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cloud_zhou - 2008/8/5 15:06:00
Survival of the Unfittest by Michael Lewitt
"Canwe doubt (remembering that many more individuals are born than canpossibly survive) that individuals having any advantage, howeverslight, over others would have the best chance of surviving andprocreating their kind? On the other hand, we may feel sure that anyvariation in the least degree injurious would be rigidly destroyed.This preservation of favourable individual differences and variations,and the destruction of those which are injurious, I have called NaturalSelection, or the Survival of the Fittest." - Charles Darwin, The Origin of Species (1859)
Honest to God, HCM istrying to find the light at the end of the dark tunnel that the U.S.economy and financial markets have become. But every time we turnaround, regulators and other power brokers continue to avoid making thehard choices necessary to deal with the problems at hand. As a result,the practices that led the current credit crisis are being preserved,and changes that could lead to more stable and healthy markets arebeing pushed into the future (perhaps forever). The last month hasprovided so much grist for this mill that we hardly know where tobegin, but begin we must. Our survey of what can only be described as aregulatory wasteland begins with the SEC's misbegotten short-sellinglegislation. Regulatory Malfunction On July 21, 2008,the United States Court of Appeals for the Third Circuit overturned a$550,000 indecency fine against CBS for airing singer Janet Jackson'swardrobe malfunction during the 2004 Super Bowl halftime show. Thecourt ruled that the Federal Communications Commission had"capriciously departed" from its policy over the past 30 years ofpolicing the airwaves with "practiced restraint" when it imposed thefine. Importantly, the court stated that, "[l]ike any agency, the FCCmay change its policies without judicial second- guessing. But itcannot change a well-established course of action without supplyingnotice of and a reasoned explanation for its policy departure." Thisdemand for consistency and fair warning in the law has been absent fromenforcement of the nation's securities laws for many years, resultingin botched prosecutions, inconsistent regulation, and damage to thesystem. The latest example of regulatory malfunction in thefinancial markets is the SEC's limitations on selling short the stocksof 19 financial firms. Readers should understand that this stopgapmeasure will have absolutely no impact on the underlying value or thelong-term stock prices of these companies. This is merely a politicalbone being thrown to those who would sooner blame short-sellers for thecredit crisis than the institutions (and the individuals responsiblefor mismanaging them) who acted in a wholly irresponsible manner. LeonCooperman, one of this generation's great investors and a man alwayswilling to speak his mind, described the situation very frankly in arecent interview in Barron's: "The financial economy is indisarray and that is really a result - and you can quote me on this -of imprudent financial activity by the commercial banks and investmentbanks. They levered themselves up. They did things that were foolish.They should be ashamed of the way they conducted themselves, and nowthey have to right that, and they are de-leveraging."1 Byengaging in selective protectionism of a few favored companies ratherthan re- imposing the uptick rule and treating all companies equally,the SEC furthered the appearance of favored treatment for largeinstitutions that raises serious moral hazard concerns and dampensconfidence in U.S. financial markets. The following is the list of the19 firms that the powers-that-be decided were worthy of specialprotection from market forces: Amongthe more interesting aspects of this list is the fact that more thanhalf the names are non- U.S. firms enjoying the protection of the U.S.regulators and the fact that some large U.S.-based firms that areclearly being pummeled by short-sellers are missing from the list (i.e.Wachovia Corp., AIG International Group, Inc., Washington Mutual). Theostensible basis for inclusion on the list - status as a primarydealers plus Fannie and Freddie - speaks to the reactionary nature ofthe rule-making. Finally, this desperate measure is yet another exampleof the capitalism-for-the poor, socialism-for-the-rich economic modelthat American financial authorities have adopted over the past twodecades. As has been widely noted, the SEC effectivelyrestricted "naked short selling" several years ago but failed toadequately enforce the rule. ("Naked short selling" involves sellingshort shares of stock that one has not borrowed or determined areborrowable. As The King Report points out, SEC Release 34-50103dated July 28, 2004 states that Rule 203(b)(3) "requires anyparticipant of a registered clearing agency...to take action on allfailures to deliver that exist in such securities ten days after normalsettlement date, i.e., 13 consecutive settlement days. Specifically,the participant is required to close out the fail to deliver positionby purchasing securities of like kind and quantity." A "thresholdsecurity" is defined as a stock experiencing an unusually high numberof fails to deliver. A "fail to deliver" is a failure to actuallydeliver shares that have been borrowed to effect a short sale and aremost commonly associated with "naked" short sales. Rule 203(b)(3) isthe rule that the SEC has failed to enforce with sufficient teeth,effectively allowing "naked" short selling to run rampant.) As aresult, when it announced that it would enforce the rule selectivelywith respect to a select number of financial stocks that had beenbattered by short sellers (ignoring the fact that a number of thesecompanies had posted tens of billions of dollars of losses due to grossmismanagement and deserved to be sold), the agency effectively admittedthat it had been failing to enforce its own rules. The SEC'sannouncement predictably sent holders of naked short positionsscrambling to borrow stock while other short sellers ran to cover theirpositions in these and other financial stocks in anticipation of arally in these shares. The result was a historic rally in financialshares that was given a boost by the bailout of Freddie and Fannie butwas wholly unrelated to any improvement in the underlying businesses ofthe companies whose stock prices rose so sharply. The realquestion is why the SEC did not reinstitute the uptick rule, which, inone of the those coincidences that you can't make up, was repealed onthe same day that the Bear Stearns' hedge fund problem came to light,June 13, 2007. Re-imposing the uptick rule on all stocks rather thantrying to protect a handful of financial stocks from the verdict of themarket would seem to be a far more enlightened method of regulation. HCM has made this point before, writing in April (The HCM Market Letter, April 1, 2008, "How To Fix It") the following: "Shortselling is an absolutely legitimate way to invest or hedge a portfolio.The SEC made a major error when it repealed the [uptick] rule lastyear. The repeal of this rule increased downside volatilityexponentially and contributed to the ability of quantitative and othercomputer-driven selling to push the market lower based on technicalrather than fundamental investment considerations. The SEC should reinstitute the [uptick] rule immediately." (emphasis in original) Inaddressing concerns that short-sellers are unfairly targeting financialstocks, the SEC had a choice about how to proceed. By taking the pathit did, it appears to have continued an unfortunate tradition ofenforcing rules that are already on the books but that practitionershave practiced with relative impunity because regulators have allowedthem to. The King Report noted that the New York Stock Exchangefined and censured J.P. Morgan Chase, Citigroup, Daiwa Securities,Goldman Sachs and Credit Suisse two years ago for failing to enforcerules against naked short selling.3 Apparently thesepenalties (which were a couple of million dollars) were insufficient toend the abuses, and the fines were treated as just another cost ofdoing business. Wall Street firms that lend stock and bonds toshort sellers earn enormous profits from such activities. According toa recent article in the Financial Times, "US prime brokeragefirms, most of which are owned by big Wall St. banks, will reap revenueof $11 bn this year" from lending stock to facilitate short-selling.4Accordingly, the securities industry has very little interest in seeingany crackdown on short-selling. Fines of a couple of million dollarsare hardly sufficient to dissuade them from ignoring the rules whenthey stand to earn billions of dollars from the activity in question.As distasteful as it is to see the largest financial institutions inthe world thumb their noses at the rules, it is even more discouragingto see the regulators allow them to do so. What most disturbed HCM aboutthe SEC's decision was the fact that it is just the latest example ofthe beggar-the-poor, boost-the-rich policies that the Americanfinancial authorities have followed over the past two decades. HCM understandsperfectly well that allowing financial institutions to fail is not aviable policy either politically or economically. But while thegovernment acted literally overnight to protect Goldman Sachs andLehman Brothers and 17 other financial institutions and their alreadywealthy executives, Congress took much longer to debate and pass amortgage rescue plan to help the millions of less fortunate homeownerswho are on the verge of losing their homes. There is obviously anenormous difference between an agency's ability to issue a ruleovernight and Congress's ability to legislate, but at some point - andthat point is coming sooner rather than later in HCM's opinion- the American people are going to ignore that distinction and ask whyWall Street continues to get bailed out before Main Street. There isnothing pre- ordained about the policy choices that are being made. AsProfessor Lawrence E. Mitchell writes in his recent book, TheSpeculation Economy, "modern American corporate capitalism is theresult of human choices. It is a system we maintain out of choice. Itis a system that has ramifications beyond the economic that have helpedto embed social norms of individualism that interfere with thecooperation necessary for a successful economy and a thriving society.It is within our power to change it, to modify its rough edges or toaccept it as it is. But these choices can only be made withunderstanding."5 Smoothing out the rough edges is a verymild version of what needs to be done. What needs to be done is to makedifficult policy choices that will necessarily involve the inflictionof pain on certain constituencies that have thus far been protectedfrom the consequences of their own sins. HCM is notproposing that the authorities stand by with their hands in theirpockets while firms like Fannie Mae and Freddie Mac or Bear Stearnsface collapse. What HCM is arguing, however, is that suchrescue plans should not provide protection for the shareholders ofthese companies. The minute the U.S. government was compelled to openthe discount window to the investment banks, it should have made itvery clear that there would be no support for the shareholders of thesecompanies. Bear Stearns' shareholders received $10/share more than theydeserved when that company was bailed out by the Federal Reserve andJ.P. Morgan Chase. This leads to a conclusion that was discussed several months ago in this publication (The HCM Market Letter,April 1, 2008, "How To Fix It"). Since it is apparent that we are notprepared to allow certain firms to fail, then we must take steps tolimit their ability to endanger the system in the first place. Thisrequires rules that impose limitations on financial institutions'leverage; eliminates their ability to conceal assets and liabilities inopaque off-balance sheet entities; restricts asymmetric compensationschemes that reward insiders for taking indecent risks with theirfirms' capital at the expense of shareholders and ultimately taxpayers;and adopt economic and monetary policies that encourage productiveinvestment rather than speculation. This is no small order, but it iseminently achievable. Moreover, it is absolutely necessary if Americancapitalism is going to continue to flourish and maintain the confidenceof the keepers of the world's capital in the years ahead.
cloud_zhou - 2008/8/5 15:07:00
Sticking One's Head In The Sand In April, HCM wrotethe following about the egregiously leveraged off-balance sheetentities known as Structured Investment Vehicles (SIVs) that inflictedso much damage on the global financial system (The HCM Market Letter, April 1, 2008, "How To Fix It"): "Offbalance sheet entities should be outlawed immediately, plain andsimple. If first Enron and now the SIVs haven't taught us the necessarylessons about hidden liabilities, the system probably doesn't deserveto survive. Speaking as someone with extensive knowledge of theseoff-balance sheet entities, it would not be difficult to render themextinct relatively easily. It would be doing the world a favor." OnJuly 30, the Financial Accounting Standards Board (FASB) reluctantlycaved in to pressure from the very institutions that created theseoff-balance sheet monstrosities and agreed to delay for one-year (aperiod that will undoubtedly become extended if the financial industryremains under pressure a year from now) the introduction of rules thatwould have forced banks to consolidate more off-balance sheet vehiclesonto their balance sheets. FASB Chairman Robert Herz did not go gentlyinto the good night, however, admitting, "t does pain me to allowsomething that has been abused by certain folks, to let that go foranother year." Mr. Herz also noted that he was "chagrined" by what hadbeen uncovered about these vehicles as the new rule was being prepared,noting that a combination of poor reporting and lax enforcement had ledto the current situation. The FASB was caught between a rockand a hard place. The reality is that banks can't absorb additionalliabilities onto their balance sheets at the current time withoutviolating capital rules. These institutions are barely capable ofremaining solvent as it is. They are continuing to report massivewrite-offs and are experiencing tremendous resistance when they try togo back to the well to raise additional capital. Accordingly, requiringthe addition of what may amount to several trillion dollars ofoff-balance sheet liabilities onto banks' balance sheets is simplyinconceivable at the present time because it would automatically renderseveral of the world's largest financial institutions (includingseveral on the protected species list from attacks from short-sellers)instantly insolvent. But giving banks a one-year reprieve may simplybuy them time to develop other strategies to keep these assets hiddenin the opaque shadow banking system. Moreover, regulators needto assure global investors that no new vehicles of this type will bepermitted to be formed in the future. News that the new rule has beendelayed suggests that the balance-of-power still lies with institutionsthat remain too large to fail and can still lord it over regulators bypointing to the catastrophic consequences that hard-and-fast accountingstandards will unleash on the financial industry. But the result isthat the system sticks its head in the sand for another year as itprays for a recovery in the value of the trillions of dollars of highlycomplex and illiquid securities (many of them derivatives). HCM would wager heavy money that we have not heard the last about delaying adoption of this rule. Merrill Lynch: The Dundering Herd MerrillLynch & Co. Inc.'s decision to dump $30.6 billion of mortgagesecurities at an average price of $0.22 on the dollar barely a weekafter its quarterly earnings announcement (which itself included a $10billion write-down on such securities!) raises more questions thananswers about the firm and the prospects for credit markets to recoverfrom their current crisis. Merrill Lynch agreed to sell thesesecurities to Lone Star Funds for $6.2 billion, yet barely two weeksearlier the sale the firm had valued those identical securities at$11.1 billion. Moreover, the sale is structured in such a way thatMerrill Lynch is financing 75 percent of the transaction. This meansthat Lone Star is on the hook for the first $1.7 billion of losses, andthen Merrill Lynch will eat any losses beyond that. In other words,another $0.05 drop in the value of these securities would leave MerrillLynch back on the hook for more losses. Either this will prove to beone of the most desperate transactions done in the annals of thecurrent credit crisis, or John Thain knows something the rest of usdon't want to know about the real value of the toxic waste he just soldto Lone Star. At the same time, Mother Merrill announced the sale of380 milion new shares of stock to raise $8.5 billion in new equitycapital. The issuance of additional shares at current prices triggereda make-whole provision in an earlier share sale to Singapore's stateinvestment agency, Temasek that cost Merrill Lynch $2.5 billion.Temasek, the firm's largest shareholder, turned around and reinvestedthis $2.5 billion in Merrill's new share offering along with anaddition $900 million. These announcements not only left Merrill Lynchshareholders severely diluted but, if they had been paying attention tothe quarterly earnings call, deluded. This transaction may constitute one of the oddest corporate announcements in recent memory.6First, it suggests that Merrill Lynch's quarterly earnings announcementwas grossly inaccurate since, with respect to these assets alone, thefirm's valuation was apparently off by a factor of 40 percent. Second,it raises serious questions about the values all financial firms areplacing on their mortgage securities. Either Merrill is alone inmis-marking its book by 40 percent, or other firms are grosslyover-valuing their holdings and will be forced to report largewrite-offs in the third quarter. What is particularly troubling (butgives the anti-quantitative HCM a wonderful dose of schadenfreude)is the enormous gap in valuations that different firms (i.e. Lone Starand Merrill Lynch) can apparently derive from securities that areallegedly valued according to mathematical models whose precision issuch that they would have problems hitting the side of a barn. Andnaturally Merrill Lynch's announcement, which included a highlydilutive share sale to compensate for the multi-billion capital losssuffered by the firm, led to a rally in the firm's stock price. Let usget this straight - the firm admits that it grossly mis-marked itsbook, reports a(nother) multi-billion dollar loss, announces a hugelydilutive stock offering, and the stock rallies? Makes perfect sense tous. And people wonder how and why the financial markets continuallyfall into crisis! Fannie and Freddie Merrill Lynch'actions raise a more serious question, however, which is why investorswould bet on a recovery in financial institutions at all at this pointin time? The reason to do so, it seems, lies more in a bet on whatpublic officials will do than on whether these companies are worthyinvestments or will have any future value. Investors betting on aturnaround in financial shares are really betting on whether governmentofficials are going to allow these companies to fail. Thus far, itappears that the answer is a resounding "no." The government hasdemonstrated that it will do everything in its power (and sometimesmore than its power expressly permits) to prevent failure. Thequestion, of course, is whether the size of the problems at some pointwill exceed even the government's grasp. The bailout of FannieMae and Freddie Mac is particularly bizarre in this respect. The veryfact that a bailout was necessary demonstrated beyond a shadow of adoubt that the entities were insolvent and that the public shareholdersshould have lost all of their money. The only reason these twocompanies were not forced to declare bankruptcy is that the U.S.government agreed to stand behind their obligations. Yet the stockscontinued to trade at a value greater than zero and will not be wipedout by the government support plan. Yet the real shareholders in termsof bearing the biggest risk of loss in these companies are no longerthe holders of the publicly traded shares but the American taxpayers,who are effectively guaranteeing the companies' multi-trillion dollarobligations. Accordingly, the taxpayers should be the ones who receivedany gains on the equity value of these dinosaurs as they arerestructured to operate in the future.7 Just becausegovernment officials state that they don't "expect" such guarantees tobe called upon doesn't erase the fact that such obligations are inplace and must be honored. To put it politely, Treasury SecretaryPaulson and Congress effectively picked the pockets of the Americanpeople by denying them the upside on their new investment in Fannie andFreddie. And despite passage of the bailout plan, investors in the agencies are not necessarily out of the woods, as HCM suggested earlier this month. On July 9, HCM warnedthat investors should be cautious in betting on the unsecuredobligations of Fannie and Freddie, writing "investors should notpresume that a federal bailout will provide a lifeline to all of thecompanies' investors....subordinated debt holders also should notexpect protection in a bailout that would not only be unprecedented insize but also cast the United States' balance sheet and currency in awholly unfavorable light." (The HCM Market Letter, July 9, 2008, "The Deepening Crisis"). HCM'scautiousness contrasted sharply with the statements and actions of bondgiant PIMCO, which has effectively bet the ranch on the debt securitiesof Freddie and Fannie based on a belief that the government would neverpermit these institutions to fail. But sure enough, proving once morethat even paranoids have enemies, S& P announced on July 25 that itwas placing Fannie and Freddie's subordinated debt and preferred stockratings on CreditWatch Negative. This was based on the fact that thelanguage in the government plan "increases the likelihood thatsubordinated debt holders and preferred stockholders would face greatersubordination risk. This heightened risk is not incorporated into[S&P's] current subordinated debt and preferred stock ratings onFannie Mae and Freddie Mac. We may lower these issue ratings one to twonotches at the conclusion of our review of the final legislation."8We very much admire the individuals at PIMCO, but we are enteringuncharted territory and recommend investors act with an extra degree ofcaution. It wouldn't be the first time that investors learned the hardway that a security that was deemed riskless turned out to be nothingof the sort.
cloud_zhou - 2008/8/5 15:07:00
Demolition Derby The slow motion death of the Americanautomobile industry is almost too painful to watch. The flood of badnews coming out of Detroit has literally swelled into a tsunami inrecent days, and there is no end in sight. First came anothercredit rating downgrade. On July 31, Standard & Poor's did anothernumber on the industry. In three separate reports, it downgradedGeneral Motors Corp. and GMAC LLC, Ford Motor Co. and Ford Motor CreditCo., and Chrysler LLC and DaimlerChrysler Financial Services AmericasLLC (DCFS). The stated rationale for these downgrades (S&P couldhave chosen a dozen reasons) was basically concern over shrinking cashflows and liquidity at all three companies and their finance arms.While S&P can hardly be blamed for stating the obvious, the ratingagency probably didn't go far enough in continuing to rate theautomakers ‘B-,' one notch above the once infamous CCC+ level. Intoday's world, of course, a CCC+ rating no longer bears the stigma thatit once did, but in the case of these companies, it is only a matter oftime before they bear the insignia of insolvency that such a ratingportends. The world is witnessing a classic case of an industry indenial. Rather than taking the truly radical steps necessary to addressits problems, Big Auto's management is still engaging in incrementalchange in the hope that it can buy itself enough time to effect achangeover to more fuel efficient models. Unfortunately, theseexecutives are doing nobody any favors by delaying the inevitablebalance sheet restructurings that are going to be a necessary componentof the endgame for their industry. Just prior to S&P'smove came the effective collapse of the automobile leasing industry. Inthe days prior to the S&P downgrade, the automobile financingindustry came totally unglued. This is the latest indication of howseverely credit is being rationed at all levels of the U.S. economy.Chrysler Finance was the first of the Big Three automakers' financearms to announce that it would stop extending automobile leases. Thisdecision, which is nothing less than catastrophic for Chrysler'svehicle sales despite unconvincing protests to the contrary by theprivately-owned carmaker, was due to the fact that leasing has beenrendered unprofitable by Chrysler Finance's rising borrowing costs andthe plunging residual value of Chrysler's gasguzzling vehicles.Chrysler debt is trading at levels that suggest an imminent bankruptcyfiling. GMAC and Ford Motor Credit are not expected toeliminate leasing entirely but are likely to severely cut back on autoleases since they can't make any money on these transactions. WellsFargo has also withdrawn from the business of financing car leases.Other financial institutions are sure to follow. The dramaticreduction in the availability of auto financing will be another nail inthe coffin of the American automobile industry (at some point thecoffin will have so many nails in it that it won't need any wood).Leases account for roughly 26 percent of annual auto sales. Just assubprime mortgage financing led many consumers into homes that theycouldn't afford, low-cost auto leases allowed many people to lease carsto which they otherwise wouldn't have had access. Leases also led manyconsumers to replace their vehicles in a much shorter period of timethan they ordinarily would have done, leading to higher auto sales.Automobile manufacturing and financing is a significant component ofthe American economy, and we are watching it being deconstructedpiece-by-piece before our very eyes. The economy is seeing the darkside of what happens when financial engineering creates false demandfor consumer goods that is unsustainable on a fundamental basis. Finally,on the last day of July and first day of August, GMAC and GM issued twolackof- earnings releases that not even the happy faces on financialtelevision could spin in a positive way. On July 31, GMAC released itssecond quarter 2008 results, a loss of $2.5 billion (that would havebeen much worse without $1.55 billion of lease support payments that GMis obligated to make to GMAC under risk-sharing and support agreementsdating from 2006.) GM reported that it has $30 billion in NorthAmerican leases, including $12 billion in SUVs and $6 billion in othertrucks. If current trends hold, GMAC is looking at further multibillionwritedowns on these vehicles. Residential Capital LLC contributed $1.9billion of losses to GMAC during the quarter compared with a $254million loss a year earlier. HCM will leave it to others to tryto find a silver lining at GMAC. The hard truth is that thedeterioration of every aspect of this company is accelerating. Notto be left out in the cold, on August 1, GM announced a grotesque $15.5billion loss for the second quarter of 2008 ($27.33/share on an $11.00stock price for those who are still counting such things). Global salesplunged by 18 percent during the quarter, with U.S. sales fading by 16percent through June. July trends continue to point sharply downward,and the effective elimination of leasing by GMAC can only furtherreduce sales. A significant portion of the loss was attributable tocharges for attrition programs (i.e. job reductions), an adjustment toits reserve for its former parts-maker Delphi Corp., and a $2 billionloss attributable to lower residual values for leased vehicles. But atthis point, HCM would seriously discount the one-time nature ofthese charges, which continue to hit GM's balance sheet with depressingregularity as the company continues to try to dig out from the detritusof its past business structure and history. Backing out these so-calledone-time charges left GM with a $6.6 billion quarterly loss, which wasstill 450 percent larger than analysts projected (which is furtherevidence that nobody, and HCM means NOBODY, has a clue about how GM is going to survive as a going concern). Thelatest news out of Detroit makes it abundantly clear that the endgamefor the Big Three is going to be massive bankruptcy restructurings. Onewould hope that politicians in Washington, particularly the twoPresidential candidates, would begin formulating national energy plansthat include restructuring plans for the American automobile industry.No viable energy plan will meet this country's needs without creatingthe proper tax and other economic incentives to build fuel-efficientvehicles. Rather than continuing to be one of the problems that lie atthe heart of the American economy, the recovery and revitalization ofthe auto industry could be a major component of an economic and energypolicy that could lead this country out of the difficult times we areexperiencing and are doomed to repeat unless we take some bold stepsright now.
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