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.

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

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.

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

Constructive uncertainty redux

Warning – this post is designed to annoy market fundamentalists and the naked short selling crowd…

The main argument against nationalising failing financial institutions at this point comes down to moral hazard.

This is a short post with the idea of turning that on its head.

Debt markets are currently illiquid and highly skittish.

It is alleged that short-sellers are causing problems – but if they are causing problems its not in the equity markets – its in the debt markets. Relatively small amounts of selling of debt can cause a very wide – and possibly self-fulfilling rise in the spread of some financial institutions.

And if financial institutions are going to be allowed to fail you can short their debt with impunity. Drive the credit spread up. The confidence collapse will make you a killing - at least according to Vanity Fair.

But thanks to Paulson et al you can’t do that any more.

AIG proves the government might make the bonds you shorted whole. Anyone shorting AIG debt just had their ass handed to them.

So if you short debt now – what you face is constructive uncertainty.

It might give the smarties some room for pause.

John Hempton

Bailouts - past and present

I can just see the argument. Congress is upset that good American taxpayer money is going to rebuild Germany.

The conservative press argue about Moral Hazard. If countries elect dictators and then try to take the world over by force and exterminate minority races there is no loss to them if you rebuild. We shouldn’t rebuild them – better leave them a smouldering ruin and lay waste Europe because otherwise we would have moral hazard.

And so the Marshall Plan died.

Fortunately it didn’t happen that way. Europe was rebuilt and the world wound up a safer place.

And so I make a plea to the world. Please dump this bailouts are a bad idea thing.

Some bailouts turn out to have been a very good idea – some are suspect. The bailout of Mexico didn’t wind up costing the taxpayer very much – and was better than the alternative – a complete social debacle on a country that last I looked shared a long border with the United States.

The Norwegian bank bail-out of 1992 cost the shareholders a pretty-penny (they lost everything). But the Norwegian economy bounced quite rapidly and the Government actually made a profit.

By contrast the first bailout of S&Ls in the early 80s set up a much larger debacle in the late 1980s (see my history of US Finance paper).

What is really required is not a blanket rule against bailouts – or a blanket rule for them – but – what is in my favourite phrase of the day “constructive ambiguity”. Oh, and sacking the management of said institution for cause and denying all the golden handshakes etc. Suing Dick Fuld would be a start too.

John Hempton

Private Equity is like so yesterday

In early 2007 if the deal was there several large private equity firms could have teamed up and found 75 billion dollars.

No problems except that they couldn’t find the deal to do.

The deal is there today. AIG, 75 billion down at 10%, 60% equity stake out the back.

Alternatively buy the whole shebang for another 4 billion and be done with it.

The deal makes sense. Certainly a whole lot more sense than paying 30% over 2006 stock market values for most large private equity deals.

But the AIG can’t be done because private equity is a shadow of its former self.

That I guess is a measure of how long the certainties of Wall Street last. A week is a long time in the markets. 18 months is like - forever...

John Hempton

Where is a trillionaire when you need them: too big to bail out

AIG has good businesses and bad businesses. Nobody much thinks that the life insurance businesses are problematic. I don’t like life insurance for reasons made clear in the Risk Aversion post – but if you are going to own a life insurance business these are about as good as it gets.

The core business – the US Domestic Broker Group (DBG) is the best diversified primary insurance company in the US. That doesn’t make it a good business but it is OK. [Insurance businesses are the ultimate payers of US legal settlements – and I wouldn’t really want that much litigation risk…]

There are other OK businesses in there.

The good businesses generate about 20 billion per year pre-tax. That is a lot of dosh.

There are some staggeringly bad businesses in there too. AIG Financial Products probably has blown up something between 30 and 100 billion. Ultimately we have no idea what the AIGFP losses are – but we do have some idea of the huge margin requirements.

The management has been profoundly stupid. In the last annual report the letter tells us how now is a great time to expand in mortgage insurance in Australia. Australia is the greatest remaining bubble in residential real estate.

I knew in March 2007 that AIG was up to its neck in super-senior exposure. That is what bought the company down - and in March 2008 AIG management still had little idea that it was in mortal danger.

Moreover past management lied about profitability. That is what the whole finite insurance thing with Berkshire was about - and it will lead to jail terms for several executives. Companies with a record for lying tend to find it hard to get money because nobody trusts them in a pinch...

But here is the rub.

There is no suggestion that the core insurance companies of AIG are impaired. AIG parent company however needs a huge amount of money – say 70 billion dollars - and it needs this largely to meet funding requirements driven by AIGFP. 70 billion is a number that petrifies everyone who looks at it.

But 70 billion is actually not that much compared to the core insurance companies. They should be easily able to repay that. Its only 3.5 years’ profits and should be repayable in 8-10 years provided there are no plagues or other nasty insurance stories.

So now suppose that you were a wise independent multi-trillionaire. Would you lend 70 billion to AIG at 10% secured by whatever you could and with an attached option to buy 60% of AIG at a notional price?

I think you would. It wouldn’t be a bad deal. (You would not do it if you accepted AIG's open ended fat-tail liabilities.)

But unfortunately I can’t see any trillionaires out there. Warren Buffett won’t do it because frankly he is not quite that rich and he will not amalgamate the life insurance companies into Berkshire. Buffett has one-giant shot in his armoury - and this one is not it.

And therein is the problem with AIG. There are no multi-trillionaires and AIG is too big to bail out.

John

PS. I don’t want to do politics on this blog. But I suspect its time for the Fed to lubricate a multi-bank bail out. The deal is as suggested here. 70 billion at 10% for with 60% of the equity.

I am not sure how the Fed lubricates it other than say putting an envelope around the losses of AIGFP.

As for the stock - I am sitting on the sidelines.

J

Am I meant to say something smart here?

I can not.

I figured almost everyone was in trouble - but in my wildest dreams it never went in this order:

New Century,
Dozens of other subprimes but without Novastar actually filing bankruptcy
Bear Stearns
Indy Mac
Fannie and Freddie
Lehman
AIG

I have shorted most the stocks on this list - but managed not to pick the order of insolvency and have been short none of them recently. AIG was not a conceiveable bankruptcy in my mind. Sure I knew about the fake accounting with finite insurance and the mortgage insurer. I even knew they owned $20 billion in "super-senior" so they were clearly stupid. But I never knew enough. The stock was always too expensive - and as I found out more it stayed too expensive...

There are plenty of people speculating as to what all this means. I will leave that to them. I want to stick to stuff I do understand. There is still a little of that around...


J