Buyer’s returning to the market?

At this year’s meeting of the Mortgage Bankers Association in Boston last week, attendance was down by half and speakers delivered presentations with titles such as “How to stay off the implode-o-meter” – a reference to a website that has chronicled the demise of 256 US mortgage lenders since late 2006.

But there was one ray of light to pierce the gloom. News broke during the conference that BlackRock, an investment manager, had struck a $15bn (£7.7bn, €9.7bn) deal to buy a portfolio of distressed subprime mortgage debt from UBS of Switzerland for 75 cents on the dollar. A sophisticated investor with deep pockets appeared to be calling the bottom, providing hope that the mortgage market might be beginning its recovery.

BlackRock, hired to manage $29bn of Bear Stearns’ illiquid assets as part of the bank’s shotgun wedding to JPMorgan, has in recent months established its reputation as an expert manager for such securities.

In previous financial crises, the emergence of such buyers for assets that have collapsed in price has helped to signal a turning point. When America’s banking system was hit by the savings and loans crisis in the early 1990s, for example, the tipping point occurred – at least in the eyes of many investors – when bidders arrived for the assets of the failed S&L institutions.

Similarly, after Japan’s banking system went into a decade-long slump, one factor that helped set a floor on asset prices was the arrival of distressed-debt funds that were willing to start buying assets from Japanese banks.

“Getting markets moving again, getting assets sold, is crucial for recovery,” says Timothy Ryan, head of Sifma, the securities industry organisation, and a former regulator who was closely involved with the sale of S&L assets at the time.

 

Bank Common Stock

With the huge rally in the market today within the financial stocks, in response, in part, I’m sure to the Fed Auction, we again have history repeating itself.

Bank capital is in part a function of the number of common shares, multiplied by the share price, which then accounts for equity capital.

When common stock prices fall, equity capital falls, thus increasing the leverage ratio of the asset side of the Balance Sheet. Exactly the opposite occurs within a rising common stock price. With the sale of additional Preferred Stock, most of it convertible, we have an interesting condition. What was dilutive, and a negative, has now become an asset as far as regulatory capital goes…a rising common stock price, raises the price in convertible Preferred shares, thus equity capital.

This is a very similar condition to 1982, when the Banks were embroiled in defaulting loans to Mexico, Argentina, Brazil, and again their Balance Sheets and equity capital were under strain. The bull market, in addition to various bailouts, saved the Banks.

Plus ça change, plus c’est la même chose

 

Treasury

The Federal Reserve announced Wednesday it will auction an additional $75 billion in super-safe Treasury securities to big investment firms, part of an ongoing effort to help strained credit markets. The auction — the fifth of its kind — will be held Thursday.

In exchange for the 28-day loan of Treasury securities, bidding firms can put up more risky investments, including certain shunned mortgage-backed securities, as collateral. In the four auctions held so far, the Fed has provided close to $158.95 billion worth of the Treasury securities to investment firms.

The goal is to make investment houses more inclined to lend to each other. It also is aimed at providing relief to the distressed market for mortgage-linked securities. Questions about their value and dumping of these securities had driven up mortgage rates, aggravating the housing slump.

There has been analysis to the fact that the Fed is exchanging Junk, for Treasury paper, which is true, but that this will impact the Fed in the same way that it impacts the Banks/Brokers.

This I believe is faulty analysis for the following reasons;
*Fed does not mark-to-market
*Assets [Junk paper] will not not ultimately be worthless

The Banks that carry these assets, have to mark-to-market, thus, every earnings reporting season they are required to take writedowns, if the assets are showing deterioration. This seriously impacts their regulatory capital, and has made inter-bank lending virtually non-existent.

The Fed simply does not have the same problem. They do not, and are not required to, and will not mark-to market, thus, the Fed can be classified as “strong hands”

Of course this leads into the second part of the argument, which is, that’s all well and good, but the Fed is being landed with worthless junk. In the short-term, there will be losses, and quite possibly long term losses. However, the losses will not aggregate at 100%

The paper has collateral behind it. The problem is twofold;
*Collateral was overvalued
*Collateral was [is] illiquid

Due to the overvaluations, there will be [probably] real losses, but, they will not worthless. See *Resolution* post for details.

The liquidity issue, is a non-issue, as long as you can hold until sales are effected. Thus, the Fed, I believe is correct in bailing out the Banks/Brokers/Fools, as had they not, the financial system itself was at risk.

Of course, new regulation [after the horse bolted] will be reinstigated, as the Bank/Brokers/Fools have demonstrated that they simply are not responsible enough to cross the road without mummy holding their hand.

 

Banks and their Balance Sheets

Losses held in equity are a problem, but possibly not in the way envisaged. Losses taken into reserve accounts or equity are or should be priced in by any competent analyst, but, they can be used in a subtle way.

The sequential effects of a practice of this sort take the following form. In a given year, 2008, the company excludes from Income certain indicated deductions, which it may mark or charge to surplus, or treat as a capitalisable expense, improving the 2008 Statement of Income.

In the following year, 2009, the accounting method is changed, the loss is recognized, or a retroactive chargeoff is made, thus reducing the 2008 Statement of Income. Then, the 2009 Statement of Income, relative, to the 2008 statement improves.

Thus, twice, the earnings are manipulated, confusing the unwary. The manipulation works so well due to many analysts paying little to no attention to the Balance Sheet of subsequent and previous years.

With the financial companies moving assets all over the Balance Sheets currently, future attention must focus on this simple manipulation when valuing the earning power of the current crop of deadbeats.

 

Bank inter-market funding

From David Gaffen;

Despite the best efforts of the Federal Reserve, financial institutions still perceive that the bank across the street they’re accustomed to lending to (and borrowing from) has some kind of risks that have not been fully accounted for.

The spread between LIBOR and three-month Treasury bills, as pointed out by Mark Gongloff in today’s Ahead of the Tape column, remains much higher than the historical trend. Tony Crescenzi, chief bond market strategist at Miller Tabak, says the ongoing credit stress is, in part, why the Federal Reserve’s $100 billion term auction facility (TAF) has been fully subscribed (that is, received as many or more bids than what is offered).

“Part of the reason for the pressures on bank rates such as LIBOR relates to the dealer community, which has tapped the banking sector via repos and other securities lending, reducing the amount of capital banks can lend,” he wrote in a commentary.

That stands in contrast to the activity in the Fed’s Term Securities Lending Facility, a more limited fund designed to alleviate some of the funding issues broker/dealers have been having. This facility has attracted fewer bids than the amount the Fed has been willing to auction — another auction is scheduled for today at 2 p.m. The most recent auction was slated at $50 billion, but only $34 billion of bids were received.

Lou Crandall, credit analyst at Wrightston ICAP, says, however, that “the TSLF is a $200 billion program targeted at a handful of leveraged dealers — the TAF is $100 billion aimed at essentially the global banking system.”

But the reduced interest in one and strong interest in the other oddly has a similar meaning. With the TSLF, dealers would have to be willing to take on collateral from their customers to exchange at the Fed’s discount window for Treasurys — but that still implies a re-leveraging, which they are trying to avoid, Mr. Crandall says.

The TAF’s popularity signals that banks remain worried about credit issues among their brethren, and instead of tapping the interbank market, they’re using the Fed’s TAF to fund their own needs, he says. So with LIBOR rates elevated, they continue to find funding elsewhere.

 

New Capital raised [so far]

Money for Banking
Capital Raises Since Oct. 1

Firm …………………………….Capital Raised (bil)
Citigroup……………………………. $23.17
Merrill Lynch……………………….. $12.8
Washington Mutual……………….. $12.04
UBS…………………………………. $11.52
Fortis Bank …………………………$7.91
Wachovia………………………….. $7
Bank of America………………….. $6.9
Total, All Firms…………………… $142.53

 

Debt

It is a truism that all debt is eventually paid.

Of course who pays the debt is the question. Either the borrower can pay, or, should the borrower default, of course the lender pays, and books a loss.

Currently the credit contraction is postulating the demise of the consumers purchasing power, thus the collapse of the economy.

Certainly with increasing unemployment, the purchasing power of the consumer will be impaired, of this there is little to no argument. However, looking past that argument, is consumer debt, going to add to and exacerbate this impairment?

Here we see that consumer debt is not at levels that could be construed as unsustainable, or at levels that should a contraction occur, result in a massive reduction in spending power.

Taking a look at Bank credit;

We see that Banks are definitely overextended and at historically high levels. This is in part why the current crisis has been so focused on the Financials.

When we take a closer look at Bank lending, the salutary fact that leaps out is the predominance of real estate lending on the Balance Sheets of the Banks, followed as far as the consumer is concerned by Credit card debt.

As a % of income, mortgage payments consume a far larger % of disposable income than does credit card servicing.

With borrowers defaulting on their mortgages, the lenders are paying the debt down, via writedowns, Fed subsidies etc. Thus we have the interesting phenomenon of actual debt contracting in the economy, reducing the service thereon, which ultimately should prove bullish to the economy.

This is not to say that there are no structual problems, as there will be, however, the pessimism that rightly prevailed prior to government intervention in the Financial sector has good reason to abate.

Once again the eleemosynary actions of the Fed look to prevail, and the philosophy of deus ex machina has paid off in spades for financial markets.

 

1864

The National Bank Act 1864 was uncomprimising and unequivocal, lending against Real Estate was forbidden. The history of American banking was littered with panics, runs and failures that could be directly linked to an overenthusiastic acceptance of real estate collateral. Land, and it’s theoretical value, suffered the bane of illiquidity in any form of panic or run to liquidity.

The Federal Reserve Act of 1913 modified the original strictures of the 1864 Act, and they were further relaxed in 1927 & 1935 and again in the 1960’s and 1970’s.

In 1961, a sub-committee of the House Banking and Currency Committee held hearings with regard to increasing the limits on real estate lending to 70% of a banks deposits. The FDIC, Treasury and American Bankers Association all supported the increase.

The traditional view, that real estate collateral was illiquid, took an about face. In times of economic recession, savings rates, thus deposits tend to increase, thus, real estate loans became a smaller % of the deposit base. Second, FDIC insurance would allow a bank to make illiquid loans…or so the new theory went.

Of course FDIC insurance is after the fact of a bank run and bankruptcy. FDIC insurance certainly encourages moral hazard and speculation, especially with the removal of the double indemnity laws, which placed owners directly in the firing line.

In 1960 Real Estate Investment Trusts [REIT's] were passed into law. The majority of the new REIT’s were bank sponsered, the 1960 version of SIV’s currently. In 1968 the Federal Housing Act was passed into law, and the housing boom was on.

Barrons declared in 1969 REIT’s as the #1 growth stock. The Mortgage REIT made it’s appearance, borrowing money at say 6%, it loaned money to developers at 12%. REIT’s by law had to distribute 90% of their earnings to qualify as a REIT and avoid paying tax. This however mandated that to grow, they had to keep borrowing.

In 1970, Chase Manhatten Bank sponsered the Chase Trust REIT. Within five years assets [debt] grew to in excess of $1 Billion [when $1 Billion was a lot of money] Chase Trust financed the building of office buildings, resorts, condominiums and shopping malls.

Loans exceeded 100% of project values, a developer could borrow 120% of the proposed project value, ending up with cash in his pocket having done absolutely nothing…sound familiar?

In the 1974-1975 recession hit the developers, and cashflow became a problem, so the servicing of debts became a problem. Chase Trust found in excess of 70% of their loans became NPL’s

By 1980 thirteen REIT’s including Chase Trust were no longer in existence, having gone bankrupt and been liquidated.

Obviously, absolutely nothing has been learned on Wall St.

 

Resolution

There have been numerous Banking meltdowns;

*Argentina 1980, 1986, 2001
*Brazil 1984
*Chile 1981
*Indonesia 1997
*Malaysia 1985, 1997
*Mexico 1992
*South Korea 1997
*Spain 1987
*Sweden 1992
*Thailand 1983, 1997
Uruguay 1982

Once the emergency measures taken to stabilize the financial system have been taken, and the initial panic passes, the more complicated work of dealing with the insolvencies can begin.

In excess of 1000 Thrifts failed during the 1980 S&L crisis. Factors that caused these failures;

*Mis-management of interest rate risk [duration/maturity mis-matches]
*High NPL levels following collapse of Real Estate prices
*Speculative investments backed by FDIC insurance

As can be seen from the above list, nothing much has changed. We still have the Banks mis-managing duration and maturity risk, we still have the Banks mis-managing NPL’s due to a complete absence of any lending criteria, to which management are directly culpable, and should be liable to incompetence charges.

The result was the Government sponsered Resolution Trust Corporation [RTC] an “Asset Management Company” whose objective was the working out of NPL’s, managing the assets until disposal.

At the peak of the S&L crisis, the RTC managed some $1 Trillion in NPL’s. The RTC was wound up after seven years, after successfully disposing of their last NPL assets.

In addition to the successful conclusion to the S&L debacle, Mexico, Sweden, South Korea, Malaysia and Indonesia all utilized the same methodology to successfully manage their systemic financial crisis.

Thus it can be seen that the model is tested and proven.

Method:

*Acquisition of assets.
The NPL assets are purchased by the AMC + the rights to any collateral that is held and foreclosed assets.

*Management of assets;
NPL’s must be actively managed, or they risk losing even more value [property maintainance etc] There are then two major strategies; selling of NPL assets to a third party, Vulture Funds, or, restructuring the debt.

*Disposal;
This is the final step. Here restructured NPL’s are either sold, or come to maturity and are discharged. Either way, this can take some time, the 1980 experience taking 7yrs.

Currently in this years current crisis, the Fed has been primarily concerned with stabilising the market via injecting liquidity for both solvent [but illiquid] and insolvent [illiquid] financial institutions. There are now signs that the panic is abating, thus, in the next stage we shall see the establishment of an AMC that will be responsible for managment and ultimate disposal of NPL assets.

 

Implications for the iBanks, from Gross

Reuters
Tougher rules could hurt Wall Street profits-PIMCO
Monday March 31, 11:46 am ET

NEW YORK (Reuters) - Wall Street profits could take a big hit if the government toughens regulations in a proposed overhaul of the U.S. financial system, the manager of the world’s biggest bond fund said on Monday.

The White House and some lawmakers have called for a regulatory sweep, not seen since the Great Depression, in the wake of the current turmoil in financial markets and the near-collapse of U.S. investment bank Bear Stearns (NYSE:BSC - News).

On Monday, Treasury Secretary Henry Paulson outlined a plan that permits the Federal Reserve to oversee the books of U.S. investment banks and other large non-bank financial companies which are currently treated differently from commercial banks and savings and loans and thrifts.

Gross, the chief investment officer of Pacific Investment Management Company, or PIMCO, anticipates such a regulatory revamp will result in higher capital standards for investment banks, bringing them closer to their commercial bank counterparts.

“There seems no way that current reserve requirements for banks will not in some nearly uniform way be imposed on investment banks,” Gross, who manages the $120 billion PIMCO Total Return Fund, wrote in his latest monthly ‘Investment Outlook’ published on Monday.

Tougher regulations, with the goal to shore up the safety and soundness of the overall banking system, will likely slash the profits of major investment houses like Goldman Sachs (NYSE:GS - News), Lehman Brothers (NYSE:LEH - News) and Merrill Lynch (NYSE:MER - News), Gross said.

Gross referred to these Wall Street firms as “shadow banks” because they have raised billions in the capital markets, rather from savings and traditional lending. Less stringent regulations had allowed Wall Street to make riskier and more profitable bets than commercial banks.

This “shadow banking system,” which consists of all the levered investment conduits, vehicles and structures created by Wall Street, is now facing liquidity constraints.

“Shadow banks will likely be forced to raise expensive capital and/or reduce the bottom line footings of their balance sheets,” he said.

This would mean lower stock prices on higher borrowing costs for investment banks, he said.

Meanwhile, more stringent regulations would mean investors would demand wider risk spreads or higher return premiums, which could be a drag on the economy, according to Gross.

“Risk spreads - from corporate bonds to equities to commercial and residential real estate - will settle at permanently higher levels. The U.S. asset-based economy will morph into a more expensive hybrid that will reign supreme for years to come,” he said.