Friday, February 20, 2009

How could a bank nationalization / reorganisation work?

Misha over at had some good questions about US bank nationalisation.

OK my 2 cents worth on what would be a less bad outcome - as opposed to what may happen.

1. Are all US government guarantees of bank debt null and void? They should be. At a minimum, taxpayers are currently on the hook for $300 billion of Citigroup's debt and $100 billion of Bank of America's debt.
Answer- Yes guarantees null and void for banks restructured. Let them bid for company if they think the debt is worth more than the money buyer’s offers for the assets.

2. Are we going to end up creating another banks that is "too big to fail" out of this mess?
Answer- Possibly depends who well sell them off to - how about selling bit off to different bidders (I would assume they are current better managed and solvent banks) depending on what they want and what they're willing to pay

3. Will stock holders and preferred shareholders both be wiped out?
Answer - Stock holders - yes wiped out - they would have already been so if not for government intervention. Preferred - depends on what you sell it for just like bankruptcy - if asset values don't cover debt as is likely then then wiped out.

4. In a normal bankruptcy process one might expect to see significant changes in management. Will the nationalization process allow the clowns who wrecked these banks to stay in control? For how long? Under what capacity? And what person or committee gets to decide those questions?
Answer- You sack the head honchos to start with - you sell off the parts, who keeps their jobs depends on the new owners, they presumably will be cutting.

5. Will the CDS liabilities be wiped out in entirety regardless of consequences? Clearly they should because otherwise taxpayers will be footing the bill. Unless this is spelled out I suspect measures will be taken to protect Goldman or whoever else is on the right side of those CDS and derivative contracts.
Answer- I don't understand the logic about canceling existing contracts other than it was an unregulated market out of control and it's costing the relevant parties an incredible amount of money. Canceling contracts selectively on this scale sounds a dangerous precedent.

6. What kind of bidding process will be put in place and in what time frame for the assets of the banks? Who decides and why?
Answer - Bigger scale suggests it may take longer than normal FDIC workout. That's why you need some extra government involvement. I don't know if this means 1 week or 1 year. In the interim the government body responsible (FDIC+help) takes control but you do business as usual (well usual in a sane world).

The way I see it you go as close to the best current model that actually works in the real world in the US (i.e. FDIC workout) and beef it up and give it more time so the scale isn't such an issue. If you try something new you don't know what may go wrong.

In addition get in there and investigate and make a few prosecutions where management has been negligent or dishonest. This serves both for moral hazard purposes and makes taxpayers feel better for making up any shortfall on the asset sale.

Wednesday, February 18, 2009

Stock markets - medium term trends

I blogged here exactly one month ago on January 18 about where I see international equity markets going in the next 3-12 months. I concluded then that..

"So in summary, the all the balance of probabilities is for more downside in stock markets all over the world for at least the next 6 months and possibly considerably longer.In a word if you're a trader - short . If you're an investor I would dump companies that have a lot of debt (even if prices are fire sale it's better than holding on while they go bust) and stay away from the banks and finance companies, commercial property and builders that are directly exposed to the largest problem areas. Personally I'm short the SP500 index in the US and 85% cash and only 15 % invested in stocks in (this is my primary home market Australia). Most of these stocks are held based on a strategy of buying stocks that are trading at a 30% plus discount to their marked-to-market net asset value (a Buffet type strategy) and have no debt. Generally I try to to be 90% invested in the stock market so here actions speak louder than words."

So how are things panning out?

Let's look at some major countries equity markets performances over the last month since I posted.
1. US - SP500 - down 8%
2. Germany - DAX - down 1%
3. UK - FTSE100 - Down 5%
4. France - CAC40 - down 1%
5. Japan - Nikki 225 - Down 10%
5. Australia - my home market - flat

So basically being short the SP500 has been a good choice the US has been one of the weakest big markets over the period. Not being heavily in the Australian market hasn't hurt me. I've made a little money on short term trades there with minimum risk. I'm now down to 10% invested in the Australian market after closing out some fundamental trades that aren't going anywhere anytime soon. There was a small rally in early February in most markets but this has died now.

Also the areas I identified as having most downside - builders, banks, other financials, commercial property - all down significantly more than the index in the US and here in Australia. Not sure about elsewhere but guess it would be similar.

So have there been any significant changes in the 9 factors I looked at in January? Not many. Taxpayers money still being put into stimulus packages or associated bailouts. Economic news still gloomy and getting gloomier - particularly in terms of contractions in international trade. Prices still too high compared with earnings and asset values, long term technical trends clearly still down etc. Possibly the one thing that appears to be changing is that the US market is not rallying as hard on stimulus and bailout plans - the faith in magic fixes is waning. As that was the main source of positive short term moves in the market that tends to make the case for being short stronger.

The one real change has been the strength of gold stocks. This bares watching both as a trading
opportunity and as an indication of the loss of confidence in US treasures as a safe haven or due to inflation fears based on government debt and the desire to inflate it away in the future. So far I have only traded gold stocks short term. However if gold gets past strong resistance at US $1000 I plan to buy gold stocks and look to short US treasuries.

So the strategy is:
1. Short SP500
2. Continue to short term trade Australian market with small positions.
3. Watch gold and treasuries markets especially around gold at US$1000 resistance.

Thursday, February 12, 2009

US recession - Febuary update - still bad

In January I blogged about a graph on US employment comparing all postwar recessions. My thoughts basically came down to - "So employment held up well early but it’s going to get uglier than in living memory and looks like living up to the “worst post war recession” hype." "

See the updated graph for the Federal Reserve here.

Basically employment continues to worsen at the same rate as the previous few months as I expected so things still look grim.

Interestingly the other graphs on the link above also show that output actually kept growing during the early stage of the recession - this has a lot to do with countries the US exports still having good growth up to mid 2008 and this coupled with the low US dollar meant US exports were still booming up to mid 2008. As the recession has spread worldwide, and the US dollar rallied, this export boom has turned around dramatically so output in now decreasing.

The longest USA post WWII recession has been 16 months. So far this one has lasted 13 months and so there is little doubt that this one will be longer. It also seems likely that the decrease in employment will be higher than any other post WWII recession. This is troubling as it suggests a somewhat different (and more damaging) dynamic in this recession than other recessions. The global nature of this recession is no doubt a large part of this and a negative for the short term while the twin consumer and government debt burdens are also troubling from a medium to longer term perspective.

Given unemployment started from a low level there is some hope it may not peak at much above 10% which at least gives some hope for a situation that may not be too disastrous in terms of people's lives and social cohesion even if output growth is slow after the recession and unemployment fails to decrease for some years.

Wednesday, February 11, 2009

Bank bailout - risky plan - macroeconomic scanarios

I number of commentators have called for the temporary nationalisation of insolvent banks rather than the current approach. These include those who saw the crisis coming such as Robinini and Soros. The people that said there wasn't a problem (Paulsen, Bernake and now Geithner) now say the problem can be fixed but without radical changes in approach to the ones that have so far failed to address the underlying issues. I believe this approach is to risky to be the one relied upon. Too risky for the for the US and world economy in the medium term.

At the moment the plan is basically to:
- provide government, loans and capital but keep banks in private hands,
- facilitate mergers as more solvent banks buy less solvent ones (often with government of Fed guarantees against losses),
- try and encourage private investors to buy the risky bad assets off banks by limiting the downside by providing government guarantees if things get worse etc.
Basically socialising the losses.

There are a number of other parties that could be bought to the table to assist before the government is required to tip[ in more capital. At the very least pressure needs to be bought on other relevant parties: management, creditors, stockholders and employees to come to the party before funds are provided. This is the usual approach when a company is insolvent and this is what banks do to their customers all the time. They need a stick to do this - usually this stick is bankruptcy. This appears too risky in this situation so the stick needs to be nationalisation.

The financial stress test that decides nationalisation is supposed to be forward looking. If so it would need to take into account:
- housing prices are going to continue to go down in the foreseeable future and then in 1 year all those ARM's reset and there's another 2 years of foreclosures based on that
- companies are going to start going into Chapter 11 as the recession goes for longer
- unemployment is likely to be higher rather than lower

It seems unlikely that many banks would pass such a stress test so presumably the banks will be pressing for a less stressful and transparent stress test that they can pass. Then when things get worse they can say it wasn't our fault the government checked us out we were just unlucky that things got worse, and can we have some more money please.

The big risk of the current approach is that if things continue to get worse despite this plan the government is in a much weaker position to go the nationalization route. You then risk the loss of US dollar safe haven status. This means a drying up of loans for treasuries and either mass insolvency for the banking system or the Fed having to print money. As presumably the Fed would print money we would then have high inflation and high interest rates to go with the high inflation. The impact of high interest rates would drive down already depressed asset prices and weakened corporations etc. It's a whole other reflexive (ie. self reinforcing) cycle) down. Then we do have something like great depression II.

Taking too much risk is what got everyone into this mess. Temporary nationalization of US banks might be less palatable in the short term but it takes much of this big risk away.

Gold prices have rallied strongly on the current Geithner plan suggesting other also see loss of US dollar reserve status is real risk in the medium term. So what are the broad macro economic scenarios going forward.

1. Best case. The plan works well (or they bit the bullet and go down the nationalisation path)along with other stimulus and banking bailout plans worldwide. The world resumes solid growth in 12-18 months. Obviously the banking systems still got some issues and governments have large debts but nothing some gradual inflation and fairly low real interest rates can't fix over 5-10 years. Presumably China and India come out of this stronger than US and Europe and the opportunities are more in developing countries as the US and Europe have to stop leveraging up.

2. Deflation case. After the US come out of negative growth there's Japan 1990's style 8-12 years of slow growth, continued asset price deflation and high unemployment.

3. Inflation case. Scarier option of high inflation, double dip severe recession and loss of confidence in US dollar if the US dollar looses safe haven status and Fed has to print money and so inflates. A lot of turmoil in currency markets as countries unpeg from dollar.

As far as what this means for asset prices.
A. Stock prices
- Best case is OK but probably no turnaround within 6 months so no hurry to be in the market. Worth watching to see which countries markets/sectors look stronger as if there is a new bull market in the next few years its' dynamic will be very different to the last one.
- Deflation case is bad for stock prices.
- Inflation case - gold stocks the obvious pick

B. Commodity prices
- Best case OK for commodity prices particularly if China and India are the stronger economies
- Deflation case - bad for commodity prices
- Inflation case - good for commodity prices

C. Gold
- Best case - bad
- Deflation case - bad
- Inflation case - very good

So no change to my general conclusion that it still makes sense to be short stocks and to have plenty of cash and to watch how things play out. Each scanario leads to radically different conclusions.