AAA-rated commercial mortgage backed securities, a key component of bank portfolios, continues to soar

TO BE NOTED: From Inner Workings:

"Commercial real estate debt rally continues May 22nd, 2009
By David Goldman

The Markit indices of AAA-rated commercial mortgage backed securities, a key component of bank portfolios, continues to soar:

This is why banks can earn enough to keep one nostril out of the water, as I told Tom Keene on Bloomberg News on Tuesday — distressed assets yield enough to compensate for high losses elsewhere. The zombie strategy, in short, is working out just dandily, thank you. This means: No collapse of US national credit for the time being, and lower volatility (hedging costs) overall — but NOT economic growth."

Bill Gross has been a contrarian indicator since Jan. 28, when he advocated buying risky securities, includink preferred

TO BE NOTED: From Inner Workings:

"National bankruptcy? Not yet May 22nd, 2009
By David Goldman

Bill Gross tumbled the Treasury markets yesterday by warnng that the US might lose it’s AAA rating. That means today is a good day to buy Treasuries. Bill Gross has been a contrarian indicator since Jan. 28, when he advocated buying risky securities, includink preferred. I’ve been watching the cost of credit protection for the US and the UK since the beginning of the year, noting in April how close we came to national bankruptcy. I wrote at the time, “Bill Gross is wrong again,” and the same applies today.

What I have argued since Jan. 23 is that the G7 sovereigns and the banks are joined together at the hip, thanks to the multi-trillion-dollar commitments that governments have made to the banks. S&P with its typical backward-looking sloth only got around to inspecting Britain’s barn door after the horses had been gone for months.

For the tenth time: The gauge to monitor is the cost of credit protection on the G7 sovereigns which Markit Partners reviews daily on a free site:

Ticker	CLIP	Name	5Y Today	Daily Chg (bp)	Weekly Chg (bp)	28 Day Chg (bp)
USGB	9A3AAA	Utd Sts Amer	29	-1	1	-19
JAPAN	4B818G	Japan	50	0	0	-19
DBR	3AB549	Fed Rep Germany	30	-2	2	-13
UKIN	9A17DE	Utd Kdom Gt Britn & Nthn Irlnd	72	-1	5	-27
FRTR	3I68EE	French Rep	36	1	2	-10
ITALY	4AB951	Rep Italy	84	-3	3	-32

The UK had been up at LIBOR +164, trading at banana-republic levels, and is now back down to manageable levels.

As the long deterioration of the economy continues, more cracks may appear in the facade of G7 credit, and it seems wise to start layering in hedges in a small way. But by and large, the sovereigns are doing very little because the banks are doing very little. The other failsafe indicator to watch is the risk of bank equities, i.e., the cost of options on bank stocks. Here’s Bank of America, one of the tippier ships in the fleet:

Implied Volatility on BAC Options Falls Faster Than Historical Volatility

BAC hedging costs are a third of their March peak.

It’s a time to pick hedges carefully (commodities, for example), not to run for the exits. Low vol means that no-one is running.

I note, by the way, that the UK banks regained the ground they lost yesterday, and that US banks are up in pre-market trading."

No animal spirits, no recovery

TO BE NOTED: From Inner Workings:

"No Risk, No Volatility, No Economy May 14th, 2009
By David Goldman

LIBOR fell today to 85 basis points, the lowest level since the crisis began. All other risk parameters look benign. My favorite is the failsafe risk measure, the cost of protection against sovereign defaults by the major industrial nations. Here are the last numbers from Markit:

G7 Industrialised Countries CDS

Ticker CLIP Name 5Y Today Daily Chg (bp) Weekly Chg (bp) 28 Day Chg (bp) USGB 9A3AAA Utd Sts Amer 23 1 -14 -22 JAPAN 4B818G Japan 50 1 -17 -23 DBR 3AB549 Fed Rep Germany 25 1 -11 -17 UKIN 9A17DE Utd Kdom Gt Britn & Nthn Irlnd 61 0 -29 -28 FRTR 3I68EE French Rep 29 2 -9 -15 ITALY 4AB951 Rep Italy 75 0 -22 -37

The US sovereign had traded at 75 basis ponts above LIBOR; it is now down to +23 basis points. Notably, the UK sovereign has tightened nearly 30 basis points over the past week. That is the one to watch, given that a systemic banking crisis threatened to overflow the banks of the Thames in emulation of Iceland only a few months ago.

This is worth taking note of. There’s no sense of systemic risk in the midst of a worldwide reversal of sentiment and retreat of stock markets. That’s because the financial system is in the zombie embrace of the governments. VIX picked up a bit yesterday, but per my expectation remains on a downward trend.

No risk, but no economy. There is no sign of improvement in world trade, and China’s export numbers yesterday were terrible. There is no real sign of life from the American consumer, as yesterday’s retail numbers suggested in the United States.

The only way to get an economy moving out of a stall of this magnitude is animal spirits. Greed has to flicker in the cowardly hearts of investors and get them out of their holes. But that is not going to happen, for greed is a bad thing. Greedy speculators who want to squeeze what they are entitled to by law out of the exploited auto workers of the Midwest will be denounced by the White House, subject to public humiliation, and given private death threats. Greedy Wall Street bankers will have their bonuses reduced by law. And those greedy capitalists who earn too much will pay a great deal more in taxes.

No animal spirits, no recovery. Send out for sandwiches. This is going to be a long, long adminstration."

To get a run out of bonds into hard assets, first people must want to own hard assets rather than locked-in cash flows

TO BE NOTED: From Inner Workings:

"How serious was yeseterday’s Treasury auction? May 8th, 2009
By David Goldman

A prominent economist writes today that he has taken his personal money out of dollars and put it into Australian and Canadian dollars, the commodity currencies. The sloppy 30-year auction today, he believes, is a true crack in the dam.

I am less certain: my core view is that America will undergo something closer to the Japanese scenario, in which economic growth stays extremely low, asset price deflation does not reverse, short-term rates stay close to zero, savings rates remain elevated, and bond yields stay low. All that has happened since March is that the end-of-the-world premium has been taken out of the Treasury market.

Remember that credit protection on the United State of America reached 75 basis points in early March — that’s where protection on Brazil was trading pre-crisis. It’s now down to “only” 35 basis points, given the success of the Fed’s and Treasury’s efforts to refloat bank equity with a few trillions of dollars of liquidity.

What the Federal Reserve and Treasury have set in motion is the mother of all crowdings-out. The Fed is compelled to buy substantial amounts of Treasuries to prevent the federal deficit from turning into a $1.8 trillion black hole that sucks in all the free savings of the world and then sum. The moment that yields start to rise, the stock market reacts negatively. There is no “give” in the economy for any substantial rise in yields: the penalty to growth expectations is exacted immediately.

By ballooning the deficit and tying the credit of the United States to the balance sheet of the banking system, the Fed has avoided panic, but has crippled the economy for the long term. There is no way to finance the deficit except by suppressing financing for everyone else. The massive amount of liquidity created by the Fed has no inflationary effect as long as the market does not wan to hold real assets — and it will not as long as the federal government sucks up the available savings. The most like scenario is a paralytic, zombie-like stasis.

The major commodity indices still remain close to their lows with an modest uptick reflecting the mildest hopes for recovery.

Red=UBS, Yellow=GSCI, Green=CRB, Blue=ROgers

source: Bloomberg

To get a run out of bonds into hard assets, first people must want to own hard assets rather than locked-in cash flows. I just don’t see it for the next couple of years.

Tags: fEDTR"

And:

"Addendum on the Treasury auction: Sovereign credit continues to improve May 8th, 2009
By David Goldman

Credit protection on the US sovereign continues to improve in tandem with the banks. We had been out to +75; now we are back to LIBOR +27 for five-year credit protection on the US sovereign.

The risk to the credit of the US Treasury comes from the link to the banking system, and as long as the frame holds (and the Fed doesn’t have to take hundreds of billions of dollars of losses on its multi-trillion-dolalr portfolio, all will appear well. All isn’t well, to be sure; since Alexander Hamilton funded the public debt in the 1790s has the credit of the US been at this kind of risk. But the frame is likely to hold, which means that the credit of the US will hold, along with the Treasury market.

From Markit Partners:

G7 Industrialised Countries CDS

Ticker CLIP Name 5Y Today Daily Chg (bp) Weekly Chg (bp) 28 Day Chg (bp) USGB 9A3AAA Utd Sts Amer 27 -8 -9 -20 JAPAN 4B818G Japan 57 -10 -13 -21 DBR 3AB549 Fed Rep Germany 25 -9 -13 -19 UKIN 9A17DE Utd Kdom Gt Britn & Nthn Irlnd 71 -11 -26 -23 FRTR 3I68EE French Rep 27 -8 -16 -19 ITALY 4AB951 Rep Italy 78 -13 -29 -41

Bank nationalization after December would have led to a generalized crash of asset prices due to massive systemic delevering.

TO BE NOTED: From Inner Workings:

"Why I changed my position on the bank bailout April 20th, 2009
By David Goldman

Last September I opposed TARP, preferring to see the FDIC take over banks that couldn’t get funded in the market place: a short, sharp shock followed by a federal takeover of asset books. In December, though, I opposed bank nationalization after the fact. Why? Because the US government already had committed trillions of dollars to market support, including trillions on the Fed’s balance sheet. The Fed was all in. The credit of the US government was at risk, as I wrote Jan. 19:

Once you start nationalizing banks and admitting that your central bank might be swamped by the size of bad asset problems, bad things happen that you want to avoid. For example: 5-year credit protection on the United Kingdom traded today at LIBOR +125 basis points. That is where Brazil was trading in mid-August, just before things got out of hand. Here’s a better one: five-year credit protection on The United States of America traded today at LIBOR +69 basis points. That is wider than Brazil was trading in May 2007, before the crisis began. The credit quality of the US is now where Brazil — Brazil! — traded prior to the crisis. Given that the Fed is all in, with $1.4 trillion of dubious junk on its balance sheet, this should surprise no-one.

If asset prices crashed BEFORE the Fed made multi-trillion dollar commitments, the Fed could have stepped in with fresh money.

With the bank rally, sovereign credit has recovered:

Ticker	CLIP	Name	5Y Today>	Daily Chg (bp)>	Weekly Chg (bp)>	28 Day Chg (bp)>
USGB	9A3AAA	Utd Sts Amer	40	0	-7	-26
JAPAN	4B818G	Japan	63	-6	-15	-35
DBR	3AB549	Fed Rep Germany	41	1	-3	-20
UKIN	9A17DE	Utd Kdom Gt Britn & Nthn Irlnd	84	-1	-10	-34
FRTR	3I68EE	French Rep	43	0	-3	-21
ITALY	4AB951	Rep Italy	106	-1	-13	-51

Source: Markit Partners

Bank nationalization after December would have led to a generalized crash of asset prices due to massive systemic delevering. The Fed would have been bankrupt. No-one would do business with anyone else without buying insurance against default, and the market for insurance would have collapsed. The system, in short, might have passed the event horizon for a black hole. We were that close.

And that is why, to answer a reader’s question, we throw good money after bad. In fact, we keep the banks afloat to try to turn bad money into sort-of-OK-money. It’s nothing to brag about, but zombie is as good as it gets."

the only alternative is to allow the banks a zombie existence cannibalizing the “toxic” assets left over from the structuring excesses of the boom

TO BE NOTED: From Inner Workings:

"And another reminder: what happens if the insurers ago? April 15th, 2009
By David Goldman

The answer is, “everything,” including the most mundane transactions in trade — because everything requires insurance. This from the FT this morning:

The front page of Wednesday’s FT runs with the following story - that the UK government’s forthcoming budget is to include a “supply-chain insurance plan”:
The scheme will form a centrepiece of the Budget initiatives to help small to medium-sized businesses cope with the recession. Its unveiling marks the culmination of months of negotiations with insurers spearheaded by Lord Mandelson, the business secretary.

The initiative responds to concerns that hundreds of supply chains are threatened by the recession-fuelled reduction in credit insurance, which protects companies that supply goods on credit against the risk that they will not get paid.

Industry has been lobbying for the government to step in for months. The EEF manufacturers’ organisation warned weeks ago: “The speed at which credit insurance is being withdrawn threatens the supply chains that are the heart of the UK’s manufacturing base.”

Supply-chain insurance is crucial to the functioning of the economy and is really one of those things that has been somewhat ignored in the financial crisis so far, what with all the other credit-linked troubles around.

The point is that forms of credit - trust - are critical to lubricating trade. The collapse of the Baltic Dry Index months ago was the thin end of the wedge: global shipping ground to a halt as participants in the market found themselves unable to secure crucial letters of credit from banks and commodity brokers that mitigated counterparty risk.

In fact, as with so much in this crisis, much of the recent ructions in trade credit can be traced back to the activities of very small specialist units at financial sector firms. In the case of trade credit and surety, the activities of the reinsurers are crucial. And the reinsurers are pulling back.

FT Alphaville understands that Swiss Re has cut 45 of 65 jobs in its credit and reinsurance department, with a view, we believe to quitting the trade credit insurance and surety bond reinsurance sector entirely by year end.

Swiss Re confirmed to FT Alphaville that activities are being reduced but precise numbers could not be confirmed. “We will continue to accommodate the needs of key core multi-line clients” a spokesman for the company said.

The numbers might seem small, but such re departments are of huge importance.

Much like the way AIG FP functioned, trade credit and surety reinsurance operations write contracts with, effectively (though not necessarily we stress, directly) a huge amount of leverage, based on the notion that such contracts being written are virtually risk free. (Indeed historically the industry was renowned for reinsurance contracts that came with secret confidential ’side letters’, hidden from regulators, promising in legally binding terms that their contracts would never be exercised). Just as AIG’s 650 people were a primary force in the explosive growth of the multi-trillion dollar CDS market, so too are small trade credit and surety reinsurance departments like Swiss Re’s, then, critical for the functioning of trillions of dollars of global trade credit insurance further down the chain.

And while Swiss Re is not the largest reinsurance player in the trade credit space, it’s pullback is nonetheless instructive. It seems representative of a broader trend - one that has the potential to be so damaging that the UK government is forced to make filling the vacuum in the trade credit space a centrepiece of its upcoming historic budget.

Indeed, brokers, trade credit insurers and surety bond companies are all understood to be very worried about the declining availability of reinsurance - which is critical to their own ability to continue to operate effectively. The government’s move should hopefully do something to fill the vacuum - but until details about what price, terms and conditions new reinsurance - government sponsored or otherwise - are available, trade insurers and indeed trade full stop will continue to languish.

Of course it was a pyramid scheme: of course the insurers who allow a load of kasha to get from Minsk to Pinsk should not have owned the bottom of the banks’ capital structure, and so forth. No-one should have owned bank preferred shares but misers living in caves in the Swiss alps living exclusively on home-grown goats’ milk, so that the vaporization of these securities under nationalization would not even have gone noticed. Bank subordinated debt should have been sold exclusively to the hoards of sleeping dragons who would not hear the crash of the isser thousands of miles away. We know that now. My recommendation is that Larry Summers and Timothy Geithner should be deputized to find sufficient dragons and Swiss misers to place the $135 billion in TARP capital injections to the banks….

…but in the meantime, the only alternative is to allow the banks a zombie existence cannibalizing the “toxic” assets left over from the structuring excesses of the boom."

It’s cheaper to refloat the banks than to go in and bail out insurers after public confidence collapses

TO BE NOTED: From Inner Workings:

"Reminder: why the Treasury needs the banks to look better April 14th, 2009
By David Goldman

The next sector to collapse would be the insurers: as I’ve said here again and again, the big pyramid scheme in the US financial system is that the insurers own the bottom of the capital structure of the banks. Bank preferreds, trust preferreds, hybrids, etc. were the favorite repast of yield-hungry insurance portfolio managers.

The big insurance companies all are trading like junk, still. Here is the cost of five-year credit protection on two of the biggest:

It’s cheaper to refloat the banks than to go in and bail out insurers after public confidence collapses."

Part of the problem is the way loan restructuring as promoted by the Treasury turns into a skimming operation for mortgage servicers

TO BE NOTED: From Inner Workings:

"If banks are up, why are asset prices down? April 14th, 2009
By David Goldman

Here’s a conundrum: the sort of “toxic assets” whose liquidity the Treasury PPIP was supposed improve continue to languish around all-time lows. The ABX Index of AAA-rated securities backed by subprime collateral issued in 2007 is shown below (click to enlarge image):

Why, indeed, should the 2007 AAA index trade at 25 cents on the dollar? Part of the problem is the way loan restructuring as promoted by the Treasury turns into a skimming operation for mortgage servicers. While loans are in restructuring from a higher to a lower interest rate, servicers keep up the payments into trusts that issue bonds to investors. By restructuring the mortgage, the servicer builds enough fees into the transaction to come out whole. The homeowner still can’t pay the mortgage, and the bondholders haven’t gotten anything.

In short, the reason that mortgage backed securities with subprime collateral are doing so badly is that loan restructuring has opened up a Pandora’s Box of potential scams. Of course, the good news is that the housing market is clearing in most parts of the country, and sales upon foreclosure are getting about 50% of value. A terminal value of 50% after four years is pretty good on a bond that costs you 25 cents today. But the risk in loan modification is that it may take a lot more than four years to get your recovery.

This rather technical issue illustrates why the banking crisis is not over: it merely has reached a point of statis in which nationalization is off the agenda, and bank stocks are sure to be worth something. If they are worth “something,” I argued, they are worth a bit more than option value. To reiterate what I said here April 3:

Right now, Citigroup (for example) is priced exactly to option value. Using the option calculator for options on Citigroup at ivolatility.com, I obtain a price for a 10-year call on Citigroup stock at a $2.74 strike of — exactly $2.41. In other words, the value of Citigroup stock is the same as that as an option on Citigroup, in the absence of dividends. At yesterday’s close, the market is saying that there might be something there, or there might not — the price of the stock is the price of a lottery ticket. Whether Citigroup exists as a going concern depends mainly on the whim of the federal government. When the market feared nationalization, the value of the option collapsed to $.97.

If we postulate that Citigroup can eke out a minimal level of profits as a zombie bank, eating the dead flesh of toxic assets (as today’s news reports suggest), then its value should be a bit higher than the pure option value. My guess is $4 to $5 is where Citigroup settles, with a comparable level of $10 or so for Bank of America. I don’t think we are going to see Citi or B of A at their old highs for decades, if ever.

Wells Fargo told us very little about where their earnings came from. After $40 billion of writedowns during the past five quarters, and the end of FAS 157, Citigroup could report almost any amount of earnings it wants for the first quarter. Given that the government is a stockholder, the Treasury desperately needs to show success, and the Treasury ultimately will decide how Citigroup cooks its books for the quarter, I expect a surprise on the upside. Even though C is trading above $4 share in the London pre-market, I wouldn’t get in the way of it. You can’t short Citigroup (no shares are available to short — I tried), those who are shorting Citi are paying 100% interest (hedge funds holding preferred against common), and options are ridiculously expensive. Probably a good thing, or somebody would get hurt doing so.

I ridiculed the Meredith Whitneys of the world when they told investors not to buy at $1 a share, or $3 for Bank of America. But the pessimist argument isn’t stupid, only one-sided. Their side of the story has some merit."

Chinese don’t know what’s inside Citigroup, don’t understand it, and don’t want the headache of owning a highly politicized piece of property

TO BE NOTED: From Inner Workings:

"How about a reverse takeover of Citi by Pudong? April 10th, 2009
By David Goldman

Citi owns a bit less than 4% of Shanghai Pudong. Bloomberg News reported this morning:

April 10 (Bloomberg) — Shanghai Pudong Development Bank Co., part-owned by Citigroup Inc., plans to raise as much as 30 billion yuan ($4.4 billion) selling shares and bonds to ensure it has enough capital to meet regulatory requirements.

The lender will raise as much as 15 billion yuan from a private placement, equivalent to as much as 20 percent of its existing shares, to 10 investors including the bank’s major shareholders, according to a filing today to Shanghai’s stock exchange. The statement didn’t say whether Citigroup will buy shares. The bank will also raise as much as 15 billion yuan issuing subordinated debt.

Hmmm….with 5.7 billion shares outstanding and a share price of 22 yuan, Shanghai Pudong has a US market cap of around $18 billion. Citicorp’s market cap is only $16.7 billion. Why shouldn’t the Chinese diversify some of their foreign exchange reserves into ownership of a major banking franchise? How about a reverse takeover by Pudong?

Well, there are some obvious reasons why not. The Chinese don’t know what’s inside Citigroup, don’t understand it, and don’t want the headache of owning a highly politicized piece of property with considerable exposure to Congressional sniping. The last thing Beijing wants is to sit in the cross-hairs while political snipers scream about selling the American economy out to foreigners. The last time someone from the region bought into Citi, moreover, it was the government of Singapore, which will get preferred shares exchanged into common equity at the equivalent of $3.25 a share. That position still is underwater.

But there is a case to be made for it, and if I were (still) an investment banker, here is what I would pitch to the Chinese authorities:

First, Citigroup’s structured portfolio of “toxic” assets is extremely cheap and manageable now that it doesn’t have to be marked to market. You own a bunch of this garbage anyway, and fund managers turn up on your doorstep daily to pitch distressed investing. You can do a whole lot better buying a distressed bank and leveraging a distressed asset play. Secondly, you can sell off most of Citi’s operations for a modest profit. America doesn’t need another branch bank after Wells Fargo/Wachovia, Chase/Washington Mutual, and Bank of America. Citi should get out of its consumer businesses and devolve into an international wholesale bank. Its main profits should be the runoff on its portfolio, which out to be worth a lot more than $3 a share. Third, by owning a major bank you get a seat at the table of corporate America. You get a peak inside the kimono at every American corporation and the inside track on future mergers and acquisitions. The business intelligence value of owning the franchise has to be worth a few billion dollars. That’s not counting Citi’s international branch network, which would give you the inside track on a dozen countries you don’t know much about. Presuming that the Obama administration throws its political shield over the deal and hails it as a great win for the American taxpayer (presuming you pay a bit more than $3.25 a share so that the Treasury can book a profit on its own 36% of Citigroup), it could be a very wise move. I wouldn’t underestimate the governance problems of running a monster like Citi — your managers will experience great frustration dealing — but at roughly $20 billion, you can afford the experience. After all, you have to learn to run great international finance franchises some time. Why not now?

At a market cap of $16.7, a smaller sovereign than China could afford to buy the joint.

As an aside: There are some very smart people at Citigroup. The franchise is worth a great deal. It took a century to assemble and couldn’t be easily reproduced. For example, in 2007 I spent a few days in Ecuador in my capacity as strategist for a hedge fund. The only major American bank active in the country was Citi, and the local office knew the economy and financial system cold. They gave me very good advice, and helped my fund make money trading Ecuadorian government debt. Citi has a global reach that no other US bank does.

As I’ve noted before by way of full disclosure: I own a bit of Citi preferred, bought at distressed levels, and I happily await conversion into common equity."

If he doesn’t let the banks make money, the insurance industry will be next to go.

TO BE NOTED: From Inner Workings:

"Recycling “toxic” assets April 3rd, 2009
By David Goldman

As I’ve indicated in several posts earlier this year, the key financial-system measure to focus on is Net Interest Margin for commercial banks:

As of the end of the fourth quarter, US banks’ net interest margin was at an all-time, probably because most of their commercial loans were revolving facilities negotiated years earlier at very tight spreads. That is changing dramatically, at least for major banks who can borrow at Treasuries +80 basis points with an FDIC guarantee, and buy distressed assets yielding an unlevered 15%-25%.

No surprise that banks want to buy more of the so-called toxic assets, not less. The Financial Times today reports that banks using federal moneiy want to buy toxic assets from other banks. The PPIF (pronounced “ppppphhhhhhhhh”) will allow banks to sell relatively sound loans at high dollar prices in order to invest the money into distressed assets at low dollar prices. The terms of PPIF make good loans more attractive to private investors getting non-recourse financing from the Treasury. Banks can raise cash at higher prices to direct money into sub-prime AAA’s at 25 cents on the dollar and 15% unlevered returns in the most extreme scenario. Banks make a reasonable, if zombie-ish sort of living out of this, private equity makes money, the taxpayer foots the bills, and the net effect on the economy is quite small. The banking system survives, and the economy sucks wind forever.

That is not quite what Geithner had in mind. But he doesn’t really have other good choices. If he doesn’t let the banks make money, the insurance industry will be next to go. And the As the FT notes today in the linked report,

Goldman and Morgan Stanley have large fund management units and have pledged to increase investments in distressed assets.

This week, John Mack, Morgan Stanley’s chief executive, told staff the bank was considering how to become “one of the firms that can buy these assets and package them where your clients will have access to them”.

Readers keep asking me how to buy these “toxic assets,” and the answer is that unless you have a minimum of seven figures to spend and an institutional-quality account with a major private banking franchise, you can’t. But if banks can create distressed-bond funds that the public can buy, they might become quite popular."