The Reality Based Community and Frannie

Warning: this post is speculative - we have no idea of the structure of the bailout - and I could completely misunderstand what is happeing.

Brad de Long can’t understand why a Frannie bailout needs to happen now.

Funnily enough nor can I except that it does. I didn’t think Paulson would act this fast – and I don’t know what he will do with the preferreds – but thinking about it the action is sensible. [I was considering buying preferreds – so I have little ability here to claim prescience…]

Let’s lay out the argument

• When Paulson got his permission to bail out Fannie and Freddie and made all the reassuring noises he made I thought that Fannie and Freddie debt spreads would drop to 30bps. They didn’t and I thought that was weird. Really weird. I blogged about it here.
  
  
• We should take the world as it is – not as we think it should be and observe that the debts are rolling over at spreads more like 130bps. This is reality and I for one am a proud member of the “reality based community”.
  
  
• There is almost 2 trillion Frannie debt rolling over at a high rate (several hundred billion a quarter). The government effectively guarantees that debt but a perverse market was forcing issue of that debt at 130bps more than Treasuries.
  
  
• If the spread on the debt remained at 130bps then Frannie were doomed. I did the maths in Fannie Mae series.
  
  
• In particular I estimated the earnings power of Fannie Mae at about 10 billion per annum. Fannie has something near a trillion in debt. If the spread is 100bps higher than it should be with the government guarantee then almost all of that earnings potential will be wasted as excess spreads on the nearly a trillion in debt. If the spread remained at 130bps over treasuries then Fannie had nearly no earnings power. No earnings power meant insolvency was inevitable because losses in the book might be something around 80 billion (see Fannie Mae Part III). As there was no earnings power it was inevitable that the government was going to bail them out sooner or later. I blogged here and here about how widening spreads could spell doom for Frannie. I must confess I did not think the spreads would remain wide (as I thought they were irrational) but they have.
  
  
• The Government might have solved this problem by explicitly guaranteeing the debt and leaving the private ownership in place. But that looks silly to me. I would have thought the implicit guarantee was enough – but 130bps tell me it wasn’t.
  
  
• Given this the government was eventually going to have to pay the Frannie senior debt. Over the next couple of years then Frannie was effectively going to raise over a trillion dollars in US government debt – but at spreads 100bps or more higher than necessary. The cost to the Federal government of delay is thus more than 10-20 billion annually over the life of that debt. If the debt had five year maturities on average then the cost just of delay could edge 100 billion.
  
  
• Moreover delay delayed the date at which the implicit government guarantee finally drove down mortgage rates – and hence increased the disruption in housing market.
  
  

The logical thing for the government to do in that circumstance is not delay. [The alternative is to cross your fingers and hope that the debt spreads on Frannie debt dropped to 30bps on their own accord.]

My understanding of US politics (erroneous it seems) suggested to me that this administration would not want to explicitly socialise the problem. Moreover many decisions of this administration are best described by delay and crossed fingers. So I am staggered by rapid logical action. But so be it and for once I think a Bush administration action is sensible.

But I am more staggered that the market forced the action. I thought that the market would see the implicit guarantee for what it was and trade Frannie senior debt at low spreads. But reality has the ability to get in the way of many things. This is just another example.

Being in government sucks. Sometimes you need to make hard decisions that are ideologically anathema. This must really pain the Republicans. But in this instance reality got in the way of ideology.

There is a second hard decision – which is what to do with the preferred. Any solution that leaves the preferreds as senior to the Government capital would indicate that the Republicans have dumped ideology entirely. I am not sure that they should wipe out the preferreds – but I would have a jaundiced view of any deal which substantially pays the preferreds before the government makes a reasonable profit on the capital that they are putting it risk.

John Hempton

Getting it wrong again! Phoney and Fraudy edition

If the details of the Fannie plan as rumoured are correct (including serious impairment to GSE Preferreds) then I might have been a day early covering my WestAmerica Bancorp.

Ouch. They say on Wall Street that you can't go broke taking a profit - but I think that is wrong. You take plenty of losses and taking small profits is not an antidote to the losses. I missed what could be a big profit. [Monday will tell...]

I had no position in the stock or preferred of the GSEs but was leaning towards buying preferreds on the basis that whilst the GSEs were probably insolvent they were not massively insolvent. [Fortunately I did not ever actually buy any stock.] I covered Fannie quite carefully in Part I, Part 1A, Part II, and Part III. It was enough to realise how little I knew and enough to keep me out of that game.

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Having got it wrong on WestAmerica you should probably ignore anything I say on the follow up - which is what does this massive move mean to the rest of the financials.

So far no details on the plan so I have no opinion.

But so far the cost of mortgage funding has remained high because of high spreads on all mortgage lenders. If the new Fannie and Freddie have better access to money at government rates and hence can lend at lower rates then it is good for everyone else's back book but not good for prospective margins... It would benefit those with bad back books (WaMu, Wachovia) and hurt those few who are still firing on all cylinders.

If the new Fannie and Freddie (sometimes called Phoney and Fraudy) do not have such access then there will be hell to pay at the banks with capital shortage.

A few banks are going to take huge losses on their GSE preferred stock if the rumours are correct.

Yours in contrition for error



John Hempton

The problem with blogging: WestAmerica Bancorp

One of my early posts was on WestAmerica Bancorp. It’s a smallish – and traditionally very well run bank in the Central Valley.

It didn’t grow into the mortgage mess – and if you look geographically at its exposures it seemed to do better than average.

Some parts of the central valley are much uglier than in my original post (see Merced). Some are not.

In my original post my case against WestAmerica came down to a few things:

• Price – it is very expensive by any reasonable comparable
• It has zero growth – indeed was slowly shrinking
• It had a large securities portfolio that produced low quality earnings

I was not down on this company. I thought it well managed – but was inevitably suffering a little – as much as anything because rampaging competitors were happy to steal its term deposit base by increasing the price they will pay. I was down on the stock…

Well the low quality earnings in the securities portfolio has begun to cause problems. The bank owns a pile of GSE preferred stock – which it has taken some losses on and which it will probably take more losses on. But this is inconvenient rather than threatening. It might derail the buy-back and indeed the buyback rate is not rapid.

Since I wrote the original article the short interest in the stock has gone from under 5% to 20%. It’s a darn crowded trade for a bank that nobody much had ever heard of. A fair bit of that increase in short interest I can attribute to my blog readership. I have certainly got the odd email. I suspect a 20% short interest in this little and not liquid financial tells you that the shorts are getting too aggressive here. I have removed my short for a small profit. I just don’t like the trade being that crowded. It means when the stock pops it might pop irrationally hard.

The short case is pretty strong – but I have been in crowded shorts before and I don’t like it. To the extent that my blog made the short more crowded I regret my posting. It makes it harder for me to profit from what is just a difficult overpriced situation.

And a 20% short in this company – something that is merely expensive – suggests that too many hedge funds are partying like it is 2006 in reverse. Short first – ask questions later.

I am not going to get long this. The short case is fundamentally right – it is just that the short is crowded.

But getting long crowded shorts when the shorts are wrong is absolutely delightful. Ambac anyone?

Weekend edition: A call for the beauty disadvantaged

Mt Isa is a mining town in remote North West Queensland Australia. Its hot and dry and (kindly) a cultural backwater. It also has a severe drought of ladies and the children suffer from lead poisoning. The ratio of single blokes to single ladies exceeds 5 to 1. If you took out the hookers it would probably be much worse.

The mayor in the tradition of small town mayors took it upon himself to rectify this situation with a call for the “beauty disadvantaged” to move to Mt Isa. You know what he thinks of his constituents when he says this:

Quite often you will see walking down the street a lass who is not so attractive with a wide smile on her face. Whether it is recollection of something previous or anticipation for the next evening, there is a degree of happiness.

Whatever – beauty is skin deep and sometimes the ugly ducklings can thrive in a portfolio. So – at least as regards to stocks – consider this a call for the beauty disadvantaged. Interesting suggestions will be examined.

The only problem of course is an observation that a single nurse in Mt Isa made regarding the Mayor’s comments. She said: “around here the odds are good, unfortunately often the goods are odd”.

I expect that to apply in most instances to the stocks too!

Bank customer service – some follow up

Felix Salmon has made the correct observation about bank customer service and private banks. His analysis:

Big retail banks tend to look at their high net worth clients and see lots of profits. So they try to pamper those clients as much as they can, with personalized service and dedicated phone numbers and, very often, lots of salespeople pushing some kind of equity derivative or other.

But their org chart, their IT system, their DNA -- it's still Big Retail Bank. If a private-banking client phones up and asks for something they can call up on their computer, then no problem. But ask for something which might be slightly different -- and you run into a brick wall.

In a real private bank, one which is built upwards from a rich client base rather than being built by skimming off the richest clients of a much broader client base, such things are much less likely to happen. In a real private bank, the client has a private banker -- a human being with first-hand knowledge of his client and the ability and authority to make things happen.

Well eventually National Australia Bank has promised precisely what Felix Salmon suggested should have happened in the first place. I wonder a little if being the writer of a well read financial blog had something to do with it. But if people have found NAB private bank helpful please mention it in the comments and I will publish. A good turn is a good turn and should be acknowledged.

More generally I have received a bit of email about bad bank customer service. Several pieces were about Royal Bank of Scotland. RBOS has done well over 100 acquisitions – and getting customer service right throughout that is difficult. However Fred Goodwin (who I think is a truly dreadful CEO) has one genuine claim-to-fame – which is that he meets his post-acquisition cost targets. He might do this at the expense of customer service – but at least he does it.

I got a general comment that regional banks (especially small town banks) are better than big city banks. They are just helpful. However its friendly but not that much fun when a staff member at a regional branch of Chase spends 15 minutes trying to solve a problem on an internal phone centre number. I guess it works – and keeps the customer happy – but it is not great customer service.

I have one email about good customer service at Fifth Third. That meets my preconceptions. I have blogged about Fifth Third here and here. However there was a comment contrary to this on Seeking Alpha when I wrote about Fifth Third there.

Finally I received a few emails about banks with financial problems solving them by cutting back on staff and hence annoying customers. I have no corroboration so I will not publish names. Mostly you could guess - and if you want to email me I am very happy.

John Hempton

PS. I also received one negative comment about Danske's merger with Sampo in Finland. That surprises me. I have held out Danske as a bank that does this particularly well. Annecdotes contrary to my thinking are much appreciated.

Epistemology for beginners:

As regular readers probably have worked out I am getting obsessive about what constitutes enough evidence to have a bet on a stock long or short. [We can and will be wrong often.]

I have seen a lot of crap written about what we know and how we know it. This blog post is both funny and useful. (HT to Felix.)

Google – the evil identity theft company

I use GMAIL and it worries me that all my life is stored on some server in the Googleplex. But I guess I trusted a company whose motto was “DON’T BE EVIL”.

Now I have just installed Chrome – the new and very slick browser from Google. Call me an early adopter!

It will not become my favourite browser until I have a feeds extension as per Firefox.

But one thing has really got me. Go to options on the tool menu on the right side and you can make all saved passwords visible. Oi – this is in an age of identity theft where I travel globally with a laptop! And I run finances from this laptop.

Firefox also has such an option – but at least you can hide it with a master password. Microsoft – for all their reputation for security flaws are just not that stupid.

If this keeps up the boys from Redmond will find their reputation restored – Vista notwithstanding.

John Hempton

PS. I have a cynical take on this. This is a browser with a really neat incognito feature. It allows you to visit sites without leaving any trace on your computer. A porn feature if you will. Google is encouraging pornography.

So you can be secure from your wife when you are checking out the internet sites of escort agencies. But you can't secure your financial passwords! Tells you about Google's priorities.

Obvious reason: Google makes lots of money on advertising sexual services. They don't lose lots on identity theft. People - even those that profess not to be evil - act according to the incentives given them.

Suing Dell – a follow up

I wrote earlier about my own experience with Dell and warranty issues.

For those that want to know – Dell folded and fixed my computer at no expense.

Background: I purchased a Dell XPS M1330 online through Grays Online – an auction system where Dell gets rid of its excess inventory.

The inventory is marked as either faulty or working. The computer I purchased was not marked as faulty.

The XPS M1330 had a fault which was widely reported – and indeed reported on Wikipedia. The fault was to do with inadequate cooling on the graphics chip – and indeed Dell changed the chip from January 2008.

I purchased the computer in March 2008 – but they had the old motherboard/faulty cooling system in the computer and did not indicate in the auction that the computer had a known fault.

I sued Dell – and the main argument came down to the fact that they sold me a computer with a motherboard/cooling system that they knew was problematic. It was thus misrepresentation.

I paid for repairs – and the repairman gave the game away. He didn’t even bother to turn the computer on to check out the fault. He just started unscrewing it and replaced the relevant bits. He then turned it on and it worked. He told me that he had done more than 50 of these computers – all the same fault, none of which was produced after late January 2008.

Dell is panned for customer service issues – but in my case the customer service issue was faulty design. If there had been no fault there would be no customer service issue. The great internet unwashed knew about this well before Dell did – with articles on the web about how to fix Dell’s design fault.

As it turned out Dell folded. They agreed to refund my repair costs and the legal costs without appearing at court. It wasn’t much money – and they probably knew they had a problem.

Dell probably should have known that I was serious when on the phone I indicated that I was going to sue them. If they thought I was bluffing they lost.

It is sure better to keep the customer happy. But much better would be to produce equipment that is not faulty.

And in that my repair-man – a nice young man from India who talked with pride about his soon-to-be-arranged marriage gave me some hope. He knew of no current Dell consumer product that had this sort of manufacturing/design problem. So maybe – just maybe – Dell is getting ahead of the game.

John

Bank customer service

Banks are notoriously bad at customer service. They know they have customer lock. People are less likely to change banks than get divorced according to the oft-cited dictum. [I do not know the original source and can't vouch for the data.]

But today I am having one of those “bank customer service days”. I am a customer of National Australia Bank private bank. Private bank is an area walled off for the "important" customers.

I need something very simple. I need a set of interest statements for my own account and the family trust for the 2006-07 tax year – and I need them in a simple form.

Surprisingly the bank cannot deliver.

This seems odd.

Moreover I am starting a hedge fund. I need to choose banking arrangements – and failure to deliver simple things to a private banking customer would rather mitigate against choosing National Australia as a service provider of any kind to a hedge fund.

So the lack of customer service is a mechanism for shooting yourself in the foot. [Banks have plenty of ways of doing that.]

For the past year all people have talked about is bank balance sheets. When insolvency beckons customer service comes second.

But if anyone notices their bank is improving their customer service let me know. Its always interesting to find a bank which retains its customers by making their life better rather than by offering looser credit terms or higher term deposit rates. Besides such banks are likely to work better for shareholders as well as customers.

John Hempton

Explaining the brokers – Part III

This is proving to be a hard series to write. The brokers are complex. To really go through the Lehman 10K is a schedule clearing event. (The same is true for Barclays and other institutions I have made the attempt on.) But I hope I have painted the world appropriately.

In Part I I described just how big the brokers have got. Enormous. Some criticisms said that I was overstating the case because I compared US brokers to possible US assets – but the brokers were global. However that criticism is unfair – I did not include the foreign investment banks which are just as big – note UBS (which long had the biggest balance sheet in Europe), Barclays (the second biggest balance sheet in the world), SocGen (which has about half the trading revenue of Goldman Sachs), BNP Paribas and Calyon (both also large), Deutsch Bank and Nomura.

In Part II I explained just why there was such a glut of excess savings in the world – and why those savings are in such a risk-averse form.

My assertion is that the brokers – more than any other institution – have become the intermediaries between the Anglo/American (and Spanish) economies and copious pools of savings.

The first way they did this was through the now thoroughly discredited securitisation market. What securitisation did was take pools of assets (some junky, some good) and create AAA rated securities by segmenting and selling off the most senior cash flows. This left equity tranches (which had high returns and natural owners) and BBB tranches which were waste at the end with no natural owners.

So investment banks worked out a trick – which was to wrap the BBB tranches up into “collateralised debt obligations”. The purpose of these was to make the BBB bits go away. They would tranche the BBBs and produce some more AAA (which was sold to “natural owners”) and some more BBBs and equity tranches.

Never failing to do something to excess Wall Street then tranched the BBB bits of CDOs to produce the notorious (and mostly worthless) CDOs of CDOs or CDO Squareds. Surprisingly they sold some of these as AAA (admittedly with a few billion of guarantees from the monolines).

Some brokers (notably Goldman and Deutsche Bank) were pretty darn good at avoiding holding the “super senior” crap at the end of this. “Super senior was a euphemism to hide the fact that the AAA stuff was really contingent on BBB stuff that was already levered.” Other brokers (notably Merrills and UBS) were particularly bad at ducking this stuff. Similarly poor were National Australia Bank in my home market. [See the forthcoming Part IV.]

None of this explains why the broker balance sheets are so big (other than UBS and Merrills). The brokers don’t need to hold the assets for any length of time to securitise (though sometimes they did). The securitisation business is “moving business” not “storage business” and assets that are held when the music stops are ubiquitously bad – but are not necessarily huge in number. [The losses from holding assets at the end however will total tens of billions – maybe even 100 billion if you count all investment banks.]

It’s the “storage business” that fascinates me. They call it “trading” which implies a “moving business” but trading as done by most investment banks involves considerable storage.

The strangest thing about it is that the people actually doing the trading had no idea the economic function that they were performing.

Put yourself in the shoes of some prop trader. Some of them do “risk arbitrage” on takeovers and the like (see the description of Goldies trading business in Robert Rubin’s “In An Uncertain World” ]

What I think the traders did – and I would love some trader to confirm or deny this via email – is sit there and say “I can buy this security, sell this security, buy this interest rate hedge, buy this credit default swap and I am balanced”. So he did it.

And over time he kept putting the positions on one way – he went long the exotic instrument (say a mortgage or a piece of credit card or CDO paper), purchased a CDS or a monoline guarantee or some other credit protection, and funded this by shorting a vanilla instrument (some AAA paper – especially a Treasury).

And as they did it the balance sheets got bigger and bigger and bigger.

The economic function that the trader was performing was turning exotic instruments issued by the West into vanilla instruments favoured by the East. They were intermediating on the trading floor. And they were the biggest intermediators in town.

Goldies prop trading profits got to 30 billion dollars. If you added up the prop trading profits of the street – and they were always profits until recently – the numbers were well over 70 billion and probably over 100 billion (depending on who and what you counted). There are approximately 110 million households in America (sorry I have not checked that number for a while) and maybe that again in the indebted developed world. The trading profits were say 500 dollars per household.

Well if they were profits to Goldies et-al they were losses to someone – somebody paid $500 per household. And struggle as I may the only service that I can think that is worth $500 per household that was provided by the trading desks of investment banks was intermediating debt. So that is what they did. The “losing side of the trade” saw the 70 billion plus paid to the trading floor of investment banks as just something embedded in their monthly interest payments. The trader saw it as a mathematical game – but it was just service provision.

Now the reason this post is hard is that the data to support this proposition is thinner than I would like.

At a first cut if the trading was really just the bring-forward mark-to-market of the book then the trading revenue as a proportion of assets should fall each year.

When I first studied this (a few years ago) that was true. But it is no longer true. Trading revenue as a proportion of assets was particularly high in 2006. One person I talked to suggested that was just because the broker balance sheets just grew faster than ever – they just did it on the OTC market and didn’t actually need to back anything with the physical. I don’t know about that – and I do not have the data to either prove it or not.

But here is a simple model which details my quandary. In it I assume Goldies balance sheet would shrink by 30% each year just through natural attrition (loans repay etc). Then I look at the addition to the balance sheet and trading revenue as a percentage of additional revenue.

This seems to suggest that trading margins (ie a bring forward of all the profits) seems to be about 6% of incremental assets added. It’s a nasty profit front load if the business shrinks because you need to hold capital based on the whole balance sheet. 2006 looks to be a particularly good year.

But finding enough data to support this thesis generally I am finding hard to do.

If anyone has a better explanation I would love to hear it.

John Hempton