Off Topic - A good way to Bicycle in the North Chicago Suburbs

It is so simple, I can't believe it took me so long to figure it out.

1. Drive with your bike to Sheridan Road.,

2. Park.

3. Ride around on the other side of Sheridan. Toward Lake Michigan.

The older suburbs on Lake Michigan are great places to cycle. On the other side of Sheridan, there is no on street parking (at least in places like Lake Forrest). So, park on the other side of the street and you can bike in a fabulous setting.

These suburbs don't do something gauche like have gates. They carefully filter out the traffic and people by subtle barriers. By the time you get to Sheridan, you have made it. They use all tactics -- one way streets, 3 increasingly more efficient ways of going north/south (I94, 41, Green Bay Road) to discourage through traffic. etc.

I just started biking close to my vehicle since the weather has been shaky lately. This encouraged me to just randomly park the vehicle (too embarrassingly large to admit-but a rental) on an attractive street and just go from there. I keep as close as it seems prudent to the vehicle and just explore.

The streets next to the Lake are very well maintained. The landscaping is immaculate. Very little traffic. This is the perfect place to casually cycle.

From the Archives:

On May 8th of last year, Richard Kline had this to say to me:

May 8, 2009 at 6:12 am
So cap vandal, there are so many problems with the putative positives you advance here regarding the stress-less tests that I’m going to pass on the rest of that list. But let’s just review:

No one said that most of the $8T in assets in the banking system are bad. The problem is that the concentration of loss is in the major financials which are holding the rest of the system, the government, and the country hostage to their busted dreams. Your rhetorical attempt to stuff the desperate losses of the Big Few under the skirts of the weary solvent many does you no credit.

Your reference to mortgage backed securities and their supposed absence from the system as a cause for relief is misconceived. This is well known, yes: most of that paper was on-sold. —And then the Big Lost Few turned around and wrote CDS swaps against those securities for face or against the bonds of those securities purchasers for face, so guess where the ‘loss’ on those securities will progressively boomerang back to? Now the bulk of those losses haven’t been realized yet because the tranching structures of those MBSs were designed to absorb the first losses internally and on the small players. Which is exactly why the Big Few are putting us through this whole dismal charade of ’solvent today, my friends’ to raise capital _before those swap losses_ are put to them. Think that THOSE exposures were adequately accounted for in these ‘tests,’ my friend? If so, I’m sure that Citi has a slice of preferred they’d love to sell you cheap. Or even dear (I mean why not, the public gets the bill?).

Then there is the matter of securitized LBO debt you haven’t managed to drag into the discussion, quite a lot of which is left on the sometime ’speculation’ banks (which is what they should be called). Think that those are marked to market, especially when the minders of accounting standards were dragooned into ‘mark and let mark’ practices?

In view of these small further matters, without even going into other relevant Concerns, that $6B at Wells, yes that $75 headline ARE COMPLETELY MEANINGLESS NUMBERS. They are numbers for the media and the rubes, but not meaningful estimates of probable losses. If you added a zero on the right end to that Wells raise we might be talking the real money. If it was indeed large private capital standing on the sidelines about to buy in to the six at Wells, I would tell its deployers, Please don’t: start your own clean major bank with it, and make a killing. Although given all the money floating around from the public put to the Big Few which they aren’t investing in the real economy, I suspect that we will have considerable shadow purchases funneld through the hedges to prop up each others equity, here. No smart money is going to buy into Wells, but others in the same boat have every incentive to take public money and quitely support each others’ capital to make the whole show go on.

The problem we have here, my friend, is that the entire core of the financial system has become an aggregated slime mold of formerly distinct Enrons, bloated 100 times larger.

And your assurance that large private capital would ne-eev-eerrrr invest in the banking system again if they were nationalized is . . . music to my ears, that sounds about right. We need a banking system which serves the country, not a greed parade that hollows it out. Most of those folks: they’re working with Other Peoples Money anyway, not their own. That money will flow to real return, and real returns will return to the banking system to attract them when said banking system is sound. Which it is not and will not be so long as sham shows like this ‘fooled yah’ examination are promoted by a government which still, as of today, refuses to regulate the financial industry in any meaningful fashion. And that outcome, my friend, sucks dynamite.

I'm not going to address Richard's points in detail. In fact, as critics go, his post was articulate and representative of the better as opposed to the worse [from my perspective] commenters.

It sounds alarmist today. On May 8th, it wasn't far from the blogosphere mainstream.

That's one reason I quit blogging. I just didn't have the energy to keep up with the shrillness. Plus, some of my premature bullishness started to be confirmed by the markets, and just sitting on my long positions was proving more profitable than trading.

What a difference in 4 months.

I'm Back....

To my loyal readers, I am back from an extended break.

No one wants to hear, "I told you so." and being right is not a good way to be popular. Still, there are times that you just can't resist.

As far as I can tell, I'm the only financial blogger that praised the "stress tests." The KBW index looks good since May 7th.

So, I'll just say it.

I was right. Find someone else with something good to say about the stress tests from that period, if you can. Or else, a little credit from my critics on "naked capitalism"

Especially those that accused me of hopeless naivete. That plus being oblivious to the facts and an apologist for banking swine.

However, owning long positions for one's own account and acting on one's opinions can provide a certain highly pleasurable reward that is MUCH better than extracting some sort of recognition from the blogosphere.

More on Roubini....

With regard to the stress test being consistent with the IMF estimates, consider the following from the blog Alea:

Still, it is useful to know whether our estimates are consistent with what has been found by others. Two studies released within the last few weeks essentially bracketed the supervisory estimate. The International Monetary Fund estimated lifetime losses that would imply a loan loss rate for U.S. banking firms of about 8 percent in a stressed scenario. One of the major rating agencies estimated an annual loan loss rate of about 4-3/4 percent in a stress scenario for the next two years.  More broadly, our informal survey of the results of a considerable number of private-sector studies and analyst reports published over the past several months generally placed our projected loss rates for key portfolios near the midpoints of the ranges of these independent estimates.

Major Roubini Goof

Professor Roubini stated that: 

The IMF recently estimated that retained earnings (after taxes and dividends) for all US banks – not just these 19 ones – would be only $300 bn total over the 2009-2010 period. The stress tests – instead – assumed much higher retained earnings - $362 bn - for these 19 banks alone for the 2009-2010 period in the more adverse scenario. Since these 19 banks account for about half of US banks assets if one were to use the IMF estimate of net retained earnings for these 19 banks their net retained earnings for 2009-2010 would be $150 bn rather than the $362 bn assumed by the regulators. While the IMF may have been too conservative in its estimates of net retained earnings it appears that regulators may have been too generous to these 19 banks in forecasting their earnings in an adverse scenario.

Professor Roubini should realize that you don't pay taxes on losses, and the funds available for loan losses are much higher than $362 billion.  The IMF figure includes dividends, which you don't pay if you are in financial difficulty and loss provisions.   In 1Q2008, BAC had about $18 billion in loan losses and pre tax, pre dividend earnings and Wells had about $10 billion. That's $28 billion for the two per quarter or or $224 billion over the two years from these two banks alone. This figure may be way too optimistic, but $150 billion from the two banks certainly isn't.

Some of the banks may have to book huge portions of their pre tax, pre provision earnings but that is a big number.  Just consider the $8 trillion in RWA and use a conservative net interest rate margin (say 2% per year) and you end up with $320 billion over the two years.  

More on the Stress Test

As the only blogger that had anything close to unequivocally favorable to say about the stress tests, I did manage to get a few hits, but not many.  I suppose people are just sick to death of yesterday's news.

There is no upside in saying anything favorable and to appear to take it seriously is to risk seeming hopelessly naive.

However, I think betting against the Fed/Treasury is a bit naive.  

The way to read it is to start backwards.  Total 2 year losses of $600 billion.  Together with the $400 or so that have already been booked, thats $1 trillion.  If these financial institutions have 1/3 of the assets exposed to the "crisis" -- that would put the total at $3 trillion.  Or big enough to be in the range of plausibility.

The next step is looking at how the $600 is going to be "funded."  I already went through this in the last post, and it seems reasonable.  

I read a bit of the RGE monitor (Roubini) and he is heavily invested in his scheme to do a "good bank/bad bank" reorganization.  Not a bad idea, but I have a feeling that he simply doesn't understand banks.

In fact, most of the disagreements seem to be people who equate banks with New York investment banks and see the rest of the financial sector as simply an appendage of New York.  I tend to see New York and investment banking as a separate business.  A lot of it could disappear with no consequence.  It already has.  The flip side is that the majority of abuses were associated with investment banking and they managed to almost blow up the world financial system.  

Investment banks don't make normal loans.  The only stand alone investment banks are GS and MS.  they have a lot of exposure to securities but not much to loans.  They don't do credit cards.  They don't deal with retail lending customers.  They did facilitate a lot of lending, but no one wants to buy these sorts of products anymore.  The so called originate to distribute model.  

As far as banks that make loans -- they seem to be making them.  I am at a loss regarding whether they should lend more or tighten standards, but they seem to be doing about the right thing.  That is, no more really stupid loans.  They do seem pretty aggressive about loaning to people that can pay them back -- but those people don't especially want to borrow.  

The general playbook of the Treasury/Fed is to subsidize interest rates and force people to either accept zero returns or start taking some risk.  This is all they can do and they are doing it in every way imaginable.  It is also directionally right as a policy move.  In fact, you have fiscal stimulus via deficit spending to go with the liberal monetary policies.  

That is the right thing to do directionally, and they seem to be doing a lot of it, which is, for lack of a better word, good.

Berkshire's 1Q Earnings Announcements

First the basics on how earnings are reported in US GAAP.  This is a big picture, non accountants overview.  They get split into two parts -- one labeled net income and the other labeled other comprehensive income (OCI).  The idea is to put normal stuff in the first bucket or items that have some finality -- like cash losses.  The other bucket gets things like unrealized capital gains and losses, which will fluctuate and make it more difficult to see how the firms operations are trending.

This treatment of unrealized capital gains and losses is not in the least controversial.  For Berkshire, the infamous long term put options would logically fall into OCI (other comprehensive income) -- since they are intended to be held for over a decade, and quarterly movements are noise.

Instead of trying to change accounting, Berkshire has developed a very simple non GAAP metric that it refers to as operating earnings.  Every quarter it puts out a statement opening with operating earnings and reconciling to GAAP.  Operating earnings exclude derivatives as well as other financial "bets" like currency trades.  They are, in fact, operating earnings, which is really what GAAP net income would like to be, if it weren't trying to be uniform across all businesses.    

Right now the volatility of the derivative book they totally overwhelms the changes in the core business earnings.  The Berkshire release saves investors and the media from having to make these adjustments themselves.

This quarter was a bit different.

1.  The earnings release was a week after the annual meeting.

2.  A "preview" of earnings was released, with the emphasis on operating earnings. They were down modestly from $1.9 billion to $1.7 billion.  Given the economy, not bad.

3.  The final published figures contained additional losses of $2 billion ($3 pre tax).  This is based on unrealized capital losses, but since Berkshire has announced that it will sell enough COP stock to get a $600 million tax refund, it labeled these losses as OTTI (Other Than Temporary Impairment) losses.  This means that they can be booked in net earnings BEFORE the stock is sold.  

4.  This huge OTTI clears the decks regarding realized capital losses for the remainder of the year.

The headline numbers should really be Berkshire's non GAAP 'Operating Earnings'.  It is the best way to make sense of the results, and any competent stock analyst would perform a similar set of adjustments.  

The press never seems to read and report on Berkshire's released operating earnings.  This year, it's all that was available when the quarter was discussed at the annual meeting.

Plus, Buffett threw in the kitchen sink by booking the OTTI when 1Q is old, old news.   This is as close as you are going to see Buffett come to spinning bad news. Nothing misleading about it, and in fact, it gives a more accurate picture.  At least the operating earnings.  Taking the OTTI losses as early as possible is something that most CEO's would like to do and Buffett can afford it.  Equity markets hate uncertainty and booking bad news ASAP tends to be good for the stock price.  Buffett may not care very much, but now the foundations have to sell some Berkshire on a regular basis, and there is an economic motivation to keep the stock price at a fair value. 

Ten Reasons the Stress Test doesn't SUCK

Before anyone gets too critical, they should actually read it. And review the spreadsheet.   A good list of the flaws can be found at naked capitalism: Yet More Stress Test Doubts.

This is an alternative point of view.

1.  After the extra extraordinary measures taken in the fall, especially the passage of the $700 billion TARP bill, the public needed some documentation. Something beyond Paulson's single sheet of paper.  Even if this is just an elaborate back of the envelope estimate, it is a single set of figures in a single document.

2.  Define "To Big To Fail"?  It has now been done.  Any "bank holding company" meaning financial institution with a banking license that has over $100 billion in assets.  It's 19 and it includes an auto finance sub (GMAC), a Life Insurer (Met), and a credit card company (American Express).  Two investment banks, two hybrids with investment and commercial banking (C, BAC).   

3.  What do the big 19 have in common?  Nothing other than size.  Most of the public outcry has been over excesses in New York Investment Banking.  Anyone think that USB's Minneapolis based bankers routinely get million dollar bonuses?  People should chill with the generalizations.  Or maybe just quit calling New York financial activity banking and the people that do it bankers.  There is an important distinction that has been deliberately blurred, and community bankers aren't happy about it.   

4.  It is a very big chunk of the traditional banking system. The two biggest, BAC and WFC have well over 20% market share of insured deposits.  I don't mind size as long as it is just vanilla banking scaled nationally.  Like the old Bank of America, when  they avoided investment banking.  A firm like Wells should think about splitting out it mortgage servicing business.   

5.  Maybe the traditional banking system really isn't the problem.  They are only involved with 20% of total lending. Per Jamie Diamon:

Traditional banks now provide only 20% of total lending in the economy(approximately $14 trillion of the total credit provided by all financial intermediaries). Right after World War II, that number was almost 60%.

 We have reps for all the players in the 'shadow' banking system.  Investment banks that did securitizations.  A credit card firm.  Brokerages that underwrite bonds.  

6.  A sense of how things could really play out.  People will either agree or disagree, but at least they have some numbers to talk about that are ground up rather then the economic aggregates tossed around by the economists.  

7.  $8 trillion in assets.  An estimate of $600 million in losses.  Two numbers that tie into published financials of specific firms.  Remember that a lot of assets were sold to non banks.  If this is 20% to 25% of the total assets exposed to losses, that corresponds to $2.4 to $3 Trillion that the economists talk about.  A lot of the worst stuff was sold off, so the $600 billion figure is big enough to be more than plausible. 

8.  What about the zillions in level 3, toxic CDO's?  Less than 2% of the total.  

At the end of 2008, the 19 BHCs held $1.5 trillion of securities, more than one‐half of which were Treasury, agencies, or sovereign securities, or high‐grade municipal debt, and so are subject to no or limited credit risk. Only about $200 billion was in non‐agency mortgage‐backed securities (MBS) and only a portion of these were recent vintage or were backed by riskier nonprime mortgages.

How much hand wringing has there been over this topic when discussing banks? Way too much, it seems. It isn't like there aren't problems, but most of the problem assets aren't owned by banks, and those that are were pretty much written down over the last year and a half.  It is a big problem, but one that was sold around the globe.  The banks thought they held the best CDO's and they definitely sold stuff that was materially worse then they kept.

9.  Just like Japan?  There are $60 billion or about 10% of the estimated total losses that have already been booked via purchase accounting adjustments associated with the larger mergers.  This includes WB, MER, WM, CW and a few others.  

You work through $600 billion in big chunks over a couple of years.  As noted above, 10% is done.  There is capital in excess of regulatory requirements right now, if needed.  This was done using 12/31 data, and over $100 billion has been done during that period.  We have 7 more quarters of earnings to use for loss provisions.  Finally, there is the $75 billion of additional common equity that is required to be raised.  

10.  Everyone can apply their own judgment against these figures.  However, I think that it isn't the banks.  It's the real economy.  People might be able to chill about banks and start thinking more about jobs, etc.  

Maybe it is just too optimistic.  If so, a next step could be to relax capital requirements IF there is strong evidence the economy has turned.  The economy is cyclical and there are lags.  Do we need to have banks that are capitalized above the regulatory level at the trough of a monster recession?  Capital is there for a reason and there are times that you relax the requirements and let the levels drop.  If you can NEVER use it, why have it in the first place.  

Buffett Succession Issue

Per Reuters:

Shareholders expressed confidence that Buffett has the succession issue well in hand. Yet, some admit that Buffett is a reason they bought the stock in the first place, and that when he leaves, they might too.

"That will be a time of real terror for a lot of people, and I don't know what I'll do," said Clifford Glassel, 68, a retired product engineer from Red Oak, Iowa who was attending his sixth meeting.

He is splitting his job into three parts. The Chairmanship goes to son, Howard, who will be there to keep tabs on the CEO and CIO. He is currently getting the same sort of training that Michael Corleone got prior to the demise of the Don.

The CEO job is to make sure that the zen form of management remains in place. A single guy with a very small staff to act as an intelligent owner. The CIO's won't get to decide how much capital to invest, just given the excess cash.

However, I expect to see another change. The first thing would be a substantial buyback the moment Warren steps down for whatever reason. The second is a rational dividend policy.

Or better yet, let the stock crater for a week or two and then announce the policies, giving a substantial break to long term, buy and hold owners.

Remember. Buffett outsourced his philanthropy to Bill Gates. Anyone that thinks he will do something stupid with a transition isn't thinking clearly.

Berkshire Meeting - Below the Radar

The most interesting comment was the following regarding the index equity puts:

He added that the company recently restructured two of its so-called equity put contracts - agreements that give an investor the right though not the obligation to buy a bucket of stocks from Berkshire at a specified date in the future. Those contracts have emerged as a subject of some debate since the stock market's plunge last fall.

Under one of the restructurings, the S&P 500 would have to rise just 13% over the next 10 years for the put to expire worthless. Before that deal, the S&P would have had to rise 72% over 18 years to preclude Berkshire from having to make a payout.

This means, among other things, that the original puts were written at the top -- 1.72 x S&P is getting close to 1500.

More interesting is the backstory. I can only speculate, but lets start with the assumption that no cash changed hands as a result of the restructuring. This would mean that the time value of the puts is negative. Or at least the last 8 years of the puts.

In addition, it would seem like the motivation to do this must have been from the mystery buyer. I don't think Berkshire would initiate restructuring deals that would be advantageous to the counterparty. They do too many deals to go around and ask to renegotiate in a way that is economically disadvantageous to the counterparties.

What it sounds like Buffett is saying is that the strike price was negotiated significantly downwards -- from close to 1500 to below 1000. In exchange for lowering the strike price, Berkshire moved the expiration date forward by 8 years.

The only thing that comes to mind is that the counterparty must have gotten an accounting benefit for the change. The Black Scholes value would surely decrease. Perhaps they are using the derivatives as a partial hedge on, for example, annuity guarantees. If the change in expiration date aligned the derivatives with the underlying risk, maybe there was an accounting benefit.

If the counterparty is a US company, I would think there would have to be some disclosure.

It would also be interesting to know notional value of the derivatives. If they are a significant piece of the total, the Black Scholes value would decrease - falling directly to Berkshire's operating earnings.

Maiden Lane

The NY Fed has released a lot of information HERE.

Alea comments on Maiden Lane I, so I won't bother. Except to say that it isn't the assets -- look at the whole balance sheet.

Per Maiden Lane III:

ML III LLC borrowed approximately $24.3 billion from the New York Fed in the form of a senior loan (Senior Loan)....

As of October 31, 2008, the Asset Portfolio had a par value of approximately $62.1 billion.

Per Maiden Lane II :

ML II LLC financed this purchase by borrowing $19.5 billion (Senior Loan) from the New York Fed.

As of October 31, 2008, the Asset Portfolio had a par value of approximately $39.3 billion.

These are not great assets. The Fed needs ML III to pay out @ 40% of par and ML III at 50% of par.

The detailed audited year end financials are quite interesting but mostly ramble on about fair value/M2M values. You can see what the assets consist of, but they have a decent chance of paying back the NYFRB with interest.

Are Creditors Sharing the Pain???

Tyler Cowen's NYT's article, titled,  Why Creditors Should Suffer, Too, slides over some fairly common misperceptions.  First, the counterparty issue:

The great beneficiaries have been the creditors and counterparties at the other end of A.I.G.’s derivatives deals — firms like Goldman Sachs, Merrill Lynch, Deutsche Bank, Société Générale, Barclays and UBS.

These firms engaged in deals that A.I.G. could not make good on. The bailout, and the regulatory regime outlined by Timothy F. Geithner, the Treasury secretary, would give firms like these every incentive to make similar deals down the road.

First, these are primarily counterparties, not creditors. They bought credit default swaps from AIG on multi sector super senior CDO's.  The counterparties used contracts that provided for collateral to be posted based on both the rating of AIG and the market value of the underlying CDO.  Because of this, they were largely protected from any deterioration in AIG's financial position.  In fact, by the time these were settled, the counterparties held about 50% of the face value of CDO's.

Thanks to an exemption from the Codes automatic stay - which bars all other creditors from terminating contracts with or seizing assets from a firm in bankruptcy - counterparties to derivatives contracts are free to terminate the contracts and then seize collateral to the extent that they are owed money.

It isn't clear what the actual losses are on the underlying credits, but the counterparties were very aggressive in demanding collateral, and may have held enough to completely avoid loss, regardless of AIG's future financial status.  So it was not possible to cram down losses to the counter parties on the most problematic AIG CDS's.  In fact, it was the continuing demands for collateral that precipitated AIG's initial cash problem in September.  

One could argue that the entire credit derivatives market should be eliminated or regulated, but at the time, the counterparties were fully collateralized and had no net risk.  

As far as the creditors, they have faced some steep haircuts already.  Citi put together a deal to essentially force holders of convertible preferred stock to swap it for equity.  Right now, Citi exchange traded debt sells for about 25 cents on the dollar, so to say they aren't sharing the pain isn't accurate.  From their press release: 

As announced on February 27, 2009, Citi is seeking to exchange approximately $27.5 billion in public and private preferred securities with a commitment from the U.S. Treasury to convert up to an additional $25 billion of its preferred securities for common stock. Assuming full participation of public preferred shareholders, Citi will convert into common shares approximately $52.5 billion in aggregate liquidation preference of preferred shares.

Exchange traded debt for Bank of America is currently selling for 50% of par. These shares sold at close to par within the last year, so the markets see the debt as being distressed.  Here are quotes on some BAC issues, which all have a par value of $25:

BAC-W BAC Capital Trust I $13.15
BAC-V BAC Capital Trust II $13.04
BAC-X BAC Capital Trust III $13.44
BAC-U BAC Capital Trust IV $11.11
BAC-Y BAC Capital Trust V $11.47
BAC-Z BAC Capital Trust VIII $11.29
BAC-B BAC Capital Trust X $11.40
BAC-C BAC Capital Trust XII $12.72

The markets are saying that the debt is distressed, and this exchanged traded debt trades frequently and in significant volume. Before encouraging the Treasury to push for some sort of concessions on these issues, don't forget that the original TARP invested public money in BAC preferred, pari passu with the existing preferred issues.  If it is necessary to convert shares similarly to Citi, it should be done by all means.  However, any debt above this level in seniority would require the more junior debt to take the first loss, and the Treasury needs to make sure that this step is essential.  

The equity goes first, then the preferred, and then the senior debt.  This is simply the capital structure of the bank, and losses must be taken in order of seniority.  This is the case, in or out of bankruptcy.  

All debt holders have taken a market loss so far.  The idea that they are being sheltered is exaggerated.  In addition, the senior debt holders aren't necessarily the enemy.  They are pension funds, mutual funds, etc.  Protection of the debt holders is, in some respects, an unintended consequence of a bailout, but it may well be fortuitous rather than unfortunate. 

FASB Change

Based on the belief that it is important to go to primary sources, here it is for today's FASB board meeting.

All I will say is that it is complicated and defies summarization.

It clarifies what constitutes an orderly market.

It discusses how to measure and account for OTTI (other than temporary impairment).  As complex as this is, don't forget that the income has two components in GAAP -- Income and OCI or Other Comprehensive Income.  A huge amount of effort goes into this distinction that is important in theory but much less so in practice.  OCI hits the balance sheet.  I am a balance sheet type and don't really care so much for this single, arbitrary distinction.  

At the March 16, 2009 meeting, Chairman Herz announced that the FASB also would address other-than-temporary impairment issues, in conjunction with the project intended to improve the application guidance used to determine fair values under Statement 157. Proposed FSP FAS 115-a, FAS 124-a, and EITF 99-20-b on other-than-temporary impairments (OTTI) is intended to provide greater clarity to investors about the credit and noncredit component of an OTTI event and to more effectively communicate when an OTTI event has occurred. As proposed, the FSP would apply to both debt and equity securities. The proposed FSP requires separate display of losses related to credit deterioration and losses related to other market factors on the income statement. Market-related losses would be recorded in other comprehensive income if it is not likely that the investor will have to sell the security prior to recovery.

What this means is that a debt security (CDO, for example) can lose value due to either expected credit losses OR other factors including liquidity preferences, market or presumed market changes, etc. The non credit components would be amortized over the remaining life of the instrument.  This goes into a new bucket in the OCI statement:

The proposed FSP would result in a new category within other comprehensive income for the portion of the other-than-temporary impairment that is unrelated to credit losses for held-to-maturity securities.

This is similar to the treatment of unrealized capital gains(losses) in the income statement.  Presumably, the decision that more securities aren't valued based on orderly markets means that the details of how to account for changes in model valuation are now more important.  Hence the linking to OCI and OTTI.

OTTI has to hit regular income.  If a firm intends and has the ability to hold a security to maturity, then the market impairment that is not credit related does not go into OTTI but into this new bucket of OCI.  

Confused?  I'm sure that the intent is to exclude the non credit based piece from regulatory capital requirements.  

Derivative Accounting aka M2M Modified

I have blogged about this a number of times.  I have been against the expansion of mark to market accounting for a number of reasons.  Here are links/reasons.

1.  Mark to market liabilities are an inherent problem.  You don't want to do it, because of the GAAP going concern principle, but in for a dime.  Most people don't know about this or believe it.

2.  M2M is basically derivative accounting.    

3.  Citi books M2M liabilities.  Do people really want to do this?  The reason I wrote this is that people seemed to flat out deny that this was being done.

4.  An extensive comment on someone else's blog post regarding M2M.  

5.  A comment on a confusing WSJ article on m2m.  

6.  GE could, in theory, buy back some of its debt at a discount.  Hence the rationale for m2m liabilities.

As a general comment, people are finally starting to say things that aren't blatantly false or stupid on CNBC and in blogs and blog comments.  

It's about time.

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.

Berkshire Hathaway - Chairman's Letter

I was much closer then Gary Ransom.  

Me: 

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.)

Gary:

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.

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.

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.  

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.

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.    

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

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.