Saturday, February 28, 2009

Berkshire Hathaway - Chairman's Letter

I was much closer then Gary Ransom.  

Therefore the liability is going to increase by about $2 billion. (note: This was only the index puts, my estimate for total derivative losses was $3 billion.)
That means Berkshire could take a fourth-quarter hit on the options, as much as $12 billion, says Fox-Pitt Kelton analyst Gary Ransom.
It looks like the total (index puts, CDS's, misc) is closer to $5 billion.  The index put liability was slightly over $3 billion.  I'm not going to bother trying to get more precise until the 10k comes out. Gary was close on the overall decline in book value, so he gets points on that.

However, the figures imply that Buffett decided to increase the volatility assumption in Black Scholes. This is significant for a couple of reasons. My thinking is that he should be using a figure that is roughly fixed -- or a 15 year rolling average. He said the following:
The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probability-
weighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing quotes as an important ingredient in an equation that predicts a probability weighted range of values for the farm a century from now.)
Though historical volatility is a useful – but far from foolproof – concept in valuing short-term options, its utility diminishes rapidly as the duration of the option lengthens. In my opinion, the valuations that the Black- Scholes formula now place on our long-term put options overstate our liability, though the overstatement will diminish as the contracts approach maturity. Even so, we will continue to use Black-Scholes when we are estimating our financial-statement liability for long-term equity puts.
Therefore, Buffett INCREASED volatility, even though he believed it was already too high, from an economic perspective.

One other factiod regarding the index puts. When Buffett originally booked them, he thought they were grossly over valued. However, he booked them with no initial income impact. In order to do this, he had to "back into" Black-Scholes parameters that would produce this result. Therefore, the fact that the parameter adjustments will be much lower then others have suggested, one reason is that they started on the high side.

Friday, February 27, 2009

WSJ on Berkshire Index Puts

The Wall Street Journal commented on the oft discussed Berkshire Hathaway index puts in its 'Ahead of the Tape' column today:
In recent years, the Omaha, Neb., holding company sold what were essentially insurance policies against a long-term decline in U.S. and foreign stocks in exchange for $4.5 billion. When the contracts expire in periods of either 15 or 20 years, Berkshire will have to fork over cash -- possibly billions -- if the indexes are below where they stood when the deals were struck.

The S&P 500 is down about 50% from its peak, and indexes around the world have cratered. Berkshire has to calculate its potential liabilities on the contracts every quarter.
In the third quarter of 2008, Berkshire said its mark-to-market liabilities on the options were $6.7 billion. Since then, stocks have fallen more, and volatility, a key element in valuing options, has soared. That means Berkshire could take a fourth-quarter hit on the options, as much as $12 billion, says Fox-Pitt Kelton analyst Gary Ransom.
I am going to use the WSJ figures and a little common sense to illustrate the economics of the options deal and the fact that the estimate of a quarterly hit of $12 billion is off by greater then a factor of 4. Before we move to simple arithmetic, I would like to point out that the appropriate volatility figure would an estimate of volatility in the future 12 years (plus) of the contracts. Therefore, the fact that we have had high volatility recently should not have much impact on an estimate of future volatility. In fact, I believe that Berkshire picked a relatively conservative (high) volatility estimate when they booked the initial estimates and will continue to use the same estimate until it seems likely that we have had a permanent change in volatility.

As a little background, The notional amount of the contracts is about $36 billion.  There are no collateral requirements and no cash will change hands until the first contracts expire in 12 years.  They are "European" options and can only be exercised at expiration.    

The Berkshire liability is calculated using Black-Scholes and the "delta" is in the low 20% range.  Delta is the change in the value divided by the change in the underlying index.  For example, if the index decreased 1/4 of its notional value in the 4th quarter or $9 billion, the liability (pretax) would only increase by about 23% of that figure.  Therefore the liability is going to increase by about $2 billion.  

However, if we want to think about a more rational way to book the options each quarter, I suggest that any change in value be "amortized" by 1/60 each quarter, based on their 15 year life.  In that case, the time premium for the option would decrease about $65 million each quarter and an additional 1/60 of the amount the option is in the money would be booked each quarter.  This is an estimate of the liability components over 15 years.     

Using the same "straight line" amortization, and assuming that the indices finish exactly where they are today, the losses would be booked at $225 million per quarter over 15 years.  However, the economics of the deal also include the cash plus the investment income.  Showing this and the total net loss (green line) below gives you the economics of the deal with the indices down 50%:
Here you can see that the loss in 15 years is a little over $10 billion.  This is based on an assumed return of 6% on the initial premium.  The idea of using a "straight line" approach to accounting for the losses is a bit extreme, and may appear unrealistically optimistic.  However, I am sure that Buffett would also prefer to book only 1/60 of the time premium if the contracts were out of the money.  

The point of this exercise is to look at the options as contracts that amortize smoothly over a 15 year period.  Even if the results are extremely unfavorable, like the assumption that indices decline 50% over a 15 year period, the quarterly economic impact isn't particularly significant.  In addition, the amount of loss would not be a problem for a company with over $100 billion in capital.   

Harley Davidson - TALF

An iconic american brand.  

It seems like people still want them, and they still want to finance them.  However, Harley has a finance subsidiary that kept some loans and securitized others.  The last successful securitizetion was in 1Q 2008.  For almost a year, Harley has had the option of holding loans on its balance sheet or cutting back production.

Harley just borrowed $600 million for "general corporate purposes" @ 15% for 6 years.  They need financing to support the additional assets and provide financial stability while they try to get back to something approaching normal.  Per the prospectus:

Harley's top line looks about the same as 2007. The big change is the amount of debt. The debt is to support the "receivables held for sale" which are the loans that *would* have been securitized, had that market not collapsed.
The increase in financial receivables held for sale as of September 28, 2008 compared to September 30, 2007 was due primarily to a reduction in asset backed securitization activity in 2008 due to capital market volatility.

Per the prospectus:
...we are working to gain access to the asset-backed securitization market through the Federal Reserve Bank’s Term Asset-backed securities Loan Facility or “TALF” program. We are researching the program and determining how we may benefit from it. Retail motorcycle loans have been included as eligible.
Anyone that wants to can spend some time researching the business. However, it is basically solid and profitable. It is financially "jammed up" by the credit crunch. It has been able to get by just bulking up on financing assets. However, the financing model won't work for long. They need to sell assets on a regular basis or take some other action. They can only park the financing receivables up to a point -- then their balance sheet goes to hell.

That's why the TALF seems like a good idea.

Thursday, February 26, 2009

Blog Calculated Risk Questions Stress Test

The blog, Calculated Risk, has become quite influential. The quality of the data and analysis as well as its accessibility has been outstanding. However, I believe they may be over reacting to possible deficiencies in the Treasury stress test. Per CR via Bloomberg:
Moody’s Investors Service said it’s reviewing all 2005, 2006 and 2007 subprime-mortgage bonds for credit-rating downgrades, covering debt with $680 billion in original balances.

The review reflects an increase in Moody’s expected losses on the underlying loan pools, the New York-based company said in a statement today. Losses for such mortgages backing 2006 securities will probably reach 28 percent to 32 percent, up from a previous projection of 22 percent, Moody’s said.

The ratings firm said that it boosted expected losses based on “the continued deterioration in home prices, rising loss severities on liquidated loans, persistent elevated default rates, and progressively diminishing prepayment rates.”
CR is concerned that the Treasury stress test may include assumptions that are even more optimistic then rating agency's base case.

A loss rate is a default rate times the loss severity of a default. For example, if you have a default rate of 50% and a loss per default of 50%, then you have an overall loss rate of .5 x .5 = .25 or 25%. To get to a loss rate of 50%, you would need an slightly worse then 70% loss rate and a 70% severity on each loss.

If you take the worst pools, this is very believable.  However, when we look back at the subprime excesses, the worst tended to be securitized.  That is, they were originated with the intention to sell to investment banks as raw material for CDO's.  Commercial banks weren't in that business, for the most part.  The originated to hold.  They may have written a lot of bad mortgages, but they know they were keeping them.

At the very least, they would have tried to keep the better loans and sell the lower quality loans.  As I have discussed before, we have two competing models of lending.  Originate to distribute/securitize and originate to hold.  The former was the provence of investment banks and the latter of commercial banks.

I wouldn't rush to judgment regarding the stress tests.  In general, all they can do is rank the banks with respect to capital strength.  They really can't do much for investment banks, due to their incredible complexity.  As far as commercial banks, they can rank them, draw a line, and take action.  That is, identify the basket cases, and sort the likely survivors by strength.

Whatever foolish decisions were made in commercial banks, they weren't creating CDO^2.   They are fundamentally different then investment banks, and the attempt to treat them the same doesn't make a lot of sense.  Unless they believe the investment banks must be kept around, and the only mechanism is to pretend they are commercial banks -- and then backstop them.  

I'm not ready to give up on Obama/Treasury yet.  

Monday, February 23, 2009

Join the Board of Directors

All this talk about banks, but people tend to not know what they don't know.  You wanna be a new director of a community bank for a day?  The KC Fed has an online course that tells you all you need to know.

This site is built around events occurring at the fictional “Insights Bank and Trust,” a small community bank where you serve as an outside director. An outline of the course is presented to the right. Early parts of the course serve as a prelude to an October board meeting, which will offer information on typical points of discussion for bank directors.

In the early sections, you will learn about your duties and responsibilities as a director (see Corporate Governance) and items to expect as you start the important job of being a bank director. You will also learn about a fraud that occurred at Insights Bank prior to the meeting; this section introduces the topic of operational risk and its controls. Subsequently, you will attend an October board meeting where the focus is on a variety of topics regarding the evaluation of a bank’s financial performance and the management of the risks to its portfolio (credit risk, market risk and liquidity risk).

In each lesson, you will find video scenarios, sample reports and reference materials that are designed to raise awareness and help directors address on-the-job issues banks often face. Printable references, helpful tips and practice exercises may also help you gain confidence to ask pertinent questions and apply new knowledge to meeting bank director’s real-life responsibilities. A list of course topics, practice exercises and supporting “meeting materials” lessons is available from the Reference View.
This is really a good course and people might really find it useful -- like how to set loan loss reserves. Here is another view of the content. Economists and people with a theoretical basis in finance might get a little taste of reality, and perhaps humility. I suppose that's asking too much.

Wednesday, February 18, 2009

U.S. Bancorp's Davis Rips TARP

In a local speech at the Thrivent Financial for Lutherans' Business Leaders Forum, US Bankcorp CEO, Richard Davis was candid in his criticism of TARP.
"I will say this very bluntly: We were told to take it. Not asked, told. 'You will take it,' " Davis said. "It doesn't matter if you were there on the first night and you were told to sign on the dotted line before you walked out of the office, or whether in the days that followed, you were told to take it."
Davis went on to say in his talk that while government officials marketed the program as a way to entice banks to lend again, TARP actually was designed to give solid banks like U.S. Bancorp some extra cash to buy weaker banks in the system. U.S. Bancorp did just that late last year when it acquired the assets of two failed banks in California, Downey Savings and Loan and PFF Bank & Trust.
"We were told to take it so that we could help Darwin synthesize the weaker banks and acquire those and put them under different leadership," he said. "We are not even allowed to mention that. ... We were supposed to say the TARP money was used for lending."
However, Davis is just one of many "traditional" bankers that is waking up to discover that the Treasury/Fed programs were not designed with them in mind. Rather, they are being dragged into the mindless nationalization debate that is primarily focused on saving the investment banks and the competing "originate to distribute" (via securitization) model.

Davis woke up in Minnesota to find he had become part of the now hated Wall Street banking cabal.  The stock price of his bank has fallen from a high of $35/share in October to $11 today. He also learned that when he was told to take the money, he was also supposed to stick to the story.  His lawyers and PR people backtracked today to minimize the damage. 
Tuesday afternoon, a U.S. Bancorp spokesman said Davis had misspoke, and meant that because the largest banks in the country took TARP money, U.S. Bancorp and others were forced to do so as well, for competitive reasons.
Clearly the Treasury feels like it is essential to get the securitization part of the credit system running again, but traditional bankers aren't willing to take one for the team -- especially if it means getting railroaded into a nationalization scheme.  As a Midwesterner, Davis seems befuddled by the Treasury and the political morass he was clearly not expecting.    


In correspondence with the SEC, USB discussed its policy regarding originate to distribute.  Other then GSE mortgages, they originate to hold.

Tuesday, February 17, 2009

Geithner's Most Important plan element least discussed

The big problems are the big investment banks, not the traditional banks.  As a nation, we have had bank problems since the 2nd National Bank.  It may not be fun, but people know how to do this.

However, the huge amount of lending through securitization by investment banks is a new issue.  Per Geither:
Consumer & Business Lending Initiative – Up to $1 Trillion: Addressing our credit crisis on all fronts means going beyond simply dealing with banks. While the intricacies of secondary markets and securitization – the bundling together and selling of loans – may be complex, they account for almost half of the credit going to Main Street as well as Wall Street. When banks making loans for small businesses, commercial real estate or autos are able to bundle and sell those loans into a vibrant and liquid secondary market, it instantly recycles money back to financial institutions to make additional loans to other worthy borrowers. When those markets freeze up, the impact on lending for consumers and businesses – small and large – can be devastating. Unable to sell loans into secondary markets, lenders freeze up, leading those seeking credit like car loans to face exorbitant rates. Between 2006 and 2008, there was a net $1.2 trillion decline in securitized lending (outside of the GSEs) in these markets. That is why a core component of the Financial Stability Plan is:
A Bold Expansion Up to $1 Trillion: This joint initiative with the Federal Reserve builds off, broadens and expands the resources of the previously announced but not yet implemented Term Asset-Backed Securities Loan Facility (TALF). The Consumer & Business Lending Initiative will support the purchase of loans by providing the financing to private investors to help unfreeze and lower interest rates for auto, small business, credit card and other consumer and business credit. Previously, Treasury was to use $20 billion to leverage $200 billion of lending from the Federal Reserve. The Financial Stability Plan will dramatically increase the size by using $100 billion to leverage up to $1 trillion and kick start lending by focusing on new loans.
This is a major rationale for saving the investment banks.  However, this will be a challenge.

1.  People got burned badly the last time they bought securitized loans.  They won't make the same mistake again.

2.  The rating agencies will have to clean up their act.  Or perhaps just cut out of the process.  If the securities have a Treasury guarantee, the rating agencies aren't needed.

3.  The originators of the loans haven't had a paycheck in a while, and may not be around.  

4.  They have to make solid loans.  The demand for loans to buy motorcycles, boats, etc. may be modest.  The people most likely to borrow are least likely to qualify.

5.  The new securities need to be bullet proof, much simpler, more transparent, and contain more protection for purchasers.  A lot of the profit was made by cutting corners in all these areas.

6.  If the securities are simpler and the process is controlled by the Treasury, then maybe you don't need rocket scientists making them and costs/fees are significantly lower.

For these reasons, half of it isn't coming back.  

Saturday, February 14, 2009

From Barrons

Barron's Gene Epstein is following up on his spectacularly bad call in the October Cover Story, regarding recovery:
We assume, however, that the Treasury secretary will soon come up with a real plan to get credit to flow more freely. If so, Mike Astrachan, Israeli economist and former Federal Reserve staff member, is so impressed by the signs of turnaround that he thinks growth could resume as soon as the second quarter.

One of these signs was the unexpected 1% increase in January retail sales, reported Thursday, measured in nominal terms. Since overall prices were probably about flat in January, this means real retail sales also rose about 1%. This was right in line with the monthly ICSC/UBS index, which was also up 1% in January. The strength was widespread across sectors, including electronics, food and beverages, and clothing. The most surprising was motor-vehicle sales, up 1.6%.

The increase reverses only a small part of the weakness in retail spending, but it does highlight a potentially revealing pattern. In our Oct. 20 story, we had thought that the fall in energy prices would soon bring a rebound in consumer spending. We proved wrong; the energy dividend was not enough.

But now we see that the steepest drop in sales occurred from June to October, around the time of the energy shock and its effects, and that since October, the weakness was less severe. Real total sales still declined over the past three months.
It was rather obvious at the time that the April tax rebate went into people's gas tanks, and that the pessimism and issues from the commodity bubble were playing havoc with the economy.  This final bubble pushed the tottering economy over the cliff.  Reversing it wasn't enough to do the job, but it counted for something.  In December, the social security COLA was about 5%, putting another $50/month in a lot of retiree's pockets.  Lower interest rates cut both ways, and I suppose that retirees are earning less on savings.  However, all the programs to lower interest rates are going to start filtering into people's pockets.  Any ARM tied to LIBOR or a Treasury Index is going to reset at record low levels.  

What does this all mean?  About the time that Roubini becomes conventional wisdom, it is time to move on.  

More Blather From the Times

Gretchen Morgensen's Column, The Worst Misstep: Geithner Added to the Doubt, is fundamentally dumb. I have the feeling that she doesn't know if loans are assets or liabilities, and ditto with deposits. However, the half hearted attempt to discuss the arithmetic of bank financial strength isn't the point.

Rather the point is that we need to quit lying and get at a higher truth.  To start with the conclusion: 
But it will also require transparent, rigorous analysis; candor with the public and investors; and a recognition that lots of debt heaped upon a pile of dubious assets has created a financial nightmare — it’s no more complicated than that.
If you can parse the sentence to determine what is debt and what is a dubious asset, and assume that debt refers to the bank's leveraged capital structure, which includes junior debt (preferred shares) and capital, and dubious assets are the loans and securities that earn interest, then maybe it makes sense.

However, the way to get to this transparent, rigorous analysis is the following:
So here’s a strong first step: the Treasury Department needs to hire out-of-work bankers to conduct what investors call a “burndown analysis” of banks’ financial positions. This is what private investors do as they go foraging for gems hidden amid the wreckage in the banking system.
A burndown analysis, because it is a worst-case exercise, typically requires very pessimistic estimates for loan performance early on and higher-than-average loss estimates for loans in later years.
And then:
A bank’s prospects also derive primarily from its deposits, not its loan book, in such an assessment. To reiterate: Any examination of a troubled financial institution needs to determine what its assets are truly worth, how much can it earn and how much capital it needs to operate at a profit.
But she had already asserted that:
it involves knowing where the economy will be in six months or a year
So, this rigorous analysis involves knowledge of the future, which is inherently unknowable. It also requires knowing short and long term interest rates. I suppose that it is reasonable to assume that the Fed can keep short term rates -- the borrowing costs of banks, low for a while. But what happens if we get some inflation and interest rates on short term rates climb? The banks earn zero or less, since they lend "long" and are funding with deposits.

Meanwhile, the "burndown analysis" tells us that the assets are worth enough less to make the banks insolvent.  Banks tend to have capital ratios of about 10% of assets, and need to maintain these levels.  Write down the assets by 10% and the capital is gone.  

Here is a simple model:  Take the peak unemployment rate - 8% times 2 times the bank's assets.  If peak unemployment is 15%, then take 15%-8% = 7% ------- multiply by 2 to get 14%.  Then multiply that by the bank's assets to get losses.  

They are all insolvent under these absurdly simplistic assumptions.  This isn't much different then Mr. Roubini's estimates published yesterday in the Times.  14% of the $14 trillion of bank assets gives you about $2 trillion vs. Roubini's $1.7 to $1.8 Trillion.  

There is no hidden "truth" that needs to be disclosed.  The only thing the markets want to know is how badly the share holders are going to be punished.  The markets learned that any new capital was going to come with a high cost, so that sliced the already modest value of financial shares.  

Constant repetition of the idea that there is a hidden, true value for assets is idiotic, simplistic, and maybe even dangerous.  People may want to know the future of the economy, but it isn't honest and transparent to pretend that you know.  

Friday, February 13, 2009

The Banks Are Already Nationalized

The Banks need to be triaged.  Especially the big banks, no?

It has already been done.  Note.... all figures are from the FDIC and the percentages are based on deposits @ 6/2008.  The banking system has about $13 Trillion in assets and $7 Trillion in deposits.  Other then a couple of big outliers, deposits are about as good as anything to denote relative size.

Right now, I am going to concentrate on the 50 largest banks that make up over 50% of total deposits.

20% have essentially failed this year.  They have either been taken over (IndyMac) or been forced to merge with most of the cleansing that comes with a traditional failure.  Wachovia is about 10%, WaMu 5%, with the others (Countrywide, etc) making up the remaining 5%.

Bank of America and Citi together have about 22% of the remaining deposits.  The fact that both of these institutions received the original TARP funds, plus an additional round of funds and asset guarantees means they have been de facto nationalized.

I am astounded at the extent to which the public has taken to the Andrew Mellon sentiment of radical liquidation.  
Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate"
"It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.”
It sounds about as good as the dieting fads that involve high colonics.  Although Mellon's suggestion wasn't deliberately put into effect, the deflationary spiral from 1929 to 1932 liquidated anyone with debt or leverage.  

Citi is in the process of liquidating itself -- trying a do it yourself version of good bank/bad bank.  BAC will need enough additional capital to effectively become nationalized.

The New York Times is using Roubini's figures of $1.7 Trillion for bank losses.  Since Banks have $13 Trillion in assets and Roubini may be including bank like institutions, the total is maybe 12% or 13% of assets.

It is hard to say where we end up, since we don't know how bad the economy will be, how much real estate prices will fall, etc.  

I'd like to make the Sheila Bair the villain here.  Wachovia and WaMu were essentially Nationalized.  However, instead of sucking it up and bearing the costs, the FDIC pushed them into "mergers."  They could have been cleaned up and then run as independent entities.  Instead, the idea was to protect the FDIC's modest resources, wipe out the stock holders and the bond and debt holders to varying extents, and give the cleansed entities to other mega mega banks.  

OK.... Sheila was on a short leash and couldn't do everything she wanted, although she went along with the mergers without much of a whimper.  

Take a look at what Wells did to Wachovia:
They have also budgeted another $20 billion in "reserve build" for 2009. This is essentially write downs at the time of purchase plus the tax refunds -- 1/3 of the $60 billion total gives an after tax figure of $40. I would have to look up WB's asset base, but it is probably in the half trillion range, giving them the full Roubini.

However, Wells didn't give themselves the full Roubini -- and no doubt were thinking that any over estimation of WB losses could be used against their own problems.
JPM did something similar with WaMu. However, BAC actually PAID for the problems in Countrywide and Merrill. If Lewis had insisted on letting them go down before picking up the pieces, he wouldn't be sitting in detention with Citi.  Whether picking up valuable deposit bases with "de risked" assets will be enough for JPM and WFC remains to be seen.

People will need to be punished to satisfy the public's blood lust.  However, the bottom line is that the government has to move assets to their balance sheet or you get a deflationary spiral immediately.  It might sound terrifying, but the only outcome that leaves the economy intact involves avoiding liquidation.  It's the same debt, it just gets labeled public instead of private.  Or gets the benefit of being treated as if it were public (without actually calling it that .... see the GSE's for an example).  

The "us/them" meme doesn't work anymore.  Everyone hates paying taxes, even the Treasury Secretary.  However, the government gets 20% off the top -- so the extent to which the economy doesn't collapse is doubly good for the taxpayer.   Plus they get 1/3 of corporate profits.  If it works reasonably well, it is for the taxpayer's benefit, not at his expense.  If it doesn't, then we get to do over the 30's.   

What is a Bank?

I'm trying to get at what people are talking about when they keep talking about the banking system.  Back in the day, it was pretty easy to figure it out.  Banks had buildings with tellers and FDIC insurance.  Brokers didn't.  No one had ever heard of an investment bank.

It goes back to the 30's.  The Glass-Steagall Act.
Mr. Glass: Here [section 21] we prohibit the large private banks whose chief business is investment business, from receiving deposits. We separate them from the deposit banking business.
Mr. Robinson of Arkansas: That means if they wish to receive deposits they must have separate institutions for that purpose?
Mr. Glass: Yes.
Basically that means that if you take insured deposits, you have to get out of the direct investment business.  That was then and this is now.  Glass-Steagall had a number of restrictive reforms that were inefficient.  It also created a safe, regulated sandbox for the average citizens and a less regulated one for those that wanted something different.  It was chipped at for years, and is now mostly gone.

Right now, the FDIC insured institutions have about $13 trillion in assets and $7 trillion in loans.  The past 5 decades have been primarily a process where more and more transactions took place outside of regular banks.  Money Market Funds were started in the early 70's and bought high grade commercial paper.  This used to be a staple of banks.  Just an example, but the regular banks tended to get "disintermediated."

You had money center banks that were somewhere between investment banks and vanilla banks.  Then you had your pure investment banks, your brokerages, and the like.  

Regular banks can go bust -- witness the S&L crisis.  However, it is a pretty simple business.  You "make assets" like loans of various types and fund them with a layer of capital and deposits.  Normal people can do this without computers.  The did for decades.

Everyone knows that you don't let your vanilla banks get to fancy, and that they need to have an organized process if they fail.  Basically, the FDIC comes in, declares it insolvent, turns the deposits (liabilities) and an equivalent amount of cash to another bank, and the depositors are up and running the next day.  The FDIC then has the residue, which consist of loans of various quality levels and the collateral that is rounded up from the busted loans.  

Then you have your capital markets operations.  This stuff is done by investment banks, brokers, etc.  Normal people can't understand it.  They didn't understand it.  It used to be hived off.

However, this is the area that is both failing and difficult.  It is also an area that got crammed back into the regulated banking system and supported with taxpayer funds.  Why?

Basically because if you tell the public, it's the banking system, they know it is important and can't fail.  If you tell them it is brokers and derivative salesmen, they are likely to say no.  So, if you want to bail out the capital markets people, regardless of where they are nominally hiding, you have to call them bankers.

Therefore, JPM acquired a huge deposit base, then scarfed up Bear Sterns, then grabbed another huge deposit base via WaMu.  City has always been a mess in one way or another, and managed to have a decent sized deposit base, although as a "money center bank" it has been been too big to fail and bailed out once already.  But in spite of its deposit base, it never was a regular bank.  Then you had Merrill Lynch absorbed by Bank of America.  Goldman and Morgan Stanley became regulated banks to grab some TARP funds.  

All of a sudden, Wall Street is pretending to be regular banks in order to tap into the bailout funds.

I don't really know if Wall Street is essential to the financial system, but, unfortunately there is a decent argument.  So much credit has bypassed normal banks via securitization that you can't say they aren't important.  However, it is a stretch to call them Banks, except to confuse the public.  

People are going nuts about nationalizing the banks.  Anything that was similar to the traditional bank has already been worked over, and the worst are history.  Indymac - gone.  WaMu - gone.  Wachovia -- gone.  National City - gone.  Not nationalized, but the stockholders were pretty much wiped out, the assets written way the hell down, and moved to someone that appeared stronger.

This is maybe 15% to 20% of the deposit base of regulated banks.  So what is it that needs to be nationalized?  It is Wall Street pretending to be regular banks.  However, they have tended to get so tangled with regular banks that it is hard to sort things out.

Unmerge BAC and MER.  Let Goldman and MS keep their TARP loans for another year or two and then pay them back.

The vanilla banking functions can continue without too much disruption.  The community and commercial banking functions can be cleaned up easily enough.  

The Capital Markets stuff is the real mess, and I have no idea how to really deal with them.  However, I would assume that the worst abuses were in the past and there is never going to be anything resembling justice.  Once you forget about that, it is just a pragmatic calculation of whether it is cheaper to bail them out or unwind them as quickly and orderly as possible.    


Thursday, February 12, 2009

How to buy $500 billion in "toxic" assets for$50 billion

Re:  The Treasury plan to use public/private money with up to 10x leverage to buy $500 billion of "toxic assets." The short answer --- you plan on losing the $50.  Unlike the other Treasury/Fed proposals, which were set up so for the taxpayer to "come out whole" -- the only way to do this little trick is to plan to blow the money.  

Since the entire process is politically toxic, time to consider the option of leveraging what they have by letting go of the constraint of getting paid back.  The public mostly doesn't believe it will happen anyway, or don't make the distinction between a loan and spending.

Right now, private investors want 15% to 20% with little risk and what banks have is assets that yield 5% to 10% with a lot of risk.   

Here is something that might work:

1.  Plan on losing the $50 billion.  Set up a choice of structures.  The Treasury would take a layer of risk.  Like the first 10%.  Or let the private investors take the first 10% and the Treasury take the next 20%.  Or let the private investors take the first 20% and let the Treasury take the next $30%.

2.  One might wonder how the Treasury could afford to take more then 10% "layers" of risk -- but the further up the structure, the lower both the frequency and severity of potential losses.  That is, if a private investor was willing to take the first 20%, it must seem viable enough that it has a 50% or better chance of not losing a penny, much less 50%.  

3.  A lot of the problem assets already have haircuts.  If they started out with some subordination and already had writedowns of 10%, 20%, etc. then the Treasury has a lot of losses between it and a payout.  

4.  This would exclude the worst stuff, like CDO^2, which were too cute by 1/2.  

5.  Anything resembling a whole loan -- like a bunch of them bundled together, should be a pretty good bet.  

6.  Loan losses have both a frequency and severity component.  That is, X% default, and those defaults produce Y% losses.  If X and Y are both 50%, then the total dollar loss is 25%.  0.5 x 0.6 = .25.  1-.25 is .75 or 75% good money.  A lot of loans had some subordination built into them, and then the stuff has been partially written down.  Yea, people made bad loans, but to get to a 50% dollar loss ratio, 70% would have to default with a 70% loss on each default.  Even some of the worst stuff can't be much worse then this.  You would have to really try hard to write a portfolio of loans this awful.  

Under the 20%/30%/50% option, the most senior 50% piece would be a decent enough credit.  The 30% guaranteed piece is as good as the Treasury.  This gives the investor 5x leverage, so they don't have to do the best deal in the world to make money.  

One might ask what is in it for the banks.  This is the big, big question -- since this would involve selling something for less then its apparent economic value.  The idea is simply this -- getting rid of "financial reporting risk" is worth enough to motivate the sellers.  That is, it doesn't matter what they think it might be worth.  The fact that they could be forced to take additional haircuts ever single quarter until things bottom may be enough to motivate them to do deals.

Even more so, any asset that has an economic value higher then its book value would be chomping at the bit to do a deal.  In this environment, any asset that would fetch MORE then book value would lead to a write up!  

People that think that there are no assets that meet this qualification need to consider the arbitrary nature of a lot of valuation and accounting processes.  Lets just assume that overall, the assets are 10% Overvalued today in the aggregate.  Given the variance in the valuation process, 20% of the assets could still be under valued.  Just assume a distribution with the mean at 90% and a standard deviation of 10%.  1/6 will be over 100%.  

 Any one want a real world example?  Here is one from the Hartford:
Book value is $11.1 billion and market value is $6.8 billion -- or about 60%. Their CMBS's have been written down 40%. It is a little complex, since they use book value for Insurance Capital Ratios and market value for GAAP Capital. Nevertheless, they don't have to sell them, they don't have to fund them, they are planning to hold to maturity, but they need positive GAAP capital to continue to exist in the real world. These things are still paying. They started out with 20% or so initial subordination. If they sold $5 billion at today's market value, that would represent par value loans of $10 billion. The investor would put up $1 billion. The Treasury would insure the next $1.5 billion, and the final $2.5 billion could be financed.  If the CMBS's pay out $6 billion, thats 100% profit.  

For various reasons, this isn't a doable deal -- but remember that the banks *thought* they were keeping the best stuff and selling off the worst stuff.

The unfortunate reality is that the sellers will be getting cherry picked and will sell their most undervalued assets based on current accounting values.  However, given the cost of additional capital -- which is essentially infinity since it isn't available at any price -- it is still an offer that couldn't be refused.

This is just a general approach that makes some sense.  It is based on the assumption that there are a decent chunk of assets that need to be booked at a liquidation value that is lower then their economic value.  After all, thats what a true toxic or troubled asset amounts to.  A busted loan is just a loss and easy to account for.  

I don't know if the real banking system has enough bona fide troubled assets to need a buyout program.  A portfolio of option arm whole loans is just a bad portfolio --  and there is no gap between accounting values which are liberal and economic values.  

The real point of this is that if the Treasury wants private involvement and wants 10 to 1 leverage, they have to take the worst parts of the deals.  And plan to lose the $50.  The big brains that created the structured crap that is at the heart of this are more then capable of coming up with innovative ways to leverage the Treasury's $50 billion.  But it would have to be spent/lost/blown.  No free lunch on this one.   

Tuesday, February 10, 2009


Courtesy of the FDIC. This is based on June data and the various merged entities (e.g. Wells + Wachovia) are combined.  Here are the numbers:

A couple of trillion out of $7 trillion of deposits. You could do the same thing for assets, etc. and get roughly the same thing. Except Citi relies less of deposits as a source of funding.

Prior to the latest round of mergers, the top 3 would be more like 20% then 30%.

Sunday, February 8, 2009


After digging into the report and the appendices, a few things stand out:

1.  The biggest complaint is that the pricing was weak on the preferred shares.  That was part of the idea, like a shot of adrenaline to the heart.  Mainline some capital.  It reminds me a little of the overdose scene from Pulp Fiction where Uma Thurmon gets a hypo straight to the heart.  

2.  They didn't mention that the Treasury gets their return TAX FREE.  

3.  The terms and conditions were based on the Berkshire/Goldman deal!  See footnote 29:
It is customary in corporate legal practice to prepare transaction documents bystarting with documents from another transaction and “marking them up”, and the Berkshire Hathaway papers appear to have been the starting point for Treasury.
All I can say is that it is nice work if you can get it -- just pull another deal off the shelf and fill in the blanks.  So what would be called plagiarism in academia is simply "marking them up" in corporate law.  Cool.

4.  In some ways, excluding pricing, the CPP program had more stringent terms and conditions then Buffett's deal.  
The terms of the CPP agreements in most other areas [excluding price]  are as good as, and in some cases better than, those in the Berkshire Hathaway agreements, although these other areas are typically less important to investors. Such other provisions include voting rights of the preferred stock, covenants restricting common stock dividends and stock repurchases, exercise period of and anti- dilution adjustments for the warrants, transfer restrictions, representations and warranties by the issuer, conditions to closing, and amendment provisions.
However, the CPP [Capital Purchase Program] missed the single most important Berkshire covenant. Namely the requirement that the top 4 executives hold and continue to hold at least 75% of their personal net worth in GS shares.
On September 28, 2008, each of Lloyd C. Blankfein, Gary D. Cohn, Jon Winkelried and David A. Viniar (each an “Executive”) executed a letter agreement with The Goldman Sachs Group, Inc. (the “Company”) in which the Executive agreed that, with certain exceptions, until the earlier of October 1, 2011 and the date of redemption of all of the Company’s 10% Cumulative Perpetual Preferred Stock, Series G, par value $0.01 per share and having a liquidation value of $100,000 per share (the “Series G Preferred Stock”), (i) the Executive will continue to satisfy the Special Transfer Restrictions (at the 75% level) which are set forth in the Amended and Restated Shareholders’ Agreement and described in the Company’s 2008 proxy statement; and (ii) the Executive, his spouse and any estate planning vehicles will not dispose of more than 10% of the aggregate number of shares of the Company’s voting common stock, par value $0.01 per share (the “Common Stock”), they beneficially owned on September 28, 2008.
In other words, they have to eat their own cooking. This is much better then trying to micro manage executive compensation. Plus, it was a deal they couldn't refuse. How could they possibly object to a deal like this in the middle of a pitch regarding how great the company is, etc.  You could argue that they will still be wealthy by conventional standards, regardless of what transpires.  However, being investment bankers and all, the fact they are chained to the company has to add to their sense of commitment.  

The Treasury is a "free rider" on this part of the deal.  They get virtually the same benefit as Buffett without doing anything.  However, this would have been great to negotiate on a company by company basis -- had that been the process.  

5.  The preferred stock of banks, especially BAC and C, has seriously tanked since the CPP was done.  However, if the banks survive, it gets redeemed and all is well.  If not, there are bigger problems.

More on Congressional Oversight of TARP

Elizabeth Warren has a blog!  Or more specifically, the Congressional Oversight Panel has a blog.  They are not happy with Paulson and who is. People are split between the guy being evil and incompetent but I think he had a deer in the headlights look that indicated that he was just over his head. Maybe I'm being too charitable, but I'm not sure it matters.

Their main beef is that Paulson didn't extract enough from the banks in TARP I, and they got a bad deal. They were pretty up front about the injection of capital via preferred shares as being a subsidy. They also used some of the money to bail out AIG and Citi. Not in the original bill and not the best deal. However, the idea that they should have extracted more is simply an opinion -- and not one that everyone shares. If the banks survive and the preferred shares get redeemed, then they will be profitable. One goal was to encourage private capital to follow the government investments. If the terms had been punitive, there would have been no chance of this happening.

Here is their current report. I don't have too much to say, although it is an "open" process, and they show their work product in some detail.
The valuation report concludes that Treasury paid substantially more for the assets it purchased under the TARP than their then-current market value. The use of a one-size-fits-all investment policy, rather than the use of risk-based pricing more commonly used in market transactions, underlies the magnitude of the discount. A number of reasons for this result have been suggested. The Panel has not determined whether these reasons are valid or whether they justify the large subsidy that was created. In addition, the Panel has not made judgments about whether the decision-making underlying these investments was sound. The rationale for the Treasury’s approach and the impact of this disparity will be subjects for the Panel’s continued study and consideration. It is important, however, for the public to understand that in many cases Treasury received far less value in stocks and warrants than the money it injected into financial institutions.
So they are saying that the Treasury overpaid, but they aren't making any judgments just yet. It doesn't take a genius to realize that if private investors are asking 10% and the Treasury is asking 5% for perpetual preferred stock [with a feature that increases the Treasury yield to 9% after 5 years, to encourage repayment]. It looks like a 20% to 40% haircut without spending more then 2 minutes pondering the facts.

The idea of subjecting this to private market benchmarks misses a central point.  The idea wasn't to subsidize the banks to help the banks, but rather to help borrowers, potential borrowers, and holders of bank debt, which include pension funds.  More important, to the extent that it works, the government gets a cut of every cent of profit.  They collect about 1/3 of corporate profits and 15% on dividends.  They end up with 18% or so of GNP.  If the GNP of $13 trillion is increased by 3% for 2 years, that is $260 billion in tax revenue.  Plus, they get the money back.  Plus a net spread of 2% or so.  A lot of assumptions here, but the counterfactual isn't that difficult to imagine.  In the absence of any action, it is hard to believe that things wouldn't be a lot worse.  


Thursday, February 5, 2009

Citi's TARP Report

Here is 43 pages of worthless, self promoting Citi chat about how they are being good corporate citizens with the TARP funds.
The United States Government has made a significant investment in major financial institutions, including Citi, under the Troubled Asset Relief Program (TARP). Citi understands that TARP is about helping the American people, and supporting U.S. businesses and our communities. Our responsibility is to put these funds to work quickly, prudently, and transparently to increase available lending and liquidity. 
This report is the first that we will publish about the activities we are undertaking in connection with the TARP program. It also explains the many other steps Citi is taking to assist American families and individuals who face financial hardship or are at risk of losing their homes.
The trouble with all this is that, among other things, TARP equity investments were not supposed to be simply lent out. Rather they were supposed to strengthen capital ratios to allow banks to increase their loans by a multiple of the capital injection. $1 in capital supports several dollars in deposits and loans.

An even bigger problem is that it is impossible to know which dollars got spent for what.  It is being made up out of whole cloth.  I would be harsher, but someone made them do it.

As I discussed in an earlier post, Elizabeth Warren, of the Congressional Oversight Committee insisted on accountability.  This is what she got.

Just For The Record ....

Although I agree that the banks needed to get bailed out, or whatever you want to call it, I don't like a lot of things that were done.

1. What's with the concentration? Per the FDIC, there are $13 Trillion of bank assets and the big 4 have $7 trillion! The idea of allowing/encouraging mergers of weaker banks with "stronger" banks is not totally dissimilar to the idea that we were going to pay for the Iraq war with their own oil money. An unrealistic way to do something on the cheap, with awful results. Sometimes it works, but in the S&L crisis, the problem institutions were shorn of their problem assets and then sold off to healthy banks. Now we have to go back and do it after the fact -- the bad bank thing -- partially because no one wanted to pay up initially.

2. What was the idea of combining BAC and MER? As long as a bank does vanilla banking, then scale doesn't change the fundamental nature of the business. Once you start combining traditional banking with a trading and investment banking becomes much more complex. BAC was over the 10% market share rule last year, when it was waived to let them buy (overpay) for LaSalle. Then they were allowed/encouraged to take of Countrywide. Then Merrill. If someone had just told Ken Lewis that he was already big enough -- we would have a pretty healthy mega bank. Instead we have a huge mess.

3. As far as terms and conditions, Buffett insisted that Goldman's senior guys have at least 75% of their net worth in their bank's common stock and not sell as long as he held his preferred stock investment. As long as the senior management is "all in" -- there is some alignment of management and shareholders. Much better then trying to micro manage executive excesses. The treasury should have put an anchor on senior management so if the ship goes down, they are on the bottom along with their share holders.

Over Paid by $78 Billion?????

The latest from the Congressional Committee that is overseeing TARP:
Elizabeth Warren, a Harvard law professor, said her group estimated the Treasury paid $254 billion in 2008 in return for stocks and warrants worth about $176 billion under the Troubled Asset Relief Program, or TARP.
Where did this figure come from? It is obvious that the Treasury didn't drive a hard bargain. That was the point at the time. The tougher the terms, the more difficult banks would have raising additional capital or repaying the TARP funds. If the Treasury was going to pay the market price, then there was no advantage to doing it in the first place. The entire idea was to lend money on terms that gave the Treasury a nice spread on the investment and relieved the capital strain on banks.
Currently, preferred shares for Bank of America are yielding in the mid teens. Certainly higher then the government deal. However, if the government continues to bail out BAC, then they get their money back. God knows TARP hasn't been much of a success so far, although it is impossible to know what would have happened if the government had just sat around and watched. However, it is grandstanding to claim that a bailout/subsidy to the banking system was a "bad deal." Its not a bug, its a feature.

Tuesday, February 3, 2009

More on Banks

[click here for the original spreadsheet with links to the filings]

Back to the big 4 and the so called bad bank.

1.  The big four are indeed big.  They have $7.5 trillion in assets and $3.3 trillion in loans.  Against these loans, they have $87 billion in provisions for bad loans.  

2.  Loans are never marked to market.  Never.  Never have, never will.  

3.  The $7.5 trillion is over a third or more of our total bank assets, on a dollar basis.

4.  They have $341 billion in capital.

5.  With the current net interest rate spreads, they are making $50 billion/quarter excluding losses.  

There is a good case for putting the various structured mortgage backed securities into a bad bank or some sort of holding entity to simply amortize.  They can't be sold AND not result in the paradox of deleveraging.  That is, the more these assets are liquidated, the worse the ratios of any entity selling.  

These isn't much of a case for doing anything with loans.  

The 4 banks in question are already bailed out.  They have been deemed too big to fail, so thats it.  They also have FDIC insurance to allow them to gather as many brokered deposits as they need.

Sunday, February 1, 2009

Toxic Assets -- Where's Waldo?

The New York Times has an article discussing just how difficult it can be to value a CDO, which is representative of what the "bad bank" proposal is up against.  
The financial institution that owns the bond calculates the value at 97 cents on the dollar, or a mere 3 percent loss. But S.& P. estimates it is worth 87 cents, based on the current loan-default rate, and could be worth 53 cents under a bleaker situation that contemplates a doubling of defaults. But even that might be optimistic, because the bond traded recently for just 38 cents on the dollar, reflecting the even gloomier outlook of investors.
The bond is backed by 9,000 second mortgages used by borrowers who put down little or no money to buy homes. Nearly a quarter of the loans are delinquent, and losses on defaulted mortgages are averaging 40 percent. The security once had a top rating, triple-A.
The article does a good job picking an asset that is truly difficult to value. Note that no one is saying that normal, whole loans are toxic. They are either good, bad, or somewhere in between -- but everyone understands what they are. The banks segregate non performing loans, and show the provision for loan losses. Everyone thinks these are optimistic, but there is an element of transparency, since it is possible to fairly easily superimpose an alternative judgment. Loan losses lag economic declines, and the reserves will not be adequate until the economy bottoms.

I took a look at the big banks.  We now have 4 -- C, BAC, JPM, and WFC.  Wells is now Wells plus Wachovia.  BAC will include Merrill Lynch and Countrywide.  JPM has hoovered up Bear Stearns and Washington Mutual.  Total assets for these banks is over $7 trillion dollars.  

I pulled figures from the September 10-Q's.  I can't find over $100 billion in toxic assets.  However, they don't make it easy -- and skimming hundreds of pages of dense SEC filings on a laptop screen isn't a great way to really dig in and do a rigorous analysis.  However, this was the general thought process:

1.  C is a basket case and already has guarantees for something like $60 billions in assets.  They are also splitting themselves up into a good bank/bad bank.  They are effectively nationalized and.

2.  BAC also has the guarantees for about the same, based on MER's 4Q blowup.  In addition, MER already wrote down most of their CDO's in 3Q.

3.  JPM says they don't need any money.  Most of the Bear assets have a government guarantee.

4.  WFC also says they don't need any more money or help.  They are showing maybe $20 billion in CDO's.  Both Wells and WB were functioning more like traditional banks, so they don't have all the capital markets residue of the others.

Here is a spreadsheet with some summary data.  It isn't totally consistent, but is roughly correct.  

Major observations -- with $7 trillion in assets, this is a big chunk of the entire banking system.  However, there is only $350 billion in tangible equity backing these assets (mostly excluding preferred stock).  Now some of the assets are cash or government guaranteed securities, and capital ratios exclude that.  Still, there is a lot of goodwill, and not a lot of capital for the assets given the overall uncertainty.

If you exclude C's off balance sheet stuff, there simply isn't the quantity of toxic assets that people are talking about.  Bad assets aren't toxic assets.  The defining quality of toxic assets is uncertainty.  

Excluding  C and JPM, I only found $70 billion.  Some of the $70 aren't toxic, and I am sure that I missed a lot.  If whole loans are excluded, I don't see how anyone could get over $150 billion if you exclude the $120 already hived off in C and BAC.  It simply isn't visible to me.

Someone needs to lay out exactly where these assets are on the balance sheets of these four companies.  Or come up with a different story.  They simply aren't there.