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.
Thursday, September 25, 2008
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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