Obviously, even if the Bailout Plan passed by a simple majority, it was not a document any Congressman was going home to brag about to his/her constituency. Main Street clearly doesn't understand or doesn't seem to care that the credit crisis, if it persists, will have a direct impact on their lives. What steps do we need to take:
1. The President, Mr. Paulson, and Mr. Bernanke need to have a heart to heart with Congress and in simplified terms explain the connection between Wall Street and Main Street.
2. Once Congress understands the elementary economic relationship of the credit crisis and its effect on John Q Public, then the Congressmen need to hold meetings in their home towns to discuss the issues with their voters.
3. When I wrote how I thought the new Fund would earn a profit for the taxpayers over time I had suggested hiring professionals to manage the process and give them economic incentive to be on the same team as Main Street. If I object to anything in the Plan, it is the vagueness of the price the Government would pay to buy the distressed mortgages. The fair price should be one where the private sector would buy it to earn an adequate return. That would not be a price to maturity where the Government might overpay. Overpaying is a clear and decisive objection by all parties unless it includes other economic value given by a company to the Government.
4. Perhaps the Plan's method of attack needs to be altered. If assets are not written down to today's perceived value, then the private sector will stay on the sidelines. At fair distressed prices, the private sector has plenty of capital to buy securities and could probably raise plenty of more when needed. If the financial sector doesn't get flushed out such that the excesses of the past decade dissipate, then the road to recovery may last ten years like it did in Japan.
5. Let's assume the Government can get companies to write down their assets to fair market values. As discussed in my other articles, the financial institutions will need to raise additional capital to remake themsleves financially sound with a strong capital base to grow and expand their businesses. My new proposal is to have the Government force these writedowns and then provide the necessary capital to the financial institutions in the form of a convertible preferred stock. In this manner, the written down assets can now be sold to the private sector as the Government has recapitalized the company. This will be a good formula to unlock the mortgage market and provide an impetus to improving the credit crisis. The taxpayers will also have an improved chance of earning a reasonable return on their money.
I am sure many new ideas will be tossed around in the next few days but the bottom line is that if nothing is done to deleverage the financial system and unlock the credit crunch, this economy is heading for the abyss.
Monday, September 29, 2008
Forget the Bailout--What Will the Market Do?
Today is an indication of how the markets will react to the credit crisis and the economic recession upon us. Perhaps not having a Bill will allow market forces to determine true asset values quicker but in a harsher manner. Many financial companies are going to fail, home prices need to decline, commercial real estate will come back to earth, and overleveraged companies are headed for bankruptcy. If we remove Government interference, all these events will occur very quickly. Why isn't the inevitable a good thing?
It may be, but the risk of the banking system totally freezing globally will cause a massive run on the Bank and dire economic consequences for many years ahead. If banks won't lend, how does a middle class person with a job buy or sell a home? How can the widget entrepreneur buy a new machine or pay for inventory during the peak season? How can one buy a car without a loan? Should we forget about credit cards because no bank will give credit anymore? This is what would happen and could happen unless this credit crisis eases soon.
We are not in normal times. This is not a joke. We have a desparate economic and financial situation and Main Street America will eventually panic. The professional investors have all lost money this year and the average investor is counting his/her losses everyday. Don't get me wrong. This market will create many opportunities and those with a five year time horizon can potentially make a mint by buying high quality stocks where the company has free cash flow and not burdened by too much debt. Nobody is going to jump into this market head first but buying qualty stocks in a down market when fear is greatest is usually the stories we read about how one made a fortune by taking a chance. This scenario will also likely be true for the real estate market over the next few years.
We are in for tough times but there will be opportunities ahead.
It may be, but the risk of the banking system totally freezing globally will cause a massive run on the Bank and dire economic consequences for many years ahead. If banks won't lend, how does a middle class person with a job buy or sell a home? How can the widget entrepreneur buy a new machine or pay for inventory during the peak season? How can one buy a car without a loan? Should we forget about credit cards because no bank will give credit anymore? This is what would happen and could happen unless this credit crisis eases soon.
We are not in normal times. This is not a joke. We have a desparate economic and financial situation and Main Street America will eventually panic. The professional investors have all lost money this year and the average investor is counting his/her losses everyday. Don't get me wrong. This market will create many opportunities and those with a five year time horizon can potentially make a mint by buying high quality stocks where the company has free cash flow and not burdened by too much debt. Nobody is going to jump into this market head first but buying qualty stocks in a down market when fear is greatest is usually the stories we read about how one made a fortune by taking a chance. This scenario will also likely be true for the real estate market over the next few years.
We are in for tough times but there will be opportunities ahead.
What Was Congress Thinking?
As I have been writing, the Bailout Plan is just a band-aid but a little plug in the dam is better than nothing. I consider the credit crisis to be the worst economic situation anybody reading this has seen in his/her lifetime; so why would Congress decide today was the day to stand on ceremony and make this new Government Fund a political issue?
The result was a Dow dropping almost 800 points, commodities falling off the cliff, and the credit markets remaining in disarray. The VIX, a volatility index which measures fear in the market, closed at 46.72. A couple of weeks ago it was around 20 and it is close to the high on 9/21/01 of 49.35. The result was massive selling in all markets as people wanted cash and as much liquidity as possible. Indiscriminate selling, as we saw, usually creates value but some Bill needs to pass to stem the downward tsunami. The Bill had to pass as a first step to unfreeze part of the mortgage market and allow banks to begin lending again. Upon a Bill passing, I expected the stock market to head south after a brief rally as the dire economic situation will become the market's focus; but without a bill, the recession will accelerate, the credit crisis will get worse, and main street will suffer for many years to come.
It looked like there were enough votes to pass this Bill until Nancy Pelosi decided the vote needed to have an equal amount of Republicans as Democrats vote yes. Withholding Democratic votes at a time when Main Street America needs this Bill to pass more than ever has to be one of the worst political maneuvers in all time. What ever happened to country first and politics second.
I believe a Bill will be reworked and get passed before the week is out or we may be headed to the Great Depression II.
The result was a Dow dropping almost 800 points, commodities falling off the cliff, and the credit markets remaining in disarray. The VIX, a volatility index which measures fear in the market, closed at 46.72. A couple of weeks ago it was around 20 and it is close to the high on 9/21/01 of 49.35. The result was massive selling in all markets as people wanted cash and as much liquidity as possible. Indiscriminate selling, as we saw, usually creates value but some Bill needs to pass to stem the downward tsunami. The Bill had to pass as a first step to unfreeze part of the mortgage market and allow banks to begin lending again. Upon a Bill passing, I expected the stock market to head south after a brief rally as the dire economic situation will become the market's focus; but without a bill, the recession will accelerate, the credit crisis will get worse, and main street will suffer for many years to come.
It looked like there were enough votes to pass this Bill until Nancy Pelosi decided the vote needed to have an equal amount of Republicans as Democrats vote yes. Withholding Democratic votes at a time when Main Street America needs this Bill to pass more than ever has to be one of the worst political maneuvers in all time. What ever happened to country first and politics second.
I believe a Bill will be reworked and get passed before the week is out or we may be headed to the Great Depression II.
Where Do We Go From Here?
Last Friday after Wamu was taken over by J.P. Morgan and Congress was scurring to finalize a Bailout Plan, I said will Wachovia be the next problem? This morning we see that Wachovia's stock evaporated over the weekend as Citigroup and Wells Fargo battled to buy the banking assets. It looks like Citi was the winner (Maybe) but the Wachovia's stock has skidded from $10 to almost zero.
I would not claim to be an expert on Citigroup but it appeared that they still had many financial problems left on their own balance sheet. Citi obviously believes the new deposit base will help solve its own credit problems. It is likely Citi will need to raise additional capital and their stock price could still get hit with any new fundraising attempt. Citi is no J.P. Morgan.
We now have a Government Bailout Fund that needs to be passed by Congress. It appears that will likely occur this week but can the American people feel secure and believe the crisis will ease? No. The stock markets still are showing red ink but they may rally if it becomes clear that the plan will get passed. As we said last week, the new Fund is just a small band-aid to a very large global problem. We have primarily focused on the stress in the U.S. financial system but a weak economy, excess leverage, and a soft housing market are trends that are pervasive throughout Europe and perhaps other parts of the world.
The New Fund will "help" to stabilize the mortgage market in the U.S. but I am most concerned now with the looming financial disasters that may arise around the world. A Global recession is developing and there are too many financial institutions around the world who may have derivative problems, mortgage concerns, capital needs or a host of other issues that could create new alarms to the financial system. Before two weeks ago, how many of you heard of Fortis, Bradford & Bingley or Hypo Real Estate? Fortis is the most known but the other two are not necessarily part of the American vocabulary.
I continue to think our markets will not rise for a while until the global financial system deleverages and the economy stabilizes. This could be a two to four year process. All governments will scramble to put out fires while consumer confidence will continue to erode as Main Street becomes more worried. This spiraling effect will continue to lead the economy down. The underlying positive is that opportunities will develop in the stock market and brighter days are ahead.
I would not claim to be an expert on Citigroup but it appeared that they still had many financial problems left on their own balance sheet. Citi obviously believes the new deposit base will help solve its own credit problems. It is likely Citi will need to raise additional capital and their stock price could still get hit with any new fundraising attempt. Citi is no J.P. Morgan.
We now have a Government Bailout Fund that needs to be passed by Congress. It appears that will likely occur this week but can the American people feel secure and believe the crisis will ease? No. The stock markets still are showing red ink but they may rally if it becomes clear that the plan will get passed. As we said last week, the new Fund is just a small band-aid to a very large global problem. We have primarily focused on the stress in the U.S. financial system but a weak economy, excess leverage, and a soft housing market are trends that are pervasive throughout Europe and perhaps other parts of the world.
The New Fund will "help" to stabilize the mortgage market in the U.S. but I am most concerned now with the looming financial disasters that may arise around the world. A Global recession is developing and there are too many financial institutions around the world who may have derivative problems, mortgage concerns, capital needs or a host of other issues that could create new alarms to the financial system. Before two weeks ago, how many of you heard of Fortis, Bradford & Bingley or Hypo Real Estate? Fortis is the most known but the other two are not necessarily part of the American vocabulary.
I continue to think our markets will not rise for a while until the global financial system deleverages and the economy stabilizes. This could be a two to four year process. All governments will scramble to put out fires while consumer confidence will continue to erode as Main Street becomes more worried. This spiraling effect will continue to lead the economy down. The underlying positive is that opportunities will develop in the stock market and brighter days are ahead.
Saturday, September 27, 2008
The Economic Debate--NOT
Last night the American people anxiously were waiting for some well thought out ideas and initiatives to solve the credit crisis. At 9pm EST John McCain and Barack Obama met face to face for their first National Debate. It was a week of jockeying, fighting, cajoling, and political squabling about the Paulson Bailout Plan. Now we had the chance to listen to our next President tell us: what he thought the plan should look like; how the $700B Fund was going to effect fiscal policy; what is the near and long-term outlooks for the economy; how was Main Street America going to be affected. Instead we got a big yawn.
As we have been discussing all week, our country is in a major financial crisis and this bailout plan is only one piece to a very complicated puzzle to flush out the excesses of an overleveraged economy. America needs a strong leader for the next four years and one who has some definitive thoughts on how to get out of the mess we are in. There is no simple answer but it is important for the American people to feel like the next leader is smart and understands the problems.
Personally, I have not decided for whom to vote and I thought last night might sway me. However, the economic discussion seemed to be short on ideas and substance while the foreign policy discussion dominated the night. Don't get me wrong. We have huge issues around the world that need to be addressed but last night the American people were keenly interested in the $700B plan and how it affected them. I came away from the debate wondering whether either candidate understood the complexity of the situation and had any ideas focused on improving our financial system and nursing our economy back to health.
As we have been discussing all week, our country is in a major financial crisis and this bailout plan is only one piece to a very complicated puzzle to flush out the excesses of an overleveraged economy. America needs a strong leader for the next four years and one who has some definitive thoughts on how to get out of the mess we are in. There is no simple answer but it is important for the American people to feel like the next leader is smart and understands the problems.
Personally, I have not decided for whom to vote and I thought last night might sway me. However, the economic discussion seemed to be short on ideas and substance while the foreign policy discussion dominated the night. Don't get me wrong. We have huge issues around the world that need to be addressed but last night the American people were keenly interested in the $700B plan and how it affected them. I came away from the debate wondering whether either candidate understood the complexity of the situation and had any ideas focused on improving our financial system and nursing our economy back to health.
Friday, September 26, 2008
The $700B Plan vs A Homeowner Plan
On September 23rd I wrote about "The $700B Quagmire". I suggested that the fund should be managed by experts who understand the assets being purchased and also have the ability to structure the right deal for each company. Congress can not use one set of guidlines that will apply to all the assets being purchased. If those assets are bought very cheap, then it will be a good deal. In other situations, if the purchase price is above fair market value, then the taxpayers should expect to get additional value in the form of debt or equity from the selling financial institution. As Paul Krugman discusses in today's NY Times Op-Ed section, we need Grown-Ups to manage this process. The oversight of this process is best served by hiring a team of experienced professionals that are incentivised to work for the taxpayers by profiting themselves on the returns of the $700B Fund.
The other large topic up for debate is how should the government help those on Main Street who can't afford their mortgages. The editorial in the NY Times today suggests the bankruptcy Court should be allowed to restructure the mortgages to reduce foreclosures and make homes affordable again to those who live in them. Wall Street may be blamed for providing the liquidity for the growth in the housing market but many people used this opportunity to take out oversized mortgages and home equity loans. In addition, speculative buying of homes helped to propel prices of homes higher and many people enriched themselves in the process. Others refinanced their mortgages and took out cash to feed their lifestyles. Wall Street is the culprit but Main Street enjoyed the ride while it lasted.
Of course, the government needs to find a solution to the housing problem but I think the NY Times editorial does not accurately explain the bankruptcy process. If a corporation has secured debt, similar to a home mortgage, and the company goes bankrupt, then the loan needs to be paid off or restructured. A restructuring will likely give the mortgage holder a lower coupon or a smaller loan. That is what the editorial is suggesting bankruptcy judges should have the ability to demand. However, in a corporate bankruptcy, the mortgage lender will also retain some if not all of the equity in the business as compensation for reducing the principal on the loan or for accepting a lower interest payment. If we apply an analagous principle to homeownership, then the financial institution whose loan is being restructured should also be compensated with an equity stake in that home. Perhaps a mechanism can and should be set up to allow the homeowner to pay back the financial institution over time to regain their equity stake in their home.
The $700B Bailout is similar to the Homeowner Plan. Both situations need to be managed by Grown-Ups and unique deal need to be structured but in the end, there is no free lunch.
The other large topic up for debate is how should the government help those on Main Street who can't afford their mortgages. The editorial in the NY Times today suggests the bankruptcy Court should be allowed to restructure the mortgages to reduce foreclosures and make homes affordable again to those who live in them. Wall Street may be blamed for providing the liquidity for the growth in the housing market but many people used this opportunity to take out oversized mortgages and home equity loans. In addition, speculative buying of homes helped to propel prices of homes higher and many people enriched themselves in the process. Others refinanced their mortgages and took out cash to feed their lifestyles. Wall Street is the culprit but Main Street enjoyed the ride while it lasted.
Of course, the government needs to find a solution to the housing problem but I think the NY Times editorial does not accurately explain the bankruptcy process. If a corporation has secured debt, similar to a home mortgage, and the company goes bankrupt, then the loan needs to be paid off or restructured. A restructuring will likely give the mortgage holder a lower coupon or a smaller loan. That is what the editorial is suggesting bankruptcy judges should have the ability to demand. However, in a corporate bankruptcy, the mortgage lender will also retain some if not all of the equity in the business as compensation for reducing the principal on the loan or for accepting a lower interest payment. If we apply an analagous principle to homeownership, then the financial institution whose loan is being restructured should also be compensated with an equity stake in that home. Perhaps a mechanism can and should be set up to allow the homeowner to pay back the financial institution over time to regain their equity stake in their home.
The $700B Bailout is similar to the Homeowner Plan. Both situations need to be managed by Grown-Ups and unique deal need to be structured but in the end, there is no free lunch.
Does Congress Know What the Credit Markets Are?
Last night another financial institution was brought to its knees as Washington Mutual, the largest savings and loan, was seized by the FDIC and subsequently sold to J.P. Morgan. How many more deaths to prime institutions do we need before Congress realizes the Government needs to act quickly to slow the financial tsunami? There is no one solution to end the current financial crisis but some form of the $700 Billion Paulson fund bill needs to be passed soon to limit some of the future damage.
The credit markets drive the stock market. Most people have no idea what I mean by that but every swoon in the market I have seen in the past 21 years was usually led by widening spreads in the credit markets. That is the situation we have today whether we look at Libor, credit default swaps, investment grade bonds, high yield bonds, or mortages. There is very little liquidity in all markets. Banks don't want to lend to each other, companies are scrambling to preserve cash (i.e. GE and GM), the housing market continues to slide, and the economy is heading into the tank. What is Congress not seeing that I see?
Did TPG think WAMU would dissappear in five months? Wasn't Bear Stearns the investment bank with poor risk controls? Oh yeah, what happened with Lehman, Merrill, and almost Goldman and Morgan Stanley? What is going to happen next week with Wachovia? Will it be independent? The economy is slipping fast and the credit markets are closing. Perhaps we have a few more days to procrastinate in order to get the best government plan but time is clearly running out. Congress needs to read the tea leaves and compromise with Mr. Paulson and Mr. Bernanke before it is too late.
The credit markets drive the stock market. Most people have no idea what I mean by that but every swoon in the market I have seen in the past 21 years was usually led by widening spreads in the credit markets. That is the situation we have today whether we look at Libor, credit default swaps, investment grade bonds, high yield bonds, or mortages. There is very little liquidity in all markets. Banks don't want to lend to each other, companies are scrambling to preserve cash (i.e. GE and GM), the housing market continues to slide, and the economy is heading into the tank. What is Congress not seeing that I see?
Did TPG think WAMU would dissappear in five months? Wasn't Bear Stearns the investment bank with poor risk controls? Oh yeah, what happened with Lehman, Merrill, and almost Goldman and Morgan Stanley? What is going to happen next week with Wachovia? Will it be independent? The economy is slipping fast and the credit markets are closing. Perhaps we have a few more days to procrastinate in order to get the best government plan but time is clearly running out. Congress needs to read the tea leaves and compromise with Mr. Paulson and Mr. Bernanke before it is too late.
Thursday, September 25, 2008
The Bailout Will Succeed but What's Next?
Next week we will be relieved that Congress and Mr. Paulson came to an agreement on the structure for the new $700 billion investment fund. The markets may rally as investors come to this conclusion. What's next? Reality is about to set in.
This new fund is going to allow the banking system to sell their weakest distressed assets to clean up their balance sheets but it will also lead to a massive recapitalization of the financial system. Equity offerings will be aplenty. These new stock infusions may come from the capital markets or invstments from private equity firms, hedge funds, sovereign funds or other smart investors. The likely result will be the lower prices for the stocks of financial institutions. The hedge funds won't need to short these stocks to come to this conclusion.
In addition, the press will start to focus on everything else going on in the economy. Home sales are still down; foreclosures continue to rise; durable goods orders drop more than expected; retail sales are weak at the most prestigious stores; and the sounds of extremely weak holiday sales are about to come roaring. The bottom line is that the government needs to pass the bill for the $700B fund but that is not going to change the fact that the economy is weak and continues to decline. The reported GDP numbers have not turned negative yet but it would be surprising if we don't imminently see that occur.
The U.S. economy has been driven by loose credit for mortages and home equity loans. Both of these avenues of liquidity have been drying up and America is financially crippled. It will take a long time to clean up this wreck but leverage needs to decline precipitously and confidence by everyone must be restored.
America is not the economic power it once was and the next few years will likely lead to some tough times but we have the human capital and a great democratic society that will lead this country to better times. Ten years from now the United States will look back at this period with disbelief but once again it will lead the world to new heights.
This new fund is going to allow the banking system to sell their weakest distressed assets to clean up their balance sheets but it will also lead to a massive recapitalization of the financial system. Equity offerings will be aplenty. These new stock infusions may come from the capital markets or invstments from private equity firms, hedge funds, sovereign funds or other smart investors. The likely result will be the lower prices for the stocks of financial institutions. The hedge funds won't need to short these stocks to come to this conclusion.
In addition, the press will start to focus on everything else going on in the economy. Home sales are still down; foreclosures continue to rise; durable goods orders drop more than expected; retail sales are weak at the most prestigious stores; and the sounds of extremely weak holiday sales are about to come roaring. The bottom line is that the government needs to pass the bill for the $700B fund but that is not going to change the fact that the economy is weak and continues to decline. The reported GDP numbers have not turned negative yet but it would be surprising if we don't imminently see that occur.
The U.S. economy has been driven by loose credit for mortages and home equity loans. Both of these avenues of liquidity have been drying up and America is financially crippled. It will take a long time to clean up this wreck but leverage needs to decline precipitously and confidence by everyone must be restored.
America is not the economic power it once was and the next few years will likely lead to some tough times but we have the human capital and a great democratic society that will lead this country to better times. Ten years from now the United States will look back at this period with disbelief but once again it will lead the world to new heights.
Is It a Bailout or One of the Best Invstments?
Much talk has taken place during the past week about the $700 Billion bailout but as I recently discussed, the government can and should make money. There is a reason why the smartest hedge fund managers and private equity professional have raised large pools of money. They expect the opportunity set for distressed assets to continue to grow and the returns over the next couple of years will far surpass those that have been garnered in the last five years.
Main Street must understand that finally they will be on the same team as the rich and famous that they read about. Mr. Paulson will get smart people to manage this $700 billion distressed fund and they will have a mandate to make the taxpayers a bunch of money. Congress needs to go back to their constituency and sell this plan not as a bailout but the best investment they will potentially ever make.
The excess leverage and the mortgage crisis have put the United States at the brink of bankruptcy but now we must deal with it and fix the problem. This new investment fund is just patching one leak in the dam but it is clearly the biggest hole.
Main Street must understand that finally they will be on the same team as the rich and famous that they read about. Mr. Paulson will get smart people to manage this $700 billion distressed fund and they will have a mandate to make the taxpayers a bunch of money. Congress needs to go back to their constituency and sell this plan not as a bailout but the best investment they will potentially ever make.
The excess leverage and the mortgage crisis have put the United States at the brink of bankruptcy but now we must deal with it and fix the problem. This new investment fund is just patching one leak in the dam but it is clearly the biggest hole.
Wednesday, September 24, 2008
The Buffett Way--The Goldman Cash Infusion
Warren Buffett finally entered the fray with his first investment in the financial sector. Many people are asking has Warren Buffet now become bullish on the financial sector as he has become an investor in Goldman Sachs? The simple answer is definitely not.
I am sure Mr. Buffett see value in some parts of the financial sector which may include distressed mortages, distressed loans, banks and insurance companies. However, he is not calling a bottom on the financial sector. Mr Buffett analyzes companies and tries to invest in world class organizations when he see long-term value created at cheap prices. That is what he sees in Goldman Sachs.
Goldman is and has been the premier investment bank that has come under some financial distress as the "market" has decided the investment banking business model is not effective in today's capital market environment. Today's montra is less leverage and stable sources of funding. Investment banks have historically been operated with high levels of leverage and short-term funding sources. This past weekend Goldman and Morgan Stanley recreated themselves and became bank holding companies. In Goldman's case they are the fourth largest bank in the United States.
As part of its transformation, Goldman probably wanted to calm the market attitude towards itself in two ways. First, they needed some added credibility and second, they chose to raise additional capital to reduce the leverage. There was only one quick way to do that quickly and it is called Warren Buffett. Goldman offered Berkshire Hathaway what appears to be a sweetheart deal in the form of a $5 billion preferred stock investment with a 10% coupon and a 10% premium call price forever. In addition, Berkshire was offered a 5-year warrant that gives it an option to buy $5 billion of Goldman common stock at a price of 115. As Goldman's price soared, they issued another $5 billion of common stock to other institutional and retail clients at a price of $123 so everyone could participate with Mr. Buffet, albeit not with the same cheap terms.
Goldman accomplished its goals and locked in the security of its future. Warren Buffett accomplished his objectives of investing in a world class global company with great management and he received terrific terms for his participation. This is not a fundamental statement about the financial services industry from what may be considered the greatest investor of all time.
I am sure Mr. Buffett see value in some parts of the financial sector which may include distressed mortages, distressed loans, banks and insurance companies. However, he is not calling a bottom on the financial sector. Mr Buffett analyzes companies and tries to invest in world class organizations when he see long-term value created at cheap prices. That is what he sees in Goldman Sachs.
Goldman is and has been the premier investment bank that has come under some financial distress as the "market" has decided the investment banking business model is not effective in today's capital market environment. Today's montra is less leverage and stable sources of funding. Investment banks have historically been operated with high levels of leverage and short-term funding sources. This past weekend Goldman and Morgan Stanley recreated themselves and became bank holding companies. In Goldman's case they are the fourth largest bank in the United States.
As part of its transformation, Goldman probably wanted to calm the market attitude towards itself in two ways. First, they needed some added credibility and second, they chose to raise additional capital to reduce the leverage. There was only one quick way to do that quickly and it is called Warren Buffett. Goldman offered Berkshire Hathaway what appears to be a sweetheart deal in the form of a $5 billion preferred stock investment with a 10% coupon and a 10% premium call price forever. In addition, Berkshire was offered a 5-year warrant that gives it an option to buy $5 billion of Goldman common stock at a price of 115. As Goldman's price soared, they issued another $5 billion of common stock to other institutional and retail clients at a price of $123 so everyone could participate with Mr. Buffet, albeit not with the same cheap terms.
Goldman accomplished its goals and locked in the security of its future. Warren Buffett accomplished his objectives of investing in a world class global company with great management and he received terrific terms for his participation. This is not a fundamental statement about the financial services industry from what may be considered the greatest investor of all time.
Tuesday, September 23, 2008
The $700 Billion Quagmire
Today, Hank Paulson and Ben Bernanke will try to convince Congress that the proposed $700B government bailout is necessary and must be acted upon immediately. They must also sell their idea to the people on Main Street. This is not an easy task as all parties are skeptical.
I may have a unique perspective on this debate as I am a 25 year Wall Street veteran with a Main Street upbringing. My career specialty was focused on high yield/junk bonds. In good times non-investment grade companies raise money to propel their growth or for private equity firms to buy companies using both equity and high yield bonds. Upon the issuance of these new securities, Wall Street sells and trades them. The buyers of the bonds are money managers, mutual funds, insurance companies, banks, and hedge funds. The function of trading junk bonds is easy until a hiccup tempers the market. We saw this happen in 1991 during the S&L Crisis, in 1998 with the Russian Crisis, and in 2001 with 9/11. In 2007, we once again had jittery markets as the mortgage crisis and the LBO fiasco came under siege. During each of these periods, money managers hoard cash and big time Wall Street traders hide under their desks. The result is limited liquidity for the trading of bonds and the curtailment of capital markets activities. Without a functioning bond market, companies cannot refinance debt coming due or raise capital to buy equipment to help their companies grow.
The current crisis is very similar to the above periods of time except it is much larger and much more serious. If this crisis continues, corporate America will suffer, Wall Street will be frozen and most importantly, Main Street will be poorer. We need to resolve this problem immediately. The $700B Fund may only be one solution and it may not be enough but the Government needs to start somewhere. Congress and Main Street cannot appreciate the complexity of the job which will be created by this Fund.
The new Fund will need to sift through many balance sheets and analyze a multitude of esoteric securities. Mr Paulson understands that the government cannot propose a cookie cutter approach to buying this debt. There is not one price or one structure that works for all distressed securities. Every situation will be different and each seller will have its own nuance. Should the government take an equity position in companies from which it buys debt? Maybe. Should the government partner with a hedge fund to buy a certain block of debt? Maybe. Should the government become a secured lender of an overleveraged company it is bailing out? Maybe. Should the government force a restructuring by negotiating with bond holders? Maybe.
My point is that this is serious business and there is no simple answer. The most important role the government will have is to hire the most sophisticated and knowledgeable professionals to help them with this $700B Fund. There is discussion about the government hiring a handful of money managers to help with the purchase of these distressed securities. This approach may create conflicts of interest as large money managers may have other funds competing to buy the same assets. I think the better approach would be for Mr. Paulson to hire a swat team with Wall Street esperience who can allign themselves with the interests of Main Street. The average person may feel comfortable if the managers of the fund will have a compensation package tied to the profits generated for the taxpayers through the purchase of securities in this new bailout Fund. If assets need to be bought at artificially high prices, then a preferred equity position may need to be taken in the company. If mortgage-backed securities can be bought at a price to ultimately generate adequate returns, then that will also be acceptible. I can guarantee you that any Wall Street professional working for an incentive to make the taxpayer's money or certainly not to lose them money, will work hard to please those on Main Street.
This debate will continue this week but Wall Street needs to meet Main Street but either way we are in crisis mode and confidence needs to be restored and the capital markets have to function normally to avoid an economic implosion.
I may have a unique perspective on this debate as I am a 25 year Wall Street veteran with a Main Street upbringing. My career specialty was focused on high yield/junk bonds. In good times non-investment grade companies raise money to propel their growth or for private equity firms to buy companies using both equity and high yield bonds. Upon the issuance of these new securities, Wall Street sells and trades them. The buyers of the bonds are money managers, mutual funds, insurance companies, banks, and hedge funds. The function of trading junk bonds is easy until a hiccup tempers the market. We saw this happen in 1991 during the S&L Crisis, in 1998 with the Russian Crisis, and in 2001 with 9/11. In 2007, we once again had jittery markets as the mortgage crisis and the LBO fiasco came under siege. During each of these periods, money managers hoard cash and big time Wall Street traders hide under their desks. The result is limited liquidity for the trading of bonds and the curtailment of capital markets activities. Without a functioning bond market, companies cannot refinance debt coming due or raise capital to buy equipment to help their companies grow.
The current crisis is very similar to the above periods of time except it is much larger and much more serious. If this crisis continues, corporate America will suffer, Wall Street will be frozen and most importantly, Main Street will be poorer. We need to resolve this problem immediately. The $700B Fund may only be one solution and it may not be enough but the Government needs to start somewhere. Congress and Main Street cannot appreciate the complexity of the job which will be created by this Fund.
The new Fund will need to sift through many balance sheets and analyze a multitude of esoteric securities. Mr Paulson understands that the government cannot propose a cookie cutter approach to buying this debt. There is not one price or one structure that works for all distressed securities. Every situation will be different and each seller will have its own nuance. Should the government take an equity position in companies from which it buys debt? Maybe. Should the government partner with a hedge fund to buy a certain block of debt? Maybe. Should the government become a secured lender of an overleveraged company it is bailing out? Maybe. Should the government force a restructuring by negotiating with bond holders? Maybe.
My point is that this is serious business and there is no simple answer. The most important role the government will have is to hire the most sophisticated and knowledgeable professionals to help them with this $700B Fund. There is discussion about the government hiring a handful of money managers to help with the purchase of these distressed securities. This approach may create conflicts of interest as large money managers may have other funds competing to buy the same assets. I think the better approach would be for Mr. Paulson to hire a swat team with Wall Street esperience who can allign themselves with the interests of Main Street. The average person may feel comfortable if the managers of the fund will have a compensation package tied to the profits generated for the taxpayers through the purchase of securities in this new bailout Fund. If assets need to be bought at artificially high prices, then a preferred equity position may need to be taken in the company. If mortgage-backed securities can be bought at a price to ultimately generate adequate returns, then that will also be acceptible. I can guarantee you that any Wall Street professional working for an incentive to make the taxpayer's money or certainly not to lose them money, will work hard to please those on Main Street.
This debate will continue this week but Wall Street needs to meet Main Street but either way we are in crisis mode and confidence needs to be restored and the capital markets have to function normally to avoid an economic implosion.
Monday, September 22, 2008
The Bank Credit Line Danger is Brewing
General Motor's announcement to draw down $3.5 billion from its credit line at J.P. Morgan and Citigroup is a sign of a liquidity concern at this distressed auto company. It might also be its concern about the lack of liquidity in the banking system. About a year ago, Sprint drew down its mega billion credit line as it wanted to have enough cash to avert a potential bankruptcy. At that time, I raised a concern with my friends and colleague that this event is just the beginning of a major new problem for all banks.
Most companies have undrawn credit lines from their banks as a means to maintain a source of liquidity in difficult times or to use during periods of increased working capital needs. From a banks perspective, these lines of credit are an insurance policy to all their customers. The banks earn fees for undrawn lines and don't expect most of them to ever use the bulk of the funds. This insurance principle allows banks in aggregate to lend trillions of these lines of credit in a fashion similar to using an actuarial table.
In strong economic times, this system works well, In fact, in weak economic times, banks also profit from these credit lines. However, in a period where leverage has escalated, the economy is very weak, and the financial system is on the brink of collapse, credit lines might be the skeleton in the closet. What do I mean by all this? Corporate America is assessing its ability to borry money in the capital markets. Bank lines of credit are generally the last source of cash a company wants to borrow as it is used for a rainy day. Well, as CFO's look outside they are starting to see the clouds looming, the thunder bellowing, and lightning striking. If the credit markets are closed to most companies, then the source of needed funding must come from somewhere else. The most likely source is the undrawn lines of credit from banks.
Many banks have started to realize how this phenomenon could drain their own liquidity. Let's look at the extreme possibility. Banks have lines of credit in aggregate which equal mulitiples of their equity capital bases. If every company gets scared that they won't have enough cash to meet their working capital needs, they will draw down all the lines of credit. Now we have a problem. From where wiill the cash come? As I stated above, banks freely give lines of credit using an actuarial type of calculation with the assumption that only a small fraction will ever be drawn upon. In the event all lines are drawn at once, there will be a run on the banking system.
Most banks have been trying to protect against this possibility by refusing to renew lines of credit as they come due or substantially making the terms of the loans more onerous to corporate America. While this effort has positive results toward mitigating the unforeseen run on the bank, will it prevent the potential disaster. It is a race between the banks reducing their exposure to sick companies and the hopeful economic expansion to strengthen both the banking system and corporate America.
Most companies have undrawn credit lines from their banks as a means to maintain a source of liquidity in difficult times or to use during periods of increased working capital needs. From a banks perspective, these lines of credit are an insurance policy to all their customers. The banks earn fees for undrawn lines and don't expect most of them to ever use the bulk of the funds. This insurance principle allows banks in aggregate to lend trillions of these lines of credit in a fashion similar to using an actuarial table.
In strong economic times, this system works well, In fact, in weak economic times, banks also profit from these credit lines. However, in a period where leverage has escalated, the economy is very weak, and the financial system is on the brink of collapse, credit lines might be the skeleton in the closet. What do I mean by all this? Corporate America is assessing its ability to borry money in the capital markets. Bank lines of credit are generally the last source of cash a company wants to borrow as it is used for a rainy day. Well, as CFO's look outside they are starting to see the clouds looming, the thunder bellowing, and lightning striking. If the credit markets are closed to most companies, then the source of needed funding must come from somewhere else. The most likely source is the undrawn lines of credit from banks.
Many banks have started to realize how this phenomenon could drain their own liquidity. Let's look at the extreme possibility. Banks have lines of credit in aggregate which equal mulitiples of their equity capital bases. If every company gets scared that they won't have enough cash to meet their working capital needs, they will draw down all the lines of credit. Now we have a problem. From where wiill the cash come? As I stated above, banks freely give lines of credit using an actuarial type of calculation with the assumption that only a small fraction will ever be drawn upon. In the event all lines are drawn at once, there will be a run on the banking system.
Most banks have been trying to protect against this possibility by refusing to renew lines of credit as they come due or substantially making the terms of the loans more onerous to corporate America. While this effort has positive results toward mitigating the unforeseen run on the bank, will it prevent the potential disaster. It is a race between the banks reducing their exposure to sick companies and the hopeful economic expansion to strengthen both the banking system and corporate America.
The Big Short Squeeze
Friday's markets had the desired effect of the New Government Plan. Global stocks soared to new heights as Mr. Paulson and Mr. Bernanke announced their new fund to help stabilize the credit markets. That plan will allow financial institutions to Dump soured assets into a new reservior of cash and most likely unlock the private sector's hoards of capital at private equity firms and hedge funds to compete in that bidding process. This will be very positive to ultimately clear out the bad assets but it does not address the Massive need to re-equitize corporate America. It also ignores the overleveraged United States Balance Sheet.
The positives of the plan were really Exaggerated by the Big Short Squeeze. Hedge funds and other investors, who manage balanced portfolios by shorting overvalued stocks, were penalized unfairly. Many of them rushed in to cover shorts on Friday which drove many stock prices to levels that don't necessarily represent the true value of the underlying companies. Investors who only buy stocks try to evaluate the fundamentals of the business and determine what fair value should be. If fair value is greater than the market value, investors in the aggregate will buy the stock. In the same vane, an investor who can short stocks, tries to determine fair value for an enterprise. If fair value is higher than the market capitalization of a stock, he may buy it. However, if fair value is lower than the market capitalization, he may short it (sell it).
Short selling is not the nemesis to the market. The short seller helps to balance the market by offsetting overly bullish long investors by allowing stock prices to move to their fair value. What we saw on Friday was not representative of a move to fair value in the market but a manipulation of prices such that stocks in the financial sector are now overvalued. Reality will set in as financial institutions need to writedown bad assets and raise equity capital to reduce the outlandish leverage that has built up over time. Stock prices for financial institutions will migrate, in time, to the levels that represent fair value. These prices will likely be at levels where short sellers accurately analyzed the true value of the companies.
The positives of the plan were really Exaggerated by the Big Short Squeeze. Hedge funds and other investors, who manage balanced portfolios by shorting overvalued stocks, were penalized unfairly. Many of them rushed in to cover shorts on Friday which drove many stock prices to levels that don't necessarily represent the true value of the underlying companies. Investors who only buy stocks try to evaluate the fundamentals of the business and determine what fair value should be. If fair value is greater than the market value, investors in the aggregate will buy the stock. In the same vane, an investor who can short stocks, tries to determine fair value for an enterprise. If fair value is higher than the market capitalization of a stock, he may buy it. However, if fair value is lower than the market capitalization, he may short it (sell it).
Short selling is not the nemesis to the market. The short seller helps to balance the market by offsetting overly bullish long investors by allowing stock prices to move to their fair value. What we saw on Friday was not representative of a move to fair value in the market but a manipulation of prices such that stocks in the financial sector are now overvalued. Reality will set in as financial institutions need to writedown bad assets and raise equity capital to reduce the outlandish leverage that has built up over time. Stock prices for financial institutions will migrate, in time, to the levels that represent fair value. These prices will likely be at levels where short sellers accurately analyzed the true value of the companies.
Thursday, September 18, 2008
Wall Street Distress
The credit crisis is well over a year old and in the past week it has climaxed with Lehman going bankrupt, the government bailing out AIG while assuming an 80% equity interest in the company, and John Thain having the great insight to sell Merrill Lynch at a relatively attractive price to Bank of America. However, these events resulted in credit drying up amongst domestic banks and foreign institutions. The Federal Reserve and its foreign counterparts executed some financial manuevers to ease the stressed markets globally. The U.S. stock markets opened today in a negative direction with much of the focus on Morgan Stanley and Goldman Sachs. Both of their stocks were volatile all day and were subjected to the steepest historical drops in their respective histories as public companies.
As the day progressed, there was a load Roar about the short sellers creating all the problems. The other whisper was about the poor job the SEC has done throughout the credit crises. Rumors swirled about potential government solutions to stem the crisis. Clearly, the government needs to get ahead of the problem as Mr. Bernanke and Mr. Paulson must be getting tired of being firemen.
I am all for a solution. However, late today the UK instituted a policy for the rest of the year that will eliminate short selling of any stocks on the London exchange. I thought that was a dumb idea until tonight when the same idea was being floated by the SEC. Many money managers, individual investors, and hedge funds short stock as a tool for risk management. In fact, many money managers are expected to hedge their portfolios as a fiduciary duty and mandate from the pension funds and endowments who gave them money to manage. The SEC is now panicking because they are going to be blamed for not being proactive throughout the crisis. Short sellers should not be able to sell a stock without borrowing it first and if they spread inaccurate rumors to drive a stock lower, they should be punished. However, the solution is not to prevent short selling of stocks but to reinstitute the uptick rule which will be a simple mechanism to prevent aggressive selling of a stock by the few hedge funds that may be recklessly profiting from the financial crisis.
As the day progressed, there was a load Roar about the short sellers creating all the problems. The other whisper was about the poor job the SEC has done throughout the credit crises. Rumors swirled about potential government solutions to stem the crisis. Clearly, the government needs to get ahead of the problem as Mr. Bernanke and Mr. Paulson must be getting tired of being firemen.
I am all for a solution. However, late today the UK instituted a policy for the rest of the year that will eliminate short selling of any stocks on the London exchange. I thought that was a dumb idea until tonight when the same idea was being floated by the SEC. Many money managers, individual investors, and hedge funds short stock as a tool for risk management. In fact, many money managers are expected to hedge their portfolios as a fiduciary duty and mandate from the pension funds and endowments who gave them money to manage. The SEC is now panicking because they are going to be blamed for not being proactive throughout the crisis. Short sellers should not be able to sell a stock without borrowing it first and if they spread inaccurate rumors to drive a stock lower, they should be punished. However, the solution is not to prevent short selling of stocks but to reinstitute the uptick rule which will be a simple mechanism to prevent aggressive selling of a stock by the few hedge funds that may be recklessly profiting from the financial crisis.
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