Thursday, October 30, 2008

Credit Default Swaps are supposed to be Weapons of Mass Destruction, so where is the Mass Destruction???

Recently the financial markets were shrieking in fear of the settlement of Lehman and Washington Mutual credit default swaps. Yet the settlement dates have past and there seems to be no impact apparent to the market. What happened? Is the CDS question overblown? Are the risk controls in place that the market is discounting?

There a few reasons to believe that the issues are still looming large in the market…

1) Just like the LTCM meltdown, it is not the settlement but the collateral requirements that will kill you

The OCC reports that investment banks believe they are hedged up to 85% of notional value of CDS.

This means the last 15% can swing in as a profit or loss, assuming no counterparty risk. For many of these hedge funds and banks, particularly for AIG, as market falls the collateral requirements on their positions must raise parabolicly. In the case of 123B loan from the US government to AIG, “tens of billions of dollars to post collateral with other financial institutions, as required by A.I.G.’s many derivatives contracts”. The "assets in a box" with the clearing bank will need to be replentished. But where will that come from in an environment like this? I am sure there are firms that are dead right now but just waiting on the banks to come seize assets on loans that are not performing.

2) Creditor will vampire the dead firms rather than kill them

The last thing any prime broker or bank needs is exposure that another client is not performing. Thus any attempt will be made to defer the inevitable while doing everything they can to obtain as much collateral before the fall. Look at how the home builders like Beazer have continued operations with no prospects of returning to profitability in the next few years. In the book Traders, Guns, & Money, the Das recounts how mid sized Indonesian firm, facing huge losses, created follow on agreements to amortize the debt with interest over longer periods of time. Whenever possible, this deferred payment plan disguised as an additional trade will be the best option for many of the major banks if they think the party will be able to last through the crisis.

3) The counterparty risk makes hedging calculations dubious

Take the UBS vs. Paramax court case where we find that UBS propped up a hedge fund and then bought CDS protection from them. The idea that hedge funds, as leveraged parties, can hold significant quantities of these securities creates a systemic risk. So if banks have 15% directional exposure, and additional 10% risk due to possibility of counterparty failure, then what are the real capital requirements that the banks need to call themselves solvent? I don't think any of the major credit default swap brokers have achieved this level of captial safety.

4) Lack of transparency to risk concentration is a riddle in itself

Yes, there were only $72B of Lehman CDS to be settled, and only $5B of that changed hands. But we do know there are 63T CDS outstanding amongst all banks. JP Morgan, BofA, C account for 15T by themselves. The 15% exposure of this notional value is worth more than the market cap of all of these banks combined. So what that we turned over one shell in this shell game and there was less than what we expected? Later we might turnover a shell and find more than what we expected. Or we find a case like AIG where they took only the side of writing protection?

The risk is very real.

In conclusion: Stronger transparency to collateral requirements will make the CDS market viable in the future when risk assessment criteria is formalized and enforced. But over 90% of existing CDS contracts span in length from 1 to 5 years. Thus there will be tremendous risk that will need to be flushed through the market that will keep the environment tenuous until industry can be considered viable, stable corner of the capital market.

This article is written in response to Felix Simon’s article “CDS the less you know the worse they look?”

Tuesday, October 21, 2008

Where do we really need the bailout? Hint: It is not the banks

All over the world $1.3T has been provided by governments to bolster the balance sheets of banks. Although this averts any immediate crisis by providing padding to the capital base of many of the most leveraged banks, it is a knee jerk reaction that does not address the root of the cause. It has been observed that the problem with banks is that the value of assets continues to go down in relation to leveraged balance sheets.

But if you gave the banks an infinite amount of money, would the issue be resolved? I contend no, because the real leverage is not tied to the lending institutions, but instead the consumers who provide the collateral to the transactions that the banks perform. The banks, for years, have tried to monetize the value of the undercapitalized consumer through interest rate hikes and extending the length of repayment. Now, with credit unavailable to finance these undercapitalized (regardless of credit rating) commitments long term, the banks are now starting to reflect the same financial situation that has been the case with the American consumer for years. Too many commitments served by way too little actual capital.

Thus before any type of resolution can occur in the credit markets, there will need to be a recapitalization of the American consumer. No more zero collateral purchases of cars, boats, homes, etc. A simple stimulus check providing $1200 is just one month worth of the payments that will need to be provided to float the American consumer. It will require at least 20 of these stimulus packages to get American family to stable balance sheet. What is the lesson in the temporary boost?

In conclusion, I approve of the use of $750B to recapitalize banks to avert an immediate destruction of the financial system. But I also approve a middle class tax cut bigger than what Obama is proposing and lots of personal bankruptcies as steps necessary for Americans to find their footing in a new, disciplined credit environment. The real "Bank of America", the wallets of the American consumer, will never truly be solvent until the people of America realize what fiscal solvency really requires.

Monday, October 20, 2008

10 Good Reasons to Short Bank of America

Bailout or no bailout, banks need to be profitable to survive. Bank of America has tremendous resources and connections to stay viable in the long term. But here are 10 good reasons to assume the BAC common stock will continue to fall through 2009 before the crisis abates.

#1 Bank of America also has a huge book of loans to homebuilders. It is time for at least a few to go bankrupt, this will be another severe dent in their portfolio. (Mish Shedlock quotes a minimum 7B+ in writeoffs coming)

#2 Bank of America must buy back $5B of auction rate securities. This is a cash transaction that takes away from their ability to lend in other areas, crimping income.

#3 Bank of America bought MBNA credit cards at the top of the market (2004). Thus Bank of America holds a very large exposure there to consumer spending decreases or increases in unemployment.

#4 In their distress with deteriorating loans, Freddie and Fannie have said that their top priority is to find recourse with fraudulent loans that have gone sour. If fraud is found, then the loan and the loss will be sent back to the originator. Until 2008, Countrywide originated over 25% of the countries loans.

#5 Countrywide has $25B in option arms still on the books that BofA is still liable for.

#6 Countrywide has $38B in debt outstanding. When Bank of America (BofA) took over Countrywide, BofA did not commit to guaranteeing the debt would be paid.

#7 When one of the Big Three automakers goes bankrupt, directly or indirectly this will mean at least a $5B hit to Bank of America

#8 Commercial Real Estate exposure is very significant

“Now what about financing of malls, retailers, office space, etc etc. A modest 10% writeoff across the board (highly likely IMO) would mean another $33 billion in writeoffs are coming from commercial real estate.”

#9 The sheer arrogence of the Merrill Lynch purchase at $26/share for a company about to go bankrupt.

#10 Bank of America has huge credit default swap counterparty risk

Bank of America currently holds over $1T in nominal credit default swaps. With deleveraging of hedge funds, parties that took the other side of their trades may not be able to pay out the insurance. In particular, if a party cannot payout on regarding a different CDS event, then the value of that party as an insurer of any other CDS contract becomes void. This could become a huge hole for BAC on many of their commercial loans.

What kind of opportunity is available for those interested in shorting the stock???

Assume a $124B market capitalization for the stock, referring to one year revenue based on 2007 revenue.

Subtract $5B writedown for homebuilder loans
Subtract $30B writedown in commercial real estate
Subtract $10B writedown of credit default swaps due to counterparty risk
Subtract $1B net writedown for auction rate securities
Subtract $5B writedown of Countrywide option ARMs
Subtract $5B writedown on prime mortgages from BAC legacy business
Subtract $1B from boomerang loans from Fannie and Freddie
Subtract $10B writedown to defease Countrywide and Merrill Lynch debt
Subtract $3B in credit card writedowns from legacy MBNA business
Subtract $5B writedown for commercial loans (industrial and especially automakers and their auto industry supply chain partners)

All of these negative events aside, within three years, Merrill Lynch and Countrywide will start to have a positive impact on earnings. But this year, we should expect the market cap of Bank of America ($124B cap) to absorb over $75B in writedowns and losses to net a market cap of $50B, which is approximately a fair value of $13/share.

Thus Lockstep Investing is recommending initiating a short position once Bank of America crosses $26 / share, exit when the stock crosses $12 / share.