It certainly was an eventful week for the market as far as news. We had bailout plans and budgets and an endless stream of governmental actions. The overall market reaction to all these attempts to save us was quite negative. President Obama just isn't inspiring confidence in the investor class, but that sure doesn't seem to be one of his priorities anyway.
A down-trending market is hard enough for investors to deal with in the first place, but this one is even worse because it is so choppy. We continue to have very random spikes up and down, especially late in the day. If you aren't doing some quick intraday flips, you have little chance of making much progress at all. Unfortunately, even the flippers are being worn down by the chaotic action.
Technically, the big picture is decidedly negative and confirms the painfully obvious fact that we are in an ugly bear market. There is a big group of traders that keep looking to play some oversold bounces, but they are too skittish to hold and end up flipping the upside moves to death. You can't blame folks for looking for some upside opportunities given how badly we have been beaten up, but waiting patiently for better action rather than anticipating it isn't a bad strategy.
Stay tough. You're not going to encounter a more difficult market all that often; all you need to do right now is survive.
Friday, February 27, 2009
A Massive Catalyst Next Week?
Could the government change the rules regarding CDSs next week? Because of the looming AIG CDS event? Or might they just let AIG fail? (If they let AIG fail, I think we go below 600 on the S and P...) If they do change the rules vis a vis CDSs, would that kind of have the same impact as changing mark to market? Or the uptick rule? I'm with Todd at Minyanville - I sense a massive binary event coming soon to the market; but do I dare hope it'll be a good one for the market? (I've been wrong often lately in my thinking that the government will do the right things for the economy, the markets, etc.) Could they actually do something right this time?
Thursday, February 26, 2009
How To Value These Damn Assets
After its chilly reception of Treasury Secretary Tim Geithner's bank-rescue plan, the market is now worried about nationalization. As well it should. Because if the Obama administration cannot come up with a viable plan to take troubled assets off their balance sheets, major banks will not recover and nationalization -- a disastrous policy -- might actually become the last resort.
Many observers suggest that the Obama administration, like the Bush administration before it, is unable to solve the problem of how to price the banks' troubled assets. If the assets are bought at their "real" values, it is said, the money the banks would get would not be enough to keep them from insolvency. But if Treasury bought these assets at the supposedly bloated values the banks are carrying them, the taxpayers would be paying too much.
In fact, neither of these statements is likely to be true. Both taxpayers and banks could come out well -- and so would our economy -- if the government were to buy the assets at their "net realizable value," which is based on an assessment of their current cash flows, discounted by their expected credit losses over time. Here's the explanation:
The accounting rules relating to assets such as mortgage-backed securities require that they be marked to market if they are held for trading, or in a category called "available for sale." Most banks hold these assets in one of these two accounts, and so mark-to-market rules apply. What happens, then, when there is virtually no market for these assets -- as has been true for at least a year? In that case, accounting rules require the banks use whatever market indicators are available.
The banks follow two steps. First, they establish the net realizable value for the portfolio. This is simply what the value of the cash flows would bring in a fully functioning market, including discounts for several factors like anticipated future losses. Paradoxically, many of the banks' most troubled assets are flowing cash near their expected rates, and thus their net realizable values are higher than the values to which they have been written down.
The banks' second step, after establishing a net realizable value, is marking the assets to market. And that is where the write-downs occur.
Because there are few if any buyers for these assets, their market value is much reduced. Potential buyers are not interested because there is no assurance they will be able to resell the assets when they need to. In other words, potential buyers are afraid of becoming distressed sellers themselves if their financing should disappear before the market becomes liquid again.
Thus, under mark-to-market rules, the banks must discount their assets' net realizable values. And because of the write-downs, the banks' apparent capital is impaired.
These facts have enormous implications for government policy. If the losses on banks' assets are principally liquidity losses, they are temporary, and the only significant issue is whether the banks have the financing to carry the assets until liquidity returns to the asset-backed market.
And if this is indeed the case, the banks are not in any sense insolvent, and nationalization would be a huge mistake. On the other hand, if the government were to buy the assets at their net realizable values -- rather than their marked-down values -- this would significantly improve the capital positions of the major banks.
A hint of the true situation was contained in a remark by Vikram Pandit, the CEO of Citibank, in testimony before the House Financial Services Committee last week. He noted that Citi marks to market and that "those marks are reflected in the losses we've taken, as well as in our income statements and balance sheets." But Mr. Pandit then went on to point out that the bank has a duty to shareholders: "And the duty is if it turns out [the assets] are marked so far below what our lifetime expected credit losses are" -- i.e., their net realizable value -- "I can't sell [them]."
In other words, Citi has marked some assets below their net realizable value, and selling them at a price lower than that value would be unfair to its shareholders. This opens a key route to a solution for the government -- buying the assets at the value that banks like Citi would be willing to sell them.
Would the taxpayer be hurt if the government buys these troubled assets at these values? Not likely. The banks have already made an assessment of the assets' net realizable values, as Mr. Pandit suggests was done at Citi. The government can quickly verify the accuracy of these valuations, including the rates used for discounting, and can of course come up with its own lower evaluation if it disagrees.
But the important point is that if the banks' net realizable values are even close to correct, taxpayers will not lose much, if anything, if the government bought the assets at those values. Because their cash flows determine their value, the government should be able to sell the assets in the future at roughly what it paid for them.
But the key benefit is the boost in the banks' capital which comes from a sale now. This would eliminate doubts about banks' solvency and free up their ability and willingness to lend again.
If this is a win-win for the banks and the government, why is it that no one has thought about doing this before? Part of the answer is that the question has been phrased incorrectly.
Most of those who recognize the problems created by mark-to-market accounting have asked that the system be suspended. This has run into opposition from the accounting industry and investor groups, who are afraid that it will be a license for banks to manipulate their financial statements.
But no change in mark-to-market accounting is necessary for the government to buy the assets at net realizable value, only a decision to buy the assets at the value they would have if there were a liquid market. Unlike a private buyer, the government does not have to worry about selling at any particular time, since it can hold the assets indefinitely.
Finally, one might ask why Mr. Geithner is claiming he needs more time to do something so simple and seemingly effective. The answer here, unfortunately, is that he seems to be barking up the wrong tree.
Mr. Geithner may believe that the banks have not written their assets down below their net realizable value. Or he may believe that others believe purchasing these troubled assets at net realizable value will be unfair to the taxpayers, and he doesn't want the criticism if he does so. That would explain why he is enlisting the private sector to make the pricing decision.
But Mr. Geithner should check his premises. There's a solution to his problem, the banks' problem and the economy's problem right in front of his face!
Many observers suggest that the Obama administration, like the Bush administration before it, is unable to solve the problem of how to price the banks' troubled assets. If the assets are bought at their "real" values, it is said, the money the banks would get would not be enough to keep them from insolvency. But if Treasury bought these assets at the supposedly bloated values the banks are carrying them, the taxpayers would be paying too much.
In fact, neither of these statements is likely to be true. Both taxpayers and banks could come out well -- and so would our economy -- if the government were to buy the assets at their "net realizable value," which is based on an assessment of their current cash flows, discounted by their expected credit losses over time. Here's the explanation:
The accounting rules relating to assets such as mortgage-backed securities require that they be marked to market if they are held for trading, or in a category called "available for sale." Most banks hold these assets in one of these two accounts, and so mark-to-market rules apply. What happens, then, when there is virtually no market for these assets -- as has been true for at least a year? In that case, accounting rules require the banks use whatever market indicators are available.
The banks follow two steps. First, they establish the net realizable value for the portfolio. This is simply what the value of the cash flows would bring in a fully functioning market, including discounts for several factors like anticipated future losses. Paradoxically, many of the banks' most troubled assets are flowing cash near their expected rates, and thus their net realizable values are higher than the values to which they have been written down.
The banks' second step, after establishing a net realizable value, is marking the assets to market. And that is where the write-downs occur.
Because there are few if any buyers for these assets, their market value is much reduced. Potential buyers are not interested because there is no assurance they will be able to resell the assets when they need to. In other words, potential buyers are afraid of becoming distressed sellers themselves if their financing should disappear before the market becomes liquid again.
Thus, under mark-to-market rules, the banks must discount their assets' net realizable values. And because of the write-downs, the banks' apparent capital is impaired.
These facts have enormous implications for government policy. If the losses on banks' assets are principally liquidity losses, they are temporary, and the only significant issue is whether the banks have the financing to carry the assets until liquidity returns to the asset-backed market.
And if this is indeed the case, the banks are not in any sense insolvent, and nationalization would be a huge mistake. On the other hand, if the government were to buy the assets at their net realizable values -- rather than their marked-down values -- this would significantly improve the capital positions of the major banks.
A hint of the true situation was contained in a remark by Vikram Pandit, the CEO of Citibank, in testimony before the House Financial Services Committee last week. He noted that Citi marks to market and that "those marks are reflected in the losses we've taken, as well as in our income statements and balance sheets." But Mr. Pandit then went on to point out that the bank has a duty to shareholders: "And the duty is if it turns out [the assets] are marked so far below what our lifetime expected credit losses are" -- i.e., their net realizable value -- "I can't sell [them]."
In other words, Citi has marked some assets below their net realizable value, and selling them at a price lower than that value would be unfair to its shareholders. This opens a key route to a solution for the government -- buying the assets at the value that banks like Citi would be willing to sell them.
Would the taxpayer be hurt if the government buys these troubled assets at these values? Not likely. The banks have already made an assessment of the assets' net realizable values, as Mr. Pandit suggests was done at Citi. The government can quickly verify the accuracy of these valuations, including the rates used for discounting, and can of course come up with its own lower evaluation if it disagrees.
But the important point is that if the banks' net realizable values are even close to correct, taxpayers will not lose much, if anything, if the government bought the assets at those values. Because their cash flows determine their value, the government should be able to sell the assets in the future at roughly what it paid for them.
But the key benefit is the boost in the banks' capital which comes from a sale now. This would eliminate doubts about banks' solvency and free up their ability and willingness to lend again.
If this is a win-win for the banks and the government, why is it that no one has thought about doing this before? Part of the answer is that the question has been phrased incorrectly.
Most of those who recognize the problems created by mark-to-market accounting have asked that the system be suspended. This has run into opposition from the accounting industry and investor groups, who are afraid that it will be a license for banks to manipulate their financial statements.
But no change in mark-to-market accounting is necessary for the government to buy the assets at net realizable value, only a decision to buy the assets at the value they would have if there were a liquid market. Unlike a private buyer, the government does not have to worry about selling at any particular time, since it can hold the assets indefinitely.
Finally, one might ask why Mr. Geithner is claiming he needs more time to do something so simple and seemingly effective. The answer here, unfortunately, is that he seems to be barking up the wrong tree.
Mr. Geithner may believe that the banks have not written their assets down below their net realizable value. Or he may believe that others believe purchasing these troubled assets at net realizable value will be unfair to the taxpayers, and he doesn't want the criticism if he does so. That would explain why he is enlisting the private sector to make the pricing decision.
But Mr. Geithner should check his premises. There's a solution to his problem, the banks' problem and the economy's problem right in front of his face!
Nowhere To Hide
After some promising action in banks the last couple days, it turned into a very discouraging day for stock market bulls. The best argument for some upside at this point was that as we digested budget news and new economic policies from the Obama administration, we'd have a bit more certainty and finally attract some buyers.
Unfortunately, the market just isn't convinced that we have the answers to our problems. In fact, we seem to just be realizing the consequences of things like national health care. The medical sector was demolished today on fears that margins would be squeezed under the proposed budget.
There has been no place to hide in this market. We are demolishing one sector at a time recently, and today it was the supposedly recession-proof health-related stocks that fell apart. We have had some bounces in groups like financials and oils, but nothing has lasted long enough to develop into leadership and drag up the rest of the market. There are just shorting opportunities rather than any real momentum.
It is a downright depressing market environment right now. Maybe that is a good contrary indicator.
Unfortunately, the market just isn't convinced that we have the answers to our problems. In fact, we seem to just be realizing the consequences of things like national health care. The medical sector was demolished today on fears that margins would be squeezed under the proposed budget.
There has been no place to hide in this market. We are demolishing one sector at a time recently, and today it was the supposedly recession-proof health-related stocks that fell apart. We have had some bounces in groups like financials and oils, but nothing has lasted long enough to develop into leadership and drag up the rest of the market. There are just shorting opportunities rather than any real momentum.
It is a downright depressing market environment right now. Maybe that is a good contrary indicator.
Wednesday, February 25, 2009
Obama Speaks; Wall Street Blamed For Everything; Market Retreats
This is no market for old men, especially those who want to hold any positions.
We started the day with some downright dull action. We were drifting around as market players were uninspired by President Obama's speech on Tuesday night and sought details on the bank bailout program.
Finally, some details of the so-called Capital Assistance Program (CAP) were announced. It provided a few key details like the conversion price of preferred stock that might be issued but it left much unsaid.
The market was happy to have something and got a bit of a rally going. Just as it started to gain steam, President Obama appeared on television yet again. The guy has been on more lately than Seinfeld reruns and of course he had to make sure he noted how Wall Street was to blame.
The market reversed sharply into the close, and the uncertainty and lack of clarity that have been our big problems flared up yet again.
It is one very tough market. We are obviously in a bear market, the bulls are trying to get a little bounce going and we are jerked around by government announcements day after day.
We started the day with some downright dull action. We were drifting around as market players were uninspired by President Obama's speech on Tuesday night and sought details on the bank bailout program.
Finally, some details of the so-called Capital Assistance Program (CAP) were announced. It provided a few key details like the conversion price of preferred stock that might be issued but it left much unsaid.
The market was happy to have something and got a bit of a rally going. Just as it started to gain steam, President Obama appeared on television yet again. The guy has been on more lately than Seinfeld reruns and of course he had to make sure he noted how Wall Street was to blame.
The market reversed sharply into the close, and the uncertainty and lack of clarity that have been our big problems flared up yet again.
It is one very tough market. We are obviously in a bear market, the bulls are trying to get a little bounce going and we are jerked around by government announcements day after day.
A Hunch About The "Bank Plan"
A key problem in getting distressed assets off the books of existing institutions is establishing a price, obviously. We know that the Obama administration wants the market to set the price. We also know that if the price is too low, banks would prefer to hold to maturity, so they will not play. If it is too high, it will be seen as unfair to taxpayers.
There are hints that the government proposal will include what we might view as a 'put.' This might be overt, guaranteeing the assets at a certain level. More likely it will be concealed, perhaps through partial government financing that is non-recourse.
The friendly financing increases the value of the distressed securities for the private bidders. It is not an out-of-pocket cost for the government, allowing
the illusion of a lower level of responsibility. The resulting price will be artificially inflated because it conveniently neglects the imbedded put. Just a
hunch....maybe all wrong...
There are hints that the government proposal will include what we might view as a 'put.' This might be overt, guaranteeing the assets at a certain level. More likely it will be concealed, perhaps through partial government financing that is non-recourse.
The friendly financing increases the value of the distressed securities for the private bidders. It is not an out-of-pocket cost for the government, allowing
the illusion of a lower level of responsibility. The resulting price will be artificially inflated because it conveniently neglects the imbedded put. Just a
hunch....maybe all wrong...
Another One I Own: CENX - A "Buy" Analysis
CENX equity is essentially a call option on aluminum price recovery. CENX reported adjusted EPS of -$0.54 vs -$0.47 consensus recently with revenues in-line. It should be noted that if aluminum prices avg $0.65/lb, the current liquidity would be used up in about 1.4 years, and the equity would be worthless; however, if the aluminum market firms over this time back to $0.85/lb, I estimate that CENX breaks even on a cash flow basis; under their long-term price assumption of $0.90/lb to $0.95/lb, the equity could be worth closer to $20/share. I believe that the stock is essentially a call option on an aluminum price recovery, with potential for the expiration date of the option to be extended, making for a potential attractive risk/reward. However, are there any positive drivers for aluminum in the short term? Possibly the near-term outlook is negative for the stock. Inventories, for the time being, appear to be building. I am patient; I own CENX.
BAC's War Of Independence - Nationalization Is Wholly Unnecessary
I estimate that the pro forma combined market capitalization of the companies that now constitute Bank of America (BAC) -- Bank of America, Merrill Lynch, Countrywide Financial, et al. -- was once in excess of $372 billion. At last Friday’s closing price, the market capitalization of the combined entity was barely north of $24 billion - an incredible $348 billion has been wiped away with breathtaking speed.
As if that weren't enough, various commentators are saying that Bank of America is worthless and needs to be nationalized. But are they right?
Bank of America currently has tangible common shareholder equity (or TCE) of about $67.5 billion. However, a reasonable estimate of the “hold-to-maturity” (or HTM) value of the losses the bank may sustain over the next few years would be about -$330.3 billion. Thus, if the bank were forced to immediately “mark” these HTM losses, it would have a tangible book value of -$263.1 billion.
The fact that it has negative tangible equity on a mark-to-HTM basis has done a great deal to spark nationalization fears.
Book value and intrinsic value are very different things. As long as Bank of America is allowed to carry its assets at acquisition cost and charge off its losses over time, the bank can organically generate enough value to pay for its losses, and still have a substantial amount of value for common shareholders. In other words, despite currently being $263 billion in the hole, Bank of America still has a positive NPV due to its ability to generate positive cash flows over time.
According to my calculations, Bank of America currently has an NPV per share in excess of $30. That's 700% higher than its closing price last Friday. As a check on my NPV valuation, I calculated the NPV of the 15 years of charge-offs and added it to our current estimate of the bank’s NPV.
The fact that the sum of these 2 values gives us a figure quite similar to the market capitalization of the combined entity prior to the crisis, gives us a pretty good indication that we're on the right track. In other words, if you subtract the NPV of the charge-offs from the market cap of the combined Bank of America entity prior to the crisis, you get a value quite similar to the one we're now estimating is the correct valuation for the company's common equity.
There are some risks to this analysis. First, it's assumed that, unlike Citibank (C), Bank of America doesn't have significant off-balance-sheet exposure that isn't reflected in its financial statements. Second, while the losses in the bank’s portfolio are estimated quite aggressively in our example, it's possible that the losses could ultimately prove to be even greater. In either case, the calculations presented here would have to be modified. It's worth noting, however, that losses would have to be more than double those estimated in our example for the NPV of Bank of America's common equity to fall below its present market capitalization.
The other risk involves government regulation. For Bank of America to be able pay for the losses it has sustained -- and to be able to create value for common shareholders -- the government will need to change current accounting rules to allow the bank to carry its assets at acquisition cost and charge off its troubled assets over time. Although there are no guarantees that the government will do this, they would be crazy not to.
There are 2 important conclusions to be derived from this analysis:
1. Taxpayer bailouts for Bank of America shareholders aren't warranted; nationalization isn't at all necessary.
2. At current levels, investment in Bank of America stock can be considered. Needless to say, an investment in the company is a very risky proposition. In particular, its success will greatly depend on government decisions regarding accounting regulations.
However, based on a pure calculation of economic value, the NPV of the Bank of America franchise for common shareholders is probably in excess of $30. Don't you think this is why CEO Ken Lewis and virtually the entire Board of Directors have been aggressively buying its shares during the months of January and February? The worse that can happen: It'll go to 0. On the other hand, if the government would simply do the right thing, gains could be in excess of 700%. The reward/risk is favorable. But please - don't invest a penny more than you can afford to lose.
Most importantly, write to President Obama, the Secretary of the Treasury, and your Representative and Senators to stop the current bank bail-out bonanza and this destructive talk of nationalization. Tell them to take the necessary steps to amend the mark-to-market rules in FAS 157 and to put in place accounting regulations that will allow banks to carry their assets at acquisition cost, and charge off their losses over time.
I'm not arguing against bailouts or nationalizations on ideological grounds. Rather, I'm saying that such measures -- which would dramatically increase our national debt and redistribute wealth unfairly -- are simply not necessary. Those who insist on arguing in favor of tax-payer funded bailouts and/or nationalization (assuming that the banks are broke and that such a solution is inevitable) are simply misinformed and are doing the nation a great disservice.
Long BAC Leaps
As if that weren't enough, various commentators are saying that Bank of America is worthless and needs to be nationalized. But are they right?
Bank of America currently has tangible common shareholder equity (or TCE) of about $67.5 billion. However, a reasonable estimate of the “hold-to-maturity” (or HTM) value of the losses the bank may sustain over the next few years would be about -$330.3 billion. Thus, if the bank were forced to immediately “mark” these HTM losses, it would have a tangible book value of -$263.1 billion.
The fact that it has negative tangible equity on a mark-to-HTM basis has done a great deal to spark nationalization fears.
Book value and intrinsic value are very different things. As long as Bank of America is allowed to carry its assets at acquisition cost and charge off its losses over time, the bank can organically generate enough value to pay for its losses, and still have a substantial amount of value for common shareholders. In other words, despite currently being $263 billion in the hole, Bank of America still has a positive NPV due to its ability to generate positive cash flows over time.
According to my calculations, Bank of America currently has an NPV per share in excess of $30. That's 700% higher than its closing price last Friday. As a check on my NPV valuation, I calculated the NPV of the 15 years of charge-offs and added it to our current estimate of the bank’s NPV.
The fact that the sum of these 2 values gives us a figure quite similar to the market capitalization of the combined entity prior to the crisis, gives us a pretty good indication that we're on the right track. In other words, if you subtract the NPV of the charge-offs from the market cap of the combined Bank of America entity prior to the crisis, you get a value quite similar to the one we're now estimating is the correct valuation for the company's common equity.
There are some risks to this analysis. First, it's assumed that, unlike Citibank (C), Bank of America doesn't have significant off-balance-sheet exposure that isn't reflected in its financial statements. Second, while the losses in the bank’s portfolio are estimated quite aggressively in our example, it's possible that the losses could ultimately prove to be even greater. In either case, the calculations presented here would have to be modified. It's worth noting, however, that losses would have to be more than double those estimated in our example for the NPV of Bank of America's common equity to fall below its present market capitalization.
The other risk involves government regulation. For Bank of America to be able pay for the losses it has sustained -- and to be able to create value for common shareholders -- the government will need to change current accounting rules to allow the bank to carry its assets at acquisition cost and charge off its troubled assets over time. Although there are no guarantees that the government will do this, they would be crazy not to.
There are 2 important conclusions to be derived from this analysis:
1. Taxpayer bailouts for Bank of America shareholders aren't warranted; nationalization isn't at all necessary.
2. At current levels, investment in Bank of America stock can be considered. Needless to say, an investment in the company is a very risky proposition. In particular, its success will greatly depend on government decisions regarding accounting regulations.
However, based on a pure calculation of economic value, the NPV of the Bank of America franchise for common shareholders is probably in excess of $30. Don't you think this is why CEO Ken Lewis and virtually the entire Board of Directors have been aggressively buying its shares during the months of January and February? The worse that can happen: It'll go to 0. On the other hand, if the government would simply do the right thing, gains could be in excess of 700%. The reward/risk is favorable. But please - don't invest a penny more than you can afford to lose.
Most importantly, write to President Obama, the Secretary of the Treasury, and your Representative and Senators to stop the current bank bail-out bonanza and this destructive talk of nationalization. Tell them to take the necessary steps to amend the mark-to-market rules in FAS 157 and to put in place accounting regulations that will allow banks to carry their assets at acquisition cost, and charge off their losses over time.
I'm not arguing against bailouts or nationalizations on ideological grounds. Rather, I'm saying that such measures -- which would dramatically increase our national debt and redistribute wealth unfairly -- are simply not necessary. Those who insist on arguing in favor of tax-payer funded bailouts and/or nationalization (assuming that the banks are broke and that such a solution is inevitable) are simply misinformed and are doing the nation a great disservice.
Long BAC Leaps
Tuesday, February 24, 2009
Classic Oversold Bear Market Bounce
The bears moved to the sidelines in front of President Obama's prime time economic speech to a joint session of Congress. The big question is whether or not there will be something more than a glorified campaign speech. Will there be some specifics about how the bank issue will be handled or some other surprises?
There is no reason for the bears to take the risk, so they covered and got out of the way. Typically, we can build a bit on a reversal like this, but as been the case lately, we are trading on news headlines and politics more than anything to do with stocks.
The market certainly was stretched sufficiently to the downside to support a decent bounce, but keep in mind that all we've done at this point is little more than recoup yesterday's losses. The big technical picture has not changed at all. We can certainly see more upside if the news flow is handled better by the Obama administration, but there are going to be plenty of critics of any plan that is announced, and sellers and shorts are going to be ready to reload.
What we have going is a classic oversold bounce in a bear market. I wouldn't be overly trusting. Tomorrow is promising to be another day of drama with the news that is about to hit.
There is no reason for the bears to take the risk, so they covered and got out of the way. Typically, we can build a bit on a reversal like this, but as been the case lately, we are trading on news headlines and politics more than anything to do with stocks.
The market certainly was stretched sufficiently to the downside to support a decent bounce, but keep in mind that all we've done at this point is little more than recoup yesterday's losses. The big technical picture has not changed at all. We can certainly see more upside if the news flow is handled better by the Obama administration, but there are going to be plenty of critics of any plan that is announced, and sellers and shorts are going to be ready to reload.
What we have going is a classic oversold bounce in a bear market. I wouldn't be overly trusting. Tomorrow is promising to be another day of drama with the news that is about to hit.
Monday, February 23, 2009
Sometimes The Best Choice Is To Step Aside And Let It Fall
One wouldn't think that this market could continue to act so poorly for so long, but with news like AIG saying the $80 billion or so it has already received from the feds isn't enough to keep it operating past next Monday, buyers are just moving aside. It is just a mess out there, and even the serial bottom-callers are becoming frustrated.
What is really weighing on the market right now is lack of a clear plan for banks. We have talk about stress tests and more lending, but isn't AIG an example of how bailouts are likely to play out? And where is Geithner? Why aren't we seeing something bold and confident when the market obviously is looking for leadership?
At this point, we don't really need to spend a lot of time analyzing all the things that are pressuring this market. We are now down almost 15% since the disastrous Geithner announcement about a bank plan, so we are becoming oversold. It has looked to me for a couple days now that a bounce was due, but we just have not had any good catalyst to force shorts to cover and get the flippers running.
President Obama is giving a prime-time speech to Congress tomorrow night, and I suspect that we could see some buying in front of that. I'm not sure there will be anything momentous, but there is no question he can give a great speech and may help brighten the mood temporarily. In any event, shorts will likely want to be out of the way.
Even if we do manage a little pre-speech bounce, this market obviously is quite confused and has no confidence in governmental plans. There isn't much else to do but to stay out of the way.
What is really weighing on the market right now is lack of a clear plan for banks. We have talk about stress tests and more lending, but isn't AIG an example of how bailouts are likely to play out? And where is Geithner? Why aren't we seeing something bold and confident when the market obviously is looking for leadership?
At this point, we don't really need to spend a lot of time analyzing all the things that are pressuring this market. We are now down almost 15% since the disastrous Geithner announcement about a bank plan, so we are becoming oversold. It has looked to me for a couple days now that a bounce was due, but we just have not had any good catalyst to force shorts to cover and get the flippers running.
President Obama is giving a prime-time speech to Congress tomorrow night, and I suspect that we could see some buying in front of that. I'm not sure there will be anything momentous, but there is no question he can give a great speech and may help brighten the mood temporarily. In any event, shorts will likely want to be out of the way.
Even if we do manage a little pre-speech bounce, this market obviously is quite confused and has no confidence in governmental plans. There isn't much else to do but to stay out of the way.
MARK TO MARKET MUST BE REPEALED!
The "market value" of these assets are the function of two variables: the cash flow and the discount rate. Clearly many assets are impaired due to cash flows. However, the asset values are also plunging due to an increase in the hurdle rate "the market" is requiring to hold them.
Let's say you are the senior loan officer of Omniscient National Bank, and every loan in your loan portfolio is performing-- and you are such a good underwriter that every loan is expected to pay back 100%. Good, you are safe, right? Noooo...
Suppose the market just decided it wants a 15% return to hold loans of your type, instead of the 7% it required before. The value of your portfolio is now 50% lower, and you are insolvent. Sheila Bair will be there Monday to close you down.
Seems unfair, doesn't it? Suspending MtM is not a solution to the cash flow problem, it is a solution to the arbitrary discount rate problem, which can cause capital violations and potential insolvency despite no egregious actions on the part of the lenders. FAS 157 must be repealed; or at least suspended, immediately.
Let's say you are the senior loan officer of Omniscient National Bank, and every loan in your loan portfolio is performing-- and you are such a good underwriter that every loan is expected to pay back 100%. Good, you are safe, right? Noooo...
Suppose the market just decided it wants a 15% return to hold loans of your type, instead of the 7% it required before. The value of your portfolio is now 50% lower, and you are insolvent. Sheila Bair will be there Monday to close you down.
Seems unfair, doesn't it? Suspending MtM is not a solution to the cash flow problem, it is a solution to the arbitrary discount rate problem, which can cause capital violations and potential insolvency despite no egregious actions on the part of the lenders. FAS 157 must be repealed; or at least suspended, immediately.
Friday, February 20, 2009
We're Saved, For The Moment (I Think)
The Obama administration has made several comments lately to the effect that they are not concerned about how weak the stock market has been following the release of their various economic and banking plans, so it was interesting to see how they released (as they are wont to do) news today just as the market was on the brink of breaking down again. If it weren't for some comments from the White House press secretary about how the Obama administration likes private ownership of banks, the indices were ready to break some important support.
We are saved for the moment, and there are even hints of some more details on the bank plan next week. With technical conditions oversold and sentiment so negative and gloomy, that may be all we need to give us a bit more upside.
A number of folks, such as Art Cashin on CNBC, are looking for a big bear market bounce here soon. That may be possible if we have the right news flow and stop reacting in such a spiky manner to every new piece of information. The buying we are seeing isn't from a foundation of confidence. It is just daytraders doing their flipping thing. There certainly isn't anything wrong with that, but it does not provide the sort of technical setup that allows us to build good-size positions. Many traders have no interest in holding positions overnight with the market as unstable as this.
One of the big problems we have in this market for the longer term is that even the bulls aren't that confident we will not see anything other than a short-term bounce. They aren't buying for the long term, and their inclination to take gains fairly fast is going to keep plenty of overhead pressure on the market.
We'll see a big short squeeze for a day or two here soon, and there will be some panic from underinvested bulls who they are missing out. Hopefully we'll have at least one good tradable rally in the near term, but as soon as the serial bottom-callers start proclaiming that the low is in again, is that a signal to sell?
We are saved for the moment, and there are even hints of some more details on the bank plan next week. With technical conditions oversold and sentiment so negative and gloomy, that may be all we need to give us a bit more upside.
A number of folks, such as Art Cashin on CNBC, are looking for a big bear market bounce here soon. That may be possible if we have the right news flow and stop reacting in such a spiky manner to every new piece of information. The buying we are seeing isn't from a foundation of confidence. It is just daytraders doing their flipping thing. There certainly isn't anything wrong with that, but it does not provide the sort of technical setup that allows us to build good-size positions. Many traders have no interest in holding positions overnight with the market as unstable as this.
One of the big problems we have in this market for the longer term is that even the bulls aren't that confident we will not see anything other than a short-term bounce. They aren't buying for the long term, and their inclination to take gains fairly fast is going to keep plenty of overhead pressure on the market.
We'll see a big short squeeze for a day or two here soon, and there will be some panic from underinvested bulls who they are missing out. Hopefully we'll have at least one good tradable rally in the near term, but as soon as the serial bottom-callers start proclaiming that the low is in again, is that a signal to sell?
Thursday, February 19, 2009
More Thoughts On The Rough Day Today
I look at a day like today and I know that the truth is that many stocks are just going away. There is no private equity value for anything and the market caps are coming down so rapidly. $3 trillion in market cap lost year over year in the top 100 companies alone. You have to have a market cap of $20 billion to be in the top 100 names last year at this time. Now it is $10 billion. All of that stock bought back , all of that debt taken down, and NOTHING to show for it. Nothing.
The Market Is Plainly Saying We Have Not Priced In The Worst
Once again the market struggled and the action under the surface was even worse than indicated by the major indices. We had close to 2 to 1 negative breadth and key financials like GE, PRU, HIG and C act like they are doomed.
There is no mystery to what is going on here. We have no certainty or clarity and the market has no confidence that we have priced in the worst. We are still trying to figure out how bad things are going to get, and until we have some sense of that, there will be few buyers.
The market trend at hand is apparently down. The usual folks will keep trying to catch a turn and we probably will see a big news-driven spike sometime soon.
Protect your capital during this vicious bear market.
There is no mystery to what is going on here. We have no certainty or clarity and the market has no confidence that we have priced in the worst. We are still trying to figure out how bad things are going to get, and until we have some sense of that, there will be few buyers.
The market trend at hand is apparently down. The usual folks will keep trying to catch a turn and we probably will see a big news-driven spike sometime soon.
Protect your capital during this vicious bear market.
Wednesday, February 18, 2009
If You Are In The Market, This Is Where The Dues Are Paid
After an ugly beating on Tuesday, the indices managed to hold up fairly well today, but buyers are obviously still lacking in confidence. There wasn't much energy at all to the slight gains in the senior indices, and under the surface breadth was quite poor once again with about 2,000 advancers to 3,800 decliners. Volume was a lighter, and leadership was in gold once again, which isn't a great leadership group. Overall, today was not exactly a resounding rebound.
The most troubling thing about this market recently is that all we seem to be doing is anticipating and reacting to news of the next governmental move. Charts and fundamentals have been largely irrelevant. Traders are just constantly trying to position in front of the next rumor or announcement, and then they quickly flip if they are lucky enough to catch the move. Very few folks are willing to ride positions for long.
I'm sure there are some traders who enjoy this sort of environment. Personally, I prefer to be able to hold positions for longer than a day or two, and other than a few gold plays, that has been nearly impossible.
When I'm feeling handcuffed by the market action, I like to remind myself that the reason we stick with the market through the difficult times is that it can be so lucrative when things change, and they always do eventually change. If it were easy it would not be so potentially rewarding.
The most troubling thing about this market recently is that all we seem to be doing is anticipating and reacting to news of the next governmental move. Charts and fundamentals have been largely irrelevant. Traders are just constantly trying to position in front of the next rumor or announcement, and then they quickly flip if they are lucky enough to catch the move. Very few folks are willing to ride positions for long.
I'm sure there are some traders who enjoy this sort of environment. Personally, I prefer to be able to hold positions for longer than a day or two, and other than a few gold plays, that has been nearly impossible.
When I'm feeling handcuffed by the market action, I like to remind myself that the reason we stick with the market through the difficult times is that it can be so lucrative when things change, and they always do eventually change. If it were easy it would not be so potentially rewarding.
Another "Take" On Yesterday's Horrific Day
There’s no way to really try and put lipstick on this pig. With breadth at about 29:4 to the negative, the indices losing an average of 4.16% and the S&P 500 failing the key 800 level (which began to act as resistance as the day wore on), it was undoubtedly a very ugly day. What’s more is that volume slowed considerably as we worked our way into the session, suggesting that we may not be oversold enough yet to generate a really good snap-back rally. Probably the most interesting thing, though – and the one which should really get our attention – is the fact that the Dow closed just 0.31 points above the November low.
There wasn’t any real catalyst to account for the pressure yesterday. The negativity was pervasive, and the only place that investors went looking to hide was precious metals. Perhaps the contrarians will be proven correct and the extreme shift in sentiment means that the weaker hands are finally being washed out. A double bottom in the Dow would certainly make for a good springboard for a nice counter-trend bounce, but as was the case before the Geithner speech, the last several employment reports and any other time when things were about to get interesting, there’s just no way to have an edge. Taking positions at this point is usually akin to nothing more than gambling.
This is obviously one nasty bear market, and trying to fight that fact is pointless. However, some day and from some point level, it will pass.
There wasn’t any real catalyst to account for the pressure yesterday. The negativity was pervasive, and the only place that investors went looking to hide was precious metals. Perhaps the contrarians will be proven correct and the extreme shift in sentiment means that the weaker hands are finally being washed out. A double bottom in the Dow would certainly make for a good springboard for a nice counter-trend bounce, but as was the case before the Geithner speech, the last several employment reports and any other time when things were about to get interesting, there’s just no way to have an edge. Taking positions at this point is usually akin to nothing more than gambling.
This is obviously one nasty bear market, and trying to fight that fact is pointless. However, some day and from some point level, it will pass.
Tuesday, February 17, 2009
Utter Hopelessness Setting In...Is That Good For The Market?
The big stimulus bill was signed by President Obama today, and the stock market was less than thrilled. As far as the market is concerned, the stimulus bill is actually old news at this point anyway, but the lack of confidence in the moves made by the Obama administration in the past couple weeks is clearly being reflected in the market. Folks have no sense of certainty about our economic future, and they aren't going to be doing much investing until they do.
We still have the extreme short-term traders out there giving us some last-hour volatility but the most notable thing about the market today was how broad the selling was. On the NYSE there were only 219 stocks advancing, while 2,905 declined. That is a very extreme level, and frankly, I'm a bit surprised the indices weren't down more.
Part of the reason the DJIA wasn't down more is that since the index is priced-weighted, stocks such as GM, C, BAC, AA and GE have a miniscule weighting compared with IBM, XOM and CVX. IBM has roughly 30 times the influence of Citigroup on the DJIA. With C down 10% or so compared with IBM's drop of 3%, that saved a lot of points for the Dow.
Nonetheless, the DJIA still managed a pretty hefty loss, and the S&P 500 dropped 4.5% and took out the key 800 support level. Volume picked up, breadth stunk, and we closed at the lows of the day. That may not bode well for the future.
Days like this make people feel they are trapped in the market, and all they want to do is escape. That creates major headwinds when we do bounce, as people take the opportunity to move back into cash with a little less damage.
What we saw today was some real discouragement. There are contrarians who will see this broad selling and very sad sentiment as a positive indicator. Perhaps it is, and we will see a bounce, but it is painfully obvious that we are in the grips of a nasty bear market, and trying to fight that fact is not a great way to make money.
We still have the extreme short-term traders out there giving us some last-hour volatility but the most notable thing about the market today was how broad the selling was. On the NYSE there were only 219 stocks advancing, while 2,905 declined. That is a very extreme level, and frankly, I'm a bit surprised the indices weren't down more.
Part of the reason the DJIA wasn't down more is that since the index is priced-weighted, stocks such as GM, C, BAC, AA and GE have a miniscule weighting compared with IBM, XOM and CVX. IBM has roughly 30 times the influence of Citigroup on the DJIA. With C down 10% or so compared with IBM's drop of 3%, that saved a lot of points for the Dow.
Nonetheless, the DJIA still managed a pretty hefty loss, and the S&P 500 dropped 4.5% and took out the key 800 support level. Volume picked up, breadth stunk, and we closed at the lows of the day. That may not bode well for the future.
Days like this make people feel they are trapped in the market, and all they want to do is escape. That creates major headwinds when we do bounce, as people take the opportunity to move back into cash with a little less damage.
What we saw today was some real discouragement. There are contrarians who will see this broad selling and very sad sentiment as a positive indicator. Perhaps it is, and we will see a bounce, but it is painfully obvious that we are in the grips of a nasty bear market, and trying to fight that fact is not a great way to make money.
Saturday, February 14, 2009
How's That For Irony?
Fed Chief's Old Home Sold
Following a Foreclosure
Banker Travis Jackson owns a piece of economic history: he bought Bernanke's childhood home at a foreclosure sale.
Friday, February 13, 2009
I Cannot Resist: More Stupidity From Congress
During the hearings with bank CEO's, Barney Frank asked for a foreclosure moratorium. Major banks are responding. Frank observed that it would be unfortunate and unfair for a foreclosure to take place right before a plan went into effect. He made an analogy to soldiers fighting WW II after the war was officially over.
This idea made more sense that Marcy Kaptur's (D) (OHIO) suggestion (in an earlier speech) to be a squatter in your home. "...possession is 99% of the law; you stay in your house." Readers may remember that in an earlier hearing Kaptur famously confused Bernanke and Paulson, repeatedly asking the Fed Chair which bank was the one where he was CEO. She finally got him to admit that he had been "CEO of the Princeton economics department." Do you think there is a wide variation in the skill and knowledge of legislators? Hearings serve many purposes, including a legislative history that may be part of later court rulings. Most legislators read questions prepared by staff and try to generate a video clip for local TV. Same thing when they speak to an empty chamber, inserting a longer text for the record.
Frank's suggestion seems to have gained traction, but what will it mean? At the minimum, I suppose we can expect housing data to be distorted for a few weeks. After that, it depends on the substance.
This idea made more sense that Marcy Kaptur's (D) (OHIO) suggestion (in an earlier speech) to be a squatter in your home. "...possession is 99% of the law; you stay in your house." Readers may remember that in an earlier hearing Kaptur famously confused Bernanke and Paulson, repeatedly asking the Fed Chair which bank was the one where he was CEO. She finally got him to admit that he had been "CEO of the Princeton economics department." Do you think there is a wide variation in the skill and knowledge of legislators? Hearings serve many purposes, including a legislative history that may be part of later court rulings. Most legislators read questions prepared by staff and try to generate a video clip for local TV. Same thing when they speak to an empty chamber, inserting a longer text for the record.
Frank's suggestion seems to have gained traction, but what will it mean? At the minimum, I suppose we can expect housing data to be distorted for a few weeks. After that, it depends on the substance.
Market Spikes Again On "News" Of Government Santa Claus Bearing Gifts (Eventually)
For the second day in a row, the market spiked up sharply on news of an upcoming mortgage bailout plan. This time the news was that President Obama will announce details next Wednesday.
Announcing an announcement of a government program is exactly what led to such a poor market response to Treasury Secretary Geithner's bank bailout program. Hopefully the difference this time will be that the mortgage plan will already be detailed and well structured.
All that we have going on in this market lately are reactions to government announcements. We spike up on some news, which always seems to come at key technical levels, sell off again, and then repeat. As someone noted on CNBC, you have to focus on trading the volatility rather than direction if you want to make money. This is not a market for momentum trading. There is a little bit of momentum in the gold sector, but most everything else is just a random see-saw.
Technically we are holding support and are back in the middle of a trading range. What is going to determine market direction is investor confidence or lack thereof. There is going to be plenty of governmental news again next week, which is going to influence confidence levels of many market participants.
Announcing an announcement of a government program is exactly what led to such a poor market response to Treasury Secretary Geithner's bank bailout program. Hopefully the difference this time will be that the mortgage plan will already be detailed and well structured.
All that we have going on in this market lately are reactions to government announcements. We spike up on some news, which always seems to come at key technical levels, sell off again, and then repeat. As someone noted on CNBC, you have to focus on trading the volatility rather than direction if you want to make money. This is not a market for momentum trading. There is a little bit of momentum in the gold sector, but most everything else is just a random see-saw.
Technically we are holding support and are back in the middle of a trading range. What is going to determine market direction is investor confidence or lack thereof. There is going to be plenty of governmental news again next week, which is going to influence confidence levels of many market participants.
Thursday, February 12, 2009
More On The Stupidity Of Congress
Yesterday, we once again witnessed political theatre
of the absurd. Bank managements
should have turned the table around and asked the
members of Congress whether they would be willing to
work for $1 until the government returns to a budget
surplus.
I am a citizen, and these are my list of grievances:
1. how poorly Congress was prepared; and
2. how disingenuous Citigroup's (C) Vikram Pandit was
in his response.
Let me be specific.
During the course of the testimony, Congress had
specific questions with regard to bankers' compensation
in 2007, 2008 and 2009.
In questioning Citigroup's Vikram Pandit, not a single
member of Congress knew to query him about the absurd
level of compensation ($165 million) he received in 2007
in connection with Citigroup's purchase of his Old Lane
hedge fund. In essence, Citigroup dramatically overpaid
for his "smallish" hedge fund in order to incent Pandit
-- the large premium over fair market value of Old Lane
was clearly 2007's compensation to him -- but, again,
nobody asked him to lump the $165 million into his 2007
compensation answer. Clearly, none had done the
research. (The Old Lane deal was a disaster. It turned
out to be another value-destructive Citigroup deal. In
June 2008, Citigroup closed down Old Lane because of
terrible performance.)
Just as poor as Congress's research was regarding
Pandit's 2007 compensation, Pandit's responses to
their compensation questions was disingenuous. When
asked about his projected 2009 compensation, Pandit,
with a smile of approval on his face, repeatedly
underscored that he had asked the Board of Directors of
Citigroup for "only $1 in salary." Not volunteering that
he received excessive compensation back in 2007 (when
he sold Old Lane) was insincere. He should have
volunteered the fact that he had previously received
such a large sum less than two years ago.
Simply stated, the Congressional inquisition was one
big waste of time, sounded like a "Saturday Night Live"
skit and likely served to further disaffect investors
who have repeatedly seen their politicians in a most
unpleasant light over the past nine months.
Yesterday's Congressional hearings were a farce, and
the transparency of our political process over the
past year has likely served as a P/E-multiple-
contracting event.
of the absurd. Bank managements
should have turned the table around and asked the
members of Congress whether they would be willing to
work for $1 until the government returns to a budget
surplus.
I am a citizen, and these are my list of grievances:
1. how poorly Congress was prepared; and
2. how disingenuous Citigroup's (C) Vikram Pandit was
in his response.
Let me be specific.
During the course of the testimony, Congress had
specific questions with regard to bankers' compensation
in 2007, 2008 and 2009.
In questioning Citigroup's Vikram Pandit, not a single
member of Congress knew to query him about the absurd
level of compensation ($165 million) he received in 2007
in connection with Citigroup's purchase of his Old Lane
hedge fund. In essence, Citigroup dramatically overpaid
for his "smallish" hedge fund in order to incent Pandit
-- the large premium over fair market value of Old Lane
was clearly 2007's compensation to him -- but, again,
nobody asked him to lump the $165 million into his 2007
compensation answer. Clearly, none had done the
research. (The Old Lane deal was a disaster. It turned
out to be another value-destructive Citigroup deal. In
June 2008, Citigroup closed down Old Lane because of
terrible performance.)
Just as poor as Congress's research was regarding
Pandit's 2007 compensation, Pandit's responses to
their compensation questions was disingenuous. When
asked about his projected 2009 compensation, Pandit,
with a smile of approval on his face, repeatedly
underscored that he had asked the Board of Directors of
Citigroup for "only $1 in salary." Not volunteering that
he received excessive compensation back in 2007 (when
he sold Old Lane) was insincere. He should have
volunteered the fact that he had previously received
such a large sum less than two years ago.
Simply stated, the Congressional inquisition was one
big waste of time, sounded like a "Saturday Night Live"
skit and likely served to further disaffect investors
who have repeatedly seen their politicians in a most
unpleasant light over the past nine months.
Yesterday's Congressional hearings were a farce, and
the transparency of our political process over the
past year has likely served as a P/E-multiple-
contracting event.
Congress Drops The Ball; This "Stimulus" Is A Damn Joke
As usual, Congress has dropped the ball, and we all lose. Commercial real estate is showing real signs of stress, and residential housing, which I think bottoms this year anyway (although at lower prices than would have occurred had we executed this correctly), is still terrible. So what does Congress do? It adds $500 to a tax credit for first-time homebuyers. Are you kidding me? What a damn joke!
I will simply come out and say it: These guys are idiots. They haven't a clue about what's ailing the system. Not a clue. It is real estate! And now it may well become unemployment. The mainstream doesn't get this at all. The New York Times' front page: "It is a quick, sweet victory for the new president and potentially a historic one." Huh? Who edits that BS? That's extraordinary.
We who actually follow the economy know the stimulus package is a total joke. How do we know that? We read. We all know that unless more jobs are created, the mortgage businesses of WFC and BAC will be much worse off (the C balance sheet is being sunk less by residential mortgages than others, but it is ugly). We also aren't even dealing with the failing home equity lines.
It is really easy to see how things can't turn around. I expected more from Congress, which puts me distinctly in the moron category. This news is terrible. I can't sugarcoat it.
The only silver lining is that they didn't give the homebuilders like TOL and LEN and DHI and PHM and KBH the credit they wanted for new homes. Hopefully that will make it so supply isn't added.
But will it matter? The foreclosure numbers show that supply may be added this month once the forbearance expires. The stimulus package has come and gone.
It was no help whatsoever for the pressing problems of this economy.
Shameful and stupid.
I will simply come out and say it: These guys are idiots. They haven't a clue about what's ailing the system. Not a clue. It is real estate! And now it may well become unemployment. The mainstream doesn't get this at all. The New York Times' front page: "It is a quick, sweet victory for the new president and potentially a historic one." Huh? Who edits that BS? That's extraordinary.
We who actually follow the economy know the stimulus package is a total joke. How do we know that? We read. We all know that unless more jobs are created, the mortgage businesses of WFC and BAC will be much worse off (the C balance sheet is being sunk less by residential mortgages than others, but it is ugly). We also aren't even dealing with the failing home equity lines.
It is really easy to see how things can't turn around. I expected more from Congress, which puts me distinctly in the moron category. This news is terrible. I can't sugarcoat it.
The only silver lining is that they didn't give the homebuilders like TOL and LEN and DHI and PHM and KBH the credit they wanted for new homes. Hopefully that will make it so supply isn't added.
But will it matter? The foreclosure numbers show that supply may be added this month once the forbearance expires. The stimulus package has come and gone.
It was no help whatsoever for the pressing problems of this economy.
Shameful and stupid.
Once Again, Some Late-Day Drama
And once again, just when the market was on the brink of a major meltdown, we have news released of another governmental program to fix our economic ills. The latest plan involved a standardized approach to writing down mortgages as well as payment supplements.
As usual, the announcement came in the last hour of trading, just as we had broken intraday support. You might think that there might actually be some market-savvy folks in the Obama administration timing these things, but we all know that can't possibly be the case.
The shorts were obviously caught by surprise and helped to fuel a euphoric leap that put the S&P 500 in the green after being down nearly 3%.
I'm sure there are some traders who are gleefully navigating these wild intraday swings, but there are many more who are frustrated with the suddenness and randomness of these moves. This trading is more akin to playing a slot machine than any sort of thoughtful speculation.
In the bigger picture this sort of intraday reversal is a technical positive. The bears are squeezed, and the underinvested bulls are worried that it might continue without them. The bulls have a chance to run a bit on this, but the history of these big jumps on talks of governmental plans has not been good.
As usual, the announcement came in the last hour of trading, just as we had broken intraday support. You might think that there might actually be some market-savvy folks in the Obama administration timing these things, but we all know that can't possibly be the case.
The shorts were obviously caught by surprise and helped to fuel a euphoric leap that put the S&P 500 in the green after being down nearly 3%.
I'm sure there are some traders who are gleefully navigating these wild intraday swings, but there are many more who are frustrated with the suddenness and randomness of these moves. This trading is more akin to playing a slot machine than any sort of thoughtful speculation.
In the bigger picture this sort of intraday reversal is a technical positive. The bears are squeezed, and the underinvested bulls are worried that it might continue without them. The bulls have a chance to run a bit on this, but the history of these big jumps on talks of governmental plans has not been good.
Having Thought Some More Regarding "Geithner's Plan," I'm Starting To Think We May Have Something Here....
Sometimes being an impatient sort, I certainly wish more concrete details were known regarding the Geithner bank plan. But the reality is that banks like BAC, JPM and WFC just received a gift and so did the broad market (eventually).
So much money has been thrown at our mortgage-backed security problem that it will never be a problem again. Balance sheets will be fortified and lending will increase. From what I'm hearing, most investors have missed the glass half-full aspect of this whole thing.
Here is why this plan is (probably?) (hopefully?) the real deal:
1. This trillion dollar superfund is actually a more viable solution to our problems than merely suspending mark-to-market ONLY would have been. As I've written at some length, MTM (FAS 157) should at least be severely altered, if not completely repealed. The most effective timeframe from that course of action was about 18 months ago, so it's long since passed. However, we all understand that we live in an era of increased transparency and getting rid of mark-to-market completely would give us less transparency.
No matter what your personal preference was with regards to mark-to-market, it's important to remember that Geithner's solution will get the job done as well. He will be able to artificially prop up the market for those "fur coats in August."
2. Geithner's superfund will act as a permanent specialist for mortgage securities. The specialist acts as the market maker to facilitate normal trading conditions during abnormal circumstances. The stock market uses specialists and so should every other kind of market that may experience short-term inefficiencies.
Specialists actually can make a lot of money. The projections for the government to generate high returns on this deal look promising. I believe this is the reason why Geithner wanted the superfund so badly: He wants to burn those in the private sector who have caused this crisis.
3.This superfund is what Hank Paulson knew we needed all along. Go all the way back to October 2007 when Paulson tried to bring the big banks together to form a fund, but quickly found out there wasn't enough private capital to do it. He needed a trillion but couldn't get it from the private or public sector.
Paulson thought TARP 1 might be sufficient for a superfund/specialist fund but the emergency had gotten so out of control that he had to use the money for capital infusions. TARP 1 ended up being a bandage for the symptoms; Geithner's superfund is the logical next step of the healing process that the Treasury has known about for over a year. For the first time we are now treating the cause!
4. It will allow the market to sustain its next rally. I have known for some time that the next bull market would not begin until a permanent solution for the banks was in place. For a moment, TARP 1 appeared to be the solution, but as soon as Paulson began emergency capital injections we knew that it wasn't the long-term fix.
Investors who fret over the lack of details are missing the big picture: The Fed finally has the right amount of money to take care of this thing. It's looking like the market will once again be a safe place to invest right after we digest the dismal first-quarter data coming our way in April. The market will be able to rally because of what Geithner just did.
This plan has been in the making for a long time -- Geithner didn't just come up with it last week. The $14 trillion mortgage security market has always needed a superfund to back it up and it finally got one. This plan provides transparency going forward, it will protect the banks from future real estate corrections and for the first time we can start thinking about finding a true bottom in this market.
The biggest winners going forward will be those stocks who have been pummeled down to nothing because of solvency issues or nationalization fears. Some of my favorites in this sector are ETFC and BAC. I'd love to see where those stocks are trading by year end.
So much money has been thrown at our mortgage-backed security problem that it will never be a problem again. Balance sheets will be fortified and lending will increase. From what I'm hearing, most investors have missed the glass half-full aspect of this whole thing.
Here is why this plan is (probably?) (hopefully?) the real deal:
1. This trillion dollar superfund is actually a more viable solution to our problems than merely suspending mark-to-market ONLY would have been. As I've written at some length, MTM (FAS 157) should at least be severely altered, if not completely repealed. The most effective timeframe from that course of action was about 18 months ago, so it's long since passed. However, we all understand that we live in an era of increased transparency and getting rid of mark-to-market completely would give us less transparency.
No matter what your personal preference was with regards to mark-to-market, it's important to remember that Geithner's solution will get the job done as well. He will be able to artificially prop up the market for those "fur coats in August."
2. Geithner's superfund will act as a permanent specialist for mortgage securities. The specialist acts as the market maker to facilitate normal trading conditions during abnormal circumstances. The stock market uses specialists and so should every other kind of market that may experience short-term inefficiencies.
Specialists actually can make a lot of money. The projections for the government to generate high returns on this deal look promising. I believe this is the reason why Geithner wanted the superfund so badly: He wants to burn those in the private sector who have caused this crisis.
3.This superfund is what Hank Paulson knew we needed all along. Go all the way back to October 2007 when Paulson tried to bring the big banks together to form a fund, but quickly found out there wasn't enough private capital to do it. He needed a trillion but couldn't get it from the private or public sector.
Paulson thought TARP 1 might be sufficient for a superfund/specialist fund but the emergency had gotten so out of control that he had to use the money for capital infusions. TARP 1 ended up being a bandage for the symptoms; Geithner's superfund is the logical next step of the healing process that the Treasury has known about for over a year. For the first time we are now treating the cause!
4. It will allow the market to sustain its next rally. I have known for some time that the next bull market would not begin until a permanent solution for the banks was in place. For a moment, TARP 1 appeared to be the solution, but as soon as Paulson began emergency capital injections we knew that it wasn't the long-term fix.
Investors who fret over the lack of details are missing the big picture: The Fed finally has the right amount of money to take care of this thing. It's looking like the market will once again be a safe place to invest right after we digest the dismal first-quarter data coming our way in April. The market will be able to rally because of what Geithner just did.
This plan has been in the making for a long time -- Geithner didn't just come up with it last week. The $14 trillion mortgage security market has always needed a superfund to back it up and it finally got one. This plan provides transparency going forward, it will protect the banks from future real estate corrections and for the first time we can start thinking about finding a true bottom in this market.
The biggest winners going forward will be those stocks who have been pummeled down to nothing because of solvency issues or nationalization fears. Some of my favorites in this sector are ETFC and BAC. I'd love to see where those stocks are trading by year end.
Wednesday, February 11, 2009
This Would Work
Now with TARP 2.0, renamed a friendly Financial Stability Plan, the idea is to entice private capital to buy these bad loans and derivatives in an effort to set the "market price." But Mr. Geithner hasn't solved the dilemma of banks not wanting to sell and become insolvent. Moreover, no one is going to buy these securities ahead of Mr. Geithner's action with the "full resources of the government" to bring down mortgage payments and reduce mortgage interest rates. Lower mortgage payments means mortgage-backed securities would be worth even less. Six months to a year from now, big banks may still be weak and the ugly "n" word of nationalization will be back.
Mr. Geithner should instead use his "stress test" and nationalize the dead banks via the FDIC -- but only for a day or so.
First, strip out all the toxic assets and put them into a holding tank inside the Treasury. Then inject $300 billion in fresh equity for both Citi and Bank of America. Create 10 billion new shares of each of the companies to replace the old ones. The book value of each share could be $30. Very quickly, a new board of directors should be created and a new management team hired. Here's the tricky part: Who owns the shares? Politics will kill a nationalized bank. So spin them out immediately.
Some $6 trillion in income taxes were paid by individuals in 2006, 2007 and 2008. On a pro-forma basis, send out those 10 billion shares of each bank to taxpayers. They paid for the recapitalization.
Each taxpayer would get about $100 worth of stock for each $1,000 of taxes paid. Of course, each taxpayer has the ability to sell these shares on the open market, maybe at $40, maybe $20, maybe $80. It depends on management, their vision, how much additional capital they are willing to raise, the dividend they declare, etc. Meanwhile, the toxic assets sitting inside the Treasury will have residual value and the proceeds from their eventual sale, I believe, will more than offset the capital injected. That would benefit all citizens, not the managements and shareholders who blew up the banking system in the first place.
Mr. Geithner should instead use his "stress test" and nationalize the dead banks via the FDIC -- but only for a day or so.
First, strip out all the toxic assets and put them into a holding tank inside the Treasury. Then inject $300 billion in fresh equity for both Citi and Bank of America. Create 10 billion new shares of each of the companies to replace the old ones. The book value of each share could be $30. Very quickly, a new board of directors should be created and a new management team hired. Here's the tricky part: Who owns the shares? Politics will kill a nationalized bank. So spin them out immediately.
Some $6 trillion in income taxes were paid by individuals in 2006, 2007 and 2008. On a pro-forma basis, send out those 10 billion shares of each bank to taxpayers. They paid for the recapitalization.
Each taxpayer would get about $100 worth of stock for each $1,000 of taxes paid. Of course, each taxpayer has the ability to sell these shares on the open market, maybe at $40, maybe $20, maybe $80. It depends on management, their vision, how much additional capital they are willing to raise, the dividend they declare, etc. Meanwhile, the toxic assets sitting inside the Treasury will have residual value and the proceeds from their eventual sale, I believe, will more than offset the capital injected. That would benefit all citizens, not the managements and shareholders who blew up the banking system in the first place.
Dropping Mark-To-Market Is No Miracle Cure, But....
Dropping mark-to-market is no miracle cure, but it would reduce the pressure on banks and regulators to make irrational choices about the disposition of questionable assets. Banking might even regain some of its appeal for equity investors, who might see an attractive bet that bank-held assets are oversold -- that is, if they don't have to worry about unpredictable regulatory actions. Real confidence is organic: not something that can be conjured from Mr. Geithner's promise that Mighty Mouse is here to save the day.
Also: Talk about "moral hazard" is fantastically beside the point right now. Our biggest banks have already been comprehensively guaranteed by the federal government, and they need comprehensive monitoring to make sure they aren't rolling the dice. Regulatory forbearance doesn't make this moral hazard worse; at this point, it simply represents the least-cost approach to finishing the job the government has taken on of holding the banking system's hand while it steps back from the abyss.
Also: Talk about "moral hazard" is fantastically beside the point right now. Our biggest banks have already been comprehensively guaranteed by the federal government, and they need comprehensive monitoring to make sure they aren't rolling the dice. Regulatory forbearance doesn't make this moral hazard worse; at this point, it simply represents the least-cost approach to finishing the job the government has taken on of holding the banking system's hand while it steps back from the abyss.
A Stabilization, Of Sorts
Outside of the fact that the market didn’t see any following through to the downside today, there just wasn’t anything to get excited about. Yes, the financials regained a little less than half of the ground they lost yesterday, but investors sure weren’t in any rush to try and pick up the pieces in other areas of the market. In fact, the continued rebound in treasuries, and the breakout move in gold only reinforces the notion that investors had their confidence badly shaken yesterday.
From a technical perspective, there’s still room for the bulls to step back up to the plate. The S&P 500 is right at lateral support levels, and the Nasdaq is only a snudge below its 50 dma (and still above the lows from the 30th). Unfortunately, they’ll have to pull themselves up by their bootstraps at this point. Like we said earlier, if they can do so without the crutch of hope for some magical formula from Washington, we might then have a better chance for a more sustainable counter-trend rally.
Take opportunities where you can find them; I still think the November lows were the lows.
From a technical perspective, there’s still room for the bulls to step back up to the plate. The S&P 500 is right at lateral support levels, and the Nasdaq is only a snudge below its 50 dma (and still above the lows from the 30th). Unfortunately, they’ll have to pull themselves up by their bootstraps at this point. Like we said earlier, if they can do so without the crutch of hope for some magical formula from Washington, we might then have a better chance for a more sustainable counter-trend rally.
Take opportunities where you can find them; I still think the November lows were the lows.
Tuesday, February 10, 2009
No Plan Details = Bad Market Day
Although the market was set up for a classic sell the news reaction today and we were by no means surprised when it started to take shape, we doubt that anyone was expecting it to be as violent as it was. While there were few who were expecting that Secretary Geithner would deliver a whole lot of specifics, the so-called plan lacked any sort of detail whatsoever. In fact, he spent most of his time discussing how we got in the mess we’re in, not how we’re going to get out.
After the intense selling right as the news came out, the market spent the rest of the day moving steadily lower, with the net result being that the Dow finished at its worst level since the November lows. While the technical damage in the Nasdaq and S&P 500 wasn’t nearly as severe, we obviously took a hit today, and it’s going to be hard for us to recover from it for awhile.
Of course, this puts us back right where we were a while ago, with the market wondering what sort of plan the government can come up with to properly value the toxic debt banks still have on their balance sheets, and get those same banks to start lending again. We know the folks in Washington want that to happen, but the feeling is that they just don’t know how to make it happen.
They will keep trying, but the only thing that’s really going to help is time.
In the meantime, we have a market that is in a precarious position. The bulls really need to step up to the plate, but it’s unclear what’s going to provide the catalyst for them to do so.
After the intense selling right as the news came out, the market spent the rest of the day moving steadily lower, with the net result being that the Dow finished at its worst level since the November lows. While the technical damage in the Nasdaq and S&P 500 wasn’t nearly as severe, we obviously took a hit today, and it’s going to be hard for us to recover from it for awhile.
Of course, this puts us back right where we were a while ago, with the market wondering what sort of plan the government can come up with to properly value the toxic debt banks still have on their balance sheets, and get those same banks to start lending again. We know the folks in Washington want that to happen, but the feeling is that they just don’t know how to make it happen.
They will keep trying, but the only thing that’s really going to help is time.
In the meantime, we have a market that is in a precarious position. The bulls really need to step up to the plate, but it’s unclear what’s going to provide the catalyst for them to do so.
And Now, The Selling Of The "News"
Although downside action immediately followed the BIG NEWS, we are in the process of stabilizing a bit as we work our way through the New York lunch hour. Selling does continue, however, sending us to fresh lows. With the KBW Bank Index down by more than 12%, there’s little question as to where most of the pain is being felt, but this terrible action we’re seeing is stretching to every corner of the market. Only materials is hovering above losses of 3% on the day while industrials and consumer discretionary are lower by more than 4%.
Of course, the media is blaming all of this on the fact that Secretary Geither was long on generalizations and short on actual facts, but we were set up for a “sell-the-news” reaction, and that’s exactly what we’re getting.
The problem, though, with the fact that we didn’t get any specifics whatsoever is that we will likely be relegated to having to deal with a market that continues to be held hostage to rumors and speculation as to how exactly the Administration plans on executing its plans. The market needed some clarity, and that’s just what we did not get. Time and price discovery, I guess.
As such, it’s going to be all that more difficult for this market to engineer a decent counter-trend move, especially when we continue to drift around without any clear leadership. We’re still above the lows from last month and are back at the middle of the recent lateral channel, but buyers are going to need to move beyond this and step back up to the plate relatively quickly. Hopefully this week...
Of course, the media is blaming all of this on the fact that Secretary Geither was long on generalizations and short on actual facts, but we were set up for a “sell-the-news” reaction, and that’s exactly what we’re getting.
The problem, though, with the fact that we didn’t get any specifics whatsoever is that we will likely be relegated to having to deal with a market that continues to be held hostage to rumors and speculation as to how exactly the Administration plans on executing its plans. The market needed some clarity, and that’s just what we did not get. Time and price discovery, I guess.
As such, it’s going to be all that more difficult for this market to engineer a decent counter-trend move, especially when we continue to drift around without any clear leadership. We’re still above the lows from last month and are back at the middle of the recent lateral channel, but buyers are going to need to move beyond this and step back up to the plate relatively quickly. Hopefully this week...
Monday, February 9, 2009
Waiting In Suspense - Let's Get On With It Already!
The market traded nervously all day as we await the big bank bailout program that is to be announced tomorrow by Treasury Secretary Geithner. The action today wasn't bad, but neither the bulls nor bears were willing to press too hard. We had some strength in regional banks and oil but the energy and commodity strength faded later in the day. Breadth was close to flat overall and volume light.
We are really in a difficult position for traders at this juncture. This announcement could be the type of binary event where we are going to see either a euphoric leap or a disappointing spike down. It is pretty much a coin flip and so well-anticipated that even the "sell the news" reaction is almost too obvious. The only thing I'm sure about is a high level of volatility.
The problem for the bullish perspective is that anything really exceptional about a new bank bailout plan is going to be leaked and priced into the market already to some extent. Something truly surprising in this announcement is probably a poor bet, even more so when the market has already traded up strongly into the news.
The good news is that the bulls are going to be tested by this news pretty quickly and we'll have much better insight into whether they really are ready for some sort of sustained bear market bounce. Bullish sentiment has been improving and one thing this market has been missing lately is confidence. Tomorrow should be interesting.
We are really in a difficult position for traders at this juncture. This announcement could be the type of binary event where we are going to see either a euphoric leap or a disappointing spike down. It is pretty much a coin flip and so well-anticipated that even the "sell the news" reaction is almost too obvious. The only thing I'm sure about is a high level of volatility.
The problem for the bullish perspective is that anything really exceptional about a new bank bailout plan is going to be leaked and priced into the market already to some extent. Something truly surprising in this announcement is probably a poor bet, even more so when the market has already traded up strongly into the news.
The good news is that the bulls are going to be tested by this news pretty quickly and we'll have much better insight into whether they really are ready for some sort of sustained bear market bounce. Bullish sentiment has been improving and one thing this market has been missing lately is confidence. Tomorrow should be interesting.
The Yield Curve Steepens - Indicating That The Recession May Not Last A Year; But Does It Also Reflect A Bigger Bond Supply?
The Treasury yield curve continues to steepen and is now at its steepest in about three months. The steepening has both good and bad connotations to it. The most important positive is the message that a yield curve typically sends.
The current yield spread between three-month T-bills and 10-year T-notes -- the key empirical gauge -- is 276 basis points, a level that historically has indicated that the chances of recession 12 months hence are very small.
In a study by Estrella and Mishkin, a yield spread of more than 121 basis points was associated with just a 5% chance of recession, which makes the current level comforting. For reference, note that the same study showed that a yield spread of -82 basis points (an inverted yield curve), produced 50% odds of a recession. The yield spread was as wide as -60 basis points in February 2007.
Some of the recent steepening of the yield curve reflects the increase in Treasury supply, with the long end of the yield curve bearing the burden, the negative angle on the steepening. If the U.S. dollar were to fall, the steepening would take on an event larger negative angle, but any weakening would have to be significant to have meaningful impact on the yield curve on the whole.
The current yield spread between three-month T-bills and 10-year T-notes -- the key empirical gauge -- is 276 basis points, a level that historically has indicated that the chances of recession 12 months hence are very small.
In a study by Estrella and Mishkin, a yield spread of more than 121 basis points was associated with just a 5% chance of recession, which makes the current level comforting. For reference, note that the same study showed that a yield spread of -82 basis points (an inverted yield curve), produced 50% odds of a recession. The yield spread was as wide as -60 basis points in February 2007.
Some of the recent steepening of the yield curve reflects the increase in Treasury supply, with the long end of the yield curve bearing the burden, the negative angle on the steepening. If the U.S. dollar were to fall, the steepening would take on an event larger negative angle, but any weakening would have to be significant to have meaningful impact on the yield curve on the whole.
A Stock I Just Bought - A Compelling Case For CENX
I just went long on shares of Century Aluminum (CENX) at around $4.30 or so.
Reason for the trade: Shares of CENX were recently down about 50% in about a week, after the company announced that it will issue $100 million (at the time 20% of the market cap, but now a much higher percentage of the market cap) to increase liquidity on the firm's balance sheet.
While hardly a death knell given that the offering price is $4.50 and that CENX has a stated book value of $29.87 or so from its latest filings.
Here's more on the company:
Century Aluminum (CENX), which trades with a forward P/E of well under 10 and EV/EBITDA of 1.6 in December of 2008, is now offering a compelling risk/reward scenario to willing investors.
Fewer companies in the commodity space have been hit as hard as Century Aluminum, which is down well over 90% since its mid-May high of around $80 or so. Century, whose main business is in the production of smelted aluminum, is principally based in Helguvik, Iceland.
Six-month spot prices for aluminum are down almost 75% from $1.50 per pound in July, to 66 cents per pound in 12/08, and low spot prices mean lower revenue and EBITDA margins.
Century, which recently increased its leverage to the spot price of aluminum, bought back forward hedge contracts from one of its largest equity and debt holders. Investor sentiment regarding this transaction was mixed; some thought that Century was taking off needed revenue hedges, while others thought the decrease of debt in the firm’s capital structure was a positive.
Century also issued a secondary of 6.5 million shares in the public market at a stock price of $62.25 per share. This netted the firm around $400 million. Right now, there is a massive glut of supply of aluminum on the market, but with companies such as Rio Tinto (RTP), Alcan and Alcoa (AA) cutting back production, the price should stabilize here.
Net sales for the third quarter of 2008 came in at $552 million, with operating income of $111 million. Earnings for the third quarter were 59 cents per share vs. a loss of 6 cents per share just one quarter ago. Total firm revenue for the full year 2008 is $1.9 billion, with EBITDA margins of 22% firm-wide.
Iceland was hit especially hard by the ongoing credit and economic crisis of 2008, because the debts of banks within the country were six times total GDP. In late October, the Icelandic parliament passed emergency power to take over the three largest commercial banks in Iceland due to massive outstanding debt notes. Iceland, which is not part of the ECB, was forced to raise the nations interest to more than 18%, in part by the terms of acquiring a loan from the International Monetary Fund.
Century’s exposure to Iceland and the ensuing economic crisis has affected the company’s short-term outlook, but with the stock down well over 90% here, it’s safe to assume that this has already been priced into the stock.
CENX successfully placed its secondary offering into the market recently. Additionally, news that Glencore Holdings, Century’s largest shareholder raised its stake from 30.2% to 38.2% helped ease investors' fears. Glencore acquired 13.2 million shares, or half of the secondary amount, helping the stock recover.
Aluminum prices also finished the week just passed nicely higher.
Long CENX
Reason for the trade: Shares of CENX were recently down about 50% in about a week, after the company announced that it will issue $100 million (at the time 20% of the market cap, but now a much higher percentage of the market cap) to increase liquidity on the firm's balance sheet.
While hardly a death knell given that the offering price is $4.50 and that CENX has a stated book value of $29.87 or so from its latest filings.
Here's more on the company:
Century Aluminum (CENX), which trades with a forward P/E of well under 10 and EV/EBITDA of 1.6 in December of 2008, is now offering a compelling risk/reward scenario to willing investors.
Fewer companies in the commodity space have been hit as hard as Century Aluminum, which is down well over 90% since its mid-May high of around $80 or so. Century, whose main business is in the production of smelted aluminum, is principally based in Helguvik, Iceland.
Six-month spot prices for aluminum are down almost 75% from $1.50 per pound in July, to 66 cents per pound in 12/08, and low spot prices mean lower revenue and EBITDA margins.
Century, which recently increased its leverage to the spot price of aluminum, bought back forward hedge contracts from one of its largest equity and debt holders. Investor sentiment regarding this transaction was mixed; some thought that Century was taking off needed revenue hedges, while others thought the decrease of debt in the firm’s capital structure was a positive.
Century also issued a secondary of 6.5 million shares in the public market at a stock price of $62.25 per share. This netted the firm around $400 million. Right now, there is a massive glut of supply of aluminum on the market, but with companies such as Rio Tinto (RTP), Alcan and Alcoa (AA) cutting back production, the price should stabilize here.
Net sales for the third quarter of 2008 came in at $552 million, with operating income of $111 million. Earnings for the third quarter were 59 cents per share vs. a loss of 6 cents per share just one quarter ago. Total firm revenue for the full year 2008 is $1.9 billion, with EBITDA margins of 22% firm-wide.
Iceland was hit especially hard by the ongoing credit and economic crisis of 2008, because the debts of banks within the country were six times total GDP. In late October, the Icelandic parliament passed emergency power to take over the three largest commercial banks in Iceland due to massive outstanding debt notes. Iceland, which is not part of the ECB, was forced to raise the nations interest to more than 18%, in part by the terms of acquiring a loan from the International Monetary Fund.
Century’s exposure to Iceland and the ensuing economic crisis has affected the company’s short-term outlook, but with the stock down well over 90% here, it’s safe to assume that this has already been priced into the stock.
CENX successfully placed its secondary offering into the market recently. Additionally, news that Glencore Holdings, Century’s largest shareholder raised its stake from 30.2% to 38.2% helped ease investors' fears. Glencore acquired 13.2 million shares, or half of the secondary amount, helping the stock recover.
Aluminum prices also finished the week just passed nicely higher.
Long CENX
Friday, February 6, 2009
It's Going To Be A Wild Day On Monday - Traders Load Up Today
The market was in a very hopeful mood today, with both a stimulus bill and a bank bailout plan likely to be announced on Monday. Traders were eager to jump in front of the news; people are expecting innovation.
The latest talk about the bank plan involves a number of things which are slowly being leaked. Such ideas as more transparency and an increased role for Fannie Mae and Freddie Mac are not going to cause wild celebration, especially since we already are looking for them.
Whatever we end up with, you can be sure that the idea of selling and/or shorting the news is going to be on the minds of many. Maybe the bears will just turn into short-squeeze fuel, but the history of sustained rallies on government action has not been positive during this bear market.
The market is totally news-driven right now, so there be some major whipsaws. It is really just a function of trying to gauge psychology more than anything. So you can forget about fundamentals and charts for a day or so and just focus on the swirling emotions. Hope is in the air, and we have a classic sell-the-news setup. It is going to be a wild day on Monday.
The latest talk about the bank plan involves a number of things which are slowly being leaked. Such ideas as more transparency and an increased role for Fannie Mae and Freddie Mac are not going to cause wild celebration, especially since we already are looking for them.
Whatever we end up with, you can be sure that the idea of selling and/or shorting the news is going to be on the minds of many. Maybe the bears will just turn into short-squeeze fuel, but the history of sustained rallies on government action has not been positive during this bear market.
The market is totally news-driven right now, so there be some major whipsaws. It is really just a function of trying to gauge psychology more than anything. So you can forget about fundamentals and charts for a day or so and just focus on the swirling emotions. Hope is in the air, and we have a classic sell-the-news setup. It is going to be a wild day on Monday.
The Toxic CDOs
It's amazing to me that the big issuers of mortgages at the top -- Merrill Lynch, Lehman Brothers and Bear Stearns, as well as New Century Financial and NovaStar -- didn't know more about what they were packaging and that they were so reliant on the agencies and insurance for protection. Nor did the insurers, like AIG (AIG) , know what they were insuring.
It is amazing because all of these entities relied on the ratings agencies, which in real life they never believed to be doing a thorough job anyway, and on their own mortgage originators, whom they didn't trust either.
No one really believed in this stuff. All of these loan packages that were put together? The smart people knew that the default rates could be huge. But every one of them had the same model. They all figured they could get away with it, that they could foist it on clients. The clients were often more than happy to trade it.
For one simple reason: They just used it for arbitrage.
I am thinking about this great arbitrage trade because of the fallen trader at Deutsche Bank, who, as the Journal says this morning, "left behind $1.8 billion hole."
You know how to leave behind a $1.8 billion hole? You buy one security and you short another and profit from a small difference. It works only if you borrow money, 20, 30 times over, and profit each month from the difference. A consistent profit. Just as consistent if you bought a CDO with Treasuries and held it. And again, borrowed 30 times your capital to profit from it.
The reason these mortgages are so intractable and can't be pulled apart is that they were only put together for this arbitrage. All of the banks, all of the hedge funds, all of the bizarre clients who bought this junk were relying on a model of unemployment -- as long as unemployment stayed low, people don't default. The model of course was wrong, and that's what wiped out the arbitrage, because the high-interest CDOs suddenly had principal risk, and the low-interest loans that they took against their collateral from the brokerages didn't.
This is all so pertinent because the CDOs weren't packaged with an eye toward maintaining the mortgages underneath, they were packaged strictly so the brokers could make profitable loans to clients to buy the CDOs to do the arbitrage.
Now 80% of the mortgages issued during 2005 to 2007 are in those CDOs, and given that most were issued by brokers who knew nothing about issuance and by scam artists who are out of business, there's simply very little worth to them.
And Merrill knew it. Lehman knew it. Bear knew it. They knew it because all they had to do was read the papers to know where their mortgages were from. They knew it because they knew the loan-to-value of the mortgages within in the CDOs. They knew it because in many cases they had funded hedge funds -- literally started hedge funds with their own borrowed capital -- which then bought this stuff from them on a 30-to-1 basis.
The credit guys knew it, but they were only making about $100,000 and they are easily dismissed. They knew that the hedge funds had to put up more margin to make this thinly capitalized trade, so therefore the bosses knew it too, but they looked the other way.
The only reason Goldman was the only firm that didn't get hit hard -- because they packaged mortgages -- was that they listened to the credit department because it was filled with partners who made a huge amount of money. That was always the Goldman way: to reward people who did a great job who saved the firm every day, not just those who drove revenues.
So Goldman wasn't caught with much inventory, and what they were caught with they were hedged against, and not with AIG for the most part. The stories that said that Goldman demanded that AIG be saved and beseeched Hank Paulson were wrong. They had some counterparty risk in this stuff, but for the most part they just ran a hedged position, and that's what saved them. (They didn't hedge the private-equity bond exposure, which is where their pain came in.)
The CDO arbitrage was largely unwound by the end of 2008, which is why there is some hope in the system. But as we see from Deutsche Bank, the arbitrage came in many forms and with many bonds, and that's not done. It is a huge user of everyone's capital, and it isn't talked about much.
It should be made aware that it was one of the intractable aspects of this era, because the CDOs were never meant to be anything but pieces of paper to leverage against Treasuries. There is nothing to look through them, and there is no master trust staff to try to fix them. There's just a bunch of guys in a room who send out foreclosure notices and don't make any money anymore.
Until all of these servicers are dealt with the way Goldman Sachs is dealing with things, by slashing the principal, the $2 trillion in issued mortgages will simply keep poisoning us (I am not even talking about whole loans, which are only 20% of the problem).
The reason housing should be fixated upon is because of the servicer problem. They keep pumping out foreclosures as fast as we draw down home inventory. Now that unemployment has spiked -- and the number this morning with revisions is much worse than people are making it out to be -- they will do it faster than there is demand unless Bernanke buys mortgage bonds and we get that $15,000 tax credit to buy just old homes. The new provision includes old and new homes, which is really bad because the homebuilders will be able to stay in business because of that clause. Another example of bad policy condoned by Obama.
The servicers are the problem. They are a legacy of the arbitrage.
They aren't being dealt with other than in the Goldman Litton servicing arm. They are choking us.
All because some hedge funds and brokers figured out a consistent way to make money month after month that was immediately inconsistent when the first homeowners started defaulting and the credit departments issued the margin calls that made the Merrills and Lehmans and Bears take back the CDOs that ultimately sunk the first two ... and now threaten to sink Bank of America, too.
It is amazing because all of these entities relied on the ratings agencies, which in real life they never believed to be doing a thorough job anyway, and on their own mortgage originators, whom they didn't trust either.
No one really believed in this stuff. All of these loan packages that were put together? The smart people knew that the default rates could be huge. But every one of them had the same model. They all figured they could get away with it, that they could foist it on clients. The clients were often more than happy to trade it.
For one simple reason: They just used it for arbitrage.
I am thinking about this great arbitrage trade because of the fallen trader at Deutsche Bank, who, as the Journal says this morning, "left behind $1.8 billion hole."
You know how to leave behind a $1.8 billion hole? You buy one security and you short another and profit from a small difference. It works only if you borrow money, 20, 30 times over, and profit each month from the difference. A consistent profit. Just as consistent if you bought a CDO with Treasuries and held it. And again, borrowed 30 times your capital to profit from it.
The reason these mortgages are so intractable and can't be pulled apart is that they were only put together for this arbitrage. All of the banks, all of the hedge funds, all of the bizarre clients who bought this junk were relying on a model of unemployment -- as long as unemployment stayed low, people don't default. The model of course was wrong, and that's what wiped out the arbitrage, because the high-interest CDOs suddenly had principal risk, and the low-interest loans that they took against their collateral from the brokerages didn't.
This is all so pertinent because the CDOs weren't packaged with an eye toward maintaining the mortgages underneath, they were packaged strictly so the brokers could make profitable loans to clients to buy the CDOs to do the arbitrage.
Now 80% of the mortgages issued during 2005 to 2007 are in those CDOs, and given that most were issued by brokers who knew nothing about issuance and by scam artists who are out of business, there's simply very little worth to them.
And Merrill knew it. Lehman knew it. Bear knew it. They knew it because all they had to do was read the papers to know where their mortgages were from. They knew it because they knew the loan-to-value of the mortgages within in the CDOs. They knew it because in many cases they had funded hedge funds -- literally started hedge funds with their own borrowed capital -- which then bought this stuff from them on a 30-to-1 basis.
The credit guys knew it, but they were only making about $100,000 and they are easily dismissed. They knew that the hedge funds had to put up more margin to make this thinly capitalized trade, so therefore the bosses knew it too, but they looked the other way.
The only reason Goldman was the only firm that didn't get hit hard -- because they packaged mortgages -- was that they listened to the credit department because it was filled with partners who made a huge amount of money. That was always the Goldman way: to reward people who did a great job who saved the firm every day, not just those who drove revenues.
So Goldman wasn't caught with much inventory, and what they were caught with they were hedged against, and not with AIG for the most part. The stories that said that Goldman demanded that AIG be saved and beseeched Hank Paulson were wrong. They had some counterparty risk in this stuff, but for the most part they just ran a hedged position, and that's what saved them. (They didn't hedge the private-equity bond exposure, which is where their pain came in.)
The CDO arbitrage was largely unwound by the end of 2008, which is why there is some hope in the system. But as we see from Deutsche Bank, the arbitrage came in many forms and with many bonds, and that's not done. It is a huge user of everyone's capital, and it isn't talked about much.
It should be made aware that it was one of the intractable aspects of this era, because the CDOs were never meant to be anything but pieces of paper to leverage against Treasuries. There is nothing to look through them, and there is no master trust staff to try to fix them. There's just a bunch of guys in a room who send out foreclosure notices and don't make any money anymore.
Until all of these servicers are dealt with the way Goldman Sachs is dealing with things, by slashing the principal, the $2 trillion in issued mortgages will simply keep poisoning us (I am not even talking about whole loans, which are only 20% of the problem).
The reason housing should be fixated upon is because of the servicer problem. They keep pumping out foreclosures as fast as we draw down home inventory. Now that unemployment has spiked -- and the number this morning with revisions is much worse than people are making it out to be -- they will do it faster than there is demand unless Bernanke buys mortgage bonds and we get that $15,000 tax credit to buy just old homes. The new provision includes old and new homes, which is really bad because the homebuilders will be able to stay in business because of that clause. Another example of bad policy condoned by Obama.
The servicers are the problem. They are a legacy of the arbitrage.
They aren't being dealt with other than in the Goldman Litton servicing arm. They are choking us.
All because some hedge funds and brokers figured out a consistent way to make money month after month that was immediately inconsistent when the first homeowners started defaulting and the credit departments issued the margin calls that made the Merrills and Lehmans and Bears take back the CDOs that ultimately sunk the first two ... and now threaten to sink Bank of America, too.
Thursday, February 5, 2009
The "Bank Plan" Can Work
The idea of ring-fencing assets that banks fear might decrease further in value is central to any solution that would compel banks to increase bank credit. With fears about further losses reduced, banks would deploy the massive amount of cash they currently hold (U.S. commercial banks currently hold 10%, or $1.1 trillion of assets, in cash, up from the usual $300 billion), as well as from their securities holdings, where banks are earning less than they could be earned from the net interest margins on new loans.
It looks likely that the Treasury and the Fed will adopt a blended approach, a menu of solutions meant to fit the variety of problems that banks have. One possibility is for the Treasury to inject cash into the Fed as seed money for a special-purpose vehicle that purchases or ring-fences the assets that banks hold. This would be constructed in a way similar to the Fed's Term Asset-Backed Securities Loan Facility (TALF), the $200 billion facility that leverages $20 billion of money from the Treasury to buffer the Fed against losses. Such a design could see the Treasury inject, say, $100 billion that the Fed leverages up to $1 trillion.
Central to any stabilization plan will be the cordoning-off of bad assets. This is necessary to unleash the mountain of cash I mentioned. The excess reserves and their potential for creating new credit (by a factor of 10 to 1) is a major source of optimism regarding the cordoning-off idea.
An added boost that will help revive bank credit will be legislation that encourages homebuying (the $15,000 tax credit for all home buyers) and TARP-related efforts to both boost homebuying through low-interest loans and stem the slide in mortgage foreclosures. Reductions in home inventories will have a major impact on home prices and therefore on financial assets and the real economy.
It looks likely that the Treasury and the Fed will adopt a blended approach, a menu of solutions meant to fit the variety of problems that banks have. One possibility is for the Treasury to inject cash into the Fed as seed money for a special-purpose vehicle that purchases or ring-fences the assets that banks hold. This would be constructed in a way similar to the Fed's Term Asset-Backed Securities Loan Facility (TALF), the $200 billion facility that leverages $20 billion of money from the Treasury to buffer the Fed against losses. Such a design could see the Treasury inject, say, $100 billion that the Fed leverages up to $1 trillion.
Central to any stabilization plan will be the cordoning-off of bad assets. This is necessary to unleash the mountain of cash I mentioned. The excess reserves and their potential for creating new credit (by a factor of 10 to 1) is a major source of optimism regarding the cordoning-off idea.
An added boost that will help revive bank credit will be legislation that encourages homebuying (the $15,000 tax credit for all home buyers) and TARP-related efforts to both boost homebuying through low-interest loans and stem the slide in mortgage foreclosures. Reductions in home inventories will have a major impact on home prices and therefore on financial assets and the real economy.
Traders Manuevering Ahead Of The News
With the "big bang" bank bailout announcement now set for Monday night and the jobs report due out on Friday morning, we have some interesting conditions in place for traders. This bank news is so highly anticipated that it is almost too obvious as a sell-the-news event.
As is the Obama administrations's style, I suspect we are going to have the details of the bank plan slowly leak out before the actual announcement and that we MAY see the sell-the-news happen before the news is out. The bulls may manage a few more good size spikes as some of the details are leaked, and they will run over the overly aggressive shorts, but is it smoother sailing from here? Not sure.
The jobs report tomorrow will also be important. Consensus predictions are for a loss of 500,000 jobs, which is certainly going to give us some ugly headlines. However the inclination of market players lately is to buy bad news. They did it this morning on the weekly unemployment claims, and with the bank news also pending, I'll be looking for a strong inclination to buy a dip on the jobs report.
This market is extremely tricky with everyone trying to game well-known news events. We are still within a trading range, and the big picture of the indices is nothing at all to be excited about, but the intraday action will almost certainly stay quite volatile over the next few days.
As is the Obama administrations's style, I suspect we are going to have the details of the bank plan slowly leak out before the actual announcement and that we MAY see the sell-the-news happen before the news is out. The bulls may manage a few more good size spikes as some of the details are leaked, and they will run over the overly aggressive shorts, but is it smoother sailing from here? Not sure.
The jobs report tomorrow will also be important. Consensus predictions are for a loss of 500,000 jobs, which is certainly going to give us some ugly headlines. However the inclination of market players lately is to buy bad news. They did it this morning on the weekly unemployment claims, and with the bank news also pending, I'll be looking for a strong inclination to buy a dip on the jobs report.
This market is extremely tricky with everyone trying to game well-known news events. We are still within a trading range, and the big picture of the indices is nothing at all to be excited about, but the intraday action will almost certainly stay quite volatile over the next few days.
China Is More Important Right Now Than What's Going On In Congress
China's gonna lead, gonna predict the turn. Is the turn at hand? There is plenty of evidence that the turn has already happened.
Let's tick them down:
1. Baltic Freight Index has more than doubled since the year has begun, from about 660 to 1498, and was up 13% just last night. That's a direct indicator of what is being shipped to China.
2. The Chinese market is up 15%. That's huge, especially when every other major market is down, down big. The Chinese stock market turned viciously bad six months before the dramatic Chinese slowdown, should we not believe it has the power to predict the upside?
3. The Chinese have begun to order iron ore; they haven't been in that market for a long time. That could be the tell for more minerals, and why copper might have bottomed.
I think China, more than anything the Senate or the House is discussing, is moving this market.
Let's tick them down:
1. Baltic Freight Index has more than doubled since the year has begun, from about 660 to 1498, and was up 13% just last night. That's a direct indicator of what is being shipped to China.
2. The Chinese market is up 15%. That's huge, especially when every other major market is down, down big. The Chinese stock market turned viciously bad six months before the dramatic Chinese slowdown, should we not believe it has the power to predict the upside?
3. The Chinese have begun to order iron ore; they haven't been in that market for a long time. That could be the tell for more minerals, and why copper might have bottomed.
I think China, more than anything the Senate or the House is discussing, is moving this market.
More On Mark-To-Market
Mark to market is the ultimate example of pricing fur coats in August. Fur coats in August should never cause this kind of catastrophic weakness in our financial system. Nobody wants to trade these things in this real estate environment, that doesn't means it will last forever. The unintended consequences of this accounting regulation represent the biggest blunder of our economic generation. Bank balance sheets should never be tied to these illiquid assets on a quarterly basis. Even the Accounting Board agrees with me. In their findings published last October they agreed that the market had become inactive and that an income approach to valuation would be much more representative of fair value than the market approach. At least 75% of these things are performing just fine. A repeal of m2m means everything for the stock market.
My Response To The Question "Why Does Mark-To-Market Matter?"
Some are wondering why mark-to-market accounting matters. They state that it is understood it might help improve some balance sheets, but it is not going to make anything more liquid. They imply it will simply result in banks coming up with new ways to value a bunch of junk they cannot sell.
I think this is one complaint by the 'long-and-wrong' crowd that's bona fide.
You have a few, small indices out there such as the ABX or CMBX for asset-backed and commercial mortgage-backed securities that can be pushed around in opaque trading. If those indices reflect lower valuations or a higher probability of default, the banks have to mark their thinly traded or non-traded holdings down to the market in accordance. That leads to a charge against the balance sheet and lowered capacity to lend.
The issue then becomes the ability of the financial system to support the real economy, not to improve the liquidity of various derivative instruments.
I agree that elimination of mark-to-market accounting and replacement with mark-to-model or "mark-to-myth" would lead to abuses by the banks. No one will ever push the pencil against themselves, or as we have seen with the British Bankers Association and LIBOR, against other members of the club. If we bring in outside pricing services to mark the assets, we have a problem the likes of which we have seen with the credit rating agencies.
At the end of the day, the assets must be valued somehow. Marking-to-market against an easily manipulated index is imperfect, as is marking to a self-serving model. The former hurts the holders of the assets; the latter will hurt almost everyone else after the inevitable abuses. Hopefully a constructive alternative can be formulated.
I think this is one complaint by the 'long-and-wrong' crowd that's bona fide.
You have a few, small indices out there such as the ABX or CMBX for asset-backed and commercial mortgage-backed securities that can be pushed around in opaque trading. If those indices reflect lower valuations or a higher probability of default, the banks have to mark their thinly traded or non-traded holdings down to the market in accordance. That leads to a charge against the balance sheet and lowered capacity to lend.
The issue then becomes the ability of the financial system to support the real economy, not to improve the liquidity of various derivative instruments.
I agree that elimination of mark-to-market accounting and replacement with mark-to-model or "mark-to-myth" would lead to abuses by the banks. No one will ever push the pencil against themselves, or as we have seen with the British Bankers Association and LIBOR, against other members of the club. If we bring in outside pricing services to mark the assets, we have a problem the likes of which we have seen with the credit rating agencies.
At the end of the day, the assets must be valued somehow. Marking-to-market against an easily manipulated index is imperfect, as is marking to a self-serving model. The former hurts the holders of the assets; the latter will hurt almost everyone else after the inevitable abuses. Hopefully a constructive alternative can be formulated.
What's Going To Happen The Rest Of 2009 In The Markets? I Don't Know; Here Are Some Logical Speculations Though
a new investment-business paradigm will emerge this year or next; if for no other reason than that the old paradigms have vanished...
in spite of the ecb's continuation of its stupid policies ("we may lower rates next month" - WHY WAIT?), the global economy will reflate - steadily at first, then at an accelerated pace (see the skyrocketing bdi lately?)
over the last 5 months or so, the global financial system has been flooded with liquidity; it is slow to work - but this cannot last forever. there has been an aggressive effort to reflate.
i have significant doubts about how all this will play out over, say, the next decade, but i think it WILL work in the short run. market participants' creeping realization that their risk-taking activities are being heavily subsidized by taxpayer funds will no doubt cause them to embark on a buying spree of epic proportions, that will bring tears of joy to capitalists of every persuasion.
yes, we will suffer from a chronic bout of inflation as a result, but economic agents should and will view this as a worthwhile tradeoff for staving off a very nasty round of DEflation.
ultimately, will we learn any lessons from the white-knuckle ride we've endured in 2008/2009? no. we never do.
in spite of the ecb's continuation of its stupid policies ("we may lower rates next month" - WHY WAIT?), the global economy will reflate - steadily at first, then at an accelerated pace (see the skyrocketing bdi lately?)
over the last 5 months or so, the global financial system has been flooded with liquidity; it is slow to work - but this cannot last forever. there has been an aggressive effort to reflate.
i have significant doubts about how all this will play out over, say, the next decade, but i think it WILL work in the short run. market participants' creeping realization that their risk-taking activities are being heavily subsidized by taxpayer funds will no doubt cause them to embark on a buying spree of epic proportions, that will bring tears of joy to capitalists of every persuasion.
yes, we will suffer from a chronic bout of inflation as a result, but economic agents should and will view this as a worthwhile tradeoff for staving off a very nasty round of DEflation.
ultimately, will we learn any lessons from the white-knuckle ride we've endured in 2008/2009? no. we never do.
Wednesday, February 4, 2009
Stuck In A Trading Range
Uncertainly over the structure of a "big bang" bank bailout jerked the market around sharply today. Financials tried to turn up after two days of weakness, but concern over how equity holders will fare under Geithner's plan weighed heavily on Bank of America, and that undermined the early positive sentiment. We did have some strength in oil, steel, gold and even semiconductors, but without some clarity as to banks, market players are quick to flip into strength and keep us contained.
If you take a step back and look at the bigger picture, we are clearly stuck in a trading range with plenty of overhead but some decent support. There is no way to have much conviction one way or the other, but one thing for sure is that this isn't a bull market, and we can't even manage to put together a very good bear market bounce so far.
A lot of folks are rightly concerned that the much-anticipated bank solution next week isn't going to restore much stock market confidence. As some of the information leaks out, it doesn't sound like anything new or innovative.
The market is always looking forward, and if this plan was going to be embraced as highly positive, we'd be rallying more now, rather than experiencing this weak action. The market isn't buying it, although some market players are trying to play the spikes caused by periodic bouts of hope. It is that hope that is keeping us from falling into the abyss. That is what a trading range is all about, so we'll see just have to wait and see how it resolves itself as more concrete news is released.
If you take a step back and look at the bigger picture, we are clearly stuck in a trading range with plenty of overhead but some decent support. There is no way to have much conviction one way or the other, but one thing for sure is that this isn't a bull market, and we can't even manage to put together a very good bear market bounce so far.
A lot of folks are rightly concerned that the much-anticipated bank solution next week isn't going to restore much stock market confidence. As some of the information leaks out, it doesn't sound like anything new or innovative.
The market is always looking forward, and if this plan was going to be embraced as highly positive, we'd be rallying more now, rather than experiencing this weak action. The market isn't buying it, although some market players are trying to play the spikes caused by periodic bouts of hope. It is that hope that is keeping us from falling into the abyss. That is what a trading range is all about, so we'll see just have to wait and see how it resolves itself as more concrete news is released.
No Credibility!
This market can't handle a Pelosi-Geithner appearance on top of a hearing about how bogus the SEC is. We just lose all credibility as a country to invest in.
Today's revelations about Bank of America's and Wells Fargo's business-as-usual -- meaning outrageous -- activities (given that they received TARP money) showed how we are not going to be able to transcend the bank stock selloff for more than a day or two.
We have to recognize that this administration will put the execs in the cross hairs and make those who are still doing well and showing it cut back and go into hiding.
Of course, it is hard to rally banks when we have no idea whether they will EVEN EXIST next Wednesday. The planless (perhaps clueless) administration -- the one that seemed to think it had figured out what to do -- is truly hurting this market. I don't know about you, but when I hear pay limits for execs -- even if they make sense -- I hear profit limits on investors. I also think that Geithner might leak, at any time, to one of his myriad fave reporters that he will CRUSH the banks' preferreds, not just the common stock. I say to that: WE WILL BE DOWN AT LEAST 10% IF THAT'S THE PLAN.
Now we feel we are back in the bad old days of weekends waiting for Bear and Lehman and Wachovia. Maybe Geithner likes drama. Funny how everyone but the media is coming around to the view that perhaps Geithner was ACTUALLY INVOLVED with the past ... a past he helped create!
It is too bad. The SKF linkage is bringing down Goldman Sachs along with Bank of America. Wells takes down Morgan Stanley. Why not? They are all in the index, which is much more powerful than the individual stocks.
That's the pattern that has defeated a lot of rallies. I am reluctant to say that this time will be different.
Long GS
Today's revelations about Bank of America's and Wells Fargo's business-as-usual -- meaning outrageous -- activities (given that they received TARP money) showed how we are not going to be able to transcend the bank stock selloff for more than a day or two.
We have to recognize that this administration will put the execs in the cross hairs and make those who are still doing well and showing it cut back and go into hiding.
Of course, it is hard to rally banks when we have no idea whether they will EVEN EXIST next Wednesday. The planless (perhaps clueless) administration -- the one that seemed to think it had figured out what to do -- is truly hurting this market. I don't know about you, but when I hear pay limits for execs -- even if they make sense -- I hear profit limits on investors. I also think that Geithner might leak, at any time, to one of his myriad fave reporters that he will CRUSH the banks' preferreds, not just the common stock. I say to that: WE WILL BE DOWN AT LEAST 10% IF THAT'S THE PLAN.
Now we feel we are back in the bad old days of weekends waiting for Bear and Lehman and Wachovia. Maybe Geithner likes drama. Funny how everyone but the media is coming around to the view that perhaps Geithner was ACTUALLY INVOLVED with the past ... a past he helped create!
It is too bad. The SKF linkage is bringing down Goldman Sachs along with Bank of America. Wells takes down Morgan Stanley. Why not? They are all in the index, which is much more powerful than the individual stocks.
That's the pattern that has defeated a lot of rallies. I am reluctant to say that this time will be different.
Long GS
At Least So Far Today, Dry Bulk Stocks Higher After Big Gain In BDI
Dry bulk shippers represent the strongest group in the market today after a big jump in the Baltic Dry Index (EGLE, EXM, OCNF, GNK, DRYS, DSX all up 10%+). The entire drybulk sector has virtually collapsed over the last year in tandem with plunging charter rates as the global economy weakened materially as the credit crisis spread.
The collapse in the Baltic Dry Index (down over 90% from 2007 highs to December lows) across all vessel markets caused a decline in vessel values which lead to collapsing stock prices. The credit market meltdown has played a significant role in the fallout. Trade finance plays a vital function in the shipping industry and the inability for shippers to garner letters of credit significantly hampered activity.
This area continues to show signs of improvement. Today the stocks are all showing large moves following the biggest gain in the Baltic Dry Index since at least 1985, according to Bloomberg.com. (The Baltic Dry Index (BDI) is an index which measures the changes in prices for shipping raw materials by sea). The Baltic Index has been rising modestly off its lows for the past month, gaining more than 70% off its lows. Some of the reasons cited as the cause of the recent upturn include the resumption of activity after the end of the Chinese New Year holiday (most important to today's move); seasonal demand; iron ore restocking by Chinese steelmakers.
The fiscal stimulus program, coupled with willing flowing capital (Chinese banks have increased lending) is also playing a role. Stimulus funds will likely flow towards infrastructure projects which will increase incremental demand for iron ore and coal and ships for transport. Higher rates will help to lift vessel values which have plunged causing the entire industry to go into capital preservation mode, eliminating dividends, selling off vessels, and canceling vessel orders. Many still remain in breach of debt covenants however and equity dilution remains a key risk.
For instance, there also has been noteworthy company-related news recently that has helped buoy some of these stocks. DRYS, which was in danger of defaulting, reached a reprieve recently, as it announced that it reached an agreement with one of its lenders to restructure two loans facilities. The stock rose 25% in response to that. In addition, on 1/20 EXM announced that it canceled its obligation to buy a Supramax vessel.
Long DRYS
The collapse in the Baltic Dry Index (down over 90% from 2007 highs to December lows) across all vessel markets caused a decline in vessel values which lead to collapsing stock prices. The credit market meltdown has played a significant role in the fallout. Trade finance plays a vital function in the shipping industry and the inability for shippers to garner letters of credit significantly hampered activity.
This area continues to show signs of improvement. Today the stocks are all showing large moves following the biggest gain in the Baltic Dry Index since at least 1985, according to Bloomberg.com. (The Baltic Dry Index (BDI) is an index which measures the changes in prices for shipping raw materials by sea). The Baltic Index has been rising modestly off its lows for the past month, gaining more than 70% off its lows. Some of the reasons cited as the cause of the recent upturn include the resumption of activity after the end of the Chinese New Year holiday (most important to today's move); seasonal demand; iron ore restocking by Chinese steelmakers.
The fiscal stimulus program, coupled with willing flowing capital (Chinese banks have increased lending) is also playing a role. Stimulus funds will likely flow towards infrastructure projects which will increase incremental demand for iron ore and coal and ships for transport. Higher rates will help to lift vessel values which have plunged causing the entire industry to go into capital preservation mode, eliminating dividends, selling off vessels, and canceling vessel orders. Many still remain in breach of debt covenants however and equity dilution remains a key risk.
For instance, there also has been noteworthy company-related news recently that has helped buoy some of these stocks. DRYS, which was in danger of defaulting, reached a reprieve recently, as it announced that it reached an agreement with one of its lenders to restructure two loans facilities. The stock rose 25% in response to that. In addition, on 1/20 EXM announced that it canceled its obligation to buy a Supramax vessel.
Long DRYS
Tuesday, February 3, 2009
I Must State This
As the fictional Hyman Roth said to the equally fictional Michael Corleone in the very real Godfather II, "This is the business we've chosen." Each of us needs to remind ourselves at all times of the rules, both the written and especially the unwritten, that govern our affairs within a given business.
To that end, an absolute good riddance to Tom Daschle, the latest entrant in the Leona Helmsley "taxes are for little people" parade. If you are going to be in public life, if that's the business you have chosen, you have to be prepared for the well-greased rubber glove as a cost of doing that business. What, Tom, did you think you were invisible?
This leaves Tim Geithner in an untenable position. I cannot imagine the career IRS examiners are very pleased about having a two-bit tax cheat's picture on their wall. It's time to spend more time with the family and pursue personal interests, Timmy Boy.
I'll be thinking about this while I prepare my future tax returns, and then have some sanctimonious political lowlife tell me about how my "fair share" should in fact be much higher.
To that end, an absolute good riddance to Tom Daschle, the latest entrant in the Leona Helmsley "taxes are for little people" parade. If you are going to be in public life, if that's the business you have chosen, you have to be prepared for the well-greased rubber glove as a cost of doing that business. What, Tom, did you think you were invisible?
This leaves Tim Geithner in an untenable position. I cannot imagine the career IRS examiners are very pleased about having a two-bit tax cheat's picture on their wall. It's time to spend more time with the family and pursue personal interests, Timmy Boy.
I'll be thinking about this while I prepare my future tax returns, and then have some sanctimonious political lowlife tell me about how my "fair share" should in fact be much higher.
Stirring Up Momentum?
It as an odd day, with the glaring weakness in financials that are obviously not acting like they are about to see relief from their lows. Nonethless market players were hungry for action and stirred up some momentum in groups like biotechnology, which are not as sensitive to earnings results.
Given the weakness today in Bank of America, American Express, General Motors, Citigroup, JPMorgan Chase and GE, we still managed some impressive point gains in the major indices. The strength was in biotechs, retail, steel, homebuilders, coal and some commodity-related names. Breadth on the Nasdaq was only about 1,550 to 1,150 and volume was just average.
The surge this afternoon may have corresponded with some headlines that Treasury Secretary Geithner plans to be "very aggressive" with fiscal policy. I don't think that is a particularly surprising revelation but the tendency of this market lately has to been to spike on any talk about potential governmental plans. It's only after they are on the table and more carefully scrutinized that the selling begins anew.
Technically, the market is in the middle of a trading range. There is some formidable resistance for the S&P 500 as it approaches the 860 area, which allows for a decent upside from here and there is also some good support at the lows we hit last month. However, it continues to be a market dominated by very short-term traders with plenty of landmines.
Given the weakness today in Bank of America, American Express, General Motors, Citigroup, JPMorgan Chase and GE, we still managed some impressive point gains in the major indices. The strength was in biotechs, retail, steel, homebuilders, coal and some commodity-related names. Breadth on the Nasdaq was only about 1,550 to 1,150 and volume was just average.
The surge this afternoon may have corresponded with some headlines that Treasury Secretary Geithner plans to be "very aggressive" with fiscal policy. I don't think that is a particularly surprising revelation but the tendency of this market lately has to been to spike on any talk about potential governmental plans. It's only after they are on the table and more carefully scrutinized that the selling begins anew.
Technically, the market is in the middle of a trading range. There is some formidable resistance for the S&P 500 as it approaches the 860 area, which allows for a decent upside from here and there is also some good support at the lows we hit last month. However, it continues to be a market dominated by very short-term traders with plenty of landmines.
Monday, February 2, 2009
Thoughts From The Morning That I Forgot, Until Now, To Post
Although the market had become extended to the upside on volume that certainly didn’t suggest any great effort on the part of the big money to start putting their captial to work (which in turn made the pullback that took shape towards the end of the week not at all surprising) the newsflow certainly didn’t do all that much to help. Once the details regarding the stimulus package became known and word got out that the bad bank plan had hit a snag, market players took that as their opportunity to head back into their bunkers.
Of course, the notion that we were going to get a neat and tidy solution to the monumental problems we are facing is absurd, but there’s been at least a hope that the government might be able to facilitate the pricing of the toxic assets that have arguably acted as the biggest headwind in this economic debacle. We’ll see if new administration and Congress can come up with some new ideas, but those who were hoping for an honest-to-goodness rescue are starting to get nervous.
Most market players understand that time is the only thing that will help us move towards the next phase in the economic cycle, but even if the stimulus bill has a host of unintended consequences along for the ride, at least it would help to restore some confidence to Main Street. So much of economics depends on pure psychology, and if folks think that the government’s actions will help get us back on the right track, then it very well could simply because the expectation that things are getting worse (or better) will oftentimes results in a self-fulfilling prophesy.
We’ll see where the folks on Capitol Hill go from here, but hopefully, Wall Street won’t get themselves in a tizzy over any new proposals and set us up for another ugly failure after the initial wave of euphoria wears off.
The good news is that we are still in okay shape from a technical perspective. We’re above the lows from the 20th, but at the same time, the indices have put in a short-term lower low since the Santa Claus rally fizzled out a month ago. Like we said on Friday, the good news is that we have some clearly defined support and resistance levels, and how the market acts around those areas will give us good insight into what the character of this market might be as we move forward.
Unfortunately, so far this morning, it doesn’t look like market players are too optimistic. We’re off the opening lows, but have pulled back again after the better than expected reading on the ISM manufacturing index. We’ll see if the bulls will be able to regroup as the day progresses, but we’re not too hopeful that they’ll be able to put together a sustained move to the upside.
All in all, the news flow continues to be negative in general, but there have been a couple of bright spots in some earnings reports and economic data. However, the overall mood seems to be rather dour, but on the other hand, further bailout or stimulus news could trigger another round of short-covering by those caught leaning the wrong way and some anxiousness to follow along by underinvested bulls.
The bottom line, then, is that we’re in an interesting spot here as we kick off the new week and month, but again, we are far from having the type of environment that lends itself to building decent positions. Never mind the fact that there just aren’t many charts out there that support any substantial buying. The important thing, then, will be to watch how the pricing action develops, and to have a game plan in place to deal with whatever gets thrown our way.
Of course, the notion that we were going to get a neat and tidy solution to the monumental problems we are facing is absurd, but there’s been at least a hope that the government might be able to facilitate the pricing of the toxic assets that have arguably acted as the biggest headwind in this economic debacle. We’ll see if new administration and Congress can come up with some new ideas, but those who were hoping for an honest-to-goodness rescue are starting to get nervous.
Most market players understand that time is the only thing that will help us move towards the next phase in the economic cycle, but even if the stimulus bill has a host of unintended consequences along for the ride, at least it would help to restore some confidence to Main Street. So much of economics depends on pure psychology, and if folks think that the government’s actions will help get us back on the right track, then it very well could simply because the expectation that things are getting worse (or better) will oftentimes results in a self-fulfilling prophesy.
We’ll see where the folks on Capitol Hill go from here, but hopefully, Wall Street won’t get themselves in a tizzy over any new proposals and set us up for another ugly failure after the initial wave of euphoria wears off.
The good news is that we are still in okay shape from a technical perspective. We’re above the lows from the 20th, but at the same time, the indices have put in a short-term lower low since the Santa Claus rally fizzled out a month ago. Like we said on Friday, the good news is that we have some clearly defined support and resistance levels, and how the market acts around those areas will give us good insight into what the character of this market might be as we move forward.
Unfortunately, so far this morning, it doesn’t look like market players are too optimistic. We’re off the opening lows, but have pulled back again after the better than expected reading on the ISM manufacturing index. We’ll see if the bulls will be able to regroup as the day progresses, but we’re not too hopeful that they’ll be able to put together a sustained move to the upside.
All in all, the news flow continues to be negative in general, but there have been a couple of bright spots in some earnings reports and economic data. However, the overall mood seems to be rather dour, but on the other hand, further bailout or stimulus news could trigger another round of short-covering by those caught leaning the wrong way and some anxiousness to follow along by underinvested bulls.
The bottom line, then, is that we’re in an interesting spot here as we kick off the new week and month, but again, we are far from having the type of environment that lends itself to building decent positions. Never mind the fact that there just aren’t many charts out there that support any substantial buying. The important thing, then, will be to watch how the pricing action develops, and to have a game plan in place to deal with whatever gets thrown our way.
Careening Between Rumors
While we don't have very upbeat action, we are holding support and the dip buyers keep stepping up. There just isn't anything very compelling about it, especially since we are dancing around mainly on news rumors.
We had some major outperformance by the Nasdaq today as big-cap technology names like Microsoft and Intel pushed higher for some reason that isn't very evident to me. On the other hand, energy and retail keep pressure on the S&P 500 and DJIA. Financials were mixed with banks like Bank of America continuing to struggle but Goldman Sachs and Morgan Stanley catching some bids.
The market is caught in a news trough right now. We know this "big bang" financial bailout plan will be announced next week and that the Senate is working on the stimulus bill but we aren't going to have the specifics for at least a week. In the meantime, we are being pushed around as new rumors circulate about potential provisions and approaches.
Technically, the market is reflecting this confused state. We are holding above the lows of January but after the failure last week, we have some pretty substantial overhead. In fact, the pattern in the Nasdaq since mid-December resembles a head-shoulders top and would look particularly ominous if we took out 1,430 or so.
We had some major outperformance by the Nasdaq today as big-cap technology names like Microsoft and Intel pushed higher for some reason that isn't very evident to me. On the other hand, energy and retail keep pressure on the S&P 500 and DJIA. Financials were mixed with banks like Bank of America continuing to struggle but Goldman Sachs and Morgan Stanley catching some bids.
The market is caught in a news trough right now. We know this "big bang" financial bailout plan will be announced next week and that the Senate is working on the stimulus bill but we aren't going to have the specifics for at least a week. In the meantime, we are being pushed around as new rumors circulate about potential provisions and approaches.
Technically, the market is reflecting this confused state. We are holding above the lows of January but after the failure last week, we have some pretty substantial overhead. In fact, the pattern in the Nasdaq since mid-December resembles a head-shoulders top and would look particularly ominous if we took out 1,430 or so.
Why CDSs Deserve To Live
There has been a lot of talk about what to do with the credit default swap (CDS) market. Given that most people had not actively followed the somewhat arcane fixed-income markets until the recent credit crisis, it is surprising how much airplay CDS have received. Are these really the root of all evil? Or do they actually fulfill a valid function in market processes?
Most people have probably heard the analogy that credit default swaps are similar to an insurance policy -- and that may not be a bad way to think about them. If I own a car, I buy insurance, paying regular premiums for the right to "put" my car to the insurance company should I get into an accident. Similarly, a CDS contract is an agreement between two parties where one pays a premium for "protection" on corporate or sovereign debt; in the event that entity should default, the protection buyer is made whole on a par claim.
But simple explanations never fully capture the complexities, and these are derivatives after all. For instance, what constitutes a default? What is the basket of securities that are deliverable? Should it matter if I own or don't own the underlying securities, given that there is a defined set of deliverables?
Before we can have an active discussion, we need to establish a better understanding of the market and its evolution, and then we can pick apart how to handle the shortcomings while maintaining the positives. For what it is worth, I believe that the positives outweigh the negatives in the case of CDS, so this market is worth delving into so we can better understand how to address it.
To start, we need to better appreciate the fixed-income markets more broadly. For the purposes of this discussion, when I refer to the fixed-income markets, I am referring to the corporate debt markets, but a lot of the concepts apply across the fixed-income spectrum. Capital structure aside, the debt markets differ from the equities markets in one key point: how the markets themselves function.
Fixed-income markets do not have exchanges -- there is no order flow to route and match. They are principal-based businesses, meaning that a dealer is on the other side of each transaction acting as principal, either buying bonds from or selling bonds to an end-user.
So if Pimco or Fidelity calls up and asks for a bid on 50 million of XYZ bond, the dealer places a bid as to where it will take down that risk (I'm talking about what happens in "normal" markets...). There is no time to accumulate an order book; dealers use their judgment as to where they can take down the risk and trade (or hedge) their way out of it.
The reason why this is the case is that the debt markets themselves are very fragmented. When we trade equity, everyone knows where to go and find the price. Stocks trade on the NYSE or Nasdaq, and anyone knows where to seek price discovery. There may be slight differences for an odd-lot or a block trade, but they all hover around that observable price.
But if you think of the debt markets, companies issue various forms of debt -- fixed rate, floating rate, secured bank loans, unsecured bonds, subordinated bonds, first mortgage bonds, callable bonds, convertible bonds, maturities that range anywhere from overnight commercial paper to 30 years and any maturity in between (and beyond), issued in various currencies and formats -- euro bonds, DTC-eligible bonds, Samurai bonds, and so on and so on. One company can have dozens, even hundreds, of individual debt issues, yet they have typically only one stock ticker. If I ask, "Where is IBM (IBM) equity trading?," you can log on to the Internet and tell me to the penny. If I ask, "Where is IBM debt trading?," you have to ask me several follow-up questions.
One other critical element is that each debt issue of a company is limited in size. Companies typically only borrow what they need at a time, so you will have debt issuance of $100 million, $200 million, maybe up to $500 million or $1 billion. Only on rare occasions do you get debt issues larger than $1 billion.
Furthermore, since the debt markets are dominated by institutions, many institutions do not lend out their portfolios. Both of these factors combine to connote that the "repo" market for corporate bonds is fragmented, meaning they are hard to borrow in order to deliver into a short sale (particularly in contrast to the equity market, where the float is the float -- it is all fungible, and much of it available to borrow).
What often happens is that if Pimco or Fidelity comes to look for a bond, it ends up in a game of "go fish." If I do not happen to be long the particular issue they are looking for, I have to pass, because I cannot guarantee I can even borrow that bond in order to short it to them. For a lot of issues, they have simply gone to "bond heaven" -- meaning no one will ever see them again, because they are locked up in an insurance company or pension fund portfolio to match a liability stream and will never trade again.
So while bonds may be quoted with a bid and an offer, the offered side generally is subject to having the bonds in inventory. Historically, only the "on-the-run" (usually larger bond deals that were recently issued) had actionable two-way activity. In short, the corporate bond market has historically been an inventory-driven business.
One must also understand that a corporate bond carries risk beyond just the company's ability to repay -- there are other embedded risks (duration and optionality, to name two). Just because I may like Company XYZ, that does not mean that I necessarily want to take on 30 years' worth of interest rate exposure.
This also raises the point that investment-grade bonds typically trade on a yield spread to Treasuries, the risk-free rate. So the parties typically agree to the spread, then agree to the risk-free rate, to give the bond's yield in order to calculate the price. You need to recalculate a price based on that yield at any given time. This has added complexity if the bond is callable or prepayable.
And although I may be comfortable with Company XYZ for the next few years, that doesn't necessarily mean I want to take on XYZ credit exposure for 20 or 30 years. Supply does not always meet demand -- there may be demand for three-year XYZ paper, but only 20-year paper exists.
These issues just scrape the surface. Many factors go into a bond's price and trading, so price discovery on fixed-income instruments can be difficult.
Because of the myriad issues a company may have outstanding in the debt markets, and because of the myriad factors that go into pricing each piece of debt, it is virtually impossible to expect a market construct other than that of a principal market to develop. You need a market maker to step in and provide temporary liquidity and then redistribute that risk. That redistribution process can take weeks. That is the principal's risk; they hopefully make some bid-ask spread to compensate for this.
Enter the credit default swap market. The CDS market helps fill in some of the gaps in the fragmented debt markets. As mentioned at the beginning, the CDS market is focused on a company's credit risk. The premium exchanged strips out other ancillary variables, such as interest rate risk (to be sure, there is some interest rate risk in the pricing model, but nothing to the extent that you see in a fixed-rate corporate bond). CDS can be for terms unrelated to a company's actual debt maturity schedule. CDS are not dependant on being able to borrow a bond, although an active repo market helps establish arbitrage boundaries.
For example, XYZ could have a 10-year bond outstanding that trades at 220 basis points more than Treasuries. To price that bond, I need to know where the 10-year Treasury is, add the spread and then price the bond. But I may not want to take 10 years of XYZ exposure, or 10 years of interest rate risk. And a dealer might not have the bonds, even if I wanted them.
With CDS, I may be able to take on XYZ credit exposure for five years and get paid 150 basis points. This distills my trade to just focus on the credit risk of XYZ for five years. I have not taken on the concomitant interest rate exposure, and I have set the term of my exposure to only five years rather than 10. I get paid 150 basis points a year, and if XYZ defaults over that time frame, I need to pay the buyer par in exchange for the defaulted bonds. If I wanted to then take on interest rate exposure, I could always go buy Treasuries with the maturity of my choice.
When the first formal credit derivatives standards were put forth in 1998, CDS won out over the total return swap (TRS) market in terms of single-name risk transfer, because CDS were viewed as a "unifier" in these fragmented markets. As opposed to the TRS market, which is based on the total return of one bond, the CDS contract allows for multiple deliverables (similar to bond futures), so liquidity extends beyond any singular debt issue. One could deliver any bond or loan, any maturity, any G7 currency, of a given company to fulfill a contract. This created bridges across all of these markets and players, from the convert arb to the bank loan portfolio manager -- they could all meet up in the CDS market. Thus we could reach price discovery that truly had input from all players in the credit markets.
I can use CDS to quickly shed or take on exposure. I can customize my exposure. Say a company only has a 10-year and 30-year bond outstanding, but I only wish to take five years of exposure. With CDS I can do so. As a market maker, I will be more willing to take down a larger block of bonds if I know I can hedge the "jump to default" exposure, thus liquidity can be increased. I can better control my "spread duration" (duration is essentially the price reaction to a change in interest rates or in this case, spread). Furthermore, the advent of the CDS market has raised the level of sophistication in pricing corporate debt into components. Generally speaking, CDS help facilitate more complete corporate debt markets.
That isn't to say that the CDS market is free of issues, but I believe the issues can be managed in a way that does not call for draconian measures such as complete abolition or require their use for hedging purposes only. In the next section, we'll take a look at some of the issues surrounding CDS -- some valid, some not so valid -- and explore possible mitigants to the concerns.
Most people have probably heard the analogy that credit default swaps are similar to an insurance policy -- and that may not be a bad way to think about them. If I own a car, I buy insurance, paying regular premiums for the right to "put" my car to the insurance company should I get into an accident. Similarly, a CDS contract is an agreement between two parties where one pays a premium for "protection" on corporate or sovereign debt; in the event that entity should default, the protection buyer is made whole on a par claim.
But simple explanations never fully capture the complexities, and these are derivatives after all. For instance, what constitutes a default? What is the basket of securities that are deliverable? Should it matter if I own or don't own the underlying securities, given that there is a defined set of deliverables?
Before we can have an active discussion, we need to establish a better understanding of the market and its evolution, and then we can pick apart how to handle the shortcomings while maintaining the positives. For what it is worth, I believe that the positives outweigh the negatives in the case of CDS, so this market is worth delving into so we can better understand how to address it.
To start, we need to better appreciate the fixed-income markets more broadly. For the purposes of this discussion, when I refer to the fixed-income markets, I am referring to the corporate debt markets, but a lot of the concepts apply across the fixed-income spectrum. Capital structure aside, the debt markets differ from the equities markets in one key point: how the markets themselves function.
Fixed-income markets do not have exchanges -- there is no order flow to route and match. They are principal-based businesses, meaning that a dealer is on the other side of each transaction acting as principal, either buying bonds from or selling bonds to an end-user.
So if Pimco or Fidelity calls up and asks for a bid on 50 million of XYZ bond, the dealer places a bid as to where it will take down that risk (I'm talking about what happens in "normal" markets...). There is no time to accumulate an order book; dealers use their judgment as to where they can take down the risk and trade (or hedge) their way out of it.
The reason why this is the case is that the debt markets themselves are very fragmented. When we trade equity, everyone knows where to go and find the price. Stocks trade on the NYSE or Nasdaq, and anyone knows where to seek price discovery. There may be slight differences for an odd-lot or a block trade, but they all hover around that observable price.
But if you think of the debt markets, companies issue various forms of debt -- fixed rate, floating rate, secured bank loans, unsecured bonds, subordinated bonds, first mortgage bonds, callable bonds, convertible bonds, maturities that range anywhere from overnight commercial paper to 30 years and any maturity in between (and beyond), issued in various currencies and formats -- euro bonds, DTC-eligible bonds, Samurai bonds, and so on and so on. One company can have dozens, even hundreds, of individual debt issues, yet they have typically only one stock ticker. If I ask, "Where is IBM (IBM) equity trading?," you can log on to the Internet and tell me to the penny. If I ask, "Where is IBM debt trading?," you have to ask me several follow-up questions.
One other critical element is that each debt issue of a company is limited in size. Companies typically only borrow what they need at a time, so you will have debt issuance of $100 million, $200 million, maybe up to $500 million or $1 billion. Only on rare occasions do you get debt issues larger than $1 billion.
Furthermore, since the debt markets are dominated by institutions, many institutions do not lend out their portfolios. Both of these factors combine to connote that the "repo" market for corporate bonds is fragmented, meaning they are hard to borrow in order to deliver into a short sale (particularly in contrast to the equity market, where the float is the float -- it is all fungible, and much of it available to borrow).
What often happens is that if Pimco or Fidelity comes to look for a bond, it ends up in a game of "go fish." If I do not happen to be long the particular issue they are looking for, I have to pass, because I cannot guarantee I can even borrow that bond in order to short it to them. For a lot of issues, they have simply gone to "bond heaven" -- meaning no one will ever see them again, because they are locked up in an insurance company or pension fund portfolio to match a liability stream and will never trade again.
So while bonds may be quoted with a bid and an offer, the offered side generally is subject to having the bonds in inventory. Historically, only the "on-the-run" (usually larger bond deals that were recently issued) had actionable two-way activity. In short, the corporate bond market has historically been an inventory-driven business.
One must also understand that a corporate bond carries risk beyond just the company's ability to repay -- there are other embedded risks (duration and optionality, to name two). Just because I may like Company XYZ, that does not mean that I necessarily want to take on 30 years' worth of interest rate exposure.
This also raises the point that investment-grade bonds typically trade on a yield spread to Treasuries, the risk-free rate. So the parties typically agree to the spread, then agree to the risk-free rate, to give the bond's yield in order to calculate the price. You need to recalculate a price based on that yield at any given time. This has added complexity if the bond is callable or prepayable.
And although I may be comfortable with Company XYZ for the next few years, that doesn't necessarily mean I want to take on XYZ credit exposure for 20 or 30 years. Supply does not always meet demand -- there may be demand for three-year XYZ paper, but only 20-year paper exists.
These issues just scrape the surface. Many factors go into a bond's price and trading, so price discovery on fixed-income instruments can be difficult.
Because of the myriad issues a company may have outstanding in the debt markets, and because of the myriad factors that go into pricing each piece of debt, it is virtually impossible to expect a market construct other than that of a principal market to develop. You need a market maker to step in and provide temporary liquidity and then redistribute that risk. That redistribution process can take weeks. That is the principal's risk; they hopefully make some bid-ask spread to compensate for this.
Enter the credit default swap market. The CDS market helps fill in some of the gaps in the fragmented debt markets. As mentioned at the beginning, the CDS market is focused on a company's credit risk. The premium exchanged strips out other ancillary variables, such as interest rate risk (to be sure, there is some interest rate risk in the pricing model, but nothing to the extent that you see in a fixed-rate corporate bond). CDS can be for terms unrelated to a company's actual debt maturity schedule. CDS are not dependant on being able to borrow a bond, although an active repo market helps establish arbitrage boundaries.
For example, XYZ could have a 10-year bond outstanding that trades at 220 basis points more than Treasuries. To price that bond, I need to know where the 10-year Treasury is, add the spread and then price the bond. But I may not want to take 10 years of XYZ exposure, or 10 years of interest rate risk. And a dealer might not have the bonds, even if I wanted them.
With CDS, I may be able to take on XYZ credit exposure for five years and get paid 150 basis points. This distills my trade to just focus on the credit risk of XYZ for five years. I have not taken on the concomitant interest rate exposure, and I have set the term of my exposure to only five years rather than 10. I get paid 150 basis points a year, and if XYZ defaults over that time frame, I need to pay the buyer par in exchange for the defaulted bonds. If I wanted to then take on interest rate exposure, I could always go buy Treasuries with the maturity of my choice.
When the first formal credit derivatives standards were put forth in 1998, CDS won out over the total return swap (TRS) market in terms of single-name risk transfer, because CDS were viewed as a "unifier" in these fragmented markets. As opposed to the TRS market, which is based on the total return of one bond, the CDS contract allows for multiple deliverables (similar to bond futures), so liquidity extends beyond any singular debt issue. One could deliver any bond or loan, any maturity, any G7 currency, of a given company to fulfill a contract. This created bridges across all of these markets and players, from the convert arb to the bank loan portfolio manager -- they could all meet up in the CDS market. Thus we could reach price discovery that truly had input from all players in the credit markets.
I can use CDS to quickly shed or take on exposure. I can customize my exposure. Say a company only has a 10-year and 30-year bond outstanding, but I only wish to take five years of exposure. With CDS I can do so. As a market maker, I will be more willing to take down a larger block of bonds if I know I can hedge the "jump to default" exposure, thus liquidity can be increased. I can better control my "spread duration" (duration is essentially the price reaction to a change in interest rates or in this case, spread). Furthermore, the advent of the CDS market has raised the level of sophistication in pricing corporate debt into components. Generally speaking, CDS help facilitate more complete corporate debt markets.
That isn't to say that the CDS market is free of issues, but I believe the issues can be managed in a way that does not call for draconian measures such as complete abolition or require their use for hedging purposes only. In the next section, we'll take a look at some of the issues surrounding CDS -- some valid, some not so valid -- and explore possible mitigants to the concerns.
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