Friday, September 25, 2009

Happy Friday Links

Whispers about Wells Fargo’s derivative book grow louder: Hat tip to Zero Hedge to posting the link to this piece from Clusterstock. We already know that the Wachovia Pick a Pay Portfolio is a huge mess. We are also seeing the Wachovia commercial book start to deteriorate. But now there are apparently concerns that the derivative contracts that Wachovia wrote could blow up as well. Based on how poorly everything else was underwritten, would that surprise anyone at all? From the Clusterstock article:

We read closely the company’s annual report. It has a brief and very boring discussion of exposure to credit derivatives. But nowhere does the company express an awareness of (or exposure to) what we now think of as Collateral Call Risk.

It was not bond defaults that killed AIG, after all. It was collateral calls.

Recall that AIG also thought that it was exercising the utmost caution, hiring a Wharton/Yale professor to build "risk models," and AIG was confident that many of the bonds on which it wrote insurance would never default. And AIG was right—many of those bonds didn’t default and still haven’t. But that wasn’t enough to save AIG.

What AIG's risk models missed was the possibility that AIG would have to post additional collateral in the event of a decline in the value or ratings of bonds that had yet to default. They had only analyzed the likelihood that they would be forced to pay off credit default swap policies insuring bond defaults.

According to the author, there is very little data available regarding what is in this derivative book. We don’t even know for sure if these contracts require Wells to post collateral if the situation starts moving against WFC (although the right to demand collateral is apparently standard with this type of contract). However, if I owned shares of WFC I would be really concerned about the rumblings coming out regarding all of the loans and derivatives inherited from the Wachovia deal. For a stock that has just about quadrupled off of its 52 week low there seem to be some significant potential headwinds that may not be currently priced in.

Excessive Executive Compensation+ Wall Street Fees= Lower Shareholder Returns: In last weekend’s piece in the NY Times, Gretchen Morgenson tackled the topic of corporate directors and their fiduciary responsibility to shareholders. The costs of excessive executive compensation are usually rather abstract and tough to quantify. However, Morgenson cites research from a man named Frederick Rowe (who is the president of a nonprofit shareholder advocacy group) who tries to pin down just how much investors lose in terms of returns as a result of dubious decisions by directors:

Mr. Rowe said investors must force directors to slash the “friction” costs that drain their companies’ coffers and diminish investment returns. “Friction takes the form of fees and costs generated by Wall Street, excessive compensation paid to company managements and all their helpers, finders’ fees for placing money, and political contributions to keep the wheels of commerce greased,” he said.

How expensive is this friction? Mr. Rowe estimates that the excess costs associated with management compensation, Wall Street fees and political expenditures by corporations reduce investor returns about 3 percent on average every year. Given that there is $10 trillion in retirement savings now invested in the stock market, pretty soon you’re talking real money.

Consider this calculation: If the stock market generates average annual returns of 8 percent over time, in 30 years that $10 trillion would have grown to more than $100 trillion. But shave 3 percent off those returns and shareholders are left with just about $40 trillion. Almost $60 trillion gets diverted.

3% per year can be the difference between a fund manager raising a ton of new money and going out of business. So, this is certainly not a trivial amount. However, the exact number is not necessarily important. What is important is to force companies to reduce friction. This can only be accomplished if large stakeholders are willing to be more active and reforms are implemented that make it easier to influence complacent or even conflicted management teams.

Moody’s agrees with me about future housing prices: After studying the real estate bust in the early 1990’s I concluded that it was very likely that real estate prices would not roar back like the stock market has. Based on the data I looked at, it took 14 years for someone who bought at the peak to see that value again. Moody’s is estimating that it could be until the 2030’s when the hardest hit areas get back to their bubble peaks. Yikes. That’s because, in reality, real estate is an illiquid asset that should not be looked at like a stock. Before the debt-fueled binge this real estate was essentially a slow growth asset that appreciated at a relatively normal trend line pace. So, for the people who are waiting to sell “when the market comes back,” I have a feeling they may be waiting a very long time, especially if everyone has the same plan. Mark Hanson often references a shadow inventory of houses that people want to sell but are in essence waiting for an uptick in values. Unfortunately, this common outlook may only increase the supply glut and offset any positive demand dynamics. From Moody’s via Zero Hedge:

Even under strong economic and demographic conditions, the demand for homes will increase moderately relative to both, with sales per households lower during the recovery period than the during the first half of this decade. The pace of new and existing single-family home sales will increase to 6.2 million per annum by 2012, well shy of the 7.5 million units sold at the peak in 2005. Similarly, homebuilding will rebound, but a lingering overhang of inventories, combined with consolidation in the industry and caution on the part of both homebuilders and lenders to builders, will keep the pace of construction from reaching the peak it achieved at the end of 2006 of over 2 million units. The overhang of inventories from the earlier construction boom will be drawn down by the end of 2011, bringing the supply and demand for homes in balance…

Hard hit areas such as Florida and California will only regain their pre-bust peak in the early 2030s, well after the nation does. New York will also be a laggard, although its overall decline in prices will be less severe. The main constraint on New York's outlook is Wall Street. In general, the length of the downturn and the length of recovery in a region will depend on the degree of aggressive lending or overinvestment in housing that occurred during the boom. On the recovery side, states with weaker job growth will also take longer to return to peak.

Moving toxic assets from one pocket to the other: If I own a stock that has lost 50% of its value and I decide to move it from my TD Ameritrade account to Charles Schwab, does the stock have a different value? Of course not. All I have done is move it from one pocket to another. But when you are a big investment bank, apparently there are different rules. Witness the magic occurring at Barclays:

Two former Barclays execs are starting a fund called Protium Finance. Protium has two equity investors who are putting in $450 million. Barclays is lending Protium $12.6 billion. Protium is using the cash to buy $12.3 billion in what we used to call toxic assets from Barclays. Protium’s 45 staff members get a management fee of $40 million per year (presumably from the equity investors, although that seems steep). Returns from the investments will be paid as follows, in this order (and this is important): (1) fund management fees; (2) a guaranteed 7% return to investors; (3) repayment of the Barclays loan; and (4) residual cash flows to the investors.

Barclays emphasized that it was not participating in regulatory arbitrage, because it is keeping the toxic assets on its balance sheet for regulatory purposes. That is, because it has a lot of exposure to those assets through its huge loan, it will continue to hold capital against those assets. So far so good.

But regulatory capital arbitrage is only one kind of arbitrage. For ordinary accounting purposes, the toxic assets are not on its balance sheet. So if they fall in value, Barclays will not have to recognize a loss – at least not until Protium defaults on its loan, which could be as far as ten years in the future. So the bank has the same true economic exposure, but can pretend it isn’t there for a long time.

Talk about a great way to hide dodgy assets and hope investors forget they are there. Even though Barclays has to hold capital based on the loan exposure, according to the structure outlined above I surmise that future losses will not flow through to the income statement. Accordingly, Barclay’s can avoid the potential EPS hit and unload assets at a price that could be far greater than what a third party would be willing to pay. If this seems like it has the potential to be a sham transaction that’s probably because that’s the case. But, since "extend and pretend" as well as "mark to whatever the bank feels like" are not only sanctioned but encouraged by the governments in charge, none of this should come as a surprise.

Where does private equity go from here? In his weekly article, Andrew Ross Sorkin of the NY Times includes commentary from Guy Hands of PE shop Terra Firma. It is a little disconcerting to hear that an insider is so bearish on the prospects for many PE firms:

Mr. Hands is not rooting for the industry’s demise, but he is predicting it will wither. The firms still have funds big enough to last them at least a decade, as they provide steady fees. “Right now, the big firms have a tower of fees,” he said. “But the tower starts to collapse over time.”

As the funds dry up, Mr. Hands expects the firms will struggle to raise enough new money to support the hundreds of employees they now employ. His prediction has a precedent — that’s what happened to venture capital after the late 1990s. The industry shrank sharply after it became clear that too much money was chasing too few deals.

But the pattern may play out in slower motion for private equity. “Neither the banks nor P.E. want to come clean about mistakes,” he wrote in his notes. “Hence companies will live as zombies unable to grow their businesses or make long-term commitments. Meanwhile banks will try to suck out as much money as they can in fees and postpone recognizing the full extent of the losses of their underwriting decisions.”

In the end, he said, “Many P.E. firms are hoping that daylight doesn’t shine on the corpses of their companies, so they are reluctant to restructure too quickly.”

Sweet, we can have zombie banks and zombie PE firms owning zombie companies. All we need now is actual zombies and the US will start to look like a Resident Evil video game. In all seriousness, Mr. Hands makes and interesting point. These over-levered companies that were acquired as a part of a bubble time LBO will likely have to fight just to stay above water. Of course this won’t be good for the jobs markets as these companies continue to try to cut costs so they can pay off their daunting debt loads. Of course, the returns from companies that can barely service their debt are likely to be quite mediocre. It’s really hard to know how this will play out but I can imagine private equity investors doubting that whatever these companies are being valued at reflects the current reality. Too bad they often have to pay fees based on some arbitrary value and really only have the option to sit and hope that the economy improves or credit markets become more favorable.

Don’t discount the possibility of a 1937-like repeat: We have been reminded over and over again about how the government during the Great Depression put the stimulus brakes on too soon and the country then plummeted back into a recession/depression in 1937. Ben Bernanke has promised that he won’t let that happen again. That means the punch bowl will be out even after all of the partygoers have gone home. This means Helicopter Ben will be dropping money from the sky even after jobs start to come back. This is one specific case in which I tend to trust Bernanke. I wholeheartedly believe that he will do anything to avoid crippling deflation and being too early in raising interest rates. The fact that there will likely be a plethora of unintended negative consequences of these actions is well documented. However, that is a topic for another time. But, as discussed in this piece from MSN (hat tip to The Pragmatic Capitalist), we have to remember that this recession is unique and the risk of a double dip cannot be ignored (regardless of what cheerleader Ben is saying):

The year of the Big Test will be 2011. By that year, the money from the first stimulus will have been spent, and the economy will either be in the midst of a sustainable recovery or not.

I think anybody who tells you they can predict now whether we'll have a sustainable recovery under way in 2011 is either out to fool you or is fooling himself.

This isn't your average recession. This is a great big global recession coupled with a great big global financial crisis.

This Great Recession is therefore much more subject to fits and starts and reversals than the average recession, because every time the economy starts to run smoothly, the banking system stands ready to throw another wrench into the works.

I'm not predicting the return of 1937 in 2011. I don't think I've got the kind of super-X-ray economic vision to call that one right either. But I would like us not to get carried away by the 57% rally in the stock market (as of the close Sept. 18) and become convinced that everything is fixed.

Can we stop talking about cash on the sidelines? I start to worry when I hear pundits coming up with non-fundamental reasons the market could go higher. A few of the most common of these are the cash on the sidelines and the managers who have missed the rally arguments. Maybe I don’t understand, but last I checked stock trading was a zero sum game (aside from transaction costs) and unless things have changed it is still true that if someone buys then someone has to sell. Doesn’t that mean that when someone comes off ofthe sidelines by buying then his or her counterparty moves onto the sidelines by selling?

Anyone advising clients to "buy the dip" based on sideline cash shows a fundamental lack of knowledge about how markets work.

For every buyer of securities there is a seller except at IPO time, secondary offerings, etc. Thus, it is virtually impossible for money to come into the market in normal day-to-day trading transactions.

For example: If one firm invests $100,000 in equities, then another firm will be selling $100,000 in securities. The end result of the transaction is "sideline cash" moves from firm A to firm B.

Furthermore, because of monetary printing, one should expect the amount of "sideline cash" to rise over time. Sideline cash is higher than it was 10 years ago and will be higher 10 years from now barring a huge number of IPOs or secondary offerings that would suck up some of that sideline cash or a period of heavy monetary draining by the Fed.

When I hear this argument I start to think people are grasping at straws to explain the rally or the potential for further gains. Same goes for the idea that the market will go higher because so many fund managers have missed the rally and in order to catch up to the S&P 500 and not miss more appreciation they will throw everything they have into the markets. Sorry, but the only arguments I actually listen to for why the market should go higher or lower are based on valuation. Everything else is just short term noise in my eyes. So when I see the S&P 500 trading at about 26x earnings (according to David Rosenberg of Gluskin Sheff) it is hard for me to believe stocks are cheap right now or that there is any reason to jump into the market head first.

(Picture courtesy of