The real reason we bailed out AIG

In reading through the news over the past few days, it’s apparent that many people are upset with the multiple AIG bailouts.  Some are upset that executives are getting bonuses (I am too) but I think the real reason for the bailouts in the first place is far worse than a few boneheaded executives paying themselves with our money – or as Bernanke says, we paid them by “printing money”.

The real reason is so billions in bailouts could be funneled to other financial firms without having to disclose it.

For example, the Washington Post reports The funds were paid from the government’s initial $85 billion emergency loan in September and included major firms such as Goldman Sachs, Societe Generale, Deutsche Bank, Merrill Lynch, Morgan Stanley, Bank of America and Barclays.

The government has already publicly bailed out Goldman Sachs, Morgan Stanley, and Bank of America  with hundreds of billions of dollars – and I think this is simply an underhanded way to funnel billions more to them to avoid bailing them out again.

The money AIG talked about in this report was from the original $85 billion bailout last year, and doesn’t include anything from the 2 subsequent bailouts.

TIME says AIG, under pressure from Congress and the press, also released the number of the counterparties to many of its credit default swaps. AIG had decided to insure the value of certain paper owned by the likes of Goldman Sachs (GS), Morgan Stanly (MS), and Deustsche Bank (DB). When the value of that paper fell, AIG was on the hook to pay off the “insurance” which kept the likes of Goldman from having to book large write downs. Those write downs might have pushed Goldman into a difficult financial situation.

And by “difficult financial situation” they mean bankrupt, broke, out business Bear Stearns/Lehmann Brothers broke.  That’s the real reason for the AIG bailouts.  Paulson and Bernanke didn’t have to publicly give their old buddies more money – they could pass billions to them through the guise of AIG bailouts.

On the subject of bonuses, The Street.com says Another issue on the table is that AIG and government officials have created a human-resources Catch-22. The firm plans to dole out $165 million in bonuses to keep the employees who created the very derivative products that ultimately destroyed AIG as a private, independent entity. The firm says it is contractually obligated to pay those bonuses, and that the employees have critical knowledge about valuing and winding down its toxic assets.

Really?  Critical knowledge about valuing and winding down the toxic crap on their books?  I’m not too bright, but I think that if your company lost $61 billion in the last quarter alone, there ain’t no one with critical knowledge at your company!

“Maybe [regulators] should have asserted more control at the start, back in the fall,” says David Steuber, co-chair of the insurance-recovery practice at Howrey LLP. “But now they’ve made some of these people indispensable, and those people are going to need to be compensated at or about the market rate.”

Oh come on!  these people are “indispensable?”  Maybe so, because there aren’t a hell of a lot of people capable of screwing up a company this badly.  Dudes, you freaking lost $61 BILLION in the 4th quarter alone – how “indispensable” can you be?!?

Are you “indespensable” because the average wino off the street might have only lost $1 billion?  Get a life assholes – you would not have a building to go to work in today if taxpayers hadn’t given you over $170 billion.  And you think you deserve a freaking bonus?!?  WTF have you been smoking, snorting, or shooting?

Idiots.  Kick their asses out on the street and stop giving them our money to blow and pass on to their buddies.  Let the comapnies who made bad bets on derivatives suffer the consequences and go broke.

gk

Bush is an idiot – another example

If you needed another example of how badly Bush sucked as leader of the US, here’s one from Today’s Daily Reckoning:

When the going was good, a small addition to the financial sector’s capital would be multiplied many times. The limit for Wall Street’s investment firms was 12 to 1…until it was increased to 33 to 1 in 2004. Thereafter, if you put $100 into an investment bank…counterparties would soon have about $3,300 worth of credits.

Easy come…easy go! When the financial system rolled over last year, the banks lost money. Suddenly, $100 less in bank capital forced the banks to reduce outstanding credit by as much as $3,300. Cash disappears and everyone is forced to cut back.

Here’s a link to a NY Times article from October 2nd, 2008 that describes how the Bush Administration made this debt crisis much worse.  The story reads in part:

But decisions made at a brief meeting on April 28, 2004, explain why the problems could spin out of control. The agency’s failure to follow through on those decisions also explains why Washington regulators did not see what was coming.

On that bright spring afternoon, the five members of the Securities and Exchange Commission met in a basement hearing room to consider an urgent plea by the big investment banks.

They wanted an exemption for their brokerage units from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then flow up to the parent company, enabling it to invest in the fast-growing but opaque world of mortgage-backed securities; credit derivatives, a form of insurance for bond holders; and other exotic instruments.

One of these days I’ve got to take the time to document all of the lame-brained, half-assed decisions that led me to conclude that Bush is an idiot – and that he’ll go down as the worst President in our history.  And it’s pretty tough to be worse than my former number one – Jimmy Carter.

gk

Sound Familiar?

Stop me if you’ve heard this one before….  The dollar and financial stocks fall, while gold and oil rise.  Damn, you already heard that one somewhere else? 

It’s a familiar refrain that seems to keep repeating, just like an obnoxious Barry Manilow song or that annoying dog commercial that goes “there might be bugs on some of you mugs but there ain’t no bugs on me”.  (Ha – now you’ve got it stuck in your head too!)

The reason that oil and gold continue to trend higher while the dollar and financial stocks continue to trend lower is one and the same – the Federal Reserve. 

The Fed continues to flood the system with cheap and/or free money.  It’s simple supply and demand.  There are more and more dollars but there hasn’t been a corresponding increase in the demand for those dollars.  So the amount of stuff a dollar will purchase continues to fall.

It’s called inflation, and it’s always CAUSED by the same thing – too much money chasing too few goods.  The classic way to explain inflation is that inflation “is always and everywhere a monetary phenomenon” (Milton Friedman) but it’s saying the same thing.

Even though this is nothing new, I’ve found that damn few people actually understand it.  And the more involved they are in the stock market, the less likely they are to understand it.  They blame inflation on rising wages, or rising oil prices, or the rising cost of (insert commodity here).  🙂

They don’t understand that rising prices are CAUSED by too much money.  When the Fed injects billions of dollars into the money supply (without a real demand for the money) prices HAVE to go up. 

Pretend I have a blog that lots of people read (we’re pretending!) and visit everyday.  Now I take the blog posts that I write and post them on 7 other sites as well.  Assuming more people don’t want to read what I have to say, the number of people visiting each site would go down – even though the total number may stay the same.

Ok, maybe that isn’t the best analogy…. Try this one.  8 people are standing around a barrel of oil.  They all need that barrel of oil, and they’ve all got about $5 to use to purchase it.  Guess what the price of that barrel of oil will be?  Yup, about $5.

Now imagine that Uncle Sam gives (or lets them borrow cheaply) each one of them another $5.  There’s still only one barrel of oil, and all of them still need it.  How much will that barrel cost now?

Does that help?  That’s what the Fed is doing with dollars.  Helicopter Ben is doing everything he can to keep the over-leveraged financial institutions afloat, but he’s simply buying time.  Borrowing money to pay off debt never works – it simply delays the inevitable.

As the dollar loses value (because there are more of them in circulation) the amount of “stuff” each dollar can buy MUST go down.  So things like oil and gold go up BECAUSE the dollar is worth less. 

This sometimes isn’t obvious because with commodities like oil and gold (and corn and soybeans and wheat and rice and pork bellies) demand can also fluctuate and cause price movements, but the underlying cause is the same.  Too many dollars in the system.

Anyhoo, the major financial institutions all owe waaay more than they own.  And they’re finding out that as the value of their assets (and the payments they receive from those assets) fall, they suddenly can’t make the payments on their debt anymore.  But then the Fed comes riding in and lets them borrow more money (using the same assets which are falling in value as collateral) and suddenly everything is supposed to be ok…. Brilliant! (Not!)

There was a report by Reuters today saying “Federal Reserve Chairman Ben Bernanke told Freddie Mac chief Richard Syron that his company and Fannie Mae could take advantage of the emergency discount window, according to a source familiar with the conversation.” 

Since it’s pretty obvious to everyone that Fannie Mae and Freddie Mac are insolvent and going under unless someone steps in, this report was a catalyst for a huge rebound in the market today.  Investors were grasping at straws looking for something, anything to save the sinking financial ship.  They grabbed onto this report and stocks reversed course over 200 points and were even briefly into positive territory today.

Then they realized that even if the report was true, it didn’t change a damn thing.  So the market sold off again into the close. After the markets closed, the Fed denied the story – but I won’t be surprised if the Fed takes action over the weekend like they did with Bear Stearns. 

They know the companies are technically bankrupt, and they’ve got to act at some point.  I don’t know what they’ll do, but they won’t stand by while the ship sinks.  They’ll continue to bail water, only to eventually figure out that the water is coming in much faster than they can bail it out.  The ship will still sink, but they can drag out this soap opera for months. 

In my opinion, they should let it sink now so we can start building the new ship.

gk

 

Just what is leverage anyway?

I was responding to some comments to a post I made to www.seekingalpha.com a few minutes ago, when I said something that I think needs to be explained further.  I mentioned “leverage” and since that’s been in the news (especially regarding financial stocks) quite a lot over the past few months, I decided to expound on it a bit.

In the comment I referenced above, I said “Let’s say you have $1 million equity in your house, and you take it out in a HELOC. You take that $1 million and put 10% down on 10 other $1 million properties – and you depend on the renters to make your payments.“

That’s leverage.  I just took $1 million in assets (my home equity) and used it to gain control on $10 million in assets.  I used the words “gain control” rather than saying “to buy” because I don’t actually own them – the bank I borrowed the other $9 million from actually owns those properties.

It’s an important distinction, because what happens to my $10 million in assets if just one renter falls behind on their payments?  Suddenly I can’t make my mortgage payments.  It’s only 10% less income, but it causes me to suddenly have to sell the whole $10 million in leveraged assets – because I can’t make the payments.

That’s what happened to Bear Stearns.  They had some assets which they leveraged (borrowed against) in order to buy (with other peoples money) other assets.  When one small part of the initial asset didn’t make their payment, the whole house of cards fell.

In my example, I used a leverage ratio of 10 to 1.  Bear Stearns was leveraged over 30 to 1.  I’ve sen some arguments from pundits (including Ben Stein) where they say the markets have over reacted; that a 10 percent jump in the rate of defaults doesn’t warrant a 20 or 30 percent drop in the stock price of financial companies. 

They’re wrong.  And they’re wrong for the reason above.  When you’re that highly leveraged; when you have 20 (or more) dollars of debt for every dollar of assets; you are hosed when just one percent of the underlying assets doesn’t pay up.

Suddenly you can’t make your payments on all the debt you’ve borrowed.  And since you really didn’t make much of a down payment anyway, you have no equity in the investment.  If you had some equity, you’d have a little breathing room.

But you don’t.  You need every dollar that you’ve counted on to make those payments – because you’ve leveraged your equity. 

And what happens when the value of thoseleveraged assets turns out to be too high?  You’re fucked.  Not only are you highly leveraged, but the base value of thoseassets has dropped, so now you are more leveraged than you were just a monthago.  And so you’re even more vulnerable when there’s a small rise in loan defaults and bankruptcies.

It’s a wild, wild world right now.  I can’t think of a single bank or REIT that I’d touch with a 10 foot pole.  Go ahead and Google the news results for the 3rd quarter of last year.  Check out all the stories that claimed that the 4th quarter was the “kitchen sink” quarter.  Be sure to read how damn near everyone thought that the banks and investment houses have finally fessed up and come clean.

Now watch the headlines during the week ahead.  Let’s se how many additional write-downs there are.  A lot of people have written me saying that I’m overestimating the impact of the sub prime stuff.  Many have told me that all of those losses for the upcoming rate adjustments (for the Option ARM’s and ARM’s written in 2005 through 2007) have been accounted for, and that there’s no where to go but up.

They may be right, but I don’t think so.  I don’t think people truly understand the impact of leverage.  I don’t think they truly understand that just a 3 or 4 percent drop in the base asset (mortgages) can cause a company to disappear.  

I’m not putting my money back into the market until I’m sure that risk has been priced in.  Given the (in my view) extremely optimistic earnings forecasts for 2008 and 2009, that risk is being ignored right now.  I may be wrong (I often am!) but I think I’ll be getting 2 or 3 percent in my money market funds while the optimists are losing 10 to 20 percent (or more) trying to bottom fish the market.

Any questions?

gk

 

Deja Vu all over again

I just posted about Bear Stearns and rumors, and the very next news article I saw was about Lehman.  It’s from Reuters, and the headline is “SEC probing if short sellers hitting Lehman: source

In part, the article says:

Shares of Lehman have fallen more than 40 percent since the beginning of February, far more than the broader index, amid market rumors the company was wobbly.

Lehman has said on multiple occasions that it has enough money to fund itself, it has ample access to financing, and that customers are standing by it.

Now where have I heard that before?

gk

False Rumors

I just read a report from Marketwatch via FoxNews that kinda ticked me off.  The report says that Market self-regulatory organizations late Monday warned traders against circulating any “sensational rumors that might reasonably be expected to affect market conditions” as well as trading on material, non-public information.

Sounds good, except the article goes on to say Although the organizations did not mention any specific companies, Bear Stearns Cos. executives had complained unfounded rumors of liquidity problems triggered actual flights of capital, leading to the firm’s near collapse.

Let me get this straight – they’re saying that “unfounded rumors of liquidity problems” were the problem with Bear Stearns?  Get real people – they might have been rumors, but they were NOT unfounded! 

Bear Stearns DID have a liquidity problem, they were leveraged 37 to 1 in illiquid investments, so they couldn’t pay up when people wanted their money.  And yet they had the gall (what is gall anyway?) to say they had plenty of liquidity ($18 billion if my memory serves) just 2 days before going under.

If you tell the truth you wont have “unfounded rumors” circulating about your company.

gk

The good, the bad, and the clueless

It was quite a day today in the financial media.  I’ve read stories tonight about why it’s great for everyone that the Fed bailed out Bear Stearns, I’ve read stories about why it’s bad that the taxpayers are bailing out Bear Stearns, and I’ve read stories where I don’t think the author had a clue what he was talking about.

But one of the best of the bunch has to be an article at Minyanville.com about why the housing market is nowhere near a bottom yet.  On page 2 of the article John Mauldin has a good synopsis of the current situation.  He states:

• 8.8 million homeowners will have mortgage balances equal to or greater than the value of their homes by the end of March.
• 30% of subprime loans written in 2005 and 2006 are already underwater.
• Nearly 3 million homeowners were behind on their mortgages at the end of 2007, with 1 million at risk of imminent foreclosure.
• As of the end of last year, 5.82% (!) of all mortgages were delinquent, the highest level in 23 years.
• 0.83% were in the process of foreclosure, also an all-time high.
• When you look at just subprime mortgages, you find that 20% are delinquent (the number is rising rapidly), and almost 6% were in foreclosure.
• Finally, the average American’s percentage of equity has fallen below 50% for the first time since 1945.

That pretty much sums up the current state of the market, but he goes on to explain why it’s going to get worse.  I’ve said much of this before, but he says it better:

As an example, 5% of home sales in January of 2007 in San Diego were foreclosures. In January of this year, 34% of existing home sales were foreclosures. [emphasis mine, gk] This is going to turn into a monster wave as ARMs reset in the coming years.As T2 notes:

 

 

“Loans with teaser rates were never supposed to reset. Reinforced by many years of experience, both lenders and borrowers assumed that home prices would keep rising and easy credit would keep flowing, allowing borrowers to refinance before the reset. Now that home prices are falling and the mortgage market has frozen up, very few borrowers can refinance, which, as shown later in this presentation, is leading to a surge in defaults -in many cases, even before the interest rate resets!

 

Mortgage lending standards became progressively worse starting in 2000, but really went off a cliff beginning in early 2005. The worst loans are those with two-year teaser rates. As the subsequent pages show, they are defaulting at unprecedented rates, especially once the interest rates reset. Such loans made in Q1 2005 started to default in high numbers in Q1 2007, which not surprisingly was the beginning of the current crisis.”

 

 It’s an excellent article and I encourage you to check it out if you like knowing what’s probably going to happen over the next few years.

gk

Wall Street Chaos

Just had to pass this on.  Excellent write up of the financial issues facing Wall Street and (though I disagree with some of it) Allan Sloan does a good job of breaking down a complex subject.  Highly readable and highly recommended.

gk

Who's going to answer the phone?

Reading this story on FoxNewsreminded me to post my thoughts on the growing cries for more government regulation of the mortgage and brokerage industries.  Basically, I think we need to stop the Fed interventions and roll back the regulations we have now.

That comes with a caveat though – no regulation and no intervention also implies no bailouts.  That means that Bear Stearns would have shut their doors last week. That means that Citi and JP Morgan wouldn’t be able to dip their hands into the Fed’s cookie jar to stay afloat.  That means that more home owners would be in foreclosure.  But I happen to think that those are all good things.

The trillions of dollars of CDO’s, CDS’s, and derivatives that are based on bad mortgages (and that are being propped up by the Fed’s intervention) need to reflect the losses they’re actually sustaining at some point.  You can’t carry a bad mortgage on the books as an asset at full face value forever, and the longer they delay writing off the losses, the longer it will take to sort through this mess.

Get it out there, get it over with, and move on. 

gk

The running of the bulls

From the 400 point rally today in the stock market, you’d think that the bulls are running rampant in Pamplona.  And you may be right, however….

Stocks are still down over 10% for the year.  The highly leveraged banks and Wall Street firms are still highly leveraged.  Massive amounts of mortgage backed securities – and their higher default rates coming this year and next – are looming.  When a CDO takes a 10% loss because the home owners can’t make the payments, that translates to a 300% loss on a 30 to 1 leveraged portfolio such as Bear Stearns and Lehman Brothers.  (Citigroup is also highly leveraged.)  The $2/share Fed “take it or leave it” financed JPM buyout of Bear Stearns still needs to be approved by shareholders.  Hmmm…. How would you vote if you owned BSC?

As I’ve written before, this unwinding of the leverage in the financial markets will take quite awhile.  The longer the Fed props up failing companies, the longer it will take to hit bottom.   JP Morgan is getting a deal only because the Fed is guaranteeing $30 billion of BSC’s “assets.”  They’re not really worth $30 billion, but the Fed took that much risk away from JP Morgan.   That’s $30 billion that US taxpayers will end up spending to finance this bailout – because the underlying securities are “riskier assets.”

 A couple of weeks ago, I thought we were headed for a repeat of the Carter years and stagflation, but it’s beginning to look more and more like we’re repeating Japan’s mistakes of the 1990’s.  Low interest rates, keeping bad debt on the books (instead of recognizing the loss and getting it over with) propping up banks with fake assets on their books, etc. 

Japan still hasn’t fully recovered from the 1990’s.  I sincerely hope that we don’t continue making the same mistakes, but today’s 3/4% drop in both the discount and Fed funds rates isn’t helping.  That only serves to drive up long term inflation, and that (rather than deflation that I’m reading about) is my long term worry.

As regular readers know, I don’t try to predict short term market swings, I simply try to stay on the right side of the market during long term trends.  I don’t know if today’s action signals a turnaround or not; my gut says no – because of the reasons listed above – but my gut doesn’t make the market move.

Regardless, I don’t see any fundamental change in the long term trends of the dollar going down, commodities (especially gold, silver, corn, and oil) going up, and the broad market (especially financials) going lower.

My feeling is that the majority on the street think that the worst news is behind us; that most people are looking for a reason to buy.  They’ve discounted all the bad news and they’re ready for another bull market.  I don’t think they’ll get it just yet.

Too many firms have too much debt.  Too many firms are leveraged enough so that a small change in the base assets (mortgages in most cases) results in a huge change to their balance sheets.  One little piece of unexpected bad news will be enough to cause a dramatic sell off.  I’m talking about a sell off big enough to trigger a halt to trading. 

I think the coming upswing in the foreclosure rate (because of all the ARM’s taken out in 2005 through 2007) hasn’t been fully factored in to the stock prices of the companies that are using these mortgages as collateral on their loans. 

When people realize how little capital is propping up these companies, share prices will drop.  The dollar will drop, and commodities will rise.  Again, I have no clue what the market will be at in a week or a month.  I don’t know if commodities will be higher a month from now or not.  But I’m betting that 10 years from now, you’ll be glad you bought gold at $1000/oz, silver at $20/oz, oil at $105/barrel, etc. 

If we really are following the deflationary path Japan took in the 90’s, the Dow may well be at 7000 10 years from now.  As it stands, buy and hold investors are down from where they were 8 years ago….  How much longer do we need to prolong the agony? Take the losses now, write off the sub prime and alt-a loans, get it over with!

Of course that’s just my opinion, I could be wrong.  🙂 

gk