - the oil price spiked from 100 to 125 dollars - and settled up $20. The forward price was not quite as strongly affected.

Somebody was short. Big time. And they needed to buy back. I have no idea how many contracts changed hands - but to push a 2.1 billion dollar per day market up 25% it had to be an awful lot.

I haven't seen the news that so-and-so-hedge-fund-I-have-never-heard-of has been roasted - but someone looks to have been roasted. And it has slipped without comment.

---

Now here is something to give you less confidence in the Paulson plan.

There was a US organisation with enough oil to meet the price spike and to buy back oil in the one-month forward contract and hence make a LARGE arbitrage profit. That organisation is ... the US Government and the strategic oil reserve.

They only had to sell now, offset by purchased in one month. My guess is that once done the oil wouldn't even need to be moved - you just meet with the liquidator of said hedge fund and settle up.

Ah well - the US government was never much good at trading.

But then we wouldn't normally want them to buy financial assets - and we wouldn't expect them to be able to determine fair value...

Would we now.



J

Tuesday, September 23, 2008

How much does it take to get the FDIC to take over a bank?

Last Friday’s FDIC event – the takeover of Ameribank – has given me some thought.

It’s a small bank – it has 8 branches, 112 million in assets and 115 million in deposits. 

NPLs were 5 percent June last year.  They were 32 percent at year end and 45 percent by June 30 this year.

45% NPLs is what it took to get an FDIC event.

There is much speculation (see WSJ, Calculated Risk etc) that WaMu might be taken over by the FDIC.

Last I looked (ie last quarter) the WaMu NPL over total assets were 3.62 percent, up from 1.29 percent a year ago or 2.17 percent at year end.  I am not comparing apples with apples.  The NPLs WaMu quotes are against total assets, not total loans – but they are still only in the low 4s.

Now there is plenty of room for NPLs to rise.  There are a lot of option ARMs in WaMu’s book –and NPLs have been rising quite consistently and in my view will continue to rise. 

But if you take the FDIC on form its not likely to confiscate WaMu soon.  It waited more than six months AFTER Ameribank reported 32% NPLs for a takeover.

In the blogosphere I am in a (small) minority of believing that WaMu will probably be OK in the end.  I know its gonna get a lot worse.  But the FDIC seems to take a lot to act – and I am not sure that that much happens at WaMu. 

Then again WaMu might run out funds – and that would force the FDIC hand.  So far there is little evidence of that but…

Monday, September 22, 2008

WSJ on WaMu

The Wall Street Journal is reporting on the (tense) WaMu negotiations.

As readers know I have a (very speculative) dog in this game as I purchased preferred shares in distress.  I would have a much bigger dog if I were allowed to short the common stock because I would have done an arb yesterday.  

That said here is what the WSJ says:

While some people close to the discussions hope a deal could be struck within days, one stumbling block is that a straightforward sale of WaMu would require the buyer to absorb the company's troubled assets.

With WaMu expecting losses of $19 billion on its mortgage portfolio during the next 2½ years, some would-be bidders favor a government-assisted takeover, people familiar with the matter said. One scenario is that the Federal Deposit Insurance Corp. would seize control of WaMu's banking unit and then sell its deposits to another bank.

Now this misses the point entirely.  WaMu has 8 billion or so of pre-tax income.  Its not growing and capital needs are falling (along with capital).   If it has only $19 billion of losses on its mortgage portfolio over the next 2.5 years then hey - its gonna be good.  It should of course reserve for the losses now (because well - they are coming).  And that reserving would make them insolvent.  

But it will reserve them over the next 18 months - and that is tolerable.  Every other bank has been spacing its loss reserving - so why not WaMu?

The problem is not $19 billion in losses.  That makes it a no-brainer - just buy WaMu at $1 a share and be done with it.  

The problem is the possibility that it is $30 billion or $40 billion.  That is possible but I believe it unlikely however many readers of this blog have the opposite opinion.

But then of course the Paulson Plan to buy mortgages will save WaMu entirely - if of course they are well connected enough to get Comrade Paulson to buy the mortgages from them rather than whoever buys them.  

I guess if Citigroup can get Comrade Paulson to buy the mortgages then Citi can buy WaMu at $1 a share.  

What is really funny is that for a bank with adequate capital buying WaMu at $1 a share is a no-brainer.  The problem is that there are not three banks with adequate capital to create an auction.   That is the state of American banking.  You would never know that from Friday's price spike.  But that is the smoke-and-mirrors in this game.



J

Paulson stops thinking, starts acting

As regular readers know I am not averse to bail-outs. The goal however is to get the best effect (ie return of normal lending, normal function of financial markets) at the least cost (bad incentives given by moral hazard).

That is hard. It requires what I would consider “constructive ambiguity”. It certainly requires that the management of the bankrupt institution are replaced and preferably humiliated. [Deny them their golden parachutes.]

The worst bailout recapitalises the institutions without imposing penalty.

And the new bailout plan looks that bad. It plans to buy mortgages from the institutions (thus injecting government money) without a change of control.

The Norwegians got it right – temporarily nationalising most of the financial system – but ensuring the crisis went away quickly. I have linked to the Norwegian history before but I still think it is a useful guide – and one that Mr Paulson should read.

Somewhere last week careful analysis got replaced with panic policy making. The short-selling rule is in my opinion insane and counter-productive. The bailout $750 billion does not contain the main necessary clauses. The government has stopped thinking and started acting.

Not good.


Saturday, September 20, 2008

Things you can’t do with the short-selling rule

This is a little winge – but it also exposes another unintended consequence.


These days financial institutions are much more concerned about their debt spreads than their stock price (though the two are correlated). They would however generally like people who short the stock and go long the distressed debt.


I desperately wanted to do so with WaMu today. WaMu common was trading at 4.25. The preferred was trading at under a quarter par.


I can’t see the common quadrupling from here. But I can see the preferred going back somewhere near par. [That would happen for instance if Citigroup purchased WaMu.]


So I so wanted to do the arb – short WaMu, long the preferred.


I was not allowed and that sucked.


Moreover as the common is liquid my shorting wouldn’t have changed the price much. The pref is illiquid and my going long would lower WaMu’s perceived cost of funds.


The rules (a) denied me a trade, and (b) made it incrementally harder for WaMu in this case.


Not the best outcome all round.



John Hempton

Ambac’s shocking press release

I have meticulously (and I mean meticulously) gone through Ambac’s reserves (and MBIAs). Ambac is fairly close to accurately reserved. MBIA is way under. Them the facts looking at individual exposures.

That said two things have gone wrong:

1. The bankruptcy of Lehman accelerated some GIC contracts stretching parent company liquidity, and

2. Moody’s put them on credit watch, possibly forcing a parent company liquidity issue.

A small downgrade (one notch) leaves the parent company solvent. A double downgrade requires the insurance regulator to let more money out of the regulated insurance entity to pay parent company obligations.

Be under no illusion – the regulator has an incentive to do this. If the parent company goes bankrupt there is a credit event under Ambac’s credit default swaps. That would accelerate the payment on the CDS – a payment that is currently deferred and may never need to be made if the losses are not as great as predicted on the CDS.

The accelerated payment would mean that the holders of the CDS get paid before the holders of any (future) defaulted municipal bonds. This essentially makes Wall Street structurally superior to Main Street – and the regulator doesn’t like that deal.

Contra: if the regulators hang tough and force the holding company to bankruptcy then the GICs get accelerated anyway – and the money will come from the regulated entity. So the regulator can’t stop it coming from the regulated entity – and might as well not try.

So when push comes to shove (and it might) the regulator will allow the parent company to downstream capital from the regulated entity to the subsidiary.

The regulator will however not allow the regulated entity to set up Connie Lee under those circumstances though – and so a lot of the upside will disappear. Still the question with Ambac comes down to whether they are appropriately reserved not the parent company liquidity. That is the subject of some later posts. Connie Lee comes later.

However just as I thought Ambac’s solvency (or questions thereof) was seriously overplayed the last time the stock was below $5 I think it is overplayed this time.

I am however seriously regretting not selling shares on the way up. Round tripping is no fun at all.

Here is the press release in its gory details.



John Hempton

Friday, September 19, 2008

SEC tries to bankrupt Wall Street

We are in the mode of dumb panic policymaking.

I wake up (jet lagged) and read that the SEC is considering a temporary ban on short-selling.

Ok - just because this is quick-off-the-mark and the SEC hasn't thought it through I thought I might do a little thinking for our pals in Washington.

Last I looked when I was short a stock the broker borrowed the stock (yes, Virgina you do get a borrow) and sold it. They then had cash.

That cash was not available to me - it was pledged to whoever provided the stock to remove or reduce the risk that the stock won't be returned.

That means it is generally available to the broker (who will generally lend me the stock from their inventory or margin or prime broker clients).

Now there are a few hundred billion of short-sales out there. Probably more than normal - but a lot in almost all markets.

And those short sales produce cash balances of a few hundred billion, most of which are available to Wall Street brokers.

If you ban short-selling those balances will taken away from Wall Street brokers.

That would be rather unpleasant. Last I looked the debt market was skittish and was hardly going to replace that money.

So I conclude that the SEC in their "infinite wisdom" are going to stick the knife into Wall Street and bankrupt the lot of them. For political optics. So they can be seen to be doing something about short-selling.

Its one thing to blame short-sellers for political effect. It is another thing altogether to risk the collapse of the financial system on some dumb-ass policy put up in a panic by incompetent bureaucrats.

Sometimes I worry about America.



John Hempton

PS.  I am aware of the limitations on the availability of this cash to brokers.  That limitation however differs by such things as the jurisdiction of the client and the arrangements between client and broker.  

I am also aware that the SEC does not wish to force short sellers to buy back existing positions - rather just stop putting new positions on.  However the effect will not be dissimilar.  

If someone can quantify the end effect on broker liquidity I would love to see the model.

But in summary: this is a darn big move with huge financial implications being discussed by the SEC in a panic after meeting with a few congressional officials just before an election.  And on the face of it, it will exacerbate the financial crisis.

That is not how policy should be made.

Wednesday, September 17, 2008

What comes around goes around

Herstatt Bank went bust in 1974. I was at primary school so I don’t remember. It’s a famous bank bust because it gave its name to time zone risk usually referred to as Herstatt risk.


The problem was that Herstatt received irrevocable payments of Deutsch Marks in the German time zone against a delivery of US Dollars in New York later the same day. Herstatt failed between acceptance and delivery.


The German failure triggered losses around the world.


Well what comes around goes around. It appears that KfW – a German government owned lender – transferred Euro 300 million to Lehman on the day of its bankruptcy.


It was very kind of the German taxpayer to contribute so much for the benefit of Lehman creditors! Far more than the US taxpayer did...


34 years is a long time for pay-back. But pay-back came.




John Hempton

General disclaimer

The content contained in this blog represents the opinions of Mr. Hempton. You should assume Mr. Hempton and his affiliates have positions in the securities discussed in this blog, and such beneficial ownership can create a conflict of interest regarding the objectivity of this blog. Statements in the blog are not guarantees of future performance and are subject to certain risks, uncertainties and other factors. Certain information in this blog concerning economic trends and performance is based on or derived from information provided by third-party sources. Mr. Hempton does not guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. Such information may change after it is posted and Mr. Hempton is not obligated to, and may not, update it. The commentary in this blog in no way constitutes a solicitation of business, an offer of a security or a solicitation to purchase a security, or investment advice. In fact, it should not be relied upon in making investment decisions, ever. It is intended solely for the entertainment of the reader, and the author. In particular this blog is not directed for investment purposes at US Persons.