Thursday, November 26, 2009

Turkey Day Readings

Before we get to today’s links, I want to wish everyone a Happy Thanksgiving. While this has been a tough year for many people it is important to reflect on the positive influences in our lives and things we are thankful for.

Tanks or a slow moving train wreck? In his missive this week, John Hussman compares the coming credit losses in home mortgages as Option ARMs reset and prime borrowers fall even further behind on their payments to tanks slowly rolling over a hill to attack villagers. This is very similar to the slow moving train wreck analogy. I think of the impending commercial real estate (CRE) problem as a slow moving train wreck. Everyone is talking about it. Bernanke, Buffett, Elizabeth Warren; you name it. Honestly, the need to refinance billions of CRE debt over the next few years and the associated difficulty based on plummeting property values is the worst kept secret in America today. The conundrum is that there is no way to quantify the damage it is going to cause. Banks are clearly extending and pretending as much as they can. They are putting up a good face but you know that some of the managers are not sleeping at all at night because they know how exposed they are to CRE. (Well, except for at Goldman because it is easy to sleep when God is clearly on your side.)

There are two reasons why I think the market has not reacted more dramatically to the continuing negative impact dodgy CRE loans will have on bank’s balance sheets and capital levels (as evidenced by the huge run-up in banks stocks and levered REITs trading at ridiculous valuations). First, everyone is hoping that markets will rebound before the refinancings are necessary. If you look at previous periods in which real estate lost a significant portion of its value, it has taken many years for prices to reach their prior peaks and in places like Japan it never happened. I actually wrote a piece on this that I think is very pertinent. So, while lenders and borrowers would be much better off if prices went up and cap rates went down, thus causing the properties to no longer be underwater, based on the data I looked at this scenario does not seem particularly likely. Second, the whole process of the unwinding of CMBS and the need to roll over property debt is sort of nebulous. In aggregate the numbers are gigantic but the pain will probably be spread out over a number of years unless vacancy rates continue to go up and lead to more actual foreclosures.

Now, why am I rambling on about CRE when Hussman’s piece was about residential real estate? Because, in contrast to the well known CRE issue, the fact that housing has not yet bottomed is actually a bit of a secret. There have been plenty of people who have called the bottom in housing and have cheered as the $8,000 homebuyer credit and normal seasonality have propped up housing data. But no matter how many RMBS the Fed buys and how much money the government gives homebuyers in an attempt to re-inflate the housing market, job losses, interest rate reset and underwater mortgages are going to cause even more foreclosures and further declines in prices. Throwing money at potential buyers does not fix the underlying problem that people took on too much debt and/or no longer have a stable flow of income. I’ll let Hussman take it from here:

Now, we face a coupling of those weak employment conditions with a mountain of adjustable resets, on mortgages that have to-date been subject to low teaser rates, interest-only payments, and other optional payment features (hence the “Option” in Option-ARM). These are precisely the mortgages that were written at the height of the housing bubble, and therefore undoubtedly carry the highest loan-to-value ratios.

The inevitability of profound credit losses here is unnervingly similar to the inevitability of profound losses following the dot-com bubble. In that event, it wasn't just that people were excited about dot-com stocks in a way that might or might not have worked out depending on how fast the economy grew. Rather, it was a structural issue that related to the dot-com industry itself – those bubble investments couldn't have worked out in a competitive economy, because market capitalizations were completely out of line with what could possibly be sustained in an industry that had virtually no cost to competitive entry. If you understood how profits evolve in a perfectly competitive market with low product differentiation, you understood that profits would not accrue to the majority of those companies even if the economy and the internet itself grew exponentially.

In the current situation, the assumption that the credit crisis is behind us is completely out of line with what possibly could result from the marriage of deep employment losses and an onerous reset schedule on mortgages that have extremely high loan-to-value ratios. A major second wave of mortgage losses isn't a question of whether the economy will post a positive GDP print this quarter or next. Rather, it is a structural feature of the debt market that is baked into the cake because of how the mortgages were designed and issued in the first place…

The past decade has been largely the experience of watching tanks rolling over a hilltop to attack the villagers celebrating below. Repeatedly, one could observe these huge objects rolling over the horizon, with an ominous knowledge that things would not work out well. But repeatedly, nobody cared as long as it looked like there might be a little punch left in the bowl. As a result, long-term investors in the S&P 500 have achieved negative total returns over a full decade. These negative returns, of course, were also predictable at the time, based on our standard methodology of applying a range of terminal multiples to an S&P 500 earnings profile that has – aside from the recent collapse – maintained a well-behaved growth channel for the better part of a century.

An interesting proposal on banking reform: Lately there have been a number of political and financial commentators speaking out about the need to return to a Glass-Steagall-influenced banking model in which commercial banks and investment banks are forced to get a divorce. The thinking, as espoused by Paul Volcker and others, is that investment banks should be free to gamble with their own money but should not be allowed to gamble with taxpayer money provided through the FDIC deposit backstop. If that forced people inclined to risk taking to move to hedge funds then so be it. At least hedge funds risk their own capital and aside from LTCM have failed without taking down the entire global economy. Personally, I happen to like the idea of going back to a partnership structure for investment banks in which the partners are always at risk of losing their own capital. That’s a much better situation than the US taxpayer being at risk when the banks lever up and do foolish things.

With the understanding that something should be done (although it looks less and less likely every passing day) to remove the taxpayer from the above equation, I came across this op-ed article in the Wall Street Journal by the deputy director of financial and enterprise affairs at the OECD that makes the case for what are known as NOHCs (as if we needed more acronyms in our lives):

One proposal, which we now submit for consideration, is that banking and financial service groups could be structured under a variant of non-operating holding companies (NOHCs), in all countries.

Under such a structure, the parent would be non-operating, raising capital on the stock exchange and investing it transparently and without any double-gearing in its operating subsidiaries—say a bank and a securities firm that would be separate legal entities with their own governance. The subsidiaries would pay dividends through the parent to shareholders out of profits. The nonoperating parent would have no legal basis to shift capital between affiliates in a crisis, and it would not be able to request "special dividends" in order to do so.

These structures allow separation insofar as prudential risk and the use of capital is concerned without the full divestment required under Glass-Steagall or in response to the recently-expressed concerns of Paul Volcker and Mervyn King—such extreme solutions should remain the proper focus of competition authorities. With an NOHC structure, technology platforms and back office functions would still be shared, permitting synergies and economies of scale and scope. Such a transparent structure would make it easier for regulators and market players to see potential weaknesses. Mark-to-market and fair value accounting would affect those affiliates most associated with securities businesses, while longer-term cost amortization would dominate for commercial banking. It would create a tougher, non-subsidized environment for securities firms, but a safer one for investors.

If a securities firm under this structure had access to limited "siloed" capital and could not share with other subsidiaries, and this were clear to the market, this would be priced into the cost of capital and reflected in margins for derivative transactions. The result would likely be smaller securities firms that are more careful in risk-taking than has been the case under the "double gearing" scenarios seen in mixed or universal bank groups.

Finally, if a securities affiliate were to fail under such a structure, the regulator could shut it down without affecting its commercial banking sister firm in a critical way—obviating the need for "living wills." Resolution mechanisms for smaller, legally separate entities would be more credible than those needed in the recent past for large mixed conglomerates—helping to deal with the "too big to fail" issue. To protect consumers, deposit insurance and other guarantees could apply to the bank without being extended to the legally separate securities firm…

The structure of organizations and how they compete will be critical to future stability. Going forward, the aim must be to keep the "credit culture" and the "equity culture" separate so that government implicit and explicit insurance does not extend to cross-subsidizing high-risk market activity, and so that contagion and counterparty risk can be reduced. The right balance must also be struck between sufficient size conducive to diversification and strong competition to meet consumer needs at reasonable costs.

I’m sure there are some drawbacks and there would be some unintended consequences from implementing this structure, but given the difficult political landscape and the lobbying power of the banks, if we could kill this many birds (too big to fail, too big to unwind, subsidies for being so large, systemic risk) with one stone, we would be in much better shape than we are right now.

The deficit bogeyman: When people are not talking about gold, commercial real estate, the US dollar or the evil being that is Goldman Sachs, they are talking about the US debt and budget deficit. The Republicans are crying about big government. The Democrats are blaming Bush tax cuts, the 2 wars and the recession for the increased borrowing and spending even as tax receipts have fallen off a cliff. The fear is that either bond vigilantes or our foreign creditors will force interest rates up as they stop buying Treasuries, thus causing the nascent recovery (that I happen to believe is a mirage) to be stifled and the cost of servicing the humungous debt burden prohibitive. Are these just scare tactics or are they legitimate concerns?

As many people have written lately, this was what was expected in Japan and never did happen. Now, I am concerned that Japan may finally have run out of time and luck as a result of the current global recession, but that is not the point. The argument is that the US could run huge deficits and without causing a crippling rise in interest rates. For those of you who are convinced that interest rates are going to go straight up as US creditors become less inclined to hold our debt and inflation starts to pick up, I suggest you take a look at this piece from James Kwak of The Baseline Scenario. I personally have no idea how this will all play out. I think two logical people could argue both sides very convincingly. That is why it is always important to understand events that could kill your investment thesis:

One of the curious things about the debt scare that is building in the media is that it is happening at a moment when long-term interest rates are very low. In other words, it’s based on a theory that the market is wrong in its collective assessment of the debt situation. I’ve heard this blamed on “non-economic actors” (that is, foreign governments that buy U.S. Treasuries not as a good investment, but for political reasons), or on a “carry trade” where investors are exploiting the steep yield curve (free short-term money, positive long-term interest rates), as Paul Krugman discusses here.

Menzie Chinn crunches some numbers. He takes a model that he and Jeff Frankel created several years ago to estimate the impact on interest rates of inflation, the future projected national debt, the output gap (economic output relative to potential), and foreign purchases of Treasuries. That last term is important, because the oft-heard fear is that foreign governments will suddenly stop buying our debt.

Using the future growth in the debt projected by the CBO, this model predicts that real interest rates will … go down by 7 basis points over the next year, assuming foreign purchases of debt are constant. The reason the impact of the debt is so small is that it’s already priced in; since the looming debt is no secret, it should already be showing up in the data.

The counterargument is that it hasn’t shown up in the data because of the “flight to safety” and foreign governments’ irrational purchases of Treasuries. So Chinn also looks at what would happen if foreign purchases of U.S. debt fell to zero, nada, zilch (which is an extreme scenario). In that case, interest rates go up by 1.3 percentage points. That’s not nothing, but it still keeps interest rates at reasonable levels by historical standards. In addition, the CBO is already incorporating higher interest rates into their forecasts; they expect the 10-year Treasury bond yield to go from 3.3% in 2009 to 4.1% in 2010, 4.4% in 2011, and 4.8% in 2012-13, and that’s built into their projections of future interest payments.

So I’ll say again: none of this is good. But if we’re going to make important policy decisions based on fear of the debt, we should have a rational way of thinking about the impact of that debt rather than just fear-mongering.

Why did AIG get bailed out and not the monolines? According to Thomas Adams of Paykin Krieg and Adams, LLP (who is a former managing director at Ambac and FGIC), it may have been due to—you guessed it—AIG’s relationship with Goldman Sachs. In this post on Naked Capitalism, Adams carefully goes through the similarities and differences between the situations facing the monoline insurers and AIG. One major difference? Goldman had little exposure to the monolines. Thus, his conclusion is that a major wild card in the decision to save AIG and let the monolines flail was the amount of money AIG owned Goldman for collateral on credit default swaps on those wonderful ABS CDOs (there are those acronyms again). Clearly there is no way to know for sure and the timing of the AIG blowup (right after Lehman went away and the financial markets were on fire) may have influenced the decision. However, after the recent revelations by Neil Barofsky about Tim Geithner’s refusal to force the banks to take haircuts on their CDS positions, I would not be surprised one bit if Goldman’s exposure to AIG was a swaying factor:

As we have been reading the latest coverage on the AIG bailout from the SIGTARP report and the Treasury Secretary Geithner’s Congressional testimony, a nagging question remains unresolved: why did AIG get bailed out but the monoline bond insurers did not?

The business that caused AIG to blow up was the same that caused the bond insurers to blow up – collateralized debt obligations backed by sub-prime mortgage bonds (ABS CDOs). This was actually one of the few business that AIG Financial Products had in common with the monolines. AIG didn’t participate in municipal insurance, MBS or other ABS deals, which were all important for the monolines.

Certainly, AIG was larger than any of the bond insurers, but in aggregate, the bond insurers had a tremendous amount of ABS CDO exposure, which at the peak was probably over $300 billion. Despite AIG’s claims to have withdrawn from subprime at the end of 2005, we have identified particular 2006 deals with substantial subprime content that AIG most assuredly did guarantee…

I hate to get sucked into the vampire squid line of thinking about Goldman, but the only explanation I can think of for why AIG got rescued and the monolines did not is because Goldman had significant exposure to AIG and did not have exposure to the monolines.

When it became clear that AIG could face bankruptcy, Goldman’s plan to profit by shorting ABS CDOs was threatened. While they had the collateral posted, thanks to the downgrades, this collateral could be tied up or lost if AIG went bankrupt. This was a real crisis for Goldman – they thought they had outsmarted the subprime market with their ABS CDOs and outsmarted all of the other banks by getting collateral posting from AIG when they got downgraded. But if AIG went away, this strategy would have blown up and cost Goldman billions.

In addition, I believe that Goldman and their helpers – including their many connections with the White House and the Fed – pumped up concerns about the systemic risk that the market was facing from a Lehman and AIG failure, so that they could force the government to step in and bail out AIG. This would also explain why Lehman was not bailed out. Lehman didn’t really matter to Goldman. But the fear created by Lehman’s failure served as a good excuse for why they should rescue AIG.

I’m going to keep writing about this until the insanity stops: I have to admit it is a little disconcerting. I have heard ostensibly smart people who work with the financial markets every day argue that stocks could continue to rally because of “money on the sidelines.” Again, last I checked, aside from IPOs and other offerings, for every share of stock bought there is an identifiable seller. So as each dollar comes from the sidelines into the market another dollar leaves the market. Now, of course irrational buyers could pay too much for certain stocks and of course that could drive prices up. However, the argument you hear has to do with liquidity on the sidelines waiting to jump into the markets; not about foolish buying in relation to market valuations. Either I am completely crazy and have lost any and all sense of how markets function or this “truism” is in fact complete hogwash. Please, if you want to buy stocks because you think the valuations are attractive, just say so. I would likely argue that in a lot of cases stocks are discounting returns and margins that are implausible given the economic backdrop, but at least the rationale for buying based on intrinsic value reflects some semblance on investment sanity. If the only reason you are buying is because you think there are other buyers waiting in line (the greater fool theory, maybe?) then I implore you to take a step back and examine the macroeconomic and company specific fundamentals.

Thankfully, I am not alone in my plight. Here is a recent piece from Comstock Funds on this topic (hat tip to The Pragmatic Capitalist):

When making our bearish case for stocks we’re amazed at how often our audience brings up the old “cash on the sidelines” argument as a reason to doubt that the current rally can tank. We have been in this business for a while and don’t remember a time when this fairy tale wasn’t trotted out as a reason to be super bullish. In fact we don’t recall any point where observers ever said that the market was going down because there was not enough cash on the sidelines.

A relatively recent example was the summer of 2007 when a majority of commentators insisted that the availability of huge amounts of global liquidly would never allow the market to retreat. The words were hardly out of their mouths (or word processors) before the ECB and the Fed were forced to pour hundreds of billions of dollars into their banking systems. As we indicated at the time, liquidity is never there when you need it.

The fact is, as John Hussman has so eloquently pointed out, the purchase or sale of a stock is net neutral with regard to cash entering or leaving the market. For every buyer there’s a seller, and for every seller there’s a buyer. When “A” buys stock for $100,000 he/she has $100,000 less cash on hand, but “B”, the seller, receives the $100,000. No net cash has entered or left the market.

The reason stocks go up or down is not a result of cash moving into or out of the market. Stocks go up when prospective purchasers are more anxious to buy than sellers are to sell. If there are more willing buyers than sellers at any given level the market has to go up to equalize demand and supply. In fact, it sometimes doesn’t take any transaction at all to move the market. If Intel reports surprisingly high earnings and Dell reports a disappointment the bid and asked price moves up or down before any transaction even takes place.

Furthermore, if even one anxious buyer of a relatively small number of shares drives up the price, the total capitalization of all the shares of that stock rises. And if the purchases are a result of a real upside earnings surprise in a key bellwether stock, the entire market can rise without a dime of new cash entering the market.

Despite the obvious truth of this case, strategists and the media always bring up the old myth of “cash on the sidelines” to justify their bullish views of the market, particularly when their arguments for the economy and valuation are flawed. If you hear anyone make this case just ignore them—it’s a fallacy. If the market rally continues from here, it will happen as a result of buyers being more anxious to buy than sellers are to sell, not because sideline cash is entering the market. If fundamental and technical conditions deteriorate as we expect, prospective purchasers will become less anxious to buy while sellers will be more willing to sell, and the market will decline by enough to equalize supply and demand.

(Picture courtesy of