Only the strongest survive (and thrive) in the CP markets

Money market funds continue to struggle to put cash to work , searching for product that would comply with pending new regulation, yet provide returns that are above treasury bills. The returns on money market funds continue to be pathetic - about 15-25 basis points annualized.

The better rated banking firms have taken notice of this demand. They now have a choice of funding themselves by borrowing from other banks or via the CP market. (Neither was really available on anything but the overnight basis in the second half of 08).


With the 3 month LIBOR hovering above 25 bp, CP funding is cheaper for banks that can get AA rating on the paper (see the CP yield curve below).





And banks are indeed taking advantage of it, issuing CP and selling it to guys like the Fidelity MM fund. That gives the larger/stronger banks a real advantage over the smaller ones. Community banks have to pay depositors 60 bp on checking accounts and over 105 bp on money market acccounts - and that's their key source of funds. The larger banks can fund themselves with CP at 20 bp. That's a significant competitive advantage.

The new issuance of CP has caused the amount of financials-issued commercial paper outstanding to spike,



source: FRB



driving up the overall CP notional.



source: Bloomberg


This new supply is easily absorbed by money market funds. The CP market has simply bifurcated into those who have the credit quality to issue paper and those who don't - there's little in between. With new regulation, money markets won't be able to buy much "tier-2" CP and there aren't other buyers out there. You are either "tier-1" or you are basically out of the market (some stronger "tier-2" can still place paper, but in limited amounts - maybe 5% of the total). For a while the Fed was buying CP via the CPFF program, but that's winding down:



source: FRB


The survivors in the CP market are some of the strongest institutions or institutionally sponsored ABCP programs. Everyone else has to look for other sources of funds.

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The bipolar nature of inflation expectations

Back in July we've discussed the tremendous uncertainty surrounding longer-term inflation expectations for the US. This is not an academic exercise. Getting it wrong could swing the US economy into a deflationary spiral (similar to Japan) at one extreme or a hyperinflationary environment on the other.

The chart below from the San Francisco Fed shows just how divergent the economists' expectations have become.





What's unprecedented about this divergence in inflation outlook is that it also shows up in the market. The following chart shows weekly prices for GLD (a gold ETF) and IEF (iShares medium term treasuries ETF) for the last few months. A rally in gold in a normal market should correspond to declines in treasuries. But here we see stability in the treasury market in the face of rising gold prices.





This is an indication of an almost bipolar market that is betting on price stability (even deflation) from credit contraction and continuing unemployment on one hand and accelerating inflation on the other. It's hard to see both occurring, simply because slow economic growth (or further contraction) in the US can not sustain significant price appreciation due to weak demand. Over time something has to give - either commodities have to sell off or longer term rates have to come up.

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Did "hedge everything" policy push Goldman into a bad deal?

Ed Grebeck, CEO of Tempus Advisors had an interesting story to share that may be pertinent to the recent Sober Look post on the Goldman - Buffett transaction:

1999: gold price declining and volatile. GS approached me [Employers Re., a subsidiary of GE capital] with a transaction to hedge their exposure to 3 gold mines [These firms had sold gold forward to Goldman to hedge their gold production]: Ashanti [Ghana; largely owned by Anglo-American], one in Indonesia [previously part of OK Tedi Gold/copper mine] and another in Southeast Asia that escapes my memory. One of the three was fringe BBB/BB. Other two were solid B. These firms also had significant "emerging market" credit issues all around, and CDS in such markets would've cost mega bps.

Trying to address the counterparty risk on the forward contracts, GS came up with a solution: number crunch "joint probability of default" into synthetic (structured finance) tranche exposure. "We want you to sell protection on MEZZ TRANCHE... which as you can see from our painstakingly researched model is... solid BBB"... our pricing is "standard for BBB, plus [small, almost infinitesimal] premium".

Goldman wanted to buy protection on these firms, but to make it cheaper, wanted protection for losses above a certain level on the portfolio of the three names (a mezz tranche CDS). And they were pricing it based on where standard BBB levels were at the time.

Ed Grebeck continues:

No serious mention of "liquidity... hedging ourselves"... other than "we [GS] don't mind if you reinsure yourself ... of course, we can help YOU hedge in cap mkts".

I rejected outright -- but I'm sure other P&C Re "convergence operations"... AIGFP (as well as other competitive silos within AIG), Swiss Re, Munich Re, names not in business today-- ACEFS, St. Paul Re, Gerling Global, Centre etc etc ... jumped at chance to "write premium for GS".

IF GS risk management went berserk 1999 over relatively small counterparty exposure to physical gold producers, imagine what they must have thought in the summer of 2008, when they saw HUGE, UNCOLLATERALIZED exposure on 10 year + S&P index to Berkshire Hathaway

The conclusion here is that with Goldman's focus on hedging all their exposures (based on internal policies), they must have been desperate to get some money out of Buffett to reduce their rapidly rising Berkshire risk (as the puts went deep into the money). It is therefore likely that Buffett was able to pressure Goldman into a transaction that was significantly skewed in his favor - not just because Goldman needed additional equity capital, but because they had to reduce their Berkshire exposure. This in fact provides additional support to a theory that Buffett took Goldman for a ride using his money losing short put positions as negotiating leverage.

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Foreclosures and the unemployment rate maps

This may be "intuitively obvious", but it's worth looking at these two maps next to each other.

Map of home foreclosures:

source: realtytrac


Map of the unemployment rate by state:


source: the Fed

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Ginnie Mae and the government sponsored mortgage machine

A quick look at who is taking all the risk on new mortgages this year reveals some interesting facts. The chart below from the Fed shows some recent trends. Very few mortgage loans are kept on banks' balance sheets these days (Bank Portfolio) - and that fraction seems to be shrinking. The private securitization MBS market (Non-agency securitized) is also down to a trickle, though is a higher fraction than the balance sheet loans.

That leaves the US government to pick up the slack. It's not really a slack, it's the bulk of the new mortgage risk. The majority of these loans are of course extended through Fannie and Freddie. But there is a limit to how much these guys can take. The agencies are financing $5 trillion in U.S. mortgages already. It only takes a slightly higher than normal default rate to become under-capitalized on a $5 trillion balance sheet. The Treasury has so far injected over $100 billion of equity into the agencies to keep them afloat. That caps Fannie's and Freddie's ability to extend more credit.

To keep mortgages flowing however, the government has to pick up the rest directly by providing guarantees and sponsoring government insured MBS issuance. It does it through Ginnie Mae. That's why Ginnie Mae's proportion of newly originated mortgages has exploded.



Source: San Francisco Fed


So what exactly is Ginnie Mae? It's a government agency that actually does not directly take significant mortgage risk. Instead it simply guarantees timely payments on mortgages that are issued or guaranteed by other government agencies. The mortgage pools Ginnie Mae guarantees are:

1. Insured by the Federal Housing Administration,
2. Guaranteed by the Department of Veterans Affairs,
3. Issued or guaranteed by the Department of Agriculture's Rural Housing Service,
4. Issued or guaranteed by the Department of Housing and Urban Development's Office of Public and Indian Housing.

So why the "double guarantee"? Ginnie Mae effectively provides the bridge financing on payments between the time a mortgage loan becomes delinquent and the time when one of the 4 agencies (above) actually makes the investor whole on the guarantee. This way if a mortgage misses a payment, Ginnie Mae makes it immediately, and then collects from the other agencies later. And it does so with a pool of loans that serves as collateral for the Ginnie Mae guaranteed MBS bonds.



source: Ginnie Mae


A Ginnie Mae MBS is effectively a US Treasury security, but issued by a different agency. This shows just how the US government has turned the whole mortgage market into a machine that it now dominates, with a number of it's tentacles participating in different aspects. The Treasury supports the agencies by funding their equity. The Fed buys their debt and the mortgage securities they issue. And to the extent Fannie and Freddie can't handle more lending, the government steps in with four other organizations and wraps up the whole present with the Ginnie Mae guarantee.

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CIT files for bankruptcy and the aftershocks begin

Icahn's attempt to throw out CIT's board in order to take control didn't work. Neither did CIT's effort to exchange debt for equity. The debt holders just didn't buy the story.

Instead, with a $1 billion DIP loan from Icahn, CIT has filed for bankruptcy. The debt holders didn't want to do it voluntarily, and now CIT will try to force the exchange in court. They plan to stuff the current debt holders with new notes (of lower face value) and equity as part of the restructuring plan. But those who owned CIT CDS protection should be happy - they will now get paid out.

CIT claims it will emerge from bankruptcy in a couple of months. But it's unclear their business model is viable at all, even if they reduce their outstanding debt. It is likely the current debt holders will put up a fight to push for a liquidation.

In any case, with debt recovering at 60-70 cents on the dollar, the $2.3 billion of TARP money CIT received as preferred equity is likely gone.

The event has been widely anticipated. The market reaction on Monday will likely be positive as the uncertainty has been somewhat taken out. But the longer-term mess this will create can not be overstated. CIT has liens on hundreds of thousands of businesses via loans the firm had extended. Many of those businesses are stuck because the liens prohibit them from additional indebtedness. That means they can not take out new loans from others (without fully repaying CIT) in their attempt to replace CIT as their lender. The process of replacing CIT will be painful and chaotic, taking it's toll on the middle market companies over the next few years.

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The Berkshire - Goldman OTC derivatives connection

The following story on Berkshire Hathaway's equity derivatives fiasco has been all but forgotten. This is surprising, given the recent push for derivatives regulation. The lack of coverage on this is also surprising, given the last statement in the quote below on counterparty exposure.

The NY Times, May-2008: Berkshire said it had a $1.2 billion pre-tax unrealized loss on put options it wrote on the Standard & Poor's 500 and three foreign stock indexes.

It also reported a $490 million pre-tax unrealized loss on contracts that require payouts if some high-yield bonds default between now and 2013.

The exposure may at first seem odd given that, in his shareholder letter in 2003, Buffett called derivatives "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

But in his letter this year, Buffett said Berkshire had already been paid for its derivatives contracts, giving it cash to invest, and that "there is no counterparty risk."

That's right, Buffett's firm was shorting long-term puts on equity indices. Berkshire had no counterparty exposure on these positions because they were options sellers, but someone obviously had exposure to them. Long-dated exposure is difficult to obtain in size beyond a year in term via exchange traded options. Plus selling exchange traded options will require a great deal of margin in spite of Berkshire's strong credit. That means these trades must have been over the counter (OTC).

Buffett's hypocritical statement on "financial weapons of mass destruction" must have meant that OTC derivatives are OK as long as someone else is taking the counterparty exposure. The question is who was that counterparty. It had to be a limited number of dealers to keep the trade secret. It also has to be someone who likes to be long long-term volatility, because unwinding this option risk could be costly. One firm that stands out is Goldman. They have been known to build long option positions by transacting with their clients. And they had been willing too pay more for those options than the competition because they were willing to own the risk. It is therefore safe to assume Goldman was in fact a key Berkshire's counterparty on these trades.

Given Berkshire's excellent credit, buying puts from Buffett was a no-brainer in terms of counterparty exposure in 2007. But in the latter part of 2008, Goldman must have been getting uneasy as the puts went deep into the money and Berkshire owed Goldman a rapidly growing amount. In the environment of the time, nobody's failure was off the table.

But then came this transaction:

The WSJ, September 2008: Goldman Sachs Group Inc. said it will get a $5 billion investment from billionaire Warren Buffett's company, marking one of the biggest expressions of confidence in the financial system since the credit crisis intensified early this month.
...
The deal is structured in two parts, giving Berkshire a stream of cash and potential ownership of roughly 10% of Goldman. Berkshire will spend $5 billion on "perpetual" preferred shares of Goldman. These are not convertible into equity but pay a fat 10% dividend.

Berkshire also will get warrants granting it the right to buy $5 billion of Goldman common stock at $115 a share, which is 8% below the 4 p.m. closing share price Tuesday of $125.05. At Goldman's roughly $50 billion market value, based on that closing price, exercising those warrants would give Berkshire about a 10% stake in Goldman.

Goldman also will go to the public to raise at least a further $2.5 billion by selling common shares. Once it does, Berkshire's stake -- if it has exercised the warrants -- would fall to about 7%. Goldman will have the right to repurchase the preferred shares at any time for a 10% premium.

The ultimate question here is how the preferred share purchase deal was linked to the massive exposure Goldman now had to Berkshire. In a way, the $5 billion cash injection may constitute a nice "margin posting" to Goldman. Were some of the put positions extinguished as part of the deal? The mass media hasn't really connected the dots on this, and it's not clear why other than to many this is an old story. But it definitely deserves another look.



If the readers have any updates on this topic, please e-mail us at tips@SoberLook.com


hat tip Ed.

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Healthcare costs and the fragile labor market

The cost of healthcare to employers has been rising at a rate of about 9% a year in the past 10 years.



source: The Kaiser Family Foundation Survey


This is an unsustainable rate that drove employment costs to levels that prohibited real wage increases, squeezed margins, and made US corporations far less competitive. This was particularly painful for smaller businesses that generated a large fraction of new job creation. Employers had no choice but to pay, until now. Employers still continue to pay those high healthcare premiums, but mostly at the expense of having far fewer employees.

Th only way they can drive costs down is to lower wages or lay off workers. Lowering wages has had an impact in limited cases, as reality sets in for the unions that employers now have the upper hand. But rising healthcare costs limit corporations' ability to cut wages because employees' share of these costs has also been rising dramatically. The combination of wage cuts and rising insurance premiums is pushing net real earnings to the breaking point. Ultimately, cost cutting comes from job reductions as employers try to survive with fewer employees.

The chart below shows the Bureau of Labor Statistics Employment Cost Index that includes healthcare insurance costs. In spite of rising premiums, the growth in costs has dropped significantly. Employers are trying to squeeze every last drop from existing workers. This allows firms to survive by driving efficiencies, but doesn't help the employment picture.



source: Bloomberg


The thinking is that with costs somewhat under control and inventories low, as orders start to pick up, employment may improve. But the situation is extremely delicate because credit, particularly to smaller business, continues to be tight. One way or another the 9% a year healthcare cost increases must end in order to see any signs of improvements in jobs. It also doesn't take extensive analysis to conclude that in this fragile environment, any government policy that increases employer healthcare costs (whether directly or through taxation) will quickly dash hopes for significant labor market recovery.

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