Toro's Running of the Bulls Market Blog

So Home Prices Never Fall, Eh?

From the Wall Street Journal

Kendrick Brinson/WSJ

This Atlanta area home, with an original principal amount of $236,000, was bundled for securitization. It was later foreclosed and sold for $30,000.

That is a decline of 87%!

And then there is this interesting snippet from Michael Lewis's article on AIG in Vanity Fair, which I highly recommend for reading.

He simply claimed that the fact was irrelevant: for the bonds to default, U.S. house prices had to fall, and Cassano didn’t believe house prices could ever fall everywhere in the country at once.

Simple assumptions and beliefs, especially when they are taken as "common knowledge," can have massive consequences. 

This is Not Japan

From The Atlantic

[I]t seems that Japan's banking crisis isn't nearly as analogous to America's as you might expect. As John Hempton has explained, Japanese banks had tons of savings, few loans, and slim margins -- just the opposite of the big banks here. And they didn't impair recovery by failing to lend, but by continuing to provide credit, for political reasons, to large industrial firms that were in terrible shape. This was the zombie relationship. Japanese savers poured money into the banks, the banks rolled over old debt to busted property companies and industrial firms, and so necessary shifts in the economy never took place.

As James Surowiecki notes, political involvement in the banking system in America has not led to a similar outcome -- the banks aren't being told to keep sinking firms afloat. The results have been plain for all to see; old industrial enterprises have been hammered, as have firms tied up in the housing boom. The destruction in "creative destruction" is taking place, leaving plenty of room for creation later.

Most Banks are Solvent. Most Banks Made Money Last Year.

A theme we have hammered on recently is that most banks are not in trouble, most banks made money last year, and most banks will survive just fine thankyouverymuch.  The collapse of the banking index, with the BKX falling 85% top to bottom, has offered some enormous, once-in-a-generation bargains to those willing to do the dirty work and dig for opportunities.

The New York Times takes up this theme in an article on how most small banks are healthy.

Forget “too big to fail.” These banks consider themselves too small to risk embarrassment. They are run by people who grew up in the towns where they work, and their main fear is getting into a financial jam that will shame them in the eyes of their neighbors.

The steep profits earned by national banks didn’t turn their heads in the last decade because they were inherently skeptical of double-digit growth rates.

“We like a nice, gentle, upward slope,” said Donald E. Goetz, the president of DeMotte State Bank, an 11-branch operation in the northwest part of Indiana.

“This kind of growth, like you see in the stock market” — Mr. Goetz ran his hand through the air, tracing the shape of a mountain range — “that doesn’t interest us.”

I have culled a list of banks that I think are healthy and great values, and expect to start buying into this downdraft.

What Worries Me

I would very much like to extend my appreciation to all the kind words yesterday.  One of the reasons why I started this blog was to provide unbiased (though, in retrospect, not always correct) observations about what is happening in the market.  If I have helped you understand things a little clearer, then I have accomplished one of the missions of this blog.

I have not gone away, at least not yet.  However, circumstances are changing such that it may no longer make sense for me to actively blog as I have done so in the past.  That decision remains to be taken, and I will continue to post, but only occasionally until decisions have been made.  Then, we will see.

I do owe at least one post as Isam reminded me in the comments yesterday. And that is what really worries me.

The economy and the markets have gone through a traumatic shock unlike anything we have seen in seven decades.  You know the story by now - housing bubble collapse, Lehman bankruptcy, subprime mess, credit market implosion, deleveraging, etc. 

I believe the market had priced all of this in, and more, given the record spreads in credit and dirt cheap valuations in equity.  If we are to break to new lows, then another convulsive shock must occur to the economy.  There must be something as big or bigger than what has already been experienced to send the market into a free-fall once again.

Bears argue that the shock is going to be commercial real estate and/or credit cards.  I disagree.  I believe the market has already priced in the decline for both.  The REIT ETF, ticker IYR, fell 77% from the highs, while credit card giant American Express fell over 80%.  Those are depression-like returns.  These are well known and have already occurred.  I also believe that both are no where near as threatening as what has already happened in the housing and mortgage markets.

But there is one thing that I believe is not well known, and it does worry me. 

And that is the potential collapse of Eastern Europe.

The collapse of the economies of Eastern Europe is an event that could rival or even surpass the collapse of the housing market, and I do not think American investors fully realize the ramifications of such a collapse. 

The region is not particularly important in terms of global output.  However, it is the exposure of European banks to the former eastern-bloc countries that could cause a chain reaction which could bring down the European banking system, causing the economy to plunge further and markets to collapse once again.  Given the hodge-podge of European financial regulation and a patchwork political system, the European authorities are less able to respond to such a crisis than the United States.

By some accounts, the eastern European countries are in worse shape than the Asian countries were at the start of the Asian Contagion in 1997, with sky-high indebtedness and large current account deficits.  Western European banks financed the borrowing in eastern Europe, and large defaults could bankrupt the European financial industry.

I do not know if the ultimate denouement is the implosion of the European banking system triggered by a collapse of the highly-indebted countries in Eastern Europe, but it worries me.

Scrap Mark to Market?

I think the mark to market accounting standard must be changed.

From Robert McTeer

In 2008, when the subprime mortgages in these pools began defaulting at a higher rate, the market for MBSs dried up.  Yet, rigid mark-to-market accounting rules, enforced by regulators, forced the drastic write-down in the value of MBSs, even when investors were both willing and able to hold them until the market improved or to maturity, when the loans would be paid off, if necessary. 

However, even though the MBSs have hardly been trading, most of the underlying mortgages are still generating income, making them worth more than their marked down prices.  Thus, a cheap way of addressing the financial crisis and saving banks is to suspend these mark-to-market rules. ...

According to Milton Friedman, mark-to-market accounting was responsible for many banks failing during the Great Depression.  In fact, President Roosevelt suspended it in 1938.  The practice reappeared  in the mid-1970s and was formally reintroduced in the early 1990s. ...

The tragedy in marking to market comes not from the write-downs per se, but from the resulting decline - dollar for dollar - in regulatory capital.  

As a general accounting rule, investments drop in value when their market price drops below their original purchase price, a situation called impairment.  Impairments can be classified as "temporary" or "other than temporary," in which case they must be written off as worthless.

For example, if a bank buys an MBS with 1,000 underlying mortgages and a few of these mortgages become "other than temporarily impaired," the bank must write down the whole bond - not just the impaired mortgages.  The write-downs would be much more modest if the same 1,000 mortgages were separated.  For example, the Federal Home Loan Bank of Seattle has a portfolio of MBSs that are predicted to only lose $12 million in the long run.  However, the MBSs were marked to market because they were classified as "other than temporarily impaired," causing the bank to report a $304 million loss.

Although the original mark down may not be justified, it can lead to a real loss of capital.  This loss of capital may lead to higher capital requirements at a time when capital is becoming scarcer. A bank's worsened condition may also require it to pay higher Federal Deposit Insurance Corporation (FDIC) deposit insurance premiums in order to preserve the deposit insurance fund.  As this process is multiplied across the banking system, these premiums may be raised across the board.

Consequently, the banks have their capital requirements increased when they can least afford it.   The FDIC, after keeping its premiums low during good times, has to raise them during bad times.  This is procyclical because it makes an economic downturn worse, and can artificially reinforce an economic boom.

And from Jason Schwarz

On April 2nd, FASB will vote on the proposed alterations to this nightmare mark to market regulation. We have heard rumors of two new proposals. The first will change the requirements for actually taking a writedown and the second will allow companies to determine whether a particular market is active or inactive and they will be able to declare a related security as ‘distressed’. I love these new proposals because they maintain transparency for investors but the new regulation won’t force the bank to raise capital during times of short term overreactions. This solves a big problem for the banks.

The question on investors' minds is how will the new mark to market rules affect the plan of the Treasury, Fed, and FDIC to pump trillions of dollars into purchasing these toxic mortgage securities? Many investors are confused because it appears that all of this money won’t be needed because of the regulatory change. Let me tell you why it is still needed. These toxic assets need a pricing mechanism. Geithner, Bernanke and company have put into place the necessary components to bolster the market for these securities. Banks won’t want to sell them off because of the new mark to market rules but there will still be trillions of dollars of demand for them. Huge demand with no supply is superb news for the banks and for lending. It’s exactly what the government wants. These toxic assets won’t be toxic any longer. Writeups will replace writedowns and bank share prices will return to prior norms. This solves another big problem for the banks.

The government is in the process of eliminating negative balance sheet pressure for the banks and at the same time they are solidifying the pricing mechanism for these toxic securities by maintaining and strengthening the market for them. It is a brilliant plan. It is the solution we have been waiting for and it has created the buy of the year.

Berkshire Hathaway - The CDS Market is Irrational

Markets at times are rational, efficient, information-processing mechanisms which correctly price asset markets.

And at other times, the market is an idiot.

This struck me - as it does every day looking at my screens - reading this article from Bloomberg.

Warren Buffett's Berkshire Hathaway Inc. and Jeffrey Immelt's General Electric Co. are being battered in the market for credit-default swaps, treating both AAA companies like junk.

Let's put aside GE for a moment, because I think there is some legitimate debate regarding this company.  But Berkshire Hathaway a junk credit? 

Investors are paying as much for contracts that protect against a default on the bonds of Omaha, Nebraska-based Berkshire, which has $25.5 billion in cash, as for KB Home, the homebuilder that lost money for seven consecutive quarters. The cost of credit-default swaps on the finance arm of GE and its $45 billion in cash is about the same as for building materials- maker Louisiana-Pacific Corp., which posted nine straight quarterly losses. ...

Swaps on Berkshire have soared 2.26 percentage points the past two weeks to 5.35 percent a year, CMA data show. That compares with 4.9 percent annually for Los Angeles-based KB Home.

Berkshire and KB Home priced the same in the credit default swap (CDS) market?  Tell me that the market isn't completely nuts right now.

Now, full disclosure, for the first time ever, I purchased Berkshire shares last week. But I would be writing this article even had I not.

There are three issues with Berkshire I see that could spook the market.  The first is that the company writes CDS swaps on corporate debt.  What is Berkshire's total exposure?

Berkshire in 2008 started writing credit-default swaps on individual companies, with contracts guaranteeing $4 billion of debt from 42 borrowers, Buffett said in the letter.

In other words, if every single borrower whose debt Berkshire insured went under, instead of $25 billion in cash, Berkshire would have $21 billion.  Berkshire does not need to post collateral on its CDS positions, so there is no threat of a financial company death spiral, as I explain below.

The next issue are the puts Buffett sold on the market.

Buffett has struck deals with firms that Berkshire hasn’t identified to protect them against declines in four equity indexes and guarantees on indexes of non-investment grade debtors that require the company to pay out when there’s a default.

The derivatives that garner the most attention are the ones Buffett wrote on stocks.  However, those options are European options, meaning they can only be put back to Berkshire when they expire, which do so in a decade.  So there is no cash liability for Berkshire until that time.  Any market-down on Berkshire's books is an accounting one, not an economic one.

Finally, there is the issue of insuring municipalities.  States and municipalities are in a great deal of trouble.  However, Berkshire entered this market within the past year, and would barely put a dent into the company's cash pile if all the contracts - which are often second and third behind other bond insurers - had to pay out, i.e. if all the municipalities failed.

Near as I can tell, Berkshire has not sold any variable annuities which are hammering the likes of Hartford Financial.  Berkshire's insurance risks are primarily the non-financial kind.  Have there been any massive earthquakes or hurricanes the past few weeks that I am not aware of?

The playbook for collapse for many financial companies has been underwrite CDS, not post enough collateral, bond spreads widen, CDS liabilities rise, CDS prices rise, underwriter's stock falls, spreads widen further, liabilities rise more, CDS prices rise further, underwriter's stock falls further, market gets fearful that the underwriter will have to issue more equity, stock falls further, CDS prices rise (sometimes with no spread widening of the issuer), ratings agency downgrades debt because of rising CDS liabilities and falling stock price, underwriter must post more collateral, underwriter's stock falls even further making it even more difficult to raise stock, ratings agencies downgrade debt again requiring more collateral be posted, and so on until the stock price has collapsed that it becomes virtually impossible to raise common share capital from private interests.  There is great interest in breaking stocks through this process.

Now, that is not to say that many firms did not deserve to go under.  Companies such as Bear Stearns, Lehman, AIG, Countrywide, and many, many others were extraordinarily stupid, and set their fate, even without any help from the derivatives market.

However, this downward spiral of fear can feed on itself. 

A lot of traders “are in a position of where it’s sort of hedge or lose your job,” Backshall said. When GE credit swaps soared to as high as 20 percent upfront yesterday, “that was likely driven just by a desk deciding to desperately hedge,” he said, “rather than a real belief” that the company had a high risk of defaulting. 

This is George Soros's theory of reflexivity, where a negative loop feeds on itself and the perception becomes reality.

This occurred during The Great Depression.  A study by an economist at the Federal Reserve found that banks which failed during the Depression were often as financially strong or stronger than banks that did not.  This, of course, runs counter to classical economic theory which postulates that investors and depositors are rational economic agents.  Rather than processing information in a rational manner, people became scared and pulled their money out of banks, regardless of the bank's financial health.

This is what I believe is occurring now.  All deposit-taking institutions and most financial companies are being taken out and shot, regardless of their intrinsic health.  Financial companies especially are prone to this irrational reality since they are highly levered institutions and can easily fail.

The CDS market, which is fairly illiquid, facilitates and enhances this process. It too can be irrational.  For example, there has been a disconnect in the high-yield market as prices in the cash market were up this year while prices in the derivatives market were down.  The difference in return has been 15% in two months.  That is enormous.  And ridiculous!

Markets can act irrationally.  I believe they are now.  Always using a market, any market including the derivatives market, as an accurate gauge of financial and economic health is folly as the perception of the market can become the reality itself.

UPDATE - Here is a post from Accrued Interest on problems in the CDS market.

Updating Banks

I posted two articles last week arguing that perhaps the banking system is not as dire as seems, which you can read here and here.

I started tracking the banks last year. I have not made an investment yet, and still think it is too early, but valuations are at the point where dipping you toe into the water might make sense.

I do not know if I will execute this strategy, but I am thinking about buying a basket of well-capitalized, profitable banks that have been thrown out with the whole industry.

I keep a list of 538 banks.  When I last checked, 27 were trading below tangible book value.  Today, 100 are trading below tangible book value, or 19% of the universe.  In total, 412 are trading below book, or 77% of the universe.  Banks, as you could imagine, have become much cheaper since last summer.

These are the banks that are trading below tangible book value, were profitable last year and are expected to be profitable this year.

Capital Bank (ticker CBKN)
Cardinal Financial (CFNL)
Cascade Financial (CASB)
Center Financial (CLFC)
Central Valley Community Bancorp (CVCY)
Community Capital (CPBK)
Crescent Financial (CRFN)
First M&F (FMFC)
First Security Group (FSGI)
Firstbank Corp (FBMI)
Heritage Oaks Bancorp (HEOP)
Horizon Bancorp (HBNC)
Intervest Bancshares (IBCA)
LNB Bancorp (LNBB)
MacKinac Financial (MFNC)
MetroCorp Bancshares (MCBI)
Northrim Bancorp (NRIM)
Parke Bancorp (PKBK)
Porter Bancorp (PBIB)
Savannah Bancorp (SAVB)
Southern Community Financial (SCMF)
Southwest Bancorp (OKSB)
Summit Financial (SMMF)
Sun Bancorp (SNBC)
VIST Financial (VIST)

Now, I am not saying these are all buys.  This is a starting list. 

Some of these trade by appointment.  The average market cap is $53 million, ranging from $10 million to $135 million.  Average assets are $1.5 billion.  The average return on equity is 4.2%, ranging from 0.2% to 12.0%.  Net interest margin averages 3.5%, with ranges between 1.8% and 5.2%.  The efficiency ratio averages 66%.  Core capital averages 10.7%, with a low of 9.2% and a high of 13.5%.  Equity to assets averages 8.7%, ranging between 5.4% and 11.3%.  Loans to deposits averages 105% while earning assets to liabilities averages 117%.

There is more stress to come in the banking sector but I believe those who buy right will make fortunes buying banks during this time.

Great Time to Buy SOME Banks

In our never-ending quest to find needles in hay-stacks - as opposed to finding them right at our feet - we present to you someone else saying something nice about banking.  From Bronte Capital

Indeed provided you can maintain access to funding the opportunities in banking are the best that they have ever been in my life. [Emphasis added] The margins are massive.  Many people want (even need) to borrow money – and if you have money to lend you can select on the absolutely best credits.  Your risk is much lower than it was on the average loan in the boom.  The implied return on equity is much higher.

Happy days.

Of course they are happy days only if can maintain your funding (far from being a given) and you do not have losses so big from the boom that you will be wiped out (also far from being a given).

But in the past most banks that have got into trouble have been recapitalised by pre-tax, pre-provision earnings.  And at the moment pre-tax, pre-provision earnings are going up.

For the record this is very different to Japan.  In Japan bank spreads collapsed to 30bps.  They did this because of the vast excess deposit bases at zero interest rates.  But I cannot find another banking crisis in which bank spreads have fallen. [Emphasis added] Does anyone else know one?

We noted another blogger yesterday making the point that this is not Japan and also saying something nice about the banking system.

Is the US Banking System Really Worthless?

No, says a veteran of bank collapses elsewhere around the world.

Banking is a unique industry. Unlike virtually any other industry on earth, banks deal in a product that never goes out of style - money. As long as a bank maintains adequate technology and human capital to compete in the marketplace, long-term profitability is virtually assured, because demand is assured. As long as a bank can generate positive cash flows, and as long as the NPV of these cash flows exceeds the NPV of the losses from the defaulted assets, then the present intrinsic value of that bank’s common equity is positive. A bank can therefore have a very negative net worth and still have a highly positive net present value.

What about the impact of the toxic assets on the balance sheet? Many may worry that allowing banks to carry negative book value (in HTM value terms) will create a “zombie bank” situation, such as that which existed in Japan. But the Japanese analogy isn’t apt. In Japan, the government forced banks to continue to lend to unprofitable companies, effectively preventing Japanese banks from being able to dig themselves out, since they were forced to throw good money after bad. [emphasis added]

This isn’t what’s happening to the US, nor should we expect it to happen. The US isn’t forcing banks to make new lows to borrowers

in default.

So is allowing the banks to operate with negative equity

in HTM terms a free lunch? No. Carrying the non-earning toxic assets on their balance sheets will cause US banks to earn a lower return on assets over the next few years; this reduces the NPV of their common equity.

There should be no free lunch for the common equity shareholders

of banks, nor need there be. That’s the point. In the example provided, bank equity holders are paying for the full value of their losses. However, they’re doing so over a number of years. There’s no need for dilutive equity offerings, and absolutely no need for government subsidies that socialize the banks’ losses. As long as banks are allowed to value their assets at acquisition cost and gradually charge them off over a period of, say, 15-20 years (similar to depreciation), the banks can continue to operate normally by collecting deposits and extending new credits to credit-worthy customers.

UPDATE - Here is a link with an overview of academic research supporting the view that by continuing to lend to insolvent firms, the Japanese banking system prolonged the stagnation, via Free Exchange.

US Government Eyeing Citi Stake

The American government is considering increasing it's stake in Citigroup to 40%.

Citigroup Inc. is in talks with federal officials that could result in the U.S. government substantially expanding its ownership of the struggling bank, according to people familiar with the situation.

While the discussions could fall apart, the government could wind up holding as much as 40% of Citigroup's common stock. Bank executives hope the stake will be closer to 25%, these people said. ...

The talks reflect a growing fear that Citigroup and other big U.S. banks could be overwhelmed by losses amid the recession and housing crisis. Last week, Citigroup's share price fell below $2 to an 18-year low. Bank executives increasingly believe that the government needs to take a larger ownership stake in the institution to stop the slide.

Under the scenario being considered, a substantial chunk of the $45 billion in preferred shares held by the government would convert into common stock, people familiar with the matter said. The government obtained those shares, equivalent to a 7.8% stake, in return for pumping capital into Citigroup.

The move wouldn't cost taxpayers additional money, but other Citigroup shareholders would see their shares diluted. A larger ownership stake by the federal government could fuel speculation that other troubled banks will line up for similar agreements. ...

As part of the plan, Citigroup officials hope to persuade private investors that have bought preferred shares -- such as the Government of Singapore Investment Corp., Abu Dhabi Investment Authority and Kuwait Investment Authority -- to follow the government's lead in converting some of those stakes into common stock, according to people familiar with the matter. That would further bolster an obscure but increasingly pivotal measure of banks' capital known as "tangible common equity," or TCE.

The TCE measurement, one of several gauges of a bank's financial strength, gives weight to common shares -- thus the interest in converting preferred shares to common stock.

Details of the rescue remain in flux. Key questions, such as the price at which the government will convert its preferred stock into common shares, haven't been resolved.

And it's possible that other options will emerge to stabilize the company. For example, the Obama administration could decide to sit tight until the results of several new "stress tests" on major banks -- broad examinations of their financial health now being mandated -- are known in a couple months, one official said.

If the deal gets nailed down, it will be Washington's third effort to aid Citigroup since last fall. In October, the Treasury Department put a total of $125 billion into eight giant financial institutions, including $25 billion to Citigroup, in exchange for preferred shares and warrants to buy stock.

Then, shortly before Thanksgiving, the government agreed to infuse another $20 billion into Citigroup as its stock tumbled. It also agreed to protect the banking company against most losses on a $301 billion pool of assets.

It is my opinion that nationalization, or some form of increased capital injections by the government into the banking system, will shore up confidence in the economy and the financial industry, at least in the near-term.  As I type this, the S&P 500 futures is trading at 777, up at least 13 points from before the news was announced.