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.

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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

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…

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.

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