Monday, March 30, 2009

Hussman:On the Urgency of Restructuring Bank and Mortgage Debt, and of Abandoning Toxic Asset Purchases

Somebody at the Fed and Treasury should be listening to John Hussman, of course they aren't. My post earlier has very similar analysis as Hussmans, but his is more in-depth and provides additional background. This is essential reading for attempting to understand the current issues affecting our financial system. I know its a lot and some of it is depressing, but knowing this stuff at least gives you perspective. Something that is needed today.

I encourage you to spend the time and read my post today and this post - if you read nothing else financial, read these.

Scott Dauenhauer CFP, MSFP, AIF

PPIP: Geithner's Goldilocks

PPIP stands for Public-Private Investment Program - this is the new plan from Treasury Secretary Timothy Geithner to heal the banks and solve the "credit and liquidity" crisis. But will it work?

The answer is of course, its impossible to know. The markets seemed to like the plan, rallying nearly 20% before falling Friday and opening down heavily this morning. Of course the market is still below the where it was when Geithner originally announced the plan. If the markets truly liked the plan they should rally significantly above that point, they have not (but of course we all hope they do).

I've spent a lot of time trying to understand this program and am getting closer. What I have figured out is the structure and the possibilities. I've also settled on my initial notion that I don't like the plan and don't see it solving our problems. Having said that, here are the issues involved.

If you recall, back in October congress paid themselves a $150 billion commission while holding the country hostage in passing what is now called TARP, it provided $700 billion to the Treasury to buy "Troubled Assets". The thinking was that if we could buy the "bad" assets from the banks we could avoid a meltdown. The meltdown occurred anyway and the plan was abandoned very shortly after it passed congress because nobody could figure out how to value the assets. The problem is "Price Discovery" or what price should taxpayers pay for these assets. The real problem was that if we overpaid for assets we would simply be re-capitalizing banks at taxpayers expense and if we paid the market price the banks would be immediately insolvent, thus requiring either an FDIC takeover, a hasty sale or the government pumping much more money into the banks. Instead the Treasury settled on forcing banks to take government money through a preferred stock issue. The banks got some of the cash needed to stay solvent and the government received preferred stock (and evidently the ability to dictate to the banks).

TARP was a stop-gap or a tourniquet. It stopped the bleeding for the short term (though internal bleeding continued and continues) in order to allow for a longer term plan to be developed.

The PPIP is structured to bring in private money (about $30 billion) and then Treasury will match it, the remainder is borrowed from the FDIC (who issues bonds to the public). The FDIC will issue up to $850 billion in bonds to the public in order to finance the PPIP with "Non-Recourse" funding. "Non-recourse" is the key to this whole program, this means that if the deals go south, the "public" part of the partnership bears no risk above what they invested, the FDIC will simply take the assets. This creates basically a new Hedge fund that follows the Freddie/Fannie Model - Taxpayers take most of the risk, but all of the return goes to the equity partners (of which at least half is the "public"). So, taxpayers bear the risk, but don't receive all the return. We've seen this movie before and we know how it ends.

What is the "new" longer term plan? Spending $1 Trillion dollars to guessed it.....Trouble Assets? Second plan is the same as the first. This time its disguised as a "public" partnership and utilizes leverage provided by the taxpayer.

So we are back to October - how do we spend $1 Trillion to buy bad assets. This is where Goldilocks comes in. There are only three possibilities (actually four, but that doesn't work with my three for now), as follows:

In purchasing the "troubled assets" from the banks we will either:

Pay too Much (Too hot scenario) - This is what the government is pushing and hoping for (and why leverage is employed) as if too much is paid for the assets the banks will effectively get rid of assets that hurt their capital position and replace them with assets that help their capital position (effectively re-capitalizing the bank to some extent). The bank wins, however if you overpay for an asset you better hope that the asset eventually performs better than everyone currently expects it to. If the assets don't perform then all you've done is move the assets from one balance sheet to another, the FDIC's. Note: This may in fact be what they really want to happen.

Pay too Little (Too Cold scenario) - This is what the government wants to avoid (and the public part wants to encourage). If you can buy an asset that is probably worth 75 cents for about 40 cents and you are able to employ non-recourse leverage, you stand to make HUGE amounts of money with very little risk. The problem is that this path doesn't help anyone but the hedge funds (isn't it strange that paying the market price hurts everyone but the investor?). If PPIP underpays for the assets it leaves a gaping hole in the bank balance sheets that needs to be filled with either more preferred stock or direct taxpayer infusions. There is really no reason for a bank to participate in this scenario.

Just Right (the Just Right option) - Paying the right price for the assets creates other problems that start with "what is the right price?". If such a price existed the marketplace would be actively buying and selling these securities. In fact such a market does exist, but the prices are so far below what the banks value the assets at that it makes no sense for the banks to sell. What the government is hoping for (and will most likely twist the arms of the banks to do) is to auction the securities at pricing that are well above current market price and reasonably below the price carried on the banks balance sheet. In this scenario it depends on the bank whether the deal would make sense, if the bank can take a reasonable haircut and increase its capital position they might do it. Of course the PPIP is overpaying for the assets (in relation to market prices) and thus their is much risk. Nothing really changes in this scenario, the bank potentially is healthier, but the bad assets still exist - they've just changed balance sheets and guess what - nobody in the market place is going to be willing to pay the "just right" price that PPIP just paid, the assets will immediately drop in value because there is no market to re-sell them into.

Finally there is another option, its the option that could happen (and should happen) but probably will be prevented unless Mark-to-Market rules are relaxed - its the Failed Auction option. When the banks put their assets on the auction block they don't actually have to sell them. Think "Ebay". On Ebay you can either put a product up with a reserve price or without a reserve price, if the reserve is met the auction will succeed, if not the auction fails, same with PPIP. The bank will select a basket of assets (keep in mind they will probably try to rig future auctions by starting with the "best-bad" assets first to show that these assets can be sold) and ask for prices, lets say the banks carry the assets on the books at 75 cents. If the PPIP doesn't come in close to that, say 70 cents, the auction will fail. Why is this bad? Let's say the PPIP bids 64 cents, under current rules a "market price" has been established and the bank, who has decided not to sell at 64 cents will have to mark their assets down to 64 cents in order to meet regulatory rules called Mark-to-Market. Let's say that auction was for $5 billion in bad assets, $750 million in capital just evaporated (calculated by taking the difference in the price carried on the balance sheet and the losing auction bid divided by the balance sheet price ((75-64)/75) and multiplying). This is an even worse, worse case scenario because no assets changed hands and the bank now has to potentially raise more capital and potentially mark down other assets it didn't auction. This also forces other banks to mark down assets that are similar. Without a relaxation of Mark-to-Market, the potential for a failed auction under PPIP would be financially devastating for the banks.

Keep in mind that the government understands the potential problems of the failed auction (at least I hope they do) and thus we are either going to see a relaxation of Mark-to-Market or the auction system installed will be rigged against failure (in other words something other than the free market will prevail).

The strange thing is that the government is an owner in both sides of almost any transaction as they own preferred stock in the bank selling the assets and they control the PPIP.......If you control both sides of an auction, you control the auction.

Either way taxpayers lose and the fundamental housing issues are not addressed.

If all of this is a way to move the assets off the banks books into a single entity (in this case the FDIC) by overpaying for assets and then attempting to utilize a thoughtful process for working the assets out and solving the housing issue, this plan just might work. Of course if the "public" investors thought this to be true....they may not participate. In addition, if it were true, why not just allow banks to move these bad assets to the FDIC in exchange for direct FDIC notes that can be used toward capital requirements and then the FDIC will partition losses and gains from those assets to those who contributed but guaranteed a floor over the duration of the assets. That would be easier and cheaper and quicker.

Finally, lets say the assets move off the banks balance sheets - will the banks immediately start lending again? Unlikely, because consumers are still too leveraged. The whole goal of the banks is to let the consumers take the losses. Hmmm, banks screw up and consumers and taxpayers bear the risk, gotta love it.

While this long summary is no way perfect and subject to change as I understand the program more, it lays out the basics and demonstrates why I don't have a lot of faith it will work as promised. If if doesn't its not like its a lot of money, what's a Trillion dollars these days anyway? By the way, I believe it will take at least $2 trillion to solve the problem, but the longer we wait the more it will cost (think Savings and Loans). So, I'm not against spending taxpayer dollars to solve the problem, I just think we should do it, bite the bullet and the taxpayers should get something in return - Equity Appreciation Rights (see my previous blog posts).

Scott Dauenhauer CFP, MSFP, AIF

Thursday, March 26, 2009

Senate Reviewing College Football

Oh the life of a Senator. Here we are in the greatest financial crisis since the Great Depression and in between the spending of massive of amounts of our tax dollars they have found time to take up the issue of the college football and how they structure their championship. Forget the fact that our banking system is wasting away because nobody wants to put together a cohesive, sensible plan to fix it....let's focus on football.

Lest you think this is a party thing (Yes, that is John Kerry), it is not, it is bi-partisan. Both parties are wasting their time equally while the country works its ass off. I love football as much as the next guy, I'm a huge Oregon Ducks fan...but this is not what we elect our representatives to do......especially in a time like this.

Next time you hear Congress demagoging an issue (like Fannie, Freddie or AGEE (AIG)) just remember how they've spent their time.

Scott Dauenhauer CFP, MSFP, AIF

Monday, March 23, 2009

New Geithner Plan Thoughts

I've linked to Hussman's thoughts on the new Geithner bank plan and I think you should read it, I think Hussman is right.

My initial thoughts about this plan are "what's new"? I don't see anything being brought to the table other than taxpayer money. Banks are going to suddenly decide to sell their "toxic" assets cheap because the Federal Government is supplying $970 billion of the $1 trillion in PPIP money, I don't think so.

And what about the homeowners? Nothing for them....except more foreclosures.....which means even lower prices for these "toxic" assets.

Is it me or did nobody blink when the administration announced another $1 trillion plan (after the Fed just last week)? The market went up, go figure. I guess the thinking is the government will make money on the deal....deja vu anyone - isn't this the same plan from six months ago? A plan to buy troubled assets from banks? Didn't we commit $700 billion for a plan called the Troubled Asset Relief Program (at a commission mind you of over $150 billion to congressional pork)?

If the banks wanted to get rid of these assets at market prices, they'd have done so by now, the fact that they haven't is proof that they won't at some special auction - why would they? If the market for a specific asset TODAY is say 40 cents on the dollar, why will the market 60 days from now be 60 cents on the dollar? Is it because the government is supplying financing? If nobody is willing to pay 40 cents today, does it sound like a good taxpayer investment to pay 60 cents 60 days from now?

I'm not getting it.

I was wrong. I thought the government might get it right by the fourth try, not so. I wonder why everyone is so upset about AIG when our Treasury Secretary basically just announced a plan that will supply hedge fund managers with $970 billion in tax payer dollars (Yes, $850 billion in FDIC notes is essentially taxpayer money as we will be the one's on the hook if the plan goes wrong....bailing out the bail out).

The Humpty Dumpty problem is not addressed, the foreclosure problem hasn't been solved and congress is wasting there time trying to confiscate money legally earned. Did anyone notice we have a financial crisis going on that deserves real attention?

I'll admit that I don't have all the answers, but this plan scares me. I'm glad Wall Street has thus far applauded, but I wonder how long it will last.

A better plan would be to require all these assets be placed into a Book Value and as they are worked out over the years the gains and losses would accrue to the institutions who contributed them, with some maximum loss and gain criteria attached. Of course, if nothing is done about the underlying collateral, the houses......nothing else really matters.

Scott Dauenhauer CFP, MSFP, AIF

Thursday, March 19, 2009

Should Bailed-Out Homeowners Be Required To Pay Restitution?

This makes a huge amount of sense. With all the money being printed, eventually hard assets will have their day again, why shouldn't some or all of the assistance be paid back at some point?

Here is an excerpt:

"Specifically, I propose that bailed-out homeowners, for the rest of their lives, give up 80% of future capital gains from the sale of their homes until the government gift is paid back. They would be required to pay back only 80% of each capital gain to give them an incentive to keep their homes in good shape and sell them at the highest price.

Homeowners currently struggling to keep their homes shouldn't mind giving up 80% of something in the future that they were not expecting to get anyway. Even if they do mind, the repayment wouldn't interfere with their current ability to make the modified mortgage payments and they should neither expect something for nothing nor be given such an offer.

The enhancement I propose is equivalent to the government taking an equity position in the future capital gains in housing for these homeowners."

Scott Dauenhauer CFP, MSFP, AIF

Wednesday, March 18, 2009

AIG: The Third Horn of the Beast

You can go ahead and place me in the category of "angry" when hearing about bonuses for the idiot's at AIG who were responsible for selling insurance on mortgage bonds that eventually soured. It seems stupid to reward such failure, of course we are doing the same for Fannie and Freddie and there is no or little outrage.

I think our anger would be better directed at members of congress who failed in their oversight duties, yet continue to be re-elected (rewarding failure). Everyone is upset at AIG, but ignoring a much larger failure, Fannie and Freddie. This is exactly what congress wants, AIG is a headfake to keep you focused away from their direct misdeeds and failures.

What exactly did AIG do to deserve such attention and such large amounts of bailout money (by the way, they are receiving less than Fannie and Freddie)? They decided to emulate the Fannie Mae and Freddie Mac business model. Fannie and Freddie were private companies with implicit government backing and their job was to buy and insure mortgages in order to maintain a liquid, orderly market. In essence they guaranteed mortgages. AIG was bailed out for doing the exact same thing, they sold insurance to other institutions to guarantee the mortgages that institution had purchased. AIG didn't do anything the federal government didn't do themselves (via Fannie and Freddie), in fact what AIG was doing was probably applauded by those in the government as it allowed for more mortgages to lower income, less creditworthy individuals. Let's also not forget that AIG was insuring AAA rated securities. These AAA ratings came from government regulated credit rating agencies.

AIG's problem was that they weren't thought of as a quasi-government agency, thus when things went south the margin calls came in, had they actually been labeled as Fannie and Freddie - there would be no margin calls and there would probably still be an AIG. Of course that ignores the fact that Fannie and Freddie BOTH failed as well and required $200 billion (and likely triple that) in bailouts. How much bonus money did Fannie and Freddie pay out to politicians over the years? No outrage?

AIG did a bunch of stupid things, but now that they are owned by the government the company is being slaughtered and turned into the whipping boy of all whipping boys. Their sin? Having the audacity to copy the Fannie/Freddie model.

AIG is now basically government owned, which would imply a AAA rating, yet its still receiving margin calls - can some explain that to me?

The Fannie/Freddie model was flawed, so was the AIG model - but let's be careful just who we direct our anger at, much of the blame lays directly at the feet of the United State Congress (both parties). We also can't allow the Fed and Treasury to escape blame, they were asleep at the wheel.

AIG is going to need a "government name", how about "AGEE" - then we'll have Fannie, Freddie and Agee - the three horned beast that brought down Wall Street and the global economy.

Scott Dauenhauer CFP, MSFP, AIF

Monday, March 16, 2009

The Tail Wags Both Ways

This is some interesting stuff if you're into statistics and believe in regression to the mean. The link is a nice graphic (PDF, otherwise I'd show it as a picture).

Scott Dauenhauer CFP, MSFP, AIF

Tuesday, March 10, 2009

Is The Financial Crisis Humpty Dumpty?

Securitization has turned a mess into a disaster. The process of taking a loan, packaging it in a security and then selling that security to investors has resulted in a stagnation of the process that needs to happen in order to put our economy back together again. The problem is that many of the "bad" loans are not owned by one investor, but hundreds or thousands of investors.

Recently I reviewed a CMO (Collateralized Mortgage Obligation) from Bank of America issued in 2005. Think of the CMO as perhaps a mutual fund, its a pool of loans instead of a pool of stocks. 144 loans were grouped together, all with similar characteristics and sold as "tranche" of this CMO, basically you had one big entity with thousands of loans that were then grouped into smaller entities and then re-sold to investors. This particular tranche had 144 loans totaling $81 million on property worth about $120 million when issued. This "tranche" was broken into $1,000 denominations to make them look more like a bond and sold off to investors, potentially 81,000 different investors ($81,000,000 divided by $1,000). It is unlikely that there were 81,000 different investors, but its not impossible. Let's just pretend there were 810 investors who each bought $100,000 of this offering.

Let's now assume that this "tranche" didn't do so well, perhaps it had a lot of properties in California and lower credit scores as well as borrowers who had lots of second liens. The "tranche" starts to go bad and the borrowers start to default, while there are some protections, there aren't much if defaults are higher than 3%, which we will assume they are. Just how do you get those 810 investors to agree to modify the 144 loans that are in this portfolio?

Let's say you are the owner of a home whose note is sold and packaged into the above CMO and is in this particular "tranche". Your house has declined by 50% and the loan's interest rate is adjusting to the point where you can't afford the payment....what now? Simple, call your lender and as for help. So you call, turns out your lender is not your lender, but your "servicer," in this case Wells Fargo. Wells Fargo tells you that they will work with the investor to modify your loan.....then they realize that there are a total of 810 investors and there is no way possible to get full agreement.....they call you back and say no.

This is a hypothetical situation, but not unlike what is going on right now. Many loans can't be modified, even though that is what needs to happen. The only way to get agreement is to own at least 51% of that "tranche" and depending on the voting rights of that CMO, perhaps more (and perhaps you even have to own a related "B" class). As you can see, in order to modify this loan, the 81,000 pieces that have been sold off have to be put back together again. Its Humpty Dumpty....we know what happened with old Humpty, he couldn't be put back together again.

So what's the solution? I don't fully have one as I can't even fully understand or comprehend the depth of some of these securities, but what is clear is that something on the legal side will have to be done.....which may not be constitutional. I can tell you that "cramdowns" are not the solution, they will just force people who shouldn't be in bankruptcy into bankruptcy...which hurts all unsecured creditors as well.

On the Agency side there are simple solutions, on the non-agency side its much more difficult, which is why we had TARP.....which didn't do what it planned on doing, then the "bad bank" idea (which could work if done right).

My overall plan would be to force all of these assets into one entity in exchange for a share of that entity and a share of the losses based on the losses the assets you contribute actually end up losing. It would be a long term entity, all assets contributed at par and there would be some government offered downside protection to induce you to participate and excessive taxation if you choose not to participate (with certain exceptions). This would force assets into one place, not requiring a valuation until the assets have been worked out - which could take years.

Scott Dauenhauer CFP, MSFP, AIF

Tim Geithner's Black Hole

The Washington Post echoes what I've been saying for months now, the cost to bailout the nations banks is about $2 Trillion. I do think however there might be some way to avoid such a large bailout. In addition, just sinking $2 Trillion into banks does nothing but bring their capital levels in line with solvency. It doesn't solve the problem The problem is housing. Imagine if Congress spoon fed the banks $2 Trillion and they did nothing in terms of reducing principal on mortgages? Its a possibility.

Any plan that fails to deal with the securitization of mortgages and putting them back together, writing down the principal and then moving on will be doomed to failure. There also has to be some regulation about securitization.

Scott Dauenhauer CFP, MSFP, AIF

Silver Lining in all this Pessimism?

Yesterday I was talking to a client and said that there is some good news out there, her response was "where?". It's ironic I said, but the good news is that all of the news is SO BAD. Try to find news that isn't hopeless and full of doom, its tough. Even good news is made to sound bad ("There not laying off teachers in Murrieta.....just wait till next year"). What I explained is that things are never as good as they seem and that things are never as bad as they seem. When things are so rosy that there is no bad news, you should be weary, when things are so dire that the news is all terrible, there is reason to have hope.

This of course is just another play on Warren Buffets "Sell at the height of optimism, Buy at the height of pessimism".

I don't know when this will end, it could be a long time, but I'm encouraged by the level of pessimism.

Here is a link to John Authers short video saying the same thing along with some interesting charts.

Scott Dauenhauer CFP, MSFP, AIF

Monday, March 09, 2009

Buffett: On Stocks and the Economy

In classic Buffett fashion, Warren Buffett talks about the US Economy, its prospects and his mistakes. Its honest, thought provoking and a little funny. My favorite part of the article:

"Over 10 years, he said, "you will do considerably better owning a group of equities" than U.S. Treasuries.

Buffett also defended his imperfectly timed October opinion piece for The New York Times, where he said he was moving non-Berkshire holdings in his personal account to stocks.

"I stand by the article," he said. "I just wish I had written it a few months later.""

Its a relatively short article that I think you will find interesting.

Scott Dauenhauer CFP, MSFP, AIF

Hussman: Buckle Up

Interesting commentary, Hussman believes the next 7 - 10 years offers buy and hold investors about a 10% rate of return and believes stocks are undervalued. However, he also thinks that stocks could get very volatile as the administration (whom he admires) ignores the fundamental problems our economy faces. His advice is to "buckle up" as the short term could be even more volatile. I hope he is wrong (as I think he hopes he is as well), but we should be prepared for more and ongoing volatility.

Scott Dauenhauer CFP, MSFP, AIF

Hussman: How To Climb Out of the Global Financial Hole

Its a bit of a long piece, but the only piece that actually gets it right on how to solve the current financial crisis. This stuff makes sense and is an echo of what I've been saying, though with added detail.

Scott Dauenhauer CFP, MSFP, AIF

Cramer Takes on the White House

Yes, I've inducted Jim Cramer into my Hall of Idiots......No, I haven't changed my mind. However, his recent writings defending himself from the administration are interesting. I try not to get political on this blog, so this story is a bit out of the ordinary. However since Cramer blasts the Left and the Right for their stupidity with this crisis I think we should be ok.

Cramer is actually right, yes, I said it. His criticism of both administrations is right on the money (no pun intended). How Paulson, Bernanke and Geithner could have seen the problems coming is beyond me - it was THEIR job to see it coming. They were asleep at the wheel. The current administration has decided at this point NOT to fix the underlying problem, instead believing that our economy can't recover without health care reform.....what?

Lending to people who couldn't pay back the money leads to a financial crisis and to solve it we should fundamentally change health-care? Sorry, but even the most devout Democrat (Jim Cramer) doesn't even buy it.

Its high time somebody decided to fix the actual problem, it actually isn't that complicated.

Scott Dauenhauer CFP, MSFP, AIF

Friday, March 06, 2009

Market Conditions: Is It Time To Panic?

Its now official, no matter how you calculate returns we are now experiencing the worst stock market decline since the great depression.

Rob Arnott states:

"Expressed in real terms, the all-time-high was 2000, not 2007. We're down 60%, in real terms, from that high. This has happened only three times in US market history. 1929-32 (-83%), 1852-57 (-66%) and 1905-21 (-65%). Another 15% drop (i.e., another 6% from peak levels) and we've got the second worst overall decline ever."

So what do we do now?

It seems rather out of touch to say "don't panic" as anytime a developed nation's stock market crashes IT IS cause for panic. People are not wrong to feel panicked, they should - the economy is falling down around them and everything we thought we knew just a year ago, isn't so. So now its time to sell your stocks, right? Put everything under the mattress and buy guns and food and clothes.......right?

Its tough to do, but most people should hang on to their stocks. They may go lower, but over the next decade there is more upside potential at this point than downside.

On November 15, 2006 I recorded a podcast titled "Misbehaviour & Risk" and pointed out the risks of stocks. After reading several great books on risk I found that stock returns are not adequately described by our current models and that stocks are much riskier than we think. I wish I had even listened to myself more. We did everything right with client portfolios, we diversified them, kept costs low, measured how much return is needed in order to meet goals......but none of that saves us from a market that drops by 61%. People who had a conservative allocation of 40% stocks are seeing 20%+ losses, something most planners would have heavily discounted just a few years ago.

I think its important to look back and see where we made our mistakes, its the only way to ensure we don't make them again and to be sure of what those mistakes actually were. Having said that, we still must figure out what to do NOW.

What to do now is to hold on. To utilize a few cliche's - "It's always darkest before the dawn" and "Invest at height of pessimism and sell at the height of optimism."

I don't know when this will end, but end it will, it always does. For those in retirement, this will make things tougher for you, for those who have 10 years or more till retirement, this could end up being the event that allows you to retire more comfortably if you take advantage of it.

I am going to reiterate that I don't know where the market is going, never have, but I do believe that there is more upside than downside.

The real risk going forward is going to be inflation. I know everyone is talking about deflation, but with the deficits we are about to run, the operative word eventually (may take several years) will be inflation.

As always, I am available to take your calls and hold your hand through this very tough process.

Scott Dauenhauer CFP, MSFP, AIF