Toro's Running of the Bulls Market Blog

Companies Do Not Trust European Stress Tests

Should you? 

From the FT

Leading UK and continental European companies are increasingly shunning banks from Spain, Italy and even Germany because they do not believe the Europe-wide stress testing of banks gave a true picture of their financial health.

Corporate treasurers from groups with revenues of more than $240bn told the Financial Times they were conducting their own tests to gauge for themselves banks’ robustness.

“What we are increasingly concerned about is credit risk,” said the treasurer of one of Germany’s largest industrial companies. “Even after the stress tests, we have to ask ourselves: are the banks healthy? The tests have opened up more questions than they have answered, especially here in Germany.”

Stuart Siddall, chief executive of the Association of Corporate Treasurers, said companies were taking a more proactive approach to assessing how financially strong banks are: “Everybody is spending a lot more time today on counterparty risk than they did before.”

Counterparty risk – the risk that a bank will default and be unable to meet its obligations – shot up the list of concerns of companies after the Lehman Brothers collapse two years ago.

Those worries had again intensified around the time of the official European bank stress tests in July, several treasurers said.

“There is an element of whether the emperor has any clothes on and what to do if he doesn’t. The stress tests were a joke,” said the treasurer of a large European media company. ...

A treasurer at a FTSE 100 company in the UK said: “We have no business with Spanish banks and a couple of Italian and German banks. If US banks are refusing to deal with these guys, then why should we?”

I doubt this is over.

Crash

I have no idea what caused the collapse intra-day today, whether it was a bad trade or the withdrawal of liquidity by the machines or what.  What I do know is that it was amazing to watch.  At one point, the Dow was down nearly 1,000 points.  I have never seen anything like it.

I got lucky.  On Monday near the close, I hedged out all my equities positions to net flat.  I had also been buying gold calls the past week and have been long the dollar since the beginning of April.  So my book since Monday's close has been long gold, long the dollar.  

I closed out most of my dollar long position and have kept only a small position.  That does not mean the euro is going to rise.  In fact, it will probably keep melting down.  Remember, it was 85 cents several years ago.  And on a purchasing power parity basis, it is worth $1.15-$1.20, so it is still expensive.

I am a long-term bull in gold but have traded in and out of the yellow metal over the past eight years.  I started buying a week ago when the price action was acting very well.  I expect that we will go back and re-test the $1225 highs, back off a bit, then blast through it.  I expect to add to positions on a break to new highs or on a light pullback.

My equities book right now looks primarily like this - long small banks, long semiconductors, short the S&P 500 and Russell 2000. 

Over the past year, I have been buying banks, primarily very small banks.  My criteria for banks has been to buy stocks trading below tangible book value that made money through the crisis and are forecasted to make money this and next year.  I own 14 banks, most that trade by appointment.  I hope to add to my bank position during this sell-off.

My semiconductors position is now a residual of a basket that I began building in 2008, and continued to buy through the end of the year and into the Spring of 2009.  At one point, I owned 18 different chip companies.  I have sold most of my basket and now own six names.  I will sell into strength.

The hedges I own are the Direxion Russell 2000 3X Bear ETF, ticker TZA.  I own the double inverse Horizons S&P 500 Bear Plus ETF in my Canadian RRSP account, ticker HSD.TO.  I also hold the double inverse Horizons S&P/TSX 60 Bear Plus Fund, ticker HXD.TO for other accounts I manage in Canada. 

My intention in buying the leveraged inverse ETFs was not to short the market but to eliminate equity beta.  Since Monday afternoon, my net position became net short, so I peeled a small part of my hedge.  Interestingly, during the 600 point 20-minute plunge this afternoon, I tried to sell some TZA, which is normally pretty liquid.  However, it did not get filled, even though I kept it open for 20 minutes. I pulled the order as the market bounced.

I have been expecting a 5%-10% correction for some time now.  Today, we got it, with the S&P 500 down 13% intra-day from the highs of a few weeks ago.  I had thought it would merely be a correction in the midst of a cyclical bull market. I'm not so sure now.  This may be a correction within a cyclical bear market but I must respect the action, and the market action today was just horrible, no matter what the reason for the sell-off. 

Sovereign debt crises are very serious, and must be respected.  I expect more downside pressure in the near-term.

No Penalty for Incompetence - Simon Johnson

Simon Johnson speaks the obvious.

Finally, Paulson really needs you to believe that once the crisis broke, he did what was necessary to save the world’s financial system. As Mrs. Thatcher liked to say, “there is no alternative.” This part of the story has been told much better by Andrew Ross Sorkin in Too Big To Fail. But the great conceit in Paulson’s book is still fascinating. He wants to convince you that the only way to save the American financial system and—by implication—the world’s economy was by keeping Wall Street essentially intact. To be sure, he says that “the Wall Street I knew had come to an end.” But what he means is that the remaining investment banks—including Goldman Sachs—became bank holding companies and therefore, for the first time in history, acquired effective government backing. 

So leading financial institutions were saved, which is not by itself an unusual event in some countries. It happens with some regularity in places with serious governance issues and endemic corruption. But even in troubled middle-income countries, such as South Korea, Turkey, Argentina, or even Russia, it is extraordinary to keep management in place when providing such support. Perhaps a few financial executives might be deemed beyond reproach and unfortunate victims of a system-wide panic. But to keep them all, with their base pay and their bonuses and their pensions? That is essentially unheard of. Perhaps there is a poor and benighted country somewhere that saved its massively incompetent financial firms in this manner, but you can search the historical records long and hard for a parallel to what Paulson pulled off. [Emphasis added]

The fallacy here is complete. Since the entire system failed—in terms of the largest banks and quasi-banks—Paulson and his supporters, including his successor at Treasury, argued that we must treat everyone generously in order to have an economic recovery. But the United States always presses for a much harder approach toward failed bankers in other countries. And with good reason: when the whole system crashes due to reckless risk-taking, you should aim to re-boot with a different incentive structure and, immediately, with much more effective regulation.

Johnson was the Chief Economist at the IMF.

The stunning thing is, despite going through one of the greatest financial crisis in the history of the country, nothing has really changed.

As a Shareholder of an Investment Bank, You Exist for the Bankers

I am not a fan of the investment bank model as a shareholder.  The collapse of Bear Stearns and Lehman, and the takeover of Merrill Lynch was not a surprise to me, though the timing and velocity of the collapse was unexpected.  This is not because I am particularly foresightful or intelligent.  Rather, I think that eventually, any business model that dramatically leverages marked-to-market securities and relies on funding through public markets is a disaster waiting to happen.  I have little doubt that had the government not stepped in to directly intervene in the capital markets, both Goldman and Morgan Stanley were goners.  And given that nothing has really changed in the structure of our financial markets, we will replay this financial crisis all over again in the not-too-distant future, with Goldman, Morgan and perhaps a few big hedge funds back at the public troughs pleading for a bailout.  And I am sure the government, run by the bankers for the bankers, will oblige.

(Remember when we used to think it was a government of the lawyers, by the lawyers, for the lawyers?  Well, say what you want about lawyers but at least they did not bring the world to the brink of collapse, unlike the bankers.)

This is one reason why I do not like to invest in investment banks.  Another reason is because the mind-set of the those who run the banks is to look after their own first.  You, as a shareholder, come second.  You as a shareholder exist to pay them.

Witness the response of the investment banks to the 50% bonus tax imposed on investment bankers by the British government. (HT to Worthwhile Canadian Initiative) 

City bankers will suffer little or no impact from the bonus supertax imposed by the government last month, according to a Financial Times poll of leading investment banks.

Most banks, polled in an anonymised survey, said they would absorb all or part of the cost of the one-off 50 per cent tax by inflating their bonus pools, even at the risk of irritating the government and their own shareholders.

The results chime with intelligence garnered by headhunters. “The tax is going to be 90 per cent absorbed by the banks,” said one senior recruitment consultant with clients in the City.

In many cases that will mean banks doubling bonus pools, with the cost of the tax borne by shareholders. Dividends, already under pressure as regulators force banks to retain earnings to boost capital, are likely to be hit, bankers concede.

As a shareholder, you come a distant second to the bankers' compensation.  Wall Street exists to make a handful of people enormously wealthy. And if that wealth is extracted from you the shareholder, so be it.

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.