Occupy automakers

With all the popular anger directed at the US banking system bailout, it's worth taking a quick look at the costs of TARP. While the US taxpayers have made $21 billion on the bank programs thus far, the TARP auto bailout is still massively in the red. With GM shares at $24, the Treasury's 26 percent stake in the automaker may take years to sell - still likely at a loss.

SoberLook.com

"Join OWS" Email Exchange

Names have been changed.  The email exchange is real.
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Dear Ron,

I spent much of Saturday marching around lower Manhattan and shouting things like "Banks got bailed out; we got sold out!". The primary result of that action for me is the realization that, however much I support Occupy Wall Street, these things are best left to people your son's age (assuming that they are not anti-OWS, like my kids are!).

But what should be obvious to everybody is that, once the bad guys realize the depth of support for OWS, they will resort to obfuscation, propaganda, embedding hidden fees and hidden risks in deals, etc.

What is needed is an organization of financial professionals who will stand against that. People who DON'T run banks, but who know about the financial markets. People who are not complicit in the chicanery, but who know what goes on. In other words, us.

Now neither of us have time to do this now, but, then again, it may not be time yet. The mood of the country is STILL not ready for meaningful financial reform, but perhaps it will be in a year or two. Kids out of the house and time for something new?

Have a great day,
Fred

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Dear Fred,

Sounds like you've had an exciting weekend. I should introduce you to a friend of mine Jerome Berry who is out there marching as well.

My personal view is that the bulk of people working for financial firms are decent folks. They don't deserve the abuse my friend got because his job was to sell insurance for AIG. There are countless people busting their ass in operations, accounting, technology, customer service, etc. Yes they get paid more than the average Joe, but trying to live in NJ with 3 kids and paying the crazy taxes and outrageous home prices puts many back at the national average or below in terms of their standard of living. And now they will be asked to pay more in taxes because OWS people need to collect their unemployment check.

There is no shortage of greedy, corrupt, and overpaid executives, but in my view they are no different than say auto, oil, pharma, food, insurance, etc. executives - all of whom get some sort of government support. It's much more fashionable however to protest against Goldman than say Exxon or Archer Daniels Midland, who in my view do much more damage to an average American than Goldman ever did. Their lobby is also more powerful than that of most financial institutions. Nobody seems to be protesting that the greedy insurance industry got bailed out (guys like Hartford or MetLife) or the auto industry got rewarded for their incompetence. Many people don't even know they were part of TARP. GE got more support from the Fed than most financial institutions. And nobody seems to be protesting against the rating agencies - who are still doing their thing.

People want me to move my money from Chase to a community bank, but I saw how community banks put real estate developers on their board and funded their "local" development projects with depositor money - just to be bailed out by the FDIC. I am not defending the large banking organizations, but I'd just like to see some balance.

With regard to setting up an organization, the best way to start is to set up a LinkedIn group. It's free and you quickly get traction. Once the group gets big enough you set up an event or two and the momentum picks up. I'd be happy to help with this.

All the best,
Ron

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Dear Ron,

The nuanced views that you put forward in your email are precisely the kind of thing that needs to be more prominent in the public discourse. For example, I assume your friend Jerome is in finance (In fact, he may have conducted the first interview that I ever had for a financial job!). You would never know from the media or from OWS that there are many people in finance who would agree with him.

While it is true that execs in other industries are just as greedy as Wall Street execs, they have less of a baleful influence over the economy as a whole. Our economy would not be in recession if it were not for the massive contraction of credit that took place as the result of the mortgage market going bust. If you have a job and most of the people you know have jobs, it is easy to forget the widespread suffering that recessions cause: divorces, bankruptcies, deteriorating health because of inability to pay for good food, drugs, and medical care, and even suicides.

Admittedly, there is plenty of blame to go around for this recession, as was expressed so eloquently by the attached column by Thomas Friedman. Nevertheless, in the eyes of the law, “everybody’s doing it,” is not a legitimate defense. Nor should it be.

As you well know, the big banks have plenty to answer for in creating the current economic mess. In Friedman’s words, either “some of our country’s best-paid bankers were overrated dopes who had no idea what they were selling, or greedy cynics who did know and turned a blind eye.” Either way, there was a massive failure in corporate governance.

There was also a massive failure in corporate governance at Enron, at WorldComm, and at GM. But Enron, WorldComm, and GM all declared bankruptcy, and there were significant management changes. Of the many banks that were technically bankrupt, only Bear and Lehman (who both happened to be competitors of Sec. Paulson’s old firm, Goldman Sachs) were allowed to go under. The remaining banks are still managed by many of the same people, people who have lost more money in the latest fiasco than all banks have ever made in the entire history of banking.

Of course, the bankers had their enablers, the rating agencies, the big accounting firms, government regulators, and the foolish people who bought homes they couldn’t afford. I hold the rating agencies especially accountable because they seem to have rated sub-prime mortgage backed securities with models that they knew were flawed. Why? Because they were being paid $250,000 for, at most, a man week’s worth of work. This isn’t quite fraud, but it sure stinks!

Anyway, that’s why I’m part of OWS.

But I am certainly open to other people's point of view. My son Peter, for example, agrees more with you than with me!

Regards,
Fred

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Dear Fred,

Thanks for the explanation. I am also very open-minded on this issue. Here are a few points for further discussion.

1. I understand the suffering caused by the recession and the contraction of credit. Personally I got hurt tremendously by this. It's just not clear to me how the large financial institutions caused the crisis. We had a real estate bubble with highly leveraged homeowners who kept leveraging to the max, taking out home equity (taking vacations) or mortgages they couldn't afford. Many were flipping homes. Many were buying with the goal to refinance later and take equity out. Just like the Dutch tulip bubble, this one burst when people could no longer refinance. And everyone got hurt including the large financial institutions.

2. Financial institutions failed not as much because of corporate governance but because of the structure of their assets and liabilities. They relied on short-term funding to finance their illiquid assets (Bear, Lehman, Citi). This has been the case long before the real estate bubble (some 30 years) and neither the Fed nor the SEC or even the Basle Committee ever told them to do otherwise. By the way, the MF Global default was due to the same problem. Their European bond holdings were 1-3 years in maturity, while they financed them overnight in the repo market. If they had locked in term financing (match-funded) these investments, MF would still be OK.

3. With respect to not allowing large banks to fail, the decision was approved by the US Congress. Neither the Bush administration nor the Fed could have done this unilaterally. So our elective representatives chose to inject capital into these firms - whether they asked for it or not. The larger firms got funding from private sources: Morgan Stanley from Mitsubishi, Goldman from Buffett, but the government forced them to take the TARP money. I don't see how it's their fault. Again, I am not defending them, just trying to understand the logic here.

4. I agree these firms overpaid their people. And the people getting paid the most were often the worst assholes and often quite incompetent. But the last time I checked, overpaying people isn't against the law. If I own a company and hire you at some ridiculous pay level, it's nobody's business but mine and other shareholders'. The shareholders of these firms didn't seem to complain as long as the companies were profitable. Maybe they should get more active on this issue when they elect their directors.

5. People running most of the large financial institutions have in fact changed. Chuck Prince at Citi got replaced, John Mack at Morgan Stanley is out, BofA/Merrill, UBS, etc. have all new management. GS, JPM, CS were the healthier of the institutions (limited losses), so their management remained.

My science background makes me a skeptic, but like I said I am quite open-minded if I see good empirical evidence. I might be the next to join OWS after all.

Enjoy your weekend downtown.
Ron

(to be continued)

SoberLook.com

PPIP to the rescue

The "bad bank" program to purchase loan assets from the balance sheets of banks called PPIP was supposed to be the mother of all bank balance sheet cleanups. The program was divided into two components: the loan program and the securities program - the Treasury would provide leverage and investors will come for the returns. The loan program was supposed to buy actual loans from banks - mortgages, consumer loans, leases, commercial property mortgages, etc. Great idea in principle, but there was a problem.

Banks don't mark loans to market, particular loans they originate (banking book). Instead banks take reserves for impaired loans or loans about to become impaired. With the reserves taken into account, the carried value of these loan portfolios had been over 90 cents on the dollar. But as an investor would you pay 90+ cents for a mortgage loan portfolio? Even with leverage, you would probably bid less, probably much less. If there is one thing investors learned from the crisis, it is that having access to cheap leverage does not justify overpaying for assets. But banks can not sell these assets at steep discounts simply because they would immediately wipe out a chunk of their already thin capital base and some would become insolvent. They need those assets to stay at 90+. Therefore the FDIC-led loan PPIP just didn't work.

So that leaves the securities portion of the PPIP, spearheaded by the US Treasury. Since generally just the larger banks were involved in running portfolios of securities backed by loans (vs. loans themselves), this portion of PPIP would only help the larger banks. All those struggling small and regional banks will have to muddle through on their own. The justification the Treasury will give for trying to help the larger banks is that the securities PPIP will raise senior tranche prices, which may stimulate new securitization (nice pipe dream), which in turn will stimulate new lending and refinancing. Somewhere down the road this would help the smaller banks. Right.

But unlike the loan program that had a major price disconnect between buyers and sellers, the securities program had a better chance. Many of these securities have been marked to market (sort of). So the Treasury offered to do the following (see attached term sheet):

Option I (called "Full Turn"):
1. Investor commits $1 of equity to invest in RMBS or CMBS senior tranche securities that used to be "AAA" (currently sitting on Jumbo Bank's balance sheet.)
2. The Treasury commits $1 for the same investment (co-invest).
3. The Treasury commits to lend $2 to finance this portfolio.

This way a dollar of private funds generates $4 of buying power and 1:1 (debt to equity) leverage (hence "full turn"). The loan term is 10 years and investor's money is locked up as well. The cost is basically LIBOR + 1%, which is what makes this attractive. The investor has 3 years to "trade" the portfolio, after which point any sale goes to pay down the government's loan.

Option II (called "Half Turn"):
Investors also have a choice to take $1 instead of $2 (in the example above). This puts the leverage at 0.5 : 1 (hence "half turn"), but allows the investor to get additional leverage. For example if these are CMBS assets, the investor can get financing via TALF in addition to the PPIP. That could really juice up the leverage.

And here is the result. The Treasury has committed $40 billion to PPIP (corresponding to $10 billion of private money). So far $12.5 billion (out of 40) has been done, all with Option-I, corresponding to $3 billion of private money. The Treasury of course is claiming success as RMBS and CMBS have rallied since the program was announced earlier in the year. We are to believe that a $12.5 billion investment has moved pricing significantly on a $2+ trillion market. But hey, in this euphoria driven credit market, who is counting?



Securities PPIP Term Sheet

ING's big Alt-A surprise

If you think the US taxpayer got a raw deal with bank bailouts, have a look at what the Dutch government has done with ING, one of the largest Dutch banks. During the crisis the Dutch authorities synthetically bought ING's structured (mostly) Alt-A portfolio of US mortgages. The Dutch government agreed to receive cash flows on $39 billion of these mortgages in return for fixed payments (effectively a TRS) at 90 cents on the dollar. This is Maiden Lane, Dutch style. During the crisis such a portfolio would not have cleared at 50 cents on the dollar (Merrill was dumping some of it's portfolios at levels below that.) And this was in addition to the $14 billion of preferred equity injection (TARP equivalent) by the Dutch government into ING.

The Dutch taxpayer is in for a surprise - time to get close and personal with their overlevered borrowers across the pond. US Alt-A mortgages are not quite sub-prime but they are not prime either. They usually have incomplete documentation, higher leverage, lower credit scores, and/or are often on properties bought for speculation. The Dutch are going to have to wait for their cash flows for a while. According to Bloomberg nearly 30% of Alt-A mortgages are delinquent by 30 days or longer. Over 22% are delinquent by 90 days or more (or in foreclosure).


Source: Bloomberg

Now the European Commission has ruled that this was such a sweet deal for ING, it violated the European Union anti-competitive subsidies rules. That is ING's European competitors who didn't get such a sweet deal are being disadvantaged. This may force ING to pay a "fair price" to the government for this portfolio protection. And that could get ugly for the bank, but will help the taxpayer recoup some of the losses. (This is in addition to the executive compensation limitations recently put in place for Dutch banks that will send senior staff leaving in droves.) From the NY Times:

“The commission supports member states’ efforts to stabilize financial markets by dealing with banks’ impaired assets,” Neelie Kroes, the E.U. competition commissioner, said in a statement. “However, state aid in the form of impaired-asset relief has to be properly remunerated and should not give undue advantages to banks.”

Now the European Commission has opened a Pandora's Box because other European states have also provided unprecedented deals to their banking institutions. And with ING's precedent, they also may be forced to pay up.

The review comes as the commission moves toward a ruling on whether similar bailouts in Britain, to the Royal Bank of Scotland and the Lloyds Banking Group, were in violation of E.U. policy. (NY Times)

This has got to be making the UK "zombie banks" nervous. In the US on the other hand, AIG and Citi must be celebrating the fact that the US is not part of the European Union.

The State Street TARP warrant sale - a fair deal or a ripoff?

From Bloomberg:

State Street Corp. paid $60 million to repurchase warrants held by the U.S. Treasury, becoming the first major financial firm to exit the government’s $700 billion rescue program.

State Street, the world’s largest money manager for institutions, previously bought back $2 billion in preferred shares it received in October under the Troubled Asset Relief Program. The Treasury released details today about the warrant sale to the Boston-based lender.

The "Armageddon Bloggers" out there will be shouting that the US Treasury and the US taxpayer have been ripped off. Well, at Sober Look we rely on facts and observations rather than the angry verbal diarrhea one often finds in cyberspace - particularly when it comes to the financial services industry.

What are these TARP warrants really worth? The Treasury owned about 5.6 million of State Street (STT) warrants with a strike price of $53.8 expiring on 12/28/18. STT closing price on Friday was $43.66. If one looks at the traded STT options out there, it is straight forward to project the implied volatility term structure based on actively quoted warrants of other securities.



For those who are interested, the reason implied volatility term structure for stocks is generally negative sloping has to do with mean-reverting nature of equities. That means that variance does not increase linearly with time (the increase is slower) and implied volatility drops off with time to maturity.

Based on this projection the midpoint for implied volatility for the STT warrants falls in the range of 20% - 25%.

Here is the impact on warrant price due to implied volatility shifts:



This puts the mid at $13.42 per share (or about 31% of the share price) and the government's position at about $74.8 MM. The Treasury sold it for $60 MM or about 80% of the mid (or about 88% of the lower range and 74% of the upper range). It's certainly better than the 66%

It is pure profit for the taxpayer in 9 months (since the government got the warrants for free as part of the convert purchase), but is it a fair deal? It's certainly better than the 66% "valuation" in previous warrant purchases as reported by the 3 Harvard professors in this report (the 3 wise men from academia that really know how warrants like these would trade):

In a normal market 80% of course is a rip-off, but in this environment it's not crazy. Think about it, if you are taking a long-term bet on the US financial sector wouldn't you demand a discount?

JPMorgan's proposal for their warrants repurchase was rejected by the US Treasury as too low. So JPMorgan told the Treasury to go ahead and auction it off. Chances are the auction will also come in at 80-85% of the "fair value", but probably better than JPMorgan's proposal - an auction would indeed be the best process for price discovery.

The key here is for the US government to get out of the business of managing a portfolio of financials' warrants and other securities as soon as possible.

The risks of holding on to TARP money

The clustering of risk among banks we discussed earlier is still holding. JPM and Citi span the risk range with two risk clusters falling within the range.

The range is now wider, approaching 400 bp. The overall spreads have backed up as credit in general is selling off after an unprecedented rally.

Investment Grade CDX (traded index)


But there is another effect in financials' credit risk. The banks that are still TARP banks have widened much more than the non-TARP (the banks that paid off the TARP money):



TARP banks are viewed now as being riskier. Morgan Stanley vs. BofA is a good example. MS CDS was wider than BofA prior to TARP repayment. Now it's the opposite. One could argue that's due to current TARP banks being weaker to begin with. But they are now capitalized as well as the non-TARP banks as return of TARP money reduced capitalization. So it's not the capitalization (strength) issue. It may be due to asset quality. That's tough to argue as well as Wells and Capital One have some ugly portfolios for example.

Or maybe the market views TARP restrictions as adding risk to the banks. Is TARP viewed as potentially cutting profitability, adding risk of loss of talent, restricting certain businesses? Is TARP associated with potential loss of clients? If a bank can't organize a golf outing for key clients, would that be viewed as a potential hit to performance (particularly when competition has none of these restrictions)? The market is saying yes.