回复: Survival of the Unfittest
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.
