Tools to Help Business Owners Understand and Survive the Financial Crisis

We’re Seven Months into the Great Mess. What’s Going to Happen Next?

Posted on April 14, 2009

Seven months ago (Monday September 15, 2008) we learned of the failure of Lehman Brothers and soon thereafter the sale of Merrill Lynch and the bailout of AIG.  These events were the culmination of a series of market shocks that had started with the demise of the sub-prime loan market, had accelerated with the collapse of the leveraged loan market starting in August 2007 and had included the takeover of Bear Stearns in March 2008.  But September 15, 2008 is the current era’s equivalent of 1929’s Black Monday.

Since September we have witnessed dramatic governmental actions designed to prevent the current crisis from descending into a downward spiral reminiscent of the 1930s.  For the moment, the stock market seems to be giving these actions (as well as our charismatic new President) a vote of confidence.  We’re also hearing from some of our clients that their operations improved in March and that they are more optimistic about their businesses looking toward the summer.  Another “green shoot” is the middle market M&A market, where I spend much of my time.  The M&A market has definitely improved since the first of the year and indications are that it will remain reasonably strong for a while, at least for profitable companies in favored industries such as government contracting, IT services and health care.

So what is the economic scorecard to date and what can we expect to see going forward?

1)    The World economy is in the midst of the first major global recession of the postwar era.  Global trade has been collapsed for many of the major exporters, particularly China, Japan and Germany.

china-exports1

While there have been some recent hints that the rate of decline is slowing (the second derivative of negative growth) or even bouncing a little, world trade is still an area of significant concern.  Additionally, there remain a number of weaker economies (the Baltics, Spain, Ireland and Hungary among others) which could precipitate a currency and/or banking crisis at any moment.

2)    U. S. government commitments to the financial system bailout now total around $10 Trillion and perhaps more.  At this point we appear to have a two tiered banking industry, with most smaller banks reasonably well capitalized, though closures of the worst continue on a weekly basis, and a number of larger banks in the intensive care ward.  Both Chairman Bernanke and Secretary Geithner have said that these larger banks will not be allowed to fail, though additional capital may be required at some point.  The Treasury has committed to bet $1 Trillion of the FDIC’s credit on a public private investment plan (PPIP) designed to fix the balance sheets of the large wholesale banks.  Secretary Geithner has indicated that a primary focus of this plan is to restore the function of the securitization markets.  As we indicated last fall, the loss of these markets has had a far greater impact on credit contraction in the U. S. than credit tightening by the banks.  In fact, politics aside, indications are that the banks have been lending more to consumers, not less, since the crisis began.

consumer-loans

The primary unresolved issue with the big banks is whether there has been an impairment of their capital large enough to wipe out shareholders and potentially some of their unsecured creditors as well.  The PPIP is predicated on the belief that mark to market accounting has forced the banks to write down mortgage assets to levels below their ultimate realizable values and that, by stabilizing these values through injection of federal guarantees; the major banks will be able to fix their balance sheets and return to their normal businesses (primarily wholesale lending, trade finance, securitization of consumer loans, mortgages and other assets, and trading of derivative contracts).

A lively debate has developed over this point, with many observers convinced that the PPIP plan (combined with the earlier AIG bailout) is an outright subsidy to the banks, without compensation to the taxpayers.  As a result, a real question exists as to whether Congress will be willing to commit additional budget dollars when the fast dwindling TARP funds run out.  To prepare for this eventuality, Treasury and the Fed have asked for new authority to place major financial holding companies into receivership in the event of insolvency.  Additionally, trial balloons are being floated to test the possibility of a forced debt for equity conversion at some of the big banks similar to that now being push for GM’s bondholders.

Our view is that the wheel is still in spin with regard to the financial solvency of some of the larger banks.  With residential mortgage defaults still working their way through the system, there are at least three major categories of bank loans at risk:

a.    Credit card receivables.  Delinquency rates are at historic highs and expectations are for further deterioration through 2009.

b.    Commercial mortgages.  Leon Black, one of the most successful distressed asset investors, recently projected it will cost the banking industry $2 Trillion to clean up losses from commercial real estate problems.

c.    Leveraged loans.  Leveraged lending peaked in 2006-2007 at the zenith of the buyout boom.  Many of these loans were made on relatively short terms and will be coming due or moving into a period of rapid amortization over the next two years.  While some of the larger loans have most likely already been haircut under mark to market rules, many others are being treated as level three assets held to maturity and have likely not yet sustained any impairment.  Many of these will eventually default, particularly if the recession drags on into 2010 or worsens further.

Countering these negatives is the strongly positive yield curve being maintained by the Fed.  This is the perfect environment for bank profitability, leading some bankers such as Jamie Dimon of J. P. Morgan Chase to argue that they will be able to earn their way out of these issues, given a reasonable amount of time.

3)    The U.S. economy is far from healed.  Consumer confidence may have bounced at the bottom, but remains at historical lows

consumer-confidence

U. S. consumer spending was in free fall at the end of January and, based on today’s surprise report to the downside, has likely not improved much since.

retail-sales

The decline in U. S. manufacturing at the end of February was even more dramatic:

manufacturing

We previously predicted that yearend financial statements would cause significant stress in companies’ relationships with their banks.  This chart below, produced by Randy Schwimmer of Churchill Financial in their On the Left newsletter, shows Q4 results for selected firms financed with leveraged loans, as well as the dramatic impact in terms or renegotiated covenants and likely interest rate increases as well.

leveraged-loans

There is nothing in this picture that supports the cheer seen in the stock market in recent weeks.  As we have written previously, the real issue that must be addressed if the economy is to recover and resume its growth is the dramatic overleveraging that has occurred since the 1990’s.  Far from addressing this issue, the Administration’s bailout plans are calculated to maintain this high level of borrowing, which hit a new record of 3.7 times GDP in Q4 of 2008.

credit-market-debt

Notwithstanding all these negatives, an enormous amount of financial stimulus have been injected into the U. S. economy over the past four to five months.  Additionally the Obama administration’s fiscal stimulus package is just now beginning to flow into the economy.   With normal lags, this is likely to begin to have an impact on the economy in the next few months.  We expect to see some near term improvement in economic activity in some sectors.  This should not be confused with the end of the economic malaise; that will only come with the deleveraging of overstressed consumer balance sheets, which will likely take several years.  In the meantime, a better tone in the financial markets may present a short window of opportunity for companies to clean up their balance sheets through refinancing, loan restructures and asset sales.

How Much Risk is the Treasury Really Assuming from the Financial Institutions?

Posted on April 7, 2009

What does it really mean to talk about saving “the banks”?  The Treasury would like us to have a mental picture of Jimmy Stewart in It’s a Wonderful Life, protecting the savings and mortgages of the good citizens of Bedford Falls.  In truth, for all material purposes, the current Public Private Investment Plan (PPIP) is about saving four mammoth financial institutions considered too big to fail, BankAmerica, Citicorp, J. P. Morgan Chase, and Wells Fargo.

These financial behemoths, each as large as a significant number of the world’s national economies, bear as much relationship to the Bedford Falls Building and Loan as a rowboat does to the Titanic.  For public consumption, however, it is convenient for the Treasury to continue to describe its efforts as a rescue of “the banks”;   rescuing hydra-headed financial giants just doesn’t have quite the same ring.  Additionally by lumping these institutions under the category of “banks” the Treasury can continue the fiction that the bailout is about “getting the banks lending again.”

Notwithstanding this fiction, as we showed last week, even Secretary Geithner has abandoned the pretense that the PPIP program is about encouraging direct bank lending in the traditional sense of taking deposits and making loans, admitting that the primary purpose of PPIP is to restore the strength of these wholesale institutions so that they can restart the private securitization markets that fueled the credit bubble earlier in the decade.  So here’s the plan.  Just remove the toxic assets from the books of the financial giants and the system will be restored to its former picture of robust health.  Hopefully the PPIP will be sufficient to fund the fix.  If not the Treasury can use its proposed new liquidation authority, invest few hundred billion dollars more to fill the gaps and sell the freshly minted “clean” institutions to the capital markets for a premium.

On its face this appears to many to be a rational bet.  With the survival of the financial system at stake, risking a few hundred billion more to clean up the banks would indeed be far less costly than another liquidity crisis like that surrounding the Lehman collapse.  Unfortunately this calculation omits one major element of risk that has the potential to increase the cost of the bailout beyond even the capacity of the Treasury to fund: i.e. the derivatives portfolios of the major banks.

Last week the Comptroller of the Currency – Administrator of National Banks issued its quarterly report on Bank Trading and Derivatives Activities – Fourth Quarter 2008.  In reviewing the report, several things become quickly apparent.

1.    Derivatives Trading is a really big business; the notional amount of all derivatives positions at all U. S. commercial banks and trust companies that participate in this business was slightly more than $200 Trillion on December 31, 2008.  That’s more than three times Gross World Product which the CIA estimates to have been a little over $62 Trillion in 2008.

2.    Over 93.7% ($188 Trillion) of this gross exposure was held by only four bank s, J. P. Morgan Chase, Bank of America, Citibank and Goldman Sachs.  One institution, J. P. Morgan Chase, accounted for $87 Trillion of the total exposure or approximately 140% of Gross World Product.

3.    While the bulk of the exposure ($181 Trillion) was in the “traditional” derivatives markets, interest rate and FOREX swaps, almost $16 Trillion was in Credit Default Swaps, up from $1 Trillion in such transactions five years earlier.

4.    What had once been a very profitable business for the major banks, turned decidedly sour in 2008, with net reported trading losses of $836 million for the year as compared with profits of $5.5 Billion in 2007 and $18.8 Billion in 2006.  Drilling down to the details, Credit Default Swaps generated losses for the banks in 2008 of $12.6 Billion, more than offsetting gains for the year in Interest Rate and Foreign Exchange trading.

The OCC report provides a lengthy explanation as to why the notional amounts dramatically overstate the risk posed to the system by these contracts.  First, the real credit exposure is not the notional amount of the contract, but the amount that the market has moved from the strike price of the swap: i.e. the net amount the counterparty would be obligated to pay to true up the contract based on current market conditions.  This is referred to as the Gross Positive Value (GPV) of the contracts.  Since this GPV is in effect an unsecured claim against another financial institution, it represents a credit risk to the holder of the claims.  At yearend total GPV held by U. S. commercial banks was $7.1 Trillion.  Actual credit exposure was much lower, however, as the holders have the legal right to set off this exposure against certain of their counter exposures to the obligor institutions (Gross Negative Fair Values).

The netted credit exposure was estimated to be only $800 billion.  Added to this was Potential Future Exposure of $782 Billion based upon the amount by which the contracts could move in favor of the obligee banks to generate a Total Credit Exposure of $1.58 Trillion.  For the top five derivatives trading banks (the four above plus the U. S. operations of HSBC) total credit exposure averaged 489% of the institutions’ Risk Based Capital at the end of the fourth quarter.  At one bank, Goldman Sachs, credit exposure was more than 1000% of Risk Based Capital.  To be fair this calculation does not take into account pledged collateral backing a portion of the credit risks, which the OCC estimates as typical averaging 30-40% of the exposure amounts, so actual credit exposure was presumably somewhat lower.

By now your head may be swimming a little.  Mine certainly was as I worked to puzzle this out.  These are very large numbers.  Notwithstanding the OCC’s implication that all of this exposure is well managed and under control, I am reminded that we heard similar assurances with regard to subprime loans and CDOs, not to mention AIG’s Credit Default Swap portfolio.  The closest analog we can observe (AIG Financial Products) does not provide much comfort.  Apparently AIG FP had Credit Default Swap exposure of $440 Billion out of total derivatives exposure of $1.6 Trillion.  To date the AIG mess has cost the Treasury/Fed approximately $170 Billion to clean up.  With bank Credit Default Swap exposure in the aggregate reported at 36 times AIG’s CDS exposure, how much risk are the Treasury/Fed/FDIC actually assuming if they take on the unsecured debts of the big banks as they seem increasingly committed to do?  While I draw some comfort from the OCC’s explanation of netting and other factors limiting bank exposure on these volatile instruments, I am left with the nagging concern that there may ultimately be more risk here than meets the eye.   Absent more facts to the contrary, I’m reminded of the immortal words of Judy Garland as Dorothy Gale, “Toto, I’ve a feeling we’re not in Kansas anymore.”

We’re The Marks

Posted on March 17, 2009

From Dictionary.com

Def. Mark - noun

15. b.   Slang.  the intended victim of a swindler, hustler, or the like: e.g. “The cardsharps picked their marks from among the tourists on the cruise ship.”

It’s midnight in Vegas.  A somewhat paunchy fiftyish guy from the Midwest has just sauntered over to the poker table.  With a bourbon in his right hand and a party girl on his left arm, he stumbles slightly before announcing “mind if I join you guys?”  The player with the dark glasses looks up briefly, mumbles something unintelligible and looks back at his cards.  The one in the cowboy hat says “howdy partner, glad to have you”.  Our hero throws his chips on the table and takes his seat.  “Boy I’m feeling lucky tonight.”

Guess who’s flying back to river city tomorrow with a lot fewer chips than he came with?

Uncle Sam stumbled into the world’s highest stakes casino last fall.  He didn’t know how to play the game, but he certainly knew how to raise the table stakes.  Nothing that has happened since then increases my confidence that the U. S. of A. will be leaving this game as a winner.

This morning Andrew Ross Sorkin of the New York Times was on Morning Joe making the case for payment of the AIG bonuses.  His core argument in an article in Tuesday’s Times is that we can’t ignore contractual rights just because they’re not politically popular.  To do so would cause untold damage to the American economy.  On Morning Joe Andrew was brave enough to take the even more unpopular position that the partially nationalized financial institutions must pay up to hire good people or the smart guys at Goldman, et. al. will clean their (and our) clocks.

That this has suddenly become a major political issue should come as no surprise to anyone.  As I said in this posting published February 15:

The big banks have tens of trillions of dollars of credit default swaps and other risk positions on their books. It’s not hard to picture recruiting calls going out from hedge funds and other trading firms not subject to the new law offering the best and brightest traders highly incentivized deals to move from the big banks to begin trading for these non-regulated firms. These traders will come armed with extensive knowledge of their former employers’ investment positions and will have every incentive to take advantage of that knowledge at the expense of their former employers and ultimately at the expense of the taxpayers who will likely soon own the big banks. And they’ll be trading against bank employees happy to take a comfortable salary and a 50% stock option bonus.

The stakes in this game aren’t millions, but trillions of dollars of taxpayer money. Odds are we just bet on the wrong champions.

An old saw on Wall Street goes like this.  “What’s the best way to end up with a $1 million account?  Start with a $10 million account.”  The Treasury and the Fed are starting with a $10 Trillion account, which they have placed on the line at the great Wall Street casino.  They clearly don’t have enough talent in house that knows how to play the game.  Even worse a political consensus is building that will block them (and their proxies at AIG, Citigroup, Bank of America, et. al.) from hiring people competent enough to play in the big leagues against the world’s best and brightest.

It is naïve indeed to think that the political and media demagogues will be any more forgiving of a government controlled bank that pays a star derivatives trader a salary of $20 million, than they are to see her earn that as a bonus.  Yet that’s what top traders earn in what is likely the most complex market ever invented by the mind of man.  If we’re not willing to pay these stars what it takes to attract them to the government owned banks, then they will most certainly be working for the competition and the competition will win.

There’s a lot of anger building over AIG handing $7-12 billion to Goldman to settle derivatives contracts.  Imagine how much anger there will be when the public learns in a couple of years that the government’s mismanagement of the major financial institutions has caused not billions, but trillions, of dollars of new losses from naïve and ill timed trades, made, not on the watch of “former management”, but under the noses of their new Treasury overlords.

There’s no way that we the people are going to win this game.  Continuing to use public funds to trade these treacherous markets is a course guaranteed to lead to a disaster on a scale that makes everything we have seen to date pale by comparison.  It’s time for the Treasury and the Fed to run, not walk, for the exit and demand that the institutions under their control cease these dangerous trading activities immediately.

We’re Fighting the Wrong War

Posted on February 28, 2009

“Generals are always fighting the last war.” Certainly this was true in Vietnam for many years. More recently we tried to refight Desert Storm in Iraq, without understanding that we were headed for another Vietnam.

But what about the economists? Are they subject to the same failings? Most certainly the answer is yes. We have now spent the last year fighting the Great Depression, when the current problem results from a very different cause. True the Great Depression followed the pricking of a stock market bubble, much like the worldwide equity bubble we experienced from 2002-2007. Yet there is one factor in the current market that is materially different from the conditions of the late 1920’s that precipitated the Great Depression of the 1930’s.

You have likely seen the chart below from Ned Davis Research sketching the history of leverage in the United States economy.

creditchart2

Leverage (Total Debt/GDP) peaked in the 1930s at ~2.6 x Gross Domestic Product. Leverage in the current economy peaked at 3.6 times GDP in 2007-2008. So what’s the difference? The difference is that there is no indication that, in the aggregate, the boom of the late 1920’s was caused by a massive leveraging of the economy. From 1923 through 1930, leverage ranged from 150% to 170% percent of GDP. On the other hand, in the current era from Q3 1998 to Q2 2008, a period similar in many ways to the boom times of the 1920s, leverage increase from ~2.6x to almost 3.6x. The massive spike in leverage to GDP from ~1.6x in 1930 to ~2.6x in 1934-36 resulted not from a credit bubble, but from the rapid decline of incomes and output while debt remained relatively constant.

The current down cycle is being driven by a phenomenon different from the forces that led to the Great Depression, i.e. a massive overleveraging of the American, and more broadly, the world economy. How did this happen? Starting in the 1980’s we learned new ways to create leverage. The then relatively recent invention of the credit card began to reach full blossom and consumers became empowered to “buy now pay later” at a previously unheard of rate. Similarly, the development of various securitization tools enabled the creation of new funding vehicles that drove a variety of markets, starting with home mortgages, but extending to all aspects of consumer, business and commercial real estate finance.

Mortgage securitization, which came into full flower from 2002-2006 with the invention of CDOs and credit default swaps, is now well chronicled. Less well understood are the mechanisms by which much of the rest of the economy became, in effect, a giant fractional banking system. The technology that drove mortgage securitization led to the ultimate securitization of “predictable” future cash flow streams from all aspects of the economy.

Not only were future consumer and business income streams securitized through pooling of credit cards, car loans, commercial real estate, equipment leases, etc., truly exotic products began to appear, such as securitizations of movie and music residuals. In 1972 the concept of royalty streams from Ziggy Stardust being securitized by Wall Street would have been thought even weirder than the music.

The net impact of all the securitization and borrowing was to bring to monetize future cash flows in order to make them spendable and investable in the present. This fueled a boom that has now clearly proven to be false. It appears that even the rapid growth major cities such as Phoenix and Las Vegas may have been fueled primarily by a housing boom built on the expectation of further growth in the future. Now the time has come to pay the piper. We are living in the future from which we borrowed in an earlier time. Now is the time to generate the excess cash flows that were leveraged so cavalierly during the boom.

It’s frequently assumed that, since the Great Depression ended as the world ramped up for World War II and government borrowed heavily to fund the war, that a massive increase in debt fueled spending dragged the U. S. out of the depression. The facts do not bear that out. The debt to GDP chart above indicates another mechanism at work during the period which may have been equally important. From 1936-1938 debt to GDP declined from 2.6x to 1.70x. Total debt to income ratios did not rise during the war years. In fact debt continued to decline a percentage of income through the mid-1950s, generally a very prosperous period for the economy. Clearly the exit from the worst of the economic malaise of the 1930s was accomplished without significant new credit creation.

There now seems to be almost unanimous agreement that future prosperity depends on the government’s ability to restart the economy’s credit creation engine. This has resulted in debt funded economic stimulus, TARP, TALF, and the nationalization of AIG, the GSEs and now Citigroup. Increasingly desperate calls from the likes of PIMCO for a restart of the securitization engine and other aspects of the Shadow Banking System indicate that the pressure comes not just from economists, but from the remnants of Wall Street as well.  This pressure comes from a misreading of the lessons of the Great Depression. The apparent growth in leverage in the 1930s was a consequence of the economic decline, not its cause.  In that scenario Keynesian stimulus made sense: fix the incomes and the leverage problem would fix itself.

In the current era on the other hand, leverage is the cause, not the result, of the economic crisis. We spent our future productive output and must now go through an extended period where we produce more than we consume. Until we wake up to this reality and develop economic theories, governmental policies and private actions to support the necessary era of capital formation and debt reduction, we are doomed to live in an era of privation where the focus remains on distributing a shrinking pie rather than growing our way out of the problem.

In For a Penny, In for a Pound

Posted on November 10, 2008

AIG announced today a deal with the Federal Reserve that will have the effect of increasing the Fed’s bailout financing to AIG from $85 Billion to in excess of $167 Billion (and most likely counting).  Any seasoned distressed company investor knows that the first new money put into any failing company is likely to be lost unless the investor is prepared to follow the initial investment with a lot more (sometimes referred to as “good money after bad”).  More than one wag has described this phenomenon as “the second mouse gets the cheese”.

The other big economic news of the day revolved around the proposed bailout of General Motors.  Clearly something is likely to happen here with three million jobs at stake and a lot of political power in play with the United Auto Workers.  Given the inevitable, wouldn’t it make more sense if the money comes in as part of a pre-packaged Chaper 11 which cleans up the company’s balance sheet before the money comes in?

I’ve never seen a successful turnaround that keeps the old, failed management on board to steer the sinking ship.  Perhaps it would make more sense to put together an ownership group that includes some Japanese auto manufacturing skill as well as some of the best business  minds in America.  Toyota, Honda, et. al. clearly know something about running a successful auto plant and they are not afraid of investing in the United States.  And Steve Jobs seems pretty successful at creating a consumer products company.  Let’s harness the best we’ve got to create real change in this vital industry, not subsidize the failures of the past.