Time to Start Selling

It already looks like there are two camps critical of the Treasury plan.  Those who think it will fail and those that think it will succeed.  Paul Krugman seems to be in both camps -- he thinks it will succeed in making rich people richer and fail to do the job.  Now the New Yorker seems to be siding with the problems of success arguments:

 It’s conceivable that this plan could work for the funds but fail to save the banks, which will still have lots more bad assets on their books. As long as it works for the funds, some very, very rich people are going to get much richer, thanks to once-in-a-lifetime favorable terms provided by the federal government and unavailable to the rest of us. What then? It will be a few years before this has played out. Maybe by that time the economy will be better, and the country will have calmed down. If not, the dynamic we have seen in the past few weeks will only become more severe, and who knows what kinds of social poison will work their way into the fabric of American life.

First of all, the Treasury will share in profits dollar for dollar with the funds. Secondly, the profits will be taxed in some fashion, at least once, before they can be spent. So the "taxpayers" get more than the rich people.

I have addressed this before, and will just say that the Treasury should be eager to sell parts of their piece to the public, to make it known that it isn't only the ultra wealthy that can make money in this.

Meanwhile, I have a feeling that most writers on this subject haven't fully read or understood the Treasury plan, and would do well to actually read it before writing extensively on it.

Kid's For Cash

It's obviously the economy, but sometimes something is just so over the top that it needs additional exposure.  Per Ian Urbina of the New York Times:

Things were different in the Luzerne County juvenile courtroom, and everyone knew it. Proceedings on average took less than two minutes. Detention center workers were told in advance how many juveniles to expect at the end of each day — even before hearings to determine their innocence or guilt. Lawyers told families not to bother hiring them. They would not be allowed to speak anyway.

Urbina does a solid reporting on this follow up article on the unbelievable corruption in a Central Pennsylvania County juvenile justice system. There is no need to repeat the major facts regarding the case against Mark A Ciavarella. The most disturbing aspect of this is that "everybody knew it". Ciavarella doesn't seem to acknowledge it, even though he agreed to plead guilty in a deal that would give him 8 years in jail.

In what authorities are calling the biggest legal scandal in state history, the two judges pleaded guilty to tax evasion and wire fraud in a scheme that involved sending thousands of juveniles to two private detention centers in exchange for $2.6 million in kickbacks.

But as he pleaded guilty last month and admitted having “disgraced” the bench, Judge Ciavarella denied that payments had influenced his sentencing decisions.

Consider his rather lengthy letter defending his actions from a critical review by his replacement, Chester B. Muroski, in a press release. I expect the facts are much more confusing and convoluted then anyone could imagine.

The prosecutors who worked in disgraced Judge Mark A. Ciavarella Jr.’s courtroom share part of the blame for the injustices he perpetrated on thousands of Luzerne County juveniles, said Marsha Levick, the legal director of the Juvenile Law Center.

Ciavarella said last May he was “wrong” to skip directly to sentencing instead of reading a required reminder of their right to an attorney. Around the same time, Ciavarella, who had presided over juvenile court from 1996 to May 2008, stepped aside as juvenile court judge and appointed Judge David W. Lupas as his replacement. Lupas, who served as district attorney from 2000 to 2008, could not be reached for comment at his chambers Friday.

In addition, Ciavarella’s daughter, Lauren, is an assistant district attorney.

Lauren, 27, followed Ciavarella into the law, and has worked as an assistant district attorney in the Luzerne County district attorney's office since last January.

Lauren needs to get a job without any hint of nepotism. Lupas should go also. Meanwhile, another judge was forced off the bench following a lengthy review for what now sound like laughably minor charges, based on testimony by Ciavarella and court staff under his authority.  Meanwhile, Ciavarella is not waiving any of his rights in his attempt to cut the best deal possible.

Ciavarella remained adamant that he did not plead guilty to any charges related to “cash for kids,” embezzlement or extortion.

“We came to [a] plea agreement because we would never agree that [the sentencing] was improper. And that’s why in the plea agreement you don’t see any of that language,” Ciavarella said.

I suppose if you have pled guilty to tax evasion and taking illegal kickbacks, then the fine points regarding whether the cash influenced his decisions can be left to individuals to decide.  Perhaps Ciavarella, like O. J. Simpson, could pen a book during his prison stay similar to Simpson's If I Did It.

If there is any justice in this matter, it will be the rather rough justice of a disgraced judge spending time in prison and then endless amounts of time and money defending the civil lawsuits that will arise out of this matter.

The abuse of power and office are shocking and outrageous.  I suppose the fact that it was eventually uncovered says something positive about democratic process.  People went into a juvenile court without a lawyer expecting to get some sort of deal and ended up in the corrections industry.  There is an element of social class (as always) associated with the victims.  However, if they watch television, they should know that you never confess and need to lawyer up as soon as possible.

Berkshire Credit Default Swaps

I dunno what they are being quoted at, but:

March 26 (Reuters) - Berkshire Hathaway Finance Corp on Thursday sold $750 million of 3-year notes in the 144a private placement market, said IFR, a Thomson Reuters service. The notes are unconditionally guaranteed by Berkshire Hathaway Inc (BRKa.N) (BRKb.N). The size of the deal was increased from an originally planned $400 million. Goldman Sachs and Morgan Stanley were the joint bookrunning managers for the sale.

BORROWER: BERKSHIRE HATHAWAY FINANCE CORP*
AMT $750 MLN COUPON 4.00 PCT MATURITY 4/15/2012
TYPE GTD NOTES ISS PRICE 99.767 FIRST PAY 10/15/2009
MOODY'S Aaa YIELD 4.082 PCT SETTLEMENT 4/2/2009
S&P TRIPLE-A SPREAD 282 BPS PAY FREQ SEMI-ANNUAL FITCH DOUBLE-A MORE THAN TREAS MAKE-WHOLE CALL 45 BPS

I don't see how the daily spikes in CDS quotes mean much when the debt markets snarf up $750 million @ 282 bp.  They can't get enough of them.  

Three Card Monte

Three card monte comes to mind when considering the Geithner plan.  Everybody knows that it is a few years too late to believe in financial alchemy, that there is a subsidy, that there is a valuable, implicit put to grease the deal.  Or even more ways the system is/can/will be gamed.   However, I'm not buying complexity here -- the subsidy is big and it's right in your face.

I suggest people read the Treasury Plan documents themselves instead of relying on secondary sources which seem lax regarding details.  From the "legacy" loan term sheet:

Leverage will be determined on a pool-by-pool basis at the FDIC’s sole discretion, with input from the Third Party Valuation Firm. It is anticipated that the debt to equity ratio will not exceed 6 to 1 for each PPIF. [note: max leverage 4 to 1 for legacy securities]

FDIC will provide credit support for PPIF financing through guarantees of debt issued by the PPIF.

Right now, FDIC backed notes are yielding 22 bps over Treasuries, or about 2 .125% on a 2 year.  Thats exactly what Wells got on a recent issue.

Let's work through a simple example, substituting a 2 year loan for roughly equivalent pool of cash flows.  Consider this a loan of 100 originated @ 5%, with a payment of 55 at the end of year 1 and 52.5 at the end of year 2.

The pools have deteriorated and 10% will default with no recovery prior to the first payment.  The new expected payments are 49.5 and 47.25.  The bank has a loan loss reserve of $10.  This assumes that the 5% interest rate imbedded in the original loan is still reasonable.

However, vulture investors today are looking to get 20% returns on their now very valuable capital.  Without financing, they would have to buy the asset for 74 to get a 20% return.

With 2.125% financing and 6x leverage, they would need about 4.7% to get 20% on their capital.  That would put the price of the loan at 90 and change.  Not much of a surprise, since the critical valuation assumption is the correct interest rate -- not the default rate.  And not much of a surprise since 4.7% is very close to 5%.  

This is something that most people aren't getting when comparing so called market prices to modeled estimates.  The risk adjusted interest rates have blown out which drive the gap more than the cash flow assumptions.  

In the example above, the gap gets bigger with a 3 year duration.  So, yes -- there is a big subsidy in the plan.  And no, it won't all go to the banks.  But the subsidy allows the new, subsidized vultures to turbo charge their bids with very cheap financing.  

Maybe this is why the New York Post reported that C and BAC are aggressively buying former AAA mortgage securities that were selling for 30% of par:

But the banks' purchase of so-called AAA-rated mortgage-backed securities, including some that use alt-A and option ARM as collateral, is raising eyebrows among even the most seasoned traders...

One Wall Street trader told The Post that what's been most puzzling about the purchases is how aggressive both banks have been in their buying, sometimes paying higher prices than competing bidders are willing to pay.

Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids.

If the 30 cent bid is based on 20% returns and 3 year durations, the securities could easily sell north of 50 cents @ 10%, leaving a nice profit for everyone but the seller. 

People are assuming that the banks models are heavily biased regarding default and recovery assumptions. But if the securities were originally priced @ 5% and the market price is now based on 20% returns, that would account for major differences.

So to the extent that the problem is the market based price of risk capital, this sort of subsidy will work without an explicit cost to anyone. Financial alchemy. The catch is that the US can borrow a lot and at surprisingly low rates. Right now. Everything the government is doing is based on the idea that they can essentially become the hedge fund of last resort, and borrow low to fund illiquid asset purchases. It works until it doesn't.  Let's hope it works.

Treasury Toxic Asset Plan

I don't get it.

However, it is very possible that this DOES NOT need to work as a prerequisite for an economic recovery.  In fact, the best case is if it sort of dies out with minimal participation -- for whatever reason -- as the economy recovers without this sort of help.

Facts:

1.  The problem is with the shadow banking system, which is largely gone.

2.  This doesn't apply to small banks.  Period.

3.  There aren't that many toxic assets.  Unless someone would like to argue otherwise -- toxic assets are those that are opaque and difficult to value.  A bad asset isn't a toxic asset.  

4.   It applies mostly to investment banks, which were doing huge amounts of securitization, but not much anymore.  Legacy assets have no bearing on whether investment banks can sell new securitized loans.  The original TALF sounded promising on that score.

5.  Non investment banks don't have a lot of non agency mortgage backed securities.  

6.  FDIC insured banks have only abut $7 trillion in loans.  They don't mark whole loans to market.  They don't need to sell them.  

7.  The plan excludes CDO^2 or any mortgage security that holds something other than whole loans. 

8.  The investment banks may need to dump some securitized loans, but who/what/etc.  

Therefore:

I don't see how this could work.

The only example that I can think of is if -- if someone like WFC wants to get rid of Pic a Pay, which already has a 40% haircut, and perhaps book a profit -- then maybe.  Most other loan portfolios are booked with a 5% loan loss reserve or something similar.  

It seems like this is just for Citi and BAC.  Why didn't we just give them the $150 billion.

Suggestion to Obama

The public isn't happy.

They will be unhappy if the Treasury or Fed loses billions on its loans.

They will be even more unhappy if the Treasury and/or Fed plus "private money" MAKE a lot of money buying toxic assets.  Per the NYT, under the headline, "Toxic Asset Plan Foresees Big Subsidies for Investors."

The plan is likely to offer generous subsidies, in the form of low-interest loans, to coax investors to form partnerships with the government to buy toxic assets from banks.

To help protect taxpayers, who would pay for the bulk of the purchases, the plan calls for auctioning assets to the highest bidders.

Assuming the reports are correct, private entities will put up $30 billion, the Treasury $120 billion, and borrow $850 billion.  This gives the hedge funds, etc. 5 x 1 leverage. If they make money, it will be considered an outrage.

Get ahead of all of this by offering to sell anyone shares in the Treasury's $120 billion stake.  For that matter, offer investors a chance to buy stakes of any/all the treasury bailouts at par.  These have to be offered to retail investors in small lots.

I would include entities like Maiden Lane III in this.

Also include a fund of bank preferred stocks.

There are a few risks here.  They may prove to be very popular and attract a lot of funds, but every dollar that the Treasury takes in can reduce their borrowing needs by an equivalent amount.

The other is that the investments will have a secondary market and there will be price discovery.  A small price to pay to give everyone a chance to bet with the big guys.

They really need to get with it, or they will soon be in a no win position.  It is so, so simple to eliminate this threat of a big give away to hedge funds -- by simply offering the same terms to individuals.  

One More Time -- Felix Salmon, BRK, CDS's

Talk about an idea that is immutable.  

Berkshire credit default swap rates mean very little.  Commenter Alden on Clusterstock 

notes that:

CDS are outrageous compared to where the actual bonds of Berkshire are trading. Those bonds are trading at about 225 bps over 5 and 10 yr treasuries. Which although seems a bit high to me for AAA, I think that the absolute yields are fairly low, about 4.25% for the 5 year, 5.25% for the 10. This is favorably compared to GE Capital, which has bonds trading with yields above 10%.

Here are quotes from Friday (click for larger view):

The idea that CDS's are the most accurate and reliable reference point for credit quality is simply conjecture.  

Consider another comment:

Given that Berkshire is -- like all insurance companies -- a leveraged financial institution

Once again, not true. First, property casualty companies don't tend to use leverage, unlike some life companies. They fund assets using their own capital and policyholder funds. Nothing close to the type of leverage used by banks or even some of the life insurers. Berkshire with huge amounts of excess capital to support their insurance operations and $23 billion in cash and cash equivalents is remarkably unleveraged.

We will have to see what will happen.  One would expect the CDS's to fall into line with the bonds, but a lot of firms have blown up on negative basis trades and the markets are chaotic.

Since Berkshire is the ONLY AAA insurer, it should be obvious that AAA isn't essential to run the insurance operation (excluding the tiny bond insurer).  

This was all covered a couple of months ago and the issue disappeared.  Even though it is back, the place to look for problems is in the market inefficiencies or manipulation or whatever is driving the CDS markets.  

How GE Can Save Itself ?

GE has some problems.  It's capital has a lot of asset ($600 billion) and some of them are going to default.  People are anticipating the problem and have already punished the shares and the debt for these potential problems.

GE has another problem.  People are selling.  No one is buying.  Prices are collapsing.  This is destroying confidence in GE, setting the stage for higher capital costs, and if the losses are sufficiently high, raising questions of solvency.

GE has an easy and interesting way to correct the imbalance between supply and demand of its debt, improve its balance sheet, book a nice profit if they start taking the capital market theorists at face value.  More specifically, the market value of GE debt has plunged.  On a M2M basis, this improves GE's capital position, via the arithmetic identity that equity = assets - liabilities.  If the liabilities decline, equity goes up -- dollar for dollar.

I am suggesting that GE use its liquidity to buy back any and all debt that is selling close to 50 cents on the dollar.  Buy $2 of debt for $1 and the capital position improves by $1.  This is identical to simply adding to capital and magically reducing debt by the same amount.  Here is an example of some exchange traded debt.  This move saves them $2 billion.

Is it realistic?  Maybe.  I am just scratching the surface with some GE Capital exchange traded debt.  They have billions more.

Could they buy it up in the market?  They could buy some, but most likely the price of the debt will rise.  However, this would help restore confidence in GE.

If you want, think of it as GE selling credit default swaps on its own debt.  Only they wouldn't be messing around in the world of derivatives, but in the real market for the underlying.  

As far as technical details, they would need some sort of dispensation from the Treasury and SEC to just start buying.  In addition, the rating agencies would need to recognize this as unequivocally positive -- which it would be.

People should get their head around the fact that either GE's debt is mispriced OR GE's market based capital is much, much stronger then it appears.  

Argue that a GE purchase would just increase the price of the debt means that the market price isn't an accurate estimate of its value.  The markets are shallow and erratic.  A little buying and the price soars.

Or it means that GE can actually realize billions of dollars of market based capital by just buying underpriced debt.  

It can't be both.  Logically impossible. 

Is Buffett Aggressively Writing Down Utility Bonds?

Reading through the figures in the back of the annual report, I noticed an interesting item. An even $1.5 billion unrealized capital loss on corporate bonds and preferred stocks. This is a surprise, although I suppose that it is reasonable to say that the market value of the preferreds would have decreased, if they were publicly traded.There were 3 big preferred deals. The Wrigley/Mars financing, the GE $3 billion deal, and the Goldman $5 billion deal.  The "fair value" section at the end of the report lists $8 billion in level 3 fixed income securities.  These may well be the Goldman and GE stakes.

 
It is possible that the unrealized losses relate to last year's $2.1 billion purchase of TXU bonds.  These table shown above includes only the insurance subs.  There are no doubt bonds carried in the holding company or financial subs.  The total of $10,230 is less then the total of the 3 large deals.  $6.5 Mars, $5 Goldman, and $3 GE.  

The TXU bonds included both regular high yield and pik/senior toggle notes.  They elected to toggle Oct 31.

These bonds were private placement, and I don't know if there are market quotes.  However, they are likely candidates for a haircut.

More on Berkshire Options

From the Annual Report

Berkshire determines the estimated fair value of equity index put option contracts based on the widely used Black-Scholes option valuation model. Inputs to that model include the current index value, strike price, discount or interest rate, dividend rate and contract expiration date. The weighted averaged discount and dividend rates used as of December 31, 2008 were each approximately 4%. Berkshire believes the most significant economic risks relate to changes in the index value component and to a lesser degree to the foreign currency component. For additional information, see Berkshire’s Market Risk Disclosures.

The Black-Scholes model also incorporates volatility estimates that measure potential price changes over time. The weighted average volatility used as of December 31, 2008 was approximately 22%. The impact on fair value as of December 31, 2008 ($10.0 billion) from changes in volatility is summarized below. The values of contracts in an actual exchange are affected by market conditions and perceptions of the buyers and sellers. Actual values in an exchange may differ significantly from the values produced by any mathematical model. Dollars are in millions. 

I think I figured out the source of my estimation error on the index puts. The assumed interest rate is 4% and I thought 5% would be more realistic. However, the shocker was the assumed dividend rate of 4%. The relatively low interest rate and the relatively high dividend rate significantly increases the delta. I am surprised especially by the use of a dividend rate equal to the interest rate.

I suppose there may be conventions regarding what parameters to use in B-S for financial reporting.  However, it does seem that the use of fairly stable, fixed parameters based on prior historical data appropriate as an estimate of future volatility, interest, and dividends is appropriate.

This is the first time that the interest and dividend assumptions have been disclosed.  I have to wonder if Buffett is trying to throw in the kitchen sink on these.  Maybe it was the external auditor's idea.