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Pathfinder Partners' e-Newsletter
July,
2009 |
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| Pathfinder e-news is a
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Thanks For Writing
In!
Thanks to those of you who have
written in - please keep those cards and letters coming
- we welcome your feedback, questions and comments.
Several of you have asked about guest-writing features
for upcoming newsletters. If you have expertise in an
area that could be of interest to our subscribers,
please email us at info@pathfinderpartnersllc.com with
information about your proposed subject matter - we will
be happy to consider it for a future edition.
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CHARTING THE
COURSE
Down the Rabbit
Hole--Where All News is Good News
By Mitch
Siegler, Senior Managing Director
On June
1, 1925, Lou Gehrig played the first game in his streak
of 2,130 consecutive games; it was the longest such
streak until Cal Ripken, Jr. broke it in 1995. June 1
also marks the birthday of Marilyn Monroe (b 1925) and
German supermodel Heidi Klum (b 1973). This June 1,
General Motors filed for bankruptcy. The market reacted
ebulliently, with the Dow rising 221 points, capping a
rise of 33% to 40% in major stock market indices since
the March 9th lows. We sense that the new and reborn GM
will bear scant resemblance to the aforementioned dates
in history either for its longevity or its beauty.
Lately, all news is good news. In May, Treasury
released the results of its Bank Stress Tests and
ordered ten banks to raise $74.6 billion capital to
cushion themselves against an estimated $599 billion in
losses. While it sounds like a big number and we've been
impressed with the speed and magnitude of the capital
raises (the big banks have reportedly raised $65 billion
in the 45 days since the Stress Test results were
announced), we don't think $74.6 gets these banks close
to where they should be from a tangible capital
perspective. And, that's before we mention the $5.2
trillion (with a "T") in off balance sheet (read "highly
leveraged") assets at just the four largest banks as of
December, 2008, per Bloomberg.
All news is good
news - the stock prices of the big banks have been bid
up, up and away. Bank stocks are cheap, they say.
Price/earnings ratios have never been lower, they tell
us. Private equity firms are piling in to buy bank
shares, we hear. While cautious types like us have
certainly missed out on one heckuva run in bank stock
prices these past 90 days, buying bank stocks in the
current environment strikes us like picking up nickels
in front of a steamroller.
Turn on CNBC and
you'll likely hear commentator Larry Kudlow spewing
forth about mustard seeds. Listen to Federal Reserve
Chairman Bernanke testify before Congress (if you must)
and try counting the number of times "green shoots"
spout from his mouth. We recently did a Google search on
"mustard seeds" and got 95,500 hits. "Green shoots"
generated 20,200 hits. We see more yellow than green
shoots, which any gardener will tell you is not a good
thing.
It's been nearly 18 months since the
official start of the recession in December, 2007.
Everyone desperately wants to believe that the worst is
over and we're turning the corner. Headwinds - including
a doubling of oil prices off their March lows and a near
doubling of the 10-year Treasury bond this year -
abound. Samuel Johnson, the 18th century English author
said "second marriages are the triumph of hope over
experience." Call us curmudgeonly if you like (we've
been called worse) but that's how we feel about all the
"green shoots" chatter.
The good news is we may
have all dodged a bullet on the "bottom falling out of
the economy" scenario that looked like a distinct
possibility earlier in the year. Sorry to burst your
bubble, though - we just don't see how we can unwind 25
years of through-the-roof consumption and low savings,
not to mention excessive leverage brought about by the
sloppy lending era - in a mere 18 months.
Morgan Stanley estimates that the 15
largest banks, which have shrunk their balance sheets by
a total of $3.6 trillion so far during this crisis, will
shrink another $2 trillion in 2009. According to Agora
Financial, the U.S. financial sector's aggregate debt
now stands at 117% of GDP. In 1982, near the dawn of the
bull market, that metric was 22%. Households aren't much
healthier - their debt is 96% of GDP, versus 47% in
1982. The unwinding of so much debt, combined with
higher rates of savings and lower consumer spending adds
up to deflation and declining values for stocks and real
estate, at least in the near term.
But, inflation
may not be far off. Pimco's Bill Gross believes the U.S.
will ultimately lose its AAA credit rating, since we're
staring at budget deficits exceeding 10% of GDP as far
as the eye can see. With the Fed funds rate essentially
zero, interest rates have only one way to go. Recent
moves in the 10-year Treasury bond suggest some think
interest rates may be heading north as early as this
fall.
Back to the economy and those burgeoning
green shoots. We were reviewing first quarter mortgage
delinquency data, courtesy of the folks at the Mortgage
Banker's Association. The overall delinquency rate rose
to 9.12%, up from 7.88% in the previous quarter and
6.35% in the same quarter in 2008. As you would expect,
subprime delinquencies continued their ascent to the
heavens, up to 24.9% at the end of March from 21.9% in
December. Staggering, considering the quasi-moratorium
on foreclosures we've had these past few months. Many
lenders who had held off on taking back properties are
now racing to do so in order to list their homes for
sale before the next shoe drops. Our sources tell us to
expect a rash of properties to hit the market starting
in July.
But, it's not just
subprime. The increase in prime, fixed rate mortgage
defaults was also pretty staggering - up to 6.06% from
5.06% in the fourth quarter (and 3.71% a year ago).
According to the MBA, prime, fixed rate loans - to
borrowers with good credit (not the ones who took on
mortgages they couldn't afford or otherwise got in over
their heads) - now represent the largest share of
foreclosures nationwide.
Mark Zandi,
chief economist at Moody's Economy.com says "As long as
foreclosures are rising, house prices will decline,
which will undermine household wealth. It will be very
difficult for the economy to gain any traction. A lot
more foreclosures are coming." We think Zandi is a
pretty smart fellow, and not just because we happen to
agree with him. As long as job losses mount,
foreclosures won't be far behind. And, recent reports
about plummeting second home and luxury home values adds
more fuel to the fire.
Enough about
residential mortgage loan defaults. We've been saying
for some time that commercial mortgages are the next
shoe to drop. There is approximately $3.5 trillion
(again, with a "T") of outstanding commercial real
estate loans, according to the Wall Street Journal.
That's more than auto, credit card and student loans,
combined. And, it's not a problem that's years in the
future. According to the MBA, more than $350 billion of
CMBS, bank, agency and life company commercial and
multifamily loans come due in 2009 and 2010; we estimate
more than half can't be refinanced.
In normal
times, the markets and financial stocks would have taken
it in the shorts on the aforementioned foreclosure and
default news. Nowadays, on the strength of the
government back-stopping everyone and everything, the
markets take it in stride. Call it what you will but we
think the default data is a pretty strong indication
that credit quality continues to decline a year and a
half into the recession.
At the May Value
Investing Congress in Pasadena, California, hedge fund
manager Jason Stock was skeptical that the U.S. banks
are on the road to recovery. That's pretty interesting
coming from a guy who is far more interested in buying
small, thinly-traded bank stocks than finding troubled
bank stocks to sell short. Stock and his partner meet
frequently with executives of small banks. They also do
grass roots work, talk with real estate brokers and
investigate local market conditions to validate what
they're being told by the bankers. According to Stock,
"Unfortunately, in our travels, based on everything
we're seeing, we still have a very bearish outlook. We
think the U.S. banking sector is significantly
undercapitalized. We think credit quality is
deteriorating and will continue to deteriorate. We think
the number of bank failures is still in the early stages
and we see a fairly sharp increase [in failures] during
2009 and 2010. We think unemployment will continue to
rise. And a big portion of our thesis is commercial real
estate. We definitely see a significant amount of losses
out on the horizon."
All the good news and green
shoots aside, we agree.
Mitch Siegler is Senior
Managing Director of Pathfinder Partners, LLC.
Prior to co-founding Pathfinder in 2006, Mitch founded
and served as CEO of several businesses and was a
partner with a boutique investment banking and venture
capital firm.
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FINDING YOUR PATH
Why We
Really Need to Rethink the Office Market
By Lorne Polger, Senior
Managing Director
In the early 1980's, my mother
was in the art business in Colorado. I recall her
coming home one day discussing a project she was working
on for one of the (then) Big Eight accounting firms. She
joked about the three office types, depending on the
employee's level of seniority within the firm, and how
the budget for the art pieces she was placing was, in
turn, dependent on the size of the offices. No cubicles
mind you; just medium sized offices, larger sized
offices, and something about the size of a small Costco
warehouse reserved for senior management.
In a
similar vein, when I started practicing law in the
1980's, our firm had an average of 1.5 secretaries to
every lawyer. Correspondingly, we needed lots of space
for the secretaries, the computers, and all those mounds
and mounds of paper and accompanying client files.
Just 25 years later, it's pretty amazing how
technological advances and bottom line economic policies
have changed our physical office needs. Generally
speaking, central business district, Class A office
space remains the location of choice for most banks,
large law, accounting and securities firms. Over the
last couple of decades, law firms have moved from a
lawyer/secretary ratio of 1:1 to 4:1. With the exception
of a few dinosaurs, lawyers now draft their own
pleadings and documents, type their own emails (who
really sends letters any more?), and even input their
own time.
The accounting world is not too
different. Over the years, firms with audit practices
came to terms with the fact that auditors don't need to
spend that much time in the office. The concept of "hot
desks", where CPA's could plug in and play in any
location, was implemented.
Brokerage
houses have moved to the cubicle system for their
producers and even banks have moved a lot of the back
office functions off site to lower priced suburban
confines.
We all log in to our company's
computer systems from home (and from the airport,
Starbucks and even the grocery store), and we
proliferate the e-world with ritualistic Blackberry
fervor. Simply put, as a society, we no longer have the
same level of reliance on getting work done in the
confines of the office that we used to. It's not even
close. In the immortal words of Seinfeld's George
Castanza, "Jerry, I've got shrinkage."
When you couple the changes in technology
with an eroding economic base, it's not too surprising
to learn that the U.S. office market continued its death
spiral in the first quarter of 2009, marking the worst
quarter since Q3 2001 and the 9/11 terrorist attacks.
National office vacancies increased by 95 basis points -
from 13.80% at year-end 2008 to 14.75% at the close of
the first quarter of 2009. A significant contributor to
this spiking vacancy rate was a further increase in
space available for sublease. Nationally, total
available sublease space rose by 7,500,000 square feet
during Q1, representing 11.1% of total vacant office
space.
For most companies, occupancy costs and
employment costs are the two largest expenses. With
everyone looking to cut costs wherever they can, it's
become not a question of if you are going to downsize
space and/or renegotiate your office lease, but a
question of when.
Most notably, all submarkets
and space classes in the U.S. registered negative
absorption in Q1. For the U.S. as a whole, net
absorption measured over 26,000,000 square feet
negative.
In a slight understatement, the
director of market research for a national brokerage
house noted: "not a ton of good news can be gleaned from
the first quarter office numbers." As we know, job
losses have accelerated throughout the calendar
year. There's little doubt that the U.S. office
market will continue to slip. Are vacancy rates of
25 or 30% on their way?
If you believe
they are, then you also have to believe that we should
begin to write the obituary for commercial office
investment in the United States, at least as to the
current chapter of buyers who drank the Kool-Aid® by
gobbling up properties at ridiculously low cap rates
from 2002 through 2007. With those levels of vacancy,
landlords will have no choice but to reduce rates to
compete and steal tenants from other buildings. We've
started to see it happen. Quarter to quarter, occupancy
rates fell in almost all markets across the country.
Average downtown Class A asking rents were down a
whopping 5.47% from the fourth quarter of 2008 to the
first quarter of 2009. You can compete and survive only
if your cost basis is low enough, you have a long term
view and you are willing to sacrifice short term income
for long term gain. However, the key qualifier there, a
low cost basis, simple does not apply to most of the
buildings purchased over the last five to six years. All
this points to how tenants are now very much in the
driver's seat, as landlords become increasingly anxious
to maintain occupancies.
Will lenders have the
stomach to hang on, and work with their borrowers by
extending loan maturities, lowering interest rates and
even reducing principal balances? Some say they will
have no choice, but we have not seen that happen yet. An
argument can be made that such loan modifications simply
defers the inevitable; that the only way for the
commercial office market to get healthy again is to
allow the banks to foreclose, sell the REO inventory at
market prices (which, in some markets could mean hits of
50% to 80% of loan amount) and reset the cost bases for
the next owner. We remain in the early innings on the
distress within the commercial office market, but
restructurings are coming quick and they're not going to
be pretty.
Lorne Polger is Senior
Managing Director of Pathfinder Partners, LLC.
Prior to co-founding Pathfinder in 2006, Lorne was a
partner with a leading San Diego law firm, where he
headed the Real Estate, Land Use and Environmental Law
group.
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WALL STREET HUMOR
Wall
Street has lost gobs of money, but that doesn't mean
traders have lost their ability to laugh. A few making
the rounds:
What are the two best
positions to be in to ride out the market crunch? Cash
and fetal.
What's the difference between a
pigeon and an investment banker? The pigeon can still
make a deposit on a BMW.
This one from Jay
Leno: "I want to warn people from Nigeria who might be
watching our show, if you get any emails from Washington
asking for money, it's a scam - don't fall for
it."
The problem today with bank balance
sheets is that on the left side, nothing's right and on
the right side, nothing's left.
Old
banker's saw: "A rolling loan gathers no
loss."
"The recent mentality of bankers on
problem loans has been 'extend and pretend.' I say,
you've got to mend or you've got to
send."
-
Stephen Coyle, Chief
Investment Officer, Cohen & Steers Realty
Partners
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SNIPPETS:
TRUTH IS STRANGER THAN FICTION
A Collection of Comical,
Outlandish, Bizarre and Frightening True
Stories
A compendium of notable
news articles relating to commercial lending which
we've edited and commented upon.
Commercial Property Faces Crisis
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Source: Wall Street
Journal
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Commercial
real-estate loans are going sour at an
accelerating pace, threatening to cause billions
of dollars in losses to banks already hurt by the
housing downturn.
The delinquency rate on
about $700 billion in securitized loans backed by
office buildings, hotels, stores and other
investment property has more than doubled since
September to 1.8% in March. Foresight
Analytics in Oakland estimates the U.S. banking
sector could suffer $250 billion in
commercial-real-estate losses in this downturn.
The research firm projects that more than 700
banks could fail as a result of their exposure to
commercial real estate.
In contrast to home
mortgages - the majority of which were made by
only ten or so giant institutions - hundreds of
small and regional banks loaded up on commercial
real estate. As of Dec. 31, more than 2,900 banks
and savings institutions had more than 300% of
their risk-based capital in commercial real-estate
loans, including both commercial mortgages and
construction loans.
At First Bank of
Beverly Hills, commercial-property debt
outstanding was 14 times the bank's total
risk-based capital at the end of 2008.
Delinquencies reached 12.9%, compared with the
average of 7% among the nation's banks and
thrifts. "In perfect hindsight, we would have done
less commercial real-estate lending," said Larry
Faigin, the bank's president and CEO in a March 25
interview. [You
don't say, Larry. First Bank of Beverly Hills was
seized by the FDIC on April 25th after no buyer
could be found.]
Commercial Property Prices Continue to
Fall
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Source:
Reuters
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Prices
of U.S. commercial property sold by institutional
investors fell 5.8% in the first quarter, marking
the fourth consecutive quarterly decline,
according to an index published by the
Massachusetts Institute of
Technology.
Meanwhile, buyers continue to
expect to pay less for properties, but sellers are
actually expecting prices to improve, leading to
fewer deals, MIT said. "Nobody can sell any
properties," said MIT Professor David Geltner,
director of research at the Center for Real
Estate. "Liquidity has almost completely dried
up."
MIT's transactions-based index (TBI)
tracks prices that pension funds and other
institutions pay or receive for commercial
properties like shopping centers, apartment
complexes and office towers. The TBI is down 21%
over the past year and 25% from its 2007 peak. Its
decline now nearly matches the 27% drop in the
commercial property downturn of the late
1980s-early 1990s, according to MIT.
The
index, with a base value of 100 in 1984, now
stands at 169. It peaked at 230 in June, 2007. A
separate index that tracks the prices that
potential buyers are willing to pay has fallen for
seven straight quarters and is down 39% from its
2007 peak.
By contrast, a measure of the
prices institutional owners of commercial
properties are willing to accept was actually up
in the first quarter, creating a disconnect
between supply and demand in the market. That is
partly because many institutional investors are
deep-pocketed, carrying little debt and not
needing to sell, Geltner said.
The next
development to watch for is an increase in
distressed property sales, he added. "That's a
good development because when the market begins to
reliquify, you begin to get transactions. They're
at lower prices, but you begin to get a
functioning market. I think we're going to move
into that phase in commercial property, though we
haven't seen it much yet. Time is on the side of
the buyers at this point."
Banks Troubled Commercial Properties
Double: $34 Billion
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Source: CoStar
Group
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Troubled
loans on income-producing commercial real estate
properties are increasing rapidly at the nation's
banks. The total is more than double what it was a
year ago with the bulk of the increase occurring
in the first quarter of
2009.
FDIC-insured banks reported
carrying $22.3 billion in nonperforming office,
industrial and retail property loans at the end of
the first quarter and another $4.3 billion in
multifamily loans. That's up from $15.7 billion
and $3 billion, respectively, just three months
ago - increases of more than 40%.
In
addition, U.S. banks were carrying $3.3 billion in
foreclosed office, industrial and retail
properties on their books and $1.3 billion in
foreclosed apartment properties.
The FDIC
also noted that other asset-quality indicators
continue to decline. Insured institutions charged
off $37.8 billion in bad loans in the first
quarter, almost double the $19.6 billion from a
year earlier. The amount of non-current (90 days
or more past due or in non-accrual status) loans
and leases rose by $59.2 billion during the
quarter and are now $154.3 billion higher than a
year ago.
The FDIC's list of problem
institutions continued to grow during the quarter
from 252 to 305 institutions, representing assets
of $220 billion. "Troubled loans continue to
accumulate, and the costs associated with impaired
assets are weighing heavily on the industry's
performance," said FDIC Chairman Sheila Bair. "The
first quarter results are telling us that the
banking industry still faces tremendous challenges
and that going forward, asset quality remains a
major concern," Bair noted.
A Housing Update
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Source: John
Maudlin's Thoughts from the
Frontline
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If
you read the headlines, you would think the
housing market has turned. Mostly they read
something like "Home Sales Rise 0.3%," and the
bulls started talking about a bottom in housing.
And while someday we will have a bottom in
housing, it won't be this month.
Of
course, home sales rose in April. It is the time
of the year when home sales rise. And 0.3%?
Really? The margin of error is close to plus or
minus 10%, so 0.3% is a meaningless number. It
will be revised. Who knows which way? [We have a
guess.]
My main thesis
since 2006 has been that the housing market was in
a bubble. We built an extra three million homes
over trend growth and those homes have to be
absorbed in the normal way, through growth of
population and the economy. We "need" about one
million new homes a year to take care of
population growth and demand. Further, we have cut
off home availability to subprime buyers, whereas
during the boom you simply had to have a pulse to
get a home loan you didn't have a chance of
actually paying.
The earliest we see a real
bottom to housing (when housing values, in
general, begin to rise) is late 2010 or 2011. We
have to work through the excess
capacity.
The Case-Shiller home price data
shows that home prices are still in free fall.
They are down almost 19% year over year and 32%
from their 2006 highs (see chart below). If we get
back to the long-term price growth trend, we would
see another average 10% drop; and as prices tend
to overshoot on the upside and the downside, in
some markets they could fall even
further.
Yet, there is
hope that we will not see a fall below trend.
Housing, in many areas is starting to once again
become affordable (see chart from Moody's below)
to more Americans, even first-time home buyers.
The cure for the housing crisis is actually lower
prices, as that brings more potential home buyers
into the market. While housing sales are still
quite depressed, what are selling are homes in
foreclosure, as buyers perceive that there are
bargains. And they are right.
On the negative
side, the supply of homes available for sale is
again rising, as more foreclosures come onto the
market.
Notice in the above
chart that the supply of homes for sale is over
ten months. But that average can be misleading. In
many areas in Florida, it is over 40 months. And
that is for homes that can be financed with
government-sponsored "conforming loans," typically
up to $719,000. But, what if your home cost more
than that? National Association of Realtors chief
economist Lawrence Yun said the supply of existing
homes for sale over $750,000 has reached a
40-month supply.
CNBC real estate reporter
Diana Olick said, "That's going to mean a new
phase of the current housing recession. So far
we've seen the 'correction' of a boom market that
was driven by faulty, exotic loan products,
investors looking to make a quick buck and average
Americans using their homes as ATMs. Now the
losses are being driven by traditional economic
factors and by sweeping price drops. Fitch Ratings
estimates that up to 75% of the modifications now
being done through the administration's Making
Home Affordable program will re-default within a
year.I'm not talking about the old modifications,
which were largely repayment plans that could
actually raise monthly payments but the new mods,
which lower monthly payments to 31% of
income."
More Prime Foreclosures In Our
Future
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Source: Mortgage
Banker's
Association
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The
Mortgage Bankers Association noted that a record
12% or 1 in 8 U.S. homeowners are now behind on
their payments or in foreclosure. 10.6% of the
mortgages in Florida are now somewhere in the
process of actual foreclosure. In Nevada,
foreclosures are 7.8%, in Arizona 5.6% and in
California 5.2%. About 25% of subprime loans, 14%
of FHA (government, taxpayer-guaranteed) loans and
a growing 6% of all prime loans are now in
foreclosure. Quoting from the MBA press
release:
"In looking at these numbers, it
is important to focus on what has changed as well
what continue to be the key drivers of
foreclosures. What has changed is the shifting of
the problem somewhat away from the subprime and
option ARM/Alt-A loans to the prime fixed-rate
loans. The foreclosure rate on prime fixed-rate
loans has doubled in the last year, and, for the
first time since the rapid growth of subprime
lending, prime fixed-rate loans now represent the
largest share of new foreclosures. In addition,
almost half of the overall increase in foreclosure
starts we saw in the first quarter was due to the
increase in prime fixed-rate loans."
How
could so many prime loans be in foreclosure? These
were people with good credit and jobs. The answer
is the very deep and lengthy recession, coupled
with high and rising unemployment. The number of
foreclosures will not abate until unemployment
starts to fall. And even optimistic forecasts
assume unemployment will keep rising into 2010.
The average homeowner with a mortgage has very
little, if any, equity. There is little room for
home equity withdrawals - if banks were lending.
And recent data shows a very serious and
un-American-like drop in credit card borrowing.
U.S. consumers are retrenching, and global trade
figures echo that.
FDIC Problem Bank List at Highest in 15
Years
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Source: Agora
Financial
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The
FDIC reported in May that 305 institutions now
grace its infamous troubled bank list, up 53 from
the end of 2008 and the highest level since 1994.
Just as scary, the troubled 305 banks control over
$220 billion in assets. The FDIC doesn't name
names, lest the natives become restless. So far
this year, 37 banks have failed.
Heads or Tails?
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Source: Cumberland
Advisors
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The following is a
excerpt of a letter issued on March 29, 2009 by
David Kotok, Chairman and Chief Investment Officer
of Cumberland Advisors
Dear Reader:
Please give me eight minutes to explain the $1.1
trillion government Public-Private Investment
Program (PPIP).
Start here with this simple
example. It's a coin toss. Heads you
win $100; tails you get nothing. How much
would you pay to play? You can play as many
times as you wish. Answer: not more that
$50. For less than $50, you would play as
often as you can. $50 is your breakeven;
only a fool would pay more.
Now add Tim
Geithner as your partner. He matches what
you invest but you, and only you, get to set the
price to play. Answer: you put up no more
than $25 as the investor and that means he matches
your number. At under $25 you play as much
as you can. $25 is your breakeven as the
investor; $50 is still the breakeven for the coin
flip.
Now let's add some of the leverage
from the FDIC. Suppose the FDIC will provide
you with a $40 non-recourse loan. You and
Geithner each put up $5 and adding in the $40
loan, you pay $50 to play, like before. If
you get heads, you pay off the loan of $40, and
you and Geithner split the rest. That means
you each get $30 for your $5. If you get
tails, you and Geithner each lose $5 and the FDIC
loses $40.
Now suppose we have an auction
to decide who will play. The highest bidder wins
the right to play as many times as he
wishes. With this example, the breakeven
price rises from $50 to $70. At $70 you put
up $15; Geithner puts up $15 and the FDIC still
loans $40. Half the time you will win $100
and use $40 to pay off the FDIC, leaving $60 for
you to split with Geithner. You will get $30
back for each $15 you play, when you win.
The other half of the time you will get zero,
since it's still a coin flip risk.
Notice
that the price to play went from a $50 breakeven
to a $70 breakeven. This happened while the
odds remained a 50-50 coin flip.
Also
notice that the leverage ratio was low when you
put up $15, Geithner put up $15, and the FDIC put
up $40. Under the Treasury PPIP plan the
leverage ratio can go as high as 6 to 1.
Using the full 6:1 leverage ratio, a coin-flip
breakeven point would be about $3.57 for the
investor.
Here is how I get that
number. You put up $3.57; Geithner puts up
$3.57; the total investor's equity is $7.14.
The FDIC loans 6 times $7.14, or $42.84.
Total price to play is $49.98. Let's call it
$50, which is the amount to play each time.
Notice that the breakeven auction price is
now $93 each time. Remember you, as the
private investor, set the auction price, because
you are the only one deciding the
bidding. Geithner is matching you and the
FDIC is loaning six times the equity.
The
leverage and risk transfer have raised the
investor's breakeven from a $50 auction price, if
you did this all by yourself and without any
leverage, to $93 when leverage is fully
deployed. The risk of winning or losing is
still a coin flip.
Let's substitute a
toxic asset on a bank's balance sheet for the
coin. Instead of a 50-50 coin flip, with PPIP we
have a toxic piece of a mortgage-backed debt
instrument that has an uncertain value. If we
use PPIP, aren't we really inflating the price
artificially?
How can we adjust for this
risk transfer that allows the auction breakeven
price to rise? That answer lies in how much
the FDIC will charge to make the non-recourse
loan. If the FDIC charges enough, it will
bring the auction price back to $50 and restore
the deal to neutrality. If the FDIC charges
more, it will bring the price below what it would
be without the leverage.
But if the
FDIC underpriced the loan cost, it would then have
subsidized the deal and allowed the auction price
to rise. That means the seller of the toxic
debt instrument got more than it was worth and the
investor made a profit because of the FDIC.
Some of the risk of payment on that
instrument transferred to the FDIC. That
means it transferred to the FDIC insurance fund,
which means it transferred to every insured
deposit in every bank that pays an insurance
premium into the fund. That means the
depositormay begetting a lower interest rate on
that deposit than he otherwise would get. That is
PPIP.
Some questions. Will this
process set a true "market price" for these toxic
assets or are we using a gambler's pricing
mechanism? Has Geithner been transparent
about this risk transfer to the FDIC? What
will the FDIC charge investors when it assumes the
6:1 leverage risk? Will it price risk fairly
or will it grant massive subsidy to
banks?
Dear reader: you decide if this is a
good thing or a bad thing. You decide if this
is how it was presented to you. You decide if
this is a sound policy solution for the US banking
system or if you believe that our government has
taken"moral hazard" to a new level with
pee-pip?
As a money manager, the Cumberland
firm will look at PPIP and may use it on behalf of
clients after we have reviewed an official form of
an offering document. As a private citizen
concerned about my country and its policy
direction,I think this reeks and stinks.
Ten Reasons Why the Stress Tests Are
"Schmess Tests" and Why the Current
Muddle-Through Approach to the Banking Crisis
May Not Succeeded
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Source: RGE
Monitor
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The following is an
excerpt of an article by RGE Monitor's Nouriel
Roubini
What shall we make of the
recently announced stress tests? Are they
credible? Will they restore confidence in our
battered financial system? Will the current
approach to resolving the financial crisis be
effective and minimize the costs of the
bailout?
These results significantly
underestimate the capital needs of these 19 large
U.S. banks. Also, the current "muddle-through"
approach to the financial crisis may accelerate
the creeping nationalization of the U.S. financial
system, exacerbate moral hazard distortions, not
resolve the too-big-to-fail problem, increase the
costs of this financial crisis, make the credit
crunch last longer and lead some near insolvent
financial institutions to become zombie banks. Let
me explain in ten points why I hold such
views:
First, the stress
tests are not stressful enough. Current
unemployment rates are already higher than those
assumed in the more adverse scenario. Even if job
losses slow to a 400-500,000 monthly range, it is
highly likely that the U.S. will reach an
unemployment rate of 10.5% by late 2009 and above
11% in 2010. The stress tests assumed that
unemployment would average 10.3% in the more
adverse scenario in 2010, not 2009. Moreover, the
stress tests found that the 19 banks needed $185
billion of additional equity; the published figure
of $75 billion is based on asset dispositions and
capital raises of $110 billion that are not yet
completed. Booking such increases in equity
before they have occurred does not seem
appropriate accounting.
Second, the
capital needs of these banks depend on a race
between new earnings that will benefit from a high
net interest rate margin and the losses from
further write-downs. It appears that
regulators overestimated such earnings for
2009-2010. The IMF recently estimated that new
earnings for all U.S. banks - not just these 19 -
would be only $300 billion in 2009-2010. The
stress tests assumed much higher earnings - $362
billion - for these 19 banks for 2009-2010 in the
more adverse scenario. Since these 19 banks
account for half of U.S. banks assets, if one uses
the IMF earnings estimates, their 2009-2010
earnings would be $150 billion vs. the $362
billion assumed by regulators. While the IMF
may have been too conservative, regulators may
have been too generous. Capital needs will be
significantly higher if earnings are lower than
assumed in the stress tests.
Third, banks
bargained hard to reduce regulators' estimates of
additional equity. According to press reports,
Citigroup was initially assessed $30 billion of
required equity; this was then reduced to $5
billion after aggressive bargaining by the bank.
Fourth, estimates
of losses on securities - $154 billion - are
likely too low. Certainly, in the last year,
regulators have been lenient and provided plenty
of forbearance - on top of expensive formal
guarantees of hundreds of billions of toxic assets
for several banks - to reduce the amount of losses
on securities. Also, if we bring forward to today
the write-downs for 2009-2010 estimated by U.S.
regulators, the tangible common equity ratio for
these all U.S. banks would be effectively 0.1%
today. So, the U.S. regulators' estimates of
equity needs of these 19 banks are heavily
dependent on earnings in 2009-2010.
Fifth, estimates
of earnings are massively beefed up by the
subsidies the government is providing the
financial system. With the Fed Funds rate now
close to 0% and with banks having borrowed about
$350 billion at close to 0% interest rates, banks
can now earn a fat net interest rate margin, a
direct subsidy. Overall, the U.S. government has
committed over $13 trillion of resources to the
financial system and already provided $3 trillion
to financial institutions. The financial
system is already a ward of the state.
Sixth, in
estimating equity needs of these 19 banks,
regulators correctly used a measure of capital -
Tangible Common Equity - that is narrower than
Tier 1 capital. Tier 1 includes many forms of
capital that are of poor quality as a buffer
against losses or outright fishy: preferred equity
and intangible assets and goodwill. While
Tier 1 capital of U.S. banks was - at the end of
2008 - about $1.55 trillion, TCE was only about
$560 billion. Regulators estimated equity
needs of the 19 banks based on a TCE ratio of
4%. However, even 4% implies a leverage
ratio of 25:1. The IMF, properly, considered a
scenario where the TCE ratio is increased to 6%
(17:1 leverage ratio), the average leverage ratio
for all U.S. banks in the mid-'90s before leverage
shot up in the credit bubble. A capital
adequacy ratio is also certainly necessary for
these banks as they are systemically important;
systemically important banks should have much
higher capital due to too-big-to-fail distortions.
Indeed, some national regulators have
already moved to increase the capital required
from their own banks. For example, Switzerland has
imposed a 16% capital ratio for its systemically
important banks, to be phased in by
2013. Thus, it would have been
appropriate that U.S. regulators request that
these 19 key banks should have a TCE ratio of at
least 6% (not 4%). The capital needs of all U.S.
banks would have been an additional $225 billion
in this case. For just these 19 banks, a 6% TCE
ratio would mean a need for an additional $100
billion of common equity.
Seventh,
considering just the need for a higher TCE ratio
for too-big-to-fail banks, all 19 banks would have
required higher TCE. Giving a clean bill of health
to half a dozen too-big-to-fail banks that have
survived this financial crisis only because of
massive government subsidies (liquidity, insurance
and guarantees) is a public disservice. It does
not recognize that these banks survived only
because of the government subsidies and
it ignores the fact that too-big-to-fail
banks should have much more tangible common equity
than they currently hold. It is reckless of
regulators to ignore the too-big-to-fail
distortion that derives from excessively low
capital ratios.
Indeed, the problem with
the current approach is that the too-big-to-fail
problem has become an even-bigger-to-fail problem
and moral hazard distortions have been sharply
increased via trillions committed to backstop the
financial system. While some significant support
of the financial system was necessary to avoid a
more severe credit crunch, the extent of the
support and subsidy of the financial system has
created the mother of all moral hazard
distortions. Also, the current approach has
led to an even-bigger-to-fail problem because of
the government inducing relatively less weak
institutions to take over weaker ones. JP Morgan
took over Bear Stearns and then WaMu; Bank of
America took over Countrywide and then Merrill
Lynch; and Wells Fargo took over Wachovia. To put
two near-zombie banks together is like having two
drunks trying to hold each other to stand
straight. To resolve this even-bigger-to-fail
problem, a strategy of taking over near-insolvent
institutions and then breaking them up in smaller,
systemically-not-important pieces would have been
appropriate. Alternatively, charging much higher
capital ratios on too-big-to-fail banks would
incentivize them to break themselves into smaller
pieces. But neither approach has been followed by
U.S. policy makers.
Eighth, the
figures published by U.S. regulators are estimates
of losses and capital/equity needs of the top 19
banks. Smaller U.S. banks (under $4 billion in
assets) will have similar losses and capital
needs. Based on the results of the stress tests,
some bank analysts have estimated that 60% of the
top 100 U.S. banks will need more capital/equity.
Note that while large U.S. banks (those with more
than $4 billion in assets) have 49% of their total
assets in real estate assets, the percentage of
real estate assets for small U.S. banks (those
with assets below $4 billion) is about 63%. Thus,
the losses for such smaller banks (as a percentage
of total assets) may end up being greater than for
large banks.
Ninth, the
current muddle through approach to the banking
crisis is predicated on the assumption that
forbearance and time will heal most wounds of most
systemically important banks. Generous assumptions
on earnings before write-downs and hope that the
economy will rapidly recover will allow banks to
earn their way out of their current massive
capital shortages.
Tenth, to avoid
creating Japanese-style zombie banks, it would
have been better to take different approaches that
minimize the long-term government ownership or
control of the financial system. There were three
possible alternative approaches that made more
sense.
One option would be a temporary
nationalization of near insolvent large banks. A
second option would be separating each troubled
bank into a good and a bad bank. A third option
would be to induce unsecured creditors - under
threat of a receivership - to convert their claims
into equity. Then, the bad assets can be taken off
the bank's balance sheet via the PPIP or a similar
program.
Each solution implies that
unsecured bank creditors take some losses and
convert their claims into equity. Instead,
the current U.S. approach is that to avoid a
temporary nationalization of insolvent banks and
to prevent unsecured creditors of banks from
taking any losses we have a creeping partial
nationalization of the financial system. Now, the
government will have to inject more preferred
shares into troubled banks and convert more of its
preferred shares into common equity. So, even
without a temporary government takeover of the
insolvent banks, we will end up with a longer-term
partial government ownership of many large banks.
The logic of the current muddle through
approach is clear: providing unlimited liquidity
and deposit guarantees to avoid bank runs and
refinancing risks; subsidizing banks and their
rebuild of capital via near zero funding rates;
rising net interest rate margins; hoping that the
economy recovers faster than expected so eventual
bank losses are lower; hoping forbearance and time
will heal most wounds by reducing the eventual
write-downs and letting banks rebuild capital via
earnings; ignoring moral hazard distortions;
avoiding takeovers of large institutions; closing
regulators' eyes on the true value of loans and
assets; and dealing with the too-big-to-fail
problem only if/when the crisis is over with
higher capital charges once banks can better
afford them.
However, the current muddle
through approach has some serious risks and
shortcomings: it significantly increases the costs
of bailing out financial institutions and creates
the mother of all moral hazard distortions as
trillions have been used to backstop the financial
system and bailout reckless bankers, traders and
investors; it ends with a possibly long-term
government control and partial ownership of the
financial system; it does not resolve the
too-big-to-fail problem; it risks keeping alive
zombie banks; it leads to a large bailout cost;
and it creates a serious exit strategy problem for
monetary policy as the tripling of the monetary
base and the central bank purchase of toxic and
illiquid assets eventually lead to price inflation
or another asset and credit bubble.
Indeed,
many Wall Street voices are starting to argue that
the crisis is over, bull times are back, they
don't need further government support, they can
repay TARP money and the government should not
over-regulate the financial system or control
bankers' compensation. This is the self-serving
chatter from the same reckless lenders, bankers
and investors whose greed and wildly distorted
bonus/compensation schemes - together with
regulators that were asleep at the wheel and
believing in self-regulation - caused the worst
economic recession and financial crisis since the
Great Depression. This is the new spin of those
whose fake gains/profits/bonuses were privatized
in the bubble times when fake wealth and bubble
profits were created and whose trillions of
dollars of losses have now been fully socialized
and paid for by the taxpayer. Their arrogance is
only second to their shameless Chutzpah.
One can
only hope that policy makers will resist these
siren calls and design a reform of the regime of
regulation and supervision of financial
institutions (more capital, less leverage, more
liquidity, incentive compatible compensation with
a bonus/malus system, higher capital charges to
deal with - and possibly break-up -
too-big-to-fail financial institutions, global
regulatory standards that that reduce the risk
that a financial crisis of this proportion will
happen
again.
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Notables and Quotables
"Troubled loans continue to
accumulate, and the costs associated with impaired
assets are weighing heavily on the industry's
performance. The first quarter results are telling us
that the banking industry still faces tremendous
challenges, and that going forward, asset quality
remains a major concern."
- FDIC Chairwoman Sheila
Blair
"There's no sign that we are
anywhere near a bottom. We witnessed the collapse of the
financial system. It was placed on life-support, and
it's still on
life-support."
- George
Soros
"The problem with government
debt growing so much is that when the time will come and
the Fed should increase interest rates, they will be
very reluctant to do so and so inflation will start to
accelerate. I am 100% sure that the U.S. will go into
hyperinflation close to "Zimbabwe-style price
insanity."
- Marc Faber,
investor and Barron's Roundtable
member
"[All those] terrible
kick-the-can-down-the-road modifications that leave
borrowers in five-year teaser, ultra-high leverage, 150%
loan-to value balloon loans [that when they start
adjusting upward will] turn millions of homeowners into
over-levered, underwater, renters and ensure housing is
a dead asset class for years to come...the
mid-to-upper-end housing market is on the precipice of
the exact cliff that the market fell off of in 2007, led
by new loan defaults. What happens to the economy when
you hit the mid-to-upper-end earners the same way the
low-to-mid end was hit with the subprime implosion? We
will find out soon enough...When we look back at the end
of 2009, anyone that made positive predictions this year
will not believe how far off they were."
- Mark Hanson, The Field
Check Group, a market research firm specializing in real
estate and mortgages
"We are seeing
pricing for all [Las Vegas real estate] asset classes
still sliding fast. The latest benchmark for a
400-unit, class-B, 1987-vintage apartment project is
$53,000 a door or about half of production cost.
Visitation is still sliding and gaming companies are
still cutting jobs. With the Fannie and Freddie
moratorium on foreclosures now over, we anticipate
another huge wave of residential foreclosures and of
course, another supply shock to the housing stock, more
price erosion, and people feeling poorer all over
again. Las Vegas will lead the west coast in
foreclosures for another year. Our four largest gaming
owners will all sell assets this year at fractions of
production cost."
- Dave Sundaram, partner, Las
Vegas' Odyssey Real Estate Capital, on that city's real
estate market and economy
"What marks
our Great Recession for greatness is neither the loss of
jobs nor the shrinkage in GDP but the immensity of the
federal response to those afflictions. The scale of the
government's intervention is much more than
unprecedented. Before 2008, it was unimaginable. We have
reached the 'kitchen sink' phase of U.S.
counter-cyclical policy. To try to exorcise the Great
Depression, President Herbert Hoover deployed fiscal and
monetary stimulus equivalent to 8.3% of gross domestic
product. To banish the demons of 2008-9, successive
administrations have spent, or encouraged to print, the
equivalent to 28.9% of GDP. A macroeconomist from Mars,
judging by these data alone, would never guess how much
more severe was that depression than this recession. The
decline in real GDP from August, 1929 to March, 1933
amounted to 27%; that from December, 2007 to date, just
1.8%...so for a slump 1/15 as severe as the Depression,
our 21st-century economy doctors administered a course
of treatment more than three times as
costly."
- James
Grant, editor of Grant's Interest Rate
Observer
"Suppose you are on a jumbo
jet flying from New York City to London and you notice
two of the four plane engines have smoke pouring out of
them, and the plane is slowly losing altitude. Somewhere
over Iceland, let's say, the plane hits an unexpected
downward wind shear and begins hurtling toward the
Earth. The pilot gets on the intercom, scares everyone
to death by acknowledging the reality of the situation,
but says he knows the corrective procedures that will
stabilize the plane - it will just take more effort and
ingenuity than he has ever used before.
Three of
the longest minutes later, the pilot gets back on the
intercom and announces that he has good news. His
extraordinary efforts are, indeed, working. The plane is
no longer plunging 3,000'/minute: It is falling only
2,998'/minute! Would you then expect your fellow
passengers to start applauding, dancing in the aisles
and ordering drinks?
Q1 2009 real GDP came
in worse than expected at -6.1%, but because it was not
worse than the -6.3% reported in Q4 2008, investors felt
compelled to raid the liquor cart. Less bad will quickly
become more bad. Don't be fooled, folks, less bad is
still bad."
-
Rob Parenteau, editor of the Richebacher Letter, writing
about the financial crisis in an article titled "Less
Bad, the New Good"
"To put two weak -
or near-zombie - banks together is like having two
drunks trying to hold each other to stand
straight."
- NYU
Professor Nouriel Roubini on recent government-supported
bank takeovers
"When you reward
failure, all you get is more failure...Thanks to the
Bush-Obama-Geithner policy of bailing out failing
companies, we now have the worst of all possible
scenarios: A taxpayer-subsidized, government-supervised
private company - an unsustainable public-private hybrid
that is too public to make its own decisions and too
private to be responsible to the taxpayers keeping it
alive."
- Marc
Faber, Barron's Roundtable participant, writing in The
Gloom Boom & Doom Report
"Government actions and interventions...caused,
prolonged and dramatically worsened the crisis. Monetary
excesses were the main cause of the boom. The Fed held
its target interest rate, especially in 2003-2005, well
below known monetary guidelines...Keeping interest rates
on the track that worked well in the past two decades,
rather than keeping rates so low, would have prevented
the boom and the bust. Researchers at the Organization
for Economic Cooperation and Development have provided
corroborating evidence from other countries: The greater
the degree of excess in a country, the larger was the
housing boom. The effects of the boom and bust were
amplified by several complicating factors including the
use of subprime and adjustable-rate mortgages, which led
to excessive risk taking. There is also evidence the
excessive risk taking was encouraged by the excessively
low interest rates. Delinquency rates and foreclosure
rates are inversely related to housing price inflation.
These rates declined rapidly during the years housing
prices rose rapidly, likely throwing mortgage
underwriting programs off track and misleading many
people. As early as 2007, policy makers misdiagnosed the
crisis as one of liquidity and prescribed the wrong
treatment."
-
John Taylor, Stanford economics professor and author of
"Getting off Track: How Government Actions and
Interventions Caused, Prolonged and Dramatically
Worsened the Financial
Crisis"
"Giving money and power
to government is like giving whiskey and car keys to
teenage boys."
-
Civil libertarian P.J. O'Rourke
"We
can sum up much of the current financial problem as
stemming from a surfeit of cheap financing that induced
investors to overpay for financial assets. Geithner's
solution is to create a surfeit of cheap financing to
induce investors to overpay for financial assets. As
Will Rogers asked, 'if stupidity got us into this mess,
why can't it get us out?'"
- James Keller, a former head
of structured products at UBS, writing in the April 6,
2009 issue of Barron's
"The
scale of fraud is immense...This whole bank scandal
makes ['20s-era] Teapot Dome look like some kid's doll
set. We have failed bankers giving advice to failed
regulators on how to deal with failed assets. How can it
result in anything but failure? If cheaters prosper,
cheaters will dominate. It is like Gresham's law: Bad
money drives out the good. Well, bad behavior drives out
good behavior, without good enforcement...
[Secretary of Treasury Geithner's] plan
perpetuates zombie banks by mispricing toxic assets that
were mispriced to the borrower and mispriced by the
lender, and which only served the unfaithful lending
agent...We already know from the real costs - through
the cleanups of IndyMac, Bear Stearns and Lehman - that
the losses will be roughly 50 to 80 cents on the dollar.
The last thing we need is a further drain on our
resources and subsidies by promoting this toxic-asset
market. By promoting this notion of too-big-to-fail, we
are allowing a pernicious influence to remain in
Washington...What would we do in other avenues of life?
What if every time we had a plane crash we said: 'It
might be divisive to investigate. We want to be
forward-looking.' Nobody would fly. It would be a
disaster. We know that with planes, every time there is
an accident, we look intensively, without the
interference of politics. That is why we have such a
safe industry. With most of America's biggest banks
insolvent, you have, in essence, a multi-trillion dollar
cover-up by publicly traded entities, which amounts to
felony securities fraud on a massive scale. These firms
will ultimately have to be forced into receivership, the
management and boards stripped of office, title and
compensation. First, there needs to be a clearing of the
air. Then, we need to gear up to pursue criminal cases.
Two years after the market collapsed, the FBI has
one-fourth the resources the agency used during the
S&L crisis. And the current crisis is ten times as
large.
Control fraud is when a seemingly
legitimate corporation uses its power as a weapon to
defraud or take something of value through deceit. In
the S&L crisis, thrifts engaged in control frauds in
order to survive. Accounting trickery was the weapon of
choice. It is at work today with the banks and it is
their Achilles heel. You report that you are highly
profitable when you engage in accounting-control fraud,
not only meeting but exceeding capital requirements.
These accounting frauds create huge bubbles, which in
turn create large bonuses, which in turn lead to huge
losses. Now, we have a situation where Treasury
Secretary Geithner can speak of a $2 trillion hole in
the banking system, at the same time all the major banks
report they are well-capitalized. And you have seen no
regulatory action against what amounts to a $2 trillion
accounting fraud. The reason we don't see it - aren't
told about it - is that if they were honest, prompt
corrective action would kick in, and they would have to
deal with the problem banks."
- William Black, deputy
director at FSLIC during the S&L crisis, now an
economics and Law Professors at University of Missouri,
Kansas City in a recent interview in
Barron's
Credits: Agora Financial, Associated
Press, Barron's, Business Week, CNBC.com, CoStar Group,
Cumberland Advisors, Forbes, Fortune, John Burns Real
Estate Consulting, John Mauldin's Thoughts from the
Frontline, Mark Faber's Doom, Boom & Gloom Report,
Moody's Economy.com, Mortgage Banker's Association,
Reuters, RGE Monitor, Wall Street
Journal.
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