Monday, September 29, 2008

Congress grows a pair - staring into the abyss

Well, today was a day you only get to experience a few times in your life. Crazy. And you know what, I'm kind of proud of Congress. Seriously. If you've read my prior posts, you know that I've been against this "bailout" (read: subsidy) since the beginning. Before I get into my thoughts on the bailout, I think it is worth explicitly stating that the S&P 500 was down about 9% today on the Wachovia news and the spate of European financial failures (B&B, Fortis, and Hypo), with final capitulation after The House showed some balls and voted down this embarrassment.

That said, I never actually expected them to have the rocks to vote nay. I promise you, it was not easy to say "no". In this case, saying no legitimately means putting the global financial system at risk but doing so because it is what is best for the very long term health of the system.

Having seen a few movies with scenes of a heroin detox process depicted, this seems fairly analogous. As the druggie gets past the state where heroin is fun and into the stage where it is depressing and painful, he knows that his best option is to seek help. But seeking help sucks. He'll often almost get help several times just to succumb to his addiction in ever more painful ways. Going through a detox appears akin to a near death experience. And while it is clearly the better outcome in the long run, it always appears to be a horrifically painful fate in the nearer term. I think that is why so often it requires an external intervention. Someone generally forces the druggie into rehab. This normally happens after they hit a series of new personal lows and start stealing from friends and family to feed the habit.

Well, it's pretty obvious that the debt induced orgy we've been on for the past three decades is our drugs and alcohol. A little debt is like having a few beers: it's great as long as you have some self-control and don't feel like you can't live without a few beers or the number of beers you need to have in order to enjoy yourself is constantly growing. Before you know it, alcoholism manifests itself as a sort of gateway drug and you're a heroin addict. Well, that's how we got from real money buyers allowing their bond portfolios to be repo'd in order to generate a few extra bips to AIG writing CDS on CDO-squareds.

This is one of those cases where I think Congress was better lucky than smart. They voted this down for all the wrong reasons, but at least the conclusion (not that it is truly concluded) was the right one. They voted this down because in our bicameral system, our Founding Fathers decided the House would have to run for re-election every two years. If the bailout bill was up for vote this time last year, I suspect it passes. But with a national election only five weeks away and their constituents against the bailout by a ratio of something like 9:1, passing the bailout was career suicide and these guys have their own addiction that they can't seem to kick: power that comes with office. The reality is, I don't think these guys have any clue that they may have just set off a daisy chain of deleveraging that was already underway, but now has the potential to accelerate in an ugly fashion.

I suspect that the run on the money markets re-accelerates (mind you, it never stopped, which nobody is really talking about). Money market funds that are not purely invested in US Treasuries often serve as a short-term funding source to businesses via things like commercial paper (CP). CP is used by Main Street businesses to manage working capital sort of like a line of credit. The CP cycle allows them to keep very little cash on hand but do things like meet payroll, which is a somewhat lumpy cash event for most businesses. Obviously, as a few businesses miss payroll, folks aren't going to be happy. But frankly, for Main Street businesses, it is a temporary problem. CP is not their life-blood; it's merely a convenience.

For Wall Street businesses and many large'ish banks, CP is part of their lifeblood. It is a funding source that they explicitly rely on. As such, when Lehman went bust, as one of the larger issuers of CP, it actually caused a few money market funds - including the oldest and largest Reserve Fund, to break the buck. This led to lots of money market fund investors to actually look at what their funds were investing in and they freaked out! Other than Treasuries, these funds are often a veritable murderers row of borrowers: Lehman, Goldman, Morgan Stanley, Fannie, Freddie, B of A, Citi, BNP Paribas, ING, ANZ, UBS, off balance sheet vehicles like SIVs, etc., etc., ad nauseum.

When money market investors actually looked at that line-up of underlying investments and realized they'd indirectly lent their cash to the global financial system, everyone ran for the door at once. But the problem is money market funds are really the only natural buyers of CP assets and as all the non-Treasury money market funds shrank at the same time, there were no natural buyers for CP assets and therefore money market funds could not meet their redemptions. Thus money market funds had to freeze redeeming investors which caused an even greater freak-out than breaking the buck. This freezing of some money market funds led to investors in other money market funds to redeem before their fund was frozen as well, effectively leading to runs on all kinds of non-Treasury money market funds.

Most money market investors think of these funds as cash alternatives (my Schwab account, for instance, actually labels my investment in money market funds as "Cash"). Not being able to get your "cash" pisses people off and the redemptions start flying.

So, this self-feeding redemption frenzy actually served as a non-traditional run-on-the-bank. As banks that rely on CP have their old CP loans mature (every month or so), they cannot issue new CP to pay-off the maturing loans. It is just like having an abnormal number of depositors leave at the same time: it causes the bank's liability structure to explode. I imagine that the Federal Home Loan Bank system is overflowing with borrowing requests right now in order to offset the CP evaporation, thus putting the entire system on pins and needles. Further, as CP availability has declined, banks have looked to each other for daily borrowing and this increase in demand coupled with the seemingly endless line of failures has caused banks to become distrustful of each other, leading LIBOR (see the accompanying graph for overnight LIBOR - yowza), swaps, the TED spread, etc. to all blow out to record wides. This means that money has simultaneously become less available and more expensive, a painful combo for an already fragile banking system. As very short term borrowing costs rose, so did longer-term borrowing costs. Everything was widening out at the same time and since lenders didn't have a good sense as to where it would end, the desire to make loans was plummeting. Anyone that actually needed cash was looked at with great skepticism.

This was the state of the market two Wednesdays ago just prior to the Treasury's bailout announcement. At the same time as that announcement, the Fed set up a few programs that would allow money market funds to get liquidity and would guarantee the value of the funds. However, with yesterday's ballsy vote by the House, even with those guarantees, we are back to where we were which is to say we are Staring into the Abyss.

The Bailout:
Hammerin' Hank Paulson is a man I respect a ton. He's in an awful, awful position. The ultimate lose/lose. But I feel like he's been a bit misleading about one thing: The Hammer continues to state that the root cause of the problems in the financial sector are housing and the related illiquid securities (for our purposes, we'll just call those securities "ABS", which is a bit broad). That is false. Those are symptoms of the root cause. The root cause is two fold:
1) too much leverage;
2) bad underwriting.

That really is a toxic combination as the each of the factors magnifies the problems of the other one. So, in my mind, any bailout plan that does not address the real root cause is not what we need and is a distraction from the end goal.

The Treasury's plan, in fact, actually rewards the bad behavior. We are protecting companies from the reality of too much leverage by buying their poorly underwritten assets at premium prices. This is a subsidy, plain and simple. And it's dumb.

If we collectively decide that it is too societally expensive to allow massive failures and we want to instill some calm amongst depositors, then some plan is needed. Thus, if we are going to put We The People's capital at risk, we absolutely must attack the core problems and begin healing. The detox must happen. The problem clearly cannot be put off again, because we may just end up overdosing and killing ourselves (if we haven't already).

So, I'd propose an alternate plan that allows companies to fail from an equity holder and non-depositor lender standpoint:
First: credit ratings agencies will be forced to compete and the current government authorized oligopoly will be loosened with an agency to monitor existing/approve new ratings agencies. Ratings scoring will be standardized and apples to apples across asset classes. The issuer will continue to pay for ratings, but the ratings agencies will have to defer 20% of their revenue to an insurance pool with a five year vesting. In any given one, three or five year period that their aggregate forecasts vary from expected outcomes by more than two standard deviations, some amount of the deferrals are forfeit. In extreme cases, fines could be levied as well. Any forfeit revenue will go to support certain aspects of the regulatory regime. Executive compensation of approved ratings agencies will be subject to the same terms outlined below for bankn executives.

Second: banks have five years to take leverage to no more than 7:1 if the asset mix stays somewhere close to history. Leverage needs to be defined, but I might start by saying that it should be defined as delta adjusted notional exposure of long assets offset by 50% of the delta adjusted notional exposure of hedges. There will still be some risk-based element to the assets that are allowed to be owned. Leverage would be allowed to max at 9:1 if only super high quality assets were owned, as determined by the regulator/ratings agencies.

Third: FDIC expands its insurance level to $250,000 and heretofore, that level is indexed to inflation.

Fourth: during that five year period, any and all FDIC insured banks or thrifts that the pertinent regulator deems at serious risk would be subject to a similar takeover structure as AIG. The government will come in, provide a senior line of credit, cram down the entire capital structure below depositors, replace management if they ran the bank when the problems occurred, receive a massive warrant package, and set a time line for disposition via sale or IPO. These rules must be clearly stated so that depositors know they can depend on them and they must be consistently applied so that lenders and owners can operate in an environment that has some amount of predictability and standardization.

Fifth: During that initial five year period and beyond, for any FDIC insured institution (or insitution involved in the capital markets as a counterparty to an FDIC insured institution with more than $10 billion of notional counterparty exposure), employee compensation in excess of $2 million per year, set to inflation, would be deferred on an even four year vesting schedule (in year one you'd get $2 million, at the end of year two, you'd get 1/4 of the deferred comp, etc.). If the government has to implement an AIG-type plan, all deferred comp is forfeit and goes to the benefit of the FDIC's insurance fund. There is no employment vesting. So, the money is yours, free and clear, as long as your bank/institution does not fail (as defined by the AIG-type takeover) within four years of your last paycheck. This is not at all a limit on compensation, it is merely a recognition that if you are going to rely on a government subsidy for your operations, you need to be incented to behave in a way that minimizes long-term failure.

Sixth: Transparency to the public/depositors must improve somehow.

Finally, the government should immediately loosen ownership restrictions on private equity buyers taking stakes in banks, but force them to over-equitize initially.
In sum, we force leverage down, transparency up, accountability up, and thus underwriting standards up. This improves confidence and soundness and provides a base to begin to grow from again. From a legislator's perspective, it protects depositors (consitituents), punishes poor business decisions, improves incentives, protects tax-payers, and limits similar situations from re-emerging in the future.

What does this mean? I'll give the quick answer here. Regardless of whether my ideas or any other are implemented (including the Treasury bailout), we are going to witness the great deleveraging of our time. Thus, there will be a one-time, painful readjustment in values in order to reflect less available, more stringent, more expensive leverage.

Historically, an 80% Loan to Value ("LTV") loan on a house has been a reasonably safe loan. The buyer's 20% was enough skin in the game to keep him/her/them honest even if it turns out the house price was a bit high. Lenders rarely lost money. A big part of this was that houses were historically appreciating assets (unlike most cars, for example) and thus the lender's margin of safety was growing in two ways: 1) every month the borrower paid back some principal on the mortgage, improving the LTV; and 2) over time the value of the home increased, also improving the LTV.

However, everything seems to have suddenly changed. Borrowers' behavior is less predictable - they are willingly defaulting on their mortgages much more often (even those that had 20% down). Further, home prices are declining. Now, from an aggregate standpoint, that same 80% LTV mortgage seems substantially less attractive to the lender. Their margin for error seems to actually be shrinking rather than growing.

So, what will the rational lender do?
1) delever their balance sheet: in response to the volume of bad loans and the increasingly transitory nature of deposits, banks are going to delever in order to feel they can safely operate. Lenders and owners will require it. Reducing blow-up risk is key. So, fewer loans will be available in aggregate unless we capitalize a bunch of new banks or existing banks raise a ton of equity;
2) raise standards: You're going to make sure the people you loan to are highly unlikely to default - so credit quality will rise, which weeds out certain borrowers;
3) raise your price: You're going to charge wider spreads to your funding costs in order to compensate you for the higher risk you perceive that is associated. This has a depressing effect on asset prices as the cost of acquiring assets rises, all else being equal;
4) lend at lower LTVs: You're going to make borrowers put more of their own skin in the game which a) gives you more protection in case they default and in case asset values continue to decline; and b) makes the borrower less likely to default since he/she/they have more to lose. This will have the effect of weeding out borrowers who haven't saved up enough to be able to put up a bigger chunk of money.

Collectively, those four factors will have a depressive effect on any asset classes that have historically been acquired with borrowed money (LBO targets, real estate, etc.) in order to reflect less competition amongst buyers, to compensate the buyers for the increased cost of borrowing, and to generate attractive returns to the equity. This deleveraging spiral obviously has the ability to feed on itself until one day, it stops.

My guess is it will correct too far and at that point, the man with cash will be in an a once-in-a-lifetime position to profit. Buy assets when the provide reasonably attractive unlevered returns for the risk assumed. Levering those returns would just be gravy.

This is a time to sit and wait. Then when big opportunities come, and they will come if this volatility and deleveraging keeps up, swing hard.


No comments: