After this long bull run, it is time for the market to take a breather. The USD is at a historical support point, fiscal stimulus is peaking. It is enough to take a risk that the SPY (SSO) will not rise another 6% (12%) in the next three months.
The author has entered in the following position.
Sell SSO Jan 2011 $47 Call at $1.22
Buy SSO Jan 2011 $48 Call at $.98
Net credit .24 with $1 risk.
Showing posts with label Short. Show all posts
Showing posts with label Short. Show all posts
Tuesday, October 26, 2010
Thursday, April 22, 2010
Short the runt PIIGS
This will be a drawn out process. But we can be sure that Greece will default in some form or fashion (i.e. restructuring). In the meantime, let's enjoy the instability and make some money shorting the national champions of the most at risk PIIGS.
A few of the facts:
*There is a run on the banks going on in Greece already, official or unofficial. Over 25% of deposits have already left the domestic banks.
* Only six people in Greece claimed income higher than 1m euros in 2008 (pervasive tax evasion)
* Greece has spent over 50 of the last 200 years in default (subprime, always)
* Greece has not had fiscal discipline in the last 10 years, why will that change in a major recession?
As for the short of Portugal Telecom and the national electric company (EDFPY.PK), the performance of the telecom and energy industries are tied to the economic health of the country.
Short NBG at $3.10 entered on 4/22
Short PT at 11.00 (limit order)
Short EDFPY.PK at $37 entered on 4/22
A few of the facts:
*There is a run on the banks going on in Greece already, official or unofficial. Over 25% of deposits have already left the domestic banks.
* Only six people in Greece claimed income higher than 1m euros in 2008 (pervasive tax evasion)
* Greece has spent over 50 of the last 200 years in default (subprime, always)
* Greece has not had fiscal discipline in the last 10 years, why will that change in a major recession?
As for the short of Portugal Telecom and the national electric company (EDFPY.PK), the performance of the telecom and energy industries are tied to the economic health of the country.
Short NBG at $3.10 entered on 4/22
Short PT at 11.00 (limit order)
Short EDFPY.PK at $37 entered on 4/22
Friday, February 12, 2010
Short Oil: USD strength will drive oil down
Over the past six months, the leveraged rise of oil prices has been largely been explained by the drop in the USD despite over two years of continuous slide in demand for oil.
Yet over the last two months the USD has started to shoot up and oil has mildly corrected in kind.
... despite reports of excessive inventory. In fact, some traders are still optimistic regarding oil in the face of these bearish indicators.
Marketwatch reports ...
"The Greek bailout is helping support global markets and the price of oil," [Mike Sander, investment adviser at Sander Capital in Seattle] said. "If Greece was leaning further along to a default, then we would have seen oil break $70 for sure."
The inverse relationship between crude prices and the U.S. dollar has decoupled over the past three sessions, which may continue if the stock market stays strong, said Jim Ritterbusch, president of Ritterbusch & Associates, in a note to investors.
A large build in U.S. oil stockpiles may also be overshadowed by developments regarding the European Union's plan to address Greece's debt issues, he said. "We expect wide price swings in both directions going forward as an unusual crosscurrent of financial guidance will occasionally be butting heads with bearish underlying oil fundamentals."
To think that data from three trading sessions identifies the decoupling of a year long trend is a little far fetched.
But as far as the Greece debt bomb destroying the price of oil, I highly doubt Greece will default either. It is not in the interest of anyone with real money that they do default. But as soon as Greece gets their bailout package, the other PIIGS will come to the trough. The question is not if one can be bailed out, but will all of the countries with debt solvency issues be bailed out. This fear will be enough to drive the market to the USD and put longer term pressure on oil.
Even without a crisis in the making, forecasts for oil consumption are not strong. Whether it is demand fundamentals or technical factors, both provide tremendous demand for the USD that makes the price of oil in USD look very expensive.
This disconnect cannot stand. Oil will correct in correspondence with the new demand for the USD.
The author is short oil by going long SCO April $16 calls purchased at $1.40.
[Oil demand chart in the US]
Yet over the last two months the USD has started to shoot up and oil has mildly corrected in kind.
... despite reports of excessive inventory. In fact, some traders are still optimistic regarding oil in the face of these bearish indicators.
Marketwatch reports ...
"The Greek bailout is helping support global markets and the price of oil," [Mike Sander, investment adviser at Sander Capital in Seattle] said. "If Greece was leaning further along to a default, then we would have seen oil break $70 for sure."
The inverse relationship between crude prices and the U.S. dollar has decoupled over the past three sessions, which may continue if the stock market stays strong, said Jim Ritterbusch, president of Ritterbusch & Associates, in a note to investors.
A large build in U.S. oil stockpiles may also be overshadowed by developments regarding the European Union's plan to address Greece's debt issues, he said. "We expect wide price swings in both directions going forward as an unusual crosscurrent of financial guidance will occasionally be butting heads with bearish underlying oil fundamentals."
To think that data from three trading sessions identifies the decoupling of a year long trend is a little far fetched.
But as far as the Greece debt bomb destroying the price of oil, I highly doubt Greece will default either. It is not in the interest of anyone with real money that they do default. But as soon as Greece gets their bailout package, the other PIIGS will come to the trough. The question is not if one can be bailed out, but will all of the countries with debt solvency issues be bailed out. This fear will be enough to drive the market to the USD and put longer term pressure on oil.
Even without a crisis in the making, forecasts for oil consumption are not strong. Whether it is demand fundamentals or technical factors, both provide tremendous demand for the USD that makes the price of oil in USD look very expensive.
This disconnect cannot stand. Oil will correct in correspondence with the new demand for the USD.
The author is short oil by going long SCO April $16 calls purchased at $1.40.
[Oil demand chart in the US]
Thursday, January 1, 2009
Goldman Sachs Pair Trade: Long and Short
Due to the credit crisis, the investment banking model is broken. Current stand alone investment banks are racing against the clock to find reliable funding source for their outsized portfolios. That being said, investment banks are voracious capitalist market makers with tremendously talented people. Goldman Sachs, the highest class of the bunch, has produced many powerful government officials and has led the world in financial innovation and ability to make profits facilitating markets.
What is an investor to do?
Recently Warren Buffett, at a pivotal time for GS, invested $5B in perpetual preferred shares of Goldman Sachs yielding 10% at par. If I were to read the tea leaves of why Warren Buffett made this investment, I would say Warren believes that despite all of the problems that Goldman Sachs has, it's track record as a profit machine will attract a white knight. Thus even if the credit crisis were to continue relentlessly and deplete all on hand resources for GS, at some point prior to any default event, a buyer will take the company private, making all preferred shareholders whole in the process.
What examples do I have for this thesis? Think about Warren Buffett and Salomon Brothers. That position started with an initial investment in preferred shares of the investment bank also. Second, look at the arrangement that PIMCO holds with Allianz as an independent subsidiary of Allianz insurance conglomerate. PIMCO has no liquidity problems despite having just as many leveraged positions.
This being said, no one can predict when the white knight will appear. In the process, Goldman could lose another 25%, or 50% or even 75% or more of it's stock price prior to being rescued. The common stock holds the greatest risk in this case, even though all classes of securities in the capital structure would suffer greatly.
Thus the position proposed is the following:
Long - Goldman Sachs A Series - Non-Cumulative Preferred Securities - Floating Rate
Short - Goldman Sachs - JAN 10 $55 put contract
(Or if you do not use options then short GS common shares directly at above $84/share)
Buy 1 put contract for every 100 preferred shares purchased
(Or short 100 shares of common for every 100 shares of preferred purchased)
Any investor should "leg" into this position. Buy puts at below $9 and buy the A series at $9/share or below.
What is an investor to do?
Recently Warren Buffett, at a pivotal time for GS, invested $5B in perpetual preferred shares of Goldman Sachs yielding 10% at par. If I were to read the tea leaves of why Warren Buffett made this investment, I would say Warren believes that despite all of the problems that Goldman Sachs has, it's track record as a profit machine will attract a white knight. Thus even if the credit crisis were to continue relentlessly and deplete all on hand resources for GS, at some point prior to any default event, a buyer will take the company private, making all preferred shareholders whole in the process.
What examples do I have for this thesis? Think about Warren Buffett and Salomon Brothers. That position started with an initial investment in preferred shares of the investment bank also. Second, look at the arrangement that PIMCO holds with Allianz as an independent subsidiary of Allianz insurance conglomerate. PIMCO has no liquidity problems despite having just as many leveraged positions.
This being said, no one can predict when the white knight will appear. In the process, Goldman could lose another 25%, or 50% or even 75% or more of it's stock price prior to being rescued. The common stock holds the greatest risk in this case, even though all classes of securities in the capital structure would suffer greatly.
Thus the position proposed is the following:
Long - Goldman Sachs A Series - Non-Cumulative Preferred Securities - Floating Rate
Short - Goldman Sachs - JAN 10 $55 put contract
(Or if you do not use options then short GS common shares directly at above $84/share)
Buy 1 put contract for every 100 preferred shares purchased
(Or short 100 shares of common for every 100 shares of preferred purchased)
Any investor should "leg" into this position. Buy puts at below $9 and buy the A series at $9/share or below.
Tuesday, December 2, 2008
8 Good Reasons to Short HSBC
1) Primary real estate exposure is Hong Kong residential mortgages
With the slowdown in China, demand for Hong Kong real estate should fall steeply.
2) Large US subprime exposure
Yes, it is still there. HSBC Finance, formerly the Household Finance Inc subprime lender, holds many loans with the expectation of holding until maturity. In fact it was one of the largest US subprime lenders until late 2007. Reading the annual report and related news articles, there are multiple mentions of securitized mortgages that were sold to HSBC affiliates or other subsidiaries. This allows HSBC to move the securities off balance sheet and avoid marking the securities to market. As a result, there is a significant chance that within months HSBC will need to raise capital in this increasingly unattractive capital raising environment.
3) Very large US consumer revolving credit exposure
The HSBC USA subsidiary is one of the largest credit card lenders in the US market.
[I will add facts to support this later.]
4) Global slowdown in key HSBC markets
US is already in a recession. UK is very close to admitting it is in a recession. China is slowing seriously and cannot see the bottom of the downturn. Thus HSBC will be pushed to recapitalize in at least two of the three major markets.
5) Madoff Discount
Thanks to Mr. Madoff's astute business model, you can erase $1B in market valuation in HSBC just due investments in Madoff managed funds alone. HSBC is now facing lawsuits due to alleged negligence advising it's clients.
6) Large Chinese manufacturing exposure
All consumer loans, industrial loans, and real estate loans made in China by multinational companies are at risk because of the huge slowdown export related manufacturing in the Greater China region. HSBC is heavily exposed to China in this manner.
7) $1T Credit Default Swap exposure
Credit default swaps, even if no default events occur, drain precious capital because of the counterparty collateral requirements. With a few potential major credit events on the horizon, CDS are a toxic security to hold.
8) Large Middle East Commercial Loan exposure
HSBC is pervasive in all areas of the former British Empire, the Middle East is no exception. But with the drop in the price of oil and the deflationary effects of the credit crisis, many of their commercial outlays in this region will be at risk or at least deserve to be marked down.
Transparency: The author is long HSBC JUN 09 $40 put options at $6.3 and
long HSBC JAN 10 puts at $3.1
With the slowdown in China, demand for Hong Kong real estate should fall steeply.
2) Large US subprime exposure
Yes, it is still there. HSBC Finance, formerly the Household Finance Inc subprime lender, holds many loans with the expectation of holding until maturity. In fact it was one of the largest US subprime lenders until late 2007. Reading the annual report and related news articles, there are multiple mentions of securitized mortgages that were sold to HSBC affiliates or other subsidiaries. This allows HSBC to move the securities off balance sheet and avoid marking the securities to market. As a result, there is a significant chance that within months HSBC will need to raise capital in this increasingly unattractive capital raising environment.
3) Very large US consumer revolving credit exposure
The HSBC USA subsidiary is one of the largest credit card lenders in the US market.
[I will add facts to support this later.]
4) Global slowdown in key HSBC markets
US is already in a recession. UK is very close to admitting it is in a recession. China is slowing seriously and cannot see the bottom of the downturn. Thus HSBC will be pushed to recapitalize in at least two of the three major markets.
5) Madoff Discount
Thanks to Mr. Madoff's astute business model, you can erase $1B in market valuation in HSBC just due investments in Madoff managed funds alone. HSBC is now facing lawsuits due to alleged negligence advising it's clients.
6) Large Chinese manufacturing exposure
All consumer loans, industrial loans, and real estate loans made in China by multinational companies are at risk because of the huge slowdown export related manufacturing in the Greater China region. HSBC is heavily exposed to China in this manner.
7) $1T Credit Default Swap exposure
Credit default swaps, even if no default events occur, drain precious capital because of the counterparty collateral requirements. With a few potential major credit events on the horizon, CDS are a toxic security to hold.
8) Large Middle East Commercial Loan exposure
HSBC is pervasive in all areas of the former British Empire, the Middle East is no exception. But with the drop in the price of oil and the deflationary effects of the credit crisis, many of their commercial outlays in this region will be at risk or at least deserve to be marked down.
Transparency: The author is long HSBC JUN 09 $40 put options at $6.3 and
long HSBC JAN 10 puts at $3.1
Friday, November 21, 2008
If I could Ultra Ultra Short Financials, I would be RICH!!!
Let’s say you saw the credit crisis coming, and wanted to short the financials.
You see two different securities that you are interested, XLF and SKF. XLF is an index that covers many of the financial companies, and SKF is an index designed to give twice the inverse return of XLF. You think about shorting XLF, but you want more return for your future predicting powers, so you buy SKF instead expecting to get double the performance. Over three months, which return is better?
Shorting XLF.
The chart above shows XLF vs. SKF over a three month period ending Nov 14, 2008.
This is the problem with the new world of leveraged ETFs. The profile states “The investment seeks daily investment results, before fees and expenses, which correspond to twice the inverse of the daily performance of the Dow Jones U.S. Financials index.” But what it does not say is that it is only accurate at certain times. Looking at the chart, it seems that huge moves short for XLF were accurately captured by SKF (Oct 4 – Oct 10), but long moves by XLF proved to be overcompensated to the downside by SKF (i.e. Oct 10 – Oct 15 and Oct 23 – Nov 3).
Moreover, over time, for reasons not explicit to the end user, the SKF index does not continue to hold the NAV over time. Thus instead of getting the inverse result, the investor only gets the inverse result “for a short duration of time” before the index falls apart again on a bear (XLF bull move) move and waits for the next XLF short surge.
For a retail investor like myself, this is disheartening. I am not sure that I have ever seen the disclaimer for this poor correlation in the index. At least their should be some standard of correlation or grading system that should be applied to all indexes that use leveraging techniques.
On the other hand, better to just keep playing than crying about the rules of the game. In any case, I plan to use this information to my advantage. As of Nov 22, SKF is now trading at $280 after one of the biggest drops in NYSE history. Will it continue? Well, even if this is the onset of the Greater Depression, the XLF index can only go to zero folks. And the market NEVER goes straight down. Thus a purchase of SKF puts based on the observations mentioned here will most definitely yield a large return as the index swap agreements are rolled over and the bounce commenses.
Transparency: The author bought JAN 09 $80 SKF PUTS at $2.4 / contract and similar positions at similar strikes and prices and closed the JAN 09 $80 SKF puts at an average of $2.85 yielding a 19% gain.
You see two different securities that you are interested, XLF and SKF. XLF is an index that covers many of the financial companies, and SKF is an index designed to give twice the inverse return of XLF. You think about shorting XLF, but you want more return for your future predicting powers, so you buy SKF instead expecting to get double the performance. Over three months, which return is better?
Shorting XLF.
The chart above shows XLF vs. SKF over a three month period ending Nov 14, 2008.
This is the problem with the new world of leveraged ETFs. The profile states “The investment seeks daily investment results, before fees and expenses, which correspond to twice the inverse of the daily performance of the Dow Jones U.S. Financials index.” But what it does not say is that it is only accurate at certain times. Looking at the chart, it seems that huge moves short for XLF were accurately captured by SKF (Oct 4 – Oct 10), but long moves by XLF proved to be overcompensated to the downside by SKF (i.e. Oct 10 – Oct 15 and Oct 23 – Nov 3).
Moreover, over time, for reasons not explicit to the end user, the SKF index does not continue to hold the NAV over time. Thus instead of getting the inverse result, the investor only gets the inverse result “for a short duration of time” before the index falls apart again on a bear (XLF bull move) move and waits for the next XLF short surge.
For a retail investor like myself, this is disheartening. I am not sure that I have ever seen the disclaimer for this poor correlation in the index. At least their should be some standard of correlation or grading system that should be applied to all indexes that use leveraging techniques.
On the other hand, better to just keep playing than crying about the rules of the game. In any case, I plan to use this information to my advantage. As of Nov 22, SKF is now trading at $280 after one of the biggest drops in NYSE history. Will it continue? Well, even if this is the onset of the Greater Depression, the XLF index can only go to zero folks. And the market NEVER goes straight down. Thus a purchase of SKF puts based on the observations mentioned here will most definitely yield a large return as the index swap agreements are rolled over and the bounce commenses.
Transparency: The author bought JAN 09 $80 SKF PUTS at $2.4 / contract and similar positions at similar strikes and prices and closed the JAN 09 $80 SKF puts at an average of $2.85 yielding a 19% gain.
Monday, November 10, 2008
Competing Shorts : Capital One or American Express?
Assume credit cards are the next crisis. Also, assume the crisis comes because the charge off rates go to historical levels that no wants to buy credit card bonds. Not a stretch of the imagination in any regard, considering the state of the US consumer. Where is the best place to be short?
Looking at options, both Capital One (COF) and American Express (AXP) charge close to the same amount on their JAN 10 $20 puts ($5.2 and $4.8 respectively).
But looking at their market situations, there is a clear advantages to both.
Capital One
• Pro: Lower average credit score to AXP customers
• Pro: Lower average income to AXP customers
• Pro: Large auto lending component to the business
• Con: Has substantial commercial lending deposits from it’s commercial bank
American Express
• Pro: Higher customer balances than COF customers
• Pro: Travel Services department (business credit cards) income is largely influenced by business capital spending in general, clearly in decline
• Con: No commercial bank to fund lending activities (used the Fed commercial lending facility early in November)
Summary:
If you look at in terms of product, COF vs. AXP is like Ford vs. BMW, AXP has a more affluent, and privileged clientele. This may provide a more orderly deleveraging and is currently reflected in the lower charge off rates for AXP customers compared to COF customers.
But if you look at it in terms of capital position, COF vs. AXP is like C vs. LEH, COF has internal capital it can use as a cushion when no one wants to buy it’s short term financing facilities. Whereas AXP, like the now defaulted Lehman Brothers, had minimal internal capital and lots of leverage that relied on securitization and commercial paper markets for operation.
Both are solid short candidates, but despite it’s pedigree, AXP is more exposed to credit market freeze and thus appears in a more precarious position.
Supporting Research:
“Capital One said this month it's restricting credit card issuance after charge-off rates spiked to 6.34% in the third quarter from 3.96% in the same period last year.”
“Banks, in turn, are trying to wean themselves from the securitization markets. They're turning to other financing such as certificate of deposit programs, but those can be costly.The market shutdown is particularly bad news for non-bank finance companies. The ability to sell off car, education and auto loans is critical to companies such Ford Motor Co.'s Ford Motor Credit, American Express Co. and student lender SLM Corp., or Sallie Mae. Without securitization markets, they have less capital to make new loans to consumers.”
“… approximately 50% of [American Express] funding was unsecured and 50% was done through securitization.
Moving to slide eight, metric performance for international consumer, we continue to have strong metrics in international consumer although we did see some slowing in billed business in the third quarter. FX adjusted growth in the first and second quarter was 10% compared to the 8% in the third quarter.” American Express CFO, Daniel Henry – EVP & CFO
“In the US while the write-off rate in the quarter was 5.9% the write-off rate in September was 6.1%. We expect the fourth quarter to be higher then the third quarter and we expect the first quarter of 2009 to be higher then the fourth quarter of 2008.” American Express CFO, Daniel Henry – EVP & CFO as reported in the American Express 3Q conf call...
Transparency: The author owns both AXP Apr 09 puts at $3/contract and COF JUN 09 $25puts at $5.58/contract.
Looking at options, both Capital One (COF) and American Express (AXP) charge close to the same amount on their JAN 10 $20 puts ($5.2 and $4.8 respectively).
But looking at their market situations, there is a clear advantages to both.
Capital One
• Pro: Lower average credit score to AXP customers
• Pro: Lower average income to AXP customers
• Pro: Large auto lending component to the business
• Con: Has substantial commercial lending deposits from it’s commercial bank
American Express
• Pro: Higher customer balances than COF customers
• Pro: Travel Services department (business credit cards) income is largely influenced by business capital spending in general, clearly in decline
• Con: No commercial bank to fund lending activities (used the Fed commercial lending facility early in November)
Summary:
If you look at in terms of product, COF vs. AXP is like Ford vs. BMW, AXP has a more affluent, and privileged clientele. This may provide a more orderly deleveraging and is currently reflected in the lower charge off rates for AXP customers compared to COF customers.
But if you look at it in terms of capital position, COF vs. AXP is like C vs. LEH, COF has internal capital it can use as a cushion when no one wants to buy it’s short term financing facilities. Whereas AXP, like the now defaulted Lehman Brothers, had minimal internal capital and lots of leverage that relied on securitization and commercial paper markets for operation.
Both are solid short candidates, but despite it’s pedigree, AXP is more exposed to credit market freeze and thus appears in a more precarious position.
Supporting Research:
“Capital One said this month it's restricting credit card issuance after charge-off rates spiked to 6.34% in the third quarter from 3.96% in the same period last year.”
“Banks, in turn, are trying to wean themselves from the securitization markets. They're turning to other financing such as certificate of deposit programs, but those can be costly.The market shutdown is particularly bad news for non-bank finance companies. The ability to sell off car, education and auto loans is critical to companies such Ford Motor Co.'s Ford Motor Credit, American Express Co. and student lender SLM Corp., or Sallie Mae. Without securitization markets, they have less capital to make new loans to consumers.”
“… approximately 50% of [American Express] funding was unsecured and 50% was done through securitization.
Moving to slide eight, metric performance for international consumer, we continue to have strong metrics in international consumer although we did see some slowing in billed business in the third quarter. FX adjusted growth in the first and second quarter was 10% compared to the 8% in the third quarter.” American Express CFO, Daniel Henry – EVP & CFO
“In the US while the write-off rate in the quarter was 5.9% the write-off rate in September was 6.1%. We expect the fourth quarter to be higher then the third quarter and we expect the first quarter of 2009 to be higher then the fourth quarter of 2008.” American Express CFO, Daniel Henry – EVP & CFO as reported in the American Express 3Q conf call...
Transparency: The author owns both AXP Apr 09 puts at $3/contract and COF JUN 09 $25puts at $5.58/contract.
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.”
http://seekingalpha.com/article/94896-bank-of-america-credit-weakness-spreading-to-commercial-loans
#9 The sheer arrogence of the Merrill Lynch purchase at $26/share for a company about to go bankrupt.
http://seekingalpha.com/article/94896-bank-of-america-credit-weakness-spreading-to-commercial-loans
#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.
#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.”
http://seekingalpha.com/article/94896-bank-of-america-credit-weakness-spreading-to-commercial-loans
#9 The sheer arrogence of the Merrill Lynch purchase at $26/share for a company about to go bankrupt.
http://seekingalpha.com/article/94896-bank-of-america-credit-weakness-spreading-to-commercial-loans
#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.
Wednesday, May 7, 2008
No credit for Capital One
The Quote of the Month
““It takes a man a long time to learn all the lessons of all his mistakes. They say there are two sides to everything. But there is only one side to the stock market; and it is not the bull side or the bear side, but the right side. It took me longer to get that general principle fixed firmly in my mind than it did most of the more technical phases of the game of stock speculation.” Jesse Livermore, “Reminiscences of a Stock Operator”.
The Position of the Month
Stock: COF
Position: Short
Basic Position Opening Price:
Above $55
Basic Position Expected closing price:
Below $40
Advanced Investor Position Opening Price:
Buy COF $50 Jan 10 puts at $10
Advanced Investor Position Closing Price:
Sell to Close at $14 / contract
The Summary
Capital One is a leveraged lender with high percentage of low quality cardholders.
The Story
Any investment related to credit cards is a bet on the American consumer. When the American consumer can hold a job, they can maintain their credit card balance. In this case, credit card companies profit on carrying fees. If Americans lose their job, then credit card costs spiral out of control. In this case, credit card companies lose money from charge offs, lost income streams, and decreased portfolio quality.
Off balance sheet securities performing poorly(1) 4/13/08 “Off-balance sheet item ($49B) has a default rate of 5.8% where the base portfolio is 3.26%.”
Credit card charge offs still at low levels considering economic outlook(2) 4/10/08 “Now, as the "almost-affirmed" recession is upon us, delinquencies will rise along with foreclosures and bankruptcies. This will surely trickle down to the lenders as the inflows they receive dwindle, outflows grow and non-recoverable debt increases. While a 6% rate may seem historically high, back in 2003, Capital One posted rates closer to 8% as the U.S. was starting on the road to recovery from a difficult 2 years of recession and the fall off from the domestic stock markets averaging near -50%.”
COF insiders are selling
(3) 3/24/08 “COF insiders are dumping shares. Whether planned or not, insiders reduced their positions by 10% during the past few months. Keep in mind that this company announced, back in February, a massive buyback program planning to redeem 10% of the total market cap. This points to the obvious strategy of the company’s management to help keep shares artificially high as they are selling. Institutions have also had the same idea and have sold off over 23 million shares during the past 6 months, effectively reducing their positions by 7%”
Americans revolving credit increasing as economy suffers
(4) 4/25/08 “Revolving debt, which typically comes from credit cards, has increased at a faster rate than overall debt since the summer of 2006 -- right about when the housing market began to implode.
The trend seems to suggest consumers are using credit cards to patch up holes in revenue that once could be filled by refinancing or selling a home. Now that home values have dropped sharply and are predicted to fall further, at least over the short term, consumers are left without the housing crutch they once relied upon.”
The story is very simple. If you think the unemployment rate is going up, then credit card companies will suffer in direct proportion to the increase in unemployment.
To underscore the link, look at the graph below and think about how it corresponds to home equity cash out phenomenon. As equity transferred from homes to consumer spending, credit cards benefited from increased revenue and lower defaults.
Moreover, projections are that credit card charge offs will continue return toward the mean in terms of historical charge off rates.
(5) "Despite these negative macroeconomic trends, credit card delinquencies and charge-offs have just recently returned to their long-term averages following a two-year period of exceptionally strong performance in the wake of the implementation of new bankruptcy legislation in 2005," Cynthia Ullrich, a senior director at Fitch, said in a statement.
The Conclusion
This investment hinges on the pretext that the credit unwind will directly effect the American consumer in terms of economic contraction and reduced leverage in household spending. Considering the current situation, this looks like a low risk investment with many different scenarios leading to the predicted outcome.
Sources
(1) Andrew Horowitz, http://seekingalpha.com/article/72030-capital-one-outlook-not-as-rosy-as-analyst-describes
(2) Andrew Horowitz, http://www.bloggingstocks.com/2008/04/10/capital-one-financial/
(3) Andrew Horowitz
(4) TheStreet.com, 4/25/08, http://www.thestreet.com/_yahoo/funds/saving-money/10413643.html?cm_ven=YAHOO&cm_cat=FREE&cm_ite=NA
(5) “Fitch study shows credit-card delinquencies and charge-offs rising, will pressure securities”
Wednesday, April 30th, Reuters, http://biz.yahoo.com/ap/080430/fitch_credit_cards.html?.v=1
““It takes a man a long time to learn all the lessons of all his mistakes. They say there are two sides to everything. But there is only one side to the stock market; and it is not the bull side or the bear side, but the right side. It took me longer to get that general principle fixed firmly in my mind than it did most of the more technical phases of the game of stock speculation.” Jesse Livermore, “Reminiscences of a Stock Operator”.
The Position of the Month
Stock: COF
Position: Short
Basic Position Opening Price:
Above $55
Basic Position Expected closing price:
Below $40
Advanced Investor Position Opening Price:
Buy COF $50 Jan 10 puts at $10
Advanced Investor Position Closing Price:
Sell to Close at $14 / contract
The Summary
Capital One is a leveraged lender with high percentage of low quality cardholders.
The Story
Any investment related to credit cards is a bet on the American consumer. When the American consumer can hold a job, they can maintain their credit card balance. In this case, credit card companies profit on carrying fees. If Americans lose their job, then credit card costs spiral out of control. In this case, credit card companies lose money from charge offs, lost income streams, and decreased portfolio quality.
Off balance sheet securities performing poorly(1) 4/13/08 “Off-balance sheet item ($49B) has a default rate of 5.8% where the base portfolio is 3.26%.”
Credit card charge offs still at low levels considering economic outlook(2) 4/10/08 “Now, as the "almost-affirmed" recession is upon us, delinquencies will rise along with foreclosures and bankruptcies. This will surely trickle down to the lenders as the inflows they receive dwindle, outflows grow and non-recoverable debt increases. While a 6% rate may seem historically high, back in 2003, Capital One posted rates closer to 8% as the U.S. was starting on the road to recovery from a difficult 2 years of recession and the fall off from the domestic stock markets averaging near -50%.”
COF insiders are selling
(3) 3/24/08 “COF insiders are dumping shares. Whether planned or not, insiders reduced their positions by 10% during the past few months. Keep in mind that this company announced, back in February, a massive buyback program planning to redeem 10% of the total market cap. This points to the obvious strategy of the company’s management to help keep shares artificially high as they are selling. Institutions have also had the same idea and have sold off over 23 million shares during the past 6 months, effectively reducing their positions by 7%”
Americans revolving credit increasing as economy suffers
(4) 4/25/08 “Revolving debt, which typically comes from credit cards, has increased at a faster rate than overall debt since the summer of 2006 -- right about when the housing market began to implode.
The trend seems to suggest consumers are using credit cards to patch up holes in revenue that once could be filled by refinancing or selling a home. Now that home values have dropped sharply and are predicted to fall further, at least over the short term, consumers are left without the housing crutch they once relied upon.”
The story is very simple. If you think the unemployment rate is going up, then credit card companies will suffer in direct proportion to the increase in unemployment.
To underscore the link, look at the graph below and think about how it corresponds to home equity cash out phenomenon. As equity transferred from homes to consumer spending, credit cards benefited from increased revenue and lower defaults.
Moreover, projections are that credit card charge offs will continue return toward the mean in terms of historical charge off rates.
(5) "Despite these negative macroeconomic trends, credit card delinquencies and charge-offs have just recently returned to their long-term averages following a two-year period of exceptionally strong performance in the wake of the implementation of new bankruptcy legislation in 2005," Cynthia Ullrich, a senior director at Fitch, said in a statement.
The Conclusion
This investment hinges on the pretext that the credit unwind will directly effect the American consumer in terms of economic contraction and reduced leverage in household spending. Considering the current situation, this looks like a low risk investment with many different scenarios leading to the predicted outcome.
Sources
(1) Andrew Horowitz, http://seekingalpha.com/article/72030-capital-one-outlook-not-as-rosy-as-analyst-describes
(2) Andrew Horowitz, http://www.bloggingstocks.com/2008/04/10/capital-one-financial/
(3) Andrew Horowitz
(4) TheStreet.com, 4/25/08, http://www.thestreet.com/_yahoo/funds/saving-money/10413643.html?cm_ven=YAHOO&cm_cat=FREE&cm_ite=NA
(5) “Fitch study shows credit-card delinquencies and charge-offs rising, will pressure securities”
Wednesday, April 30th, Reuters, http://biz.yahoo.com/ap/080430/fitch_credit_cards.html?.v=1
Tuesday, March 25, 2008
UBS no longer a haven
The Quote of the Month
“Please, God, just one more bubble!” quoted from Warren Buffet’s 2007 Letter to the Shareholders of Berkshire Hathaway
The Position of the Month
Stock: UBS
Position: Short
Basic Position Opening Price
Above $30
Basic Position Expected closing price
Below $15
Advanced Investor Position Opening Price
Buy UBS $35 Jan 09 puts at $8.50 / contract or lower
Advanced Investor Position Closing Price
Sell to Close at $19 / contract
The Summary
UBS is overleveraged and delaying an inevitable unwind. In the meantime, it is destroying centuries old customer confidence in Swiss banking.
Currently UBS is in a state of crisis. As Jim Cramer once said "Whenever you smell smoke, behind the door there is probably a giant conflagration!" The smoke is currently seeping out of UBS in the form of desperate measures to raise liquidity.
* UBS recently dumped $25B Alt-A mortgages due to liquidity concerns
“Analysts said they believed UBS had sold its Alt-A investments -- U.S. mortgages ranked between prime and subprime – to bond manager Pimco for 70 cents to the dollar, taking a deep discount on a 26.6 billion Swiss franc ($25.7 billion) portfolio.” Chris: A sure sign of cash concerns is bulk sales of loans.
* UBS still holds $400B in repurchase agreements for funding
“Analysts also said they expected the ailing bank making further writedowns on a massive 400 billion franc portfolio of repurchase agreements as it rushes to cut its exposure to the capital markets in general and to risky assets in particular.” Chris: This just shows how many assets they are holding out to avoid liquidating in an unforgiving market.
UBS tried to sell it’s Paine Webber brokerage arm to raise cash
“Swiss bank UBS, another bank suffering from the credit crunch, recently shopped its PaineWebber brokerage unit in an effort to drum up cash but failed to find the right buyer. (BAC, Wells Fargo and Barclays all declined).”
UBS needs to raise cash in a unforgiving market. There are tons competing assets sales, but all the potential customers are overleveraged and marketing the same securities themselves or prudent and choosier by the day. UBS needs to find solutions fast, while the clock on $400B in debt deteriorating in value is ticking away.
The Story
In the movie Die Hard, the evil villain says that after stealing $20m in bonds and lock safe baubles, he planned to store them in a “Swiss bank account and sit on the beach collecting 6%”. He might want to rethink that strategy.
For much of the 20th century Switzerland was considered the world’s safe haven for banking. African dictators, European despots, and Nazi war criminals all found it an oasis for savings in tumultuous times. In the latter part of the century, Swiss banking consolidated to two names, Union Bank of Switzerland and Credit Suisse.
At some point all this revere and sticky old money was not enough. The old money wanted higher returns and hedge funds came en vogue. UBS, providing the connections to the massive money of the old world, became a key prime broker to the hedge funds. Prime brokers are the home for hedge funds, housing them, executing their trades, finding investors, providing reports, cleaning up accounts, and even providing seed money and loans. This is very profitable considering 33% of volume in the market is hedge fund activity.
While times were good, the relationship was cozy. Now that the order of the day is deleveraging and the levered hedge funds, stuck in illiquid positions, are now more of a liability than an asset. The loans outstanding at UBS total more than $400B and cash on hand is $19B. Sounds impressive, but Bear had $17B on hand the day it folded. With the obvious implied leverage there is no doubt in my mind that UBS has been busy at the Fed discount window trading securities for treasuries that people will take for cash. The problem is that the Fed is lending only for 28 days. Every 28 days the value of the mortgage backed securities that UBS directly or indirectly is exposed to goes down in value. The house decline will not stop any time soon. So the predicament at UBS will continue to be more precarious as the weeks go by.
The Scorecard
Position #1: C
Direction: Short
Start Price: 27.3
Current Price: 23.78
Start Date: Jan 13, 2008
Position #2: UBS
Direction: Short
Start Price: Not reached yet
Current Price: 29.56
Start Date: TBD
“Please, God, just one more bubble!” quoted from Warren Buffet’s 2007 Letter to the Shareholders of Berkshire Hathaway
The Position of the Month
Stock: UBS
Position: Short
Basic Position Opening Price
Above $30
Basic Position Expected closing price
Below $15
Advanced Investor Position Opening Price
Buy UBS $35 Jan 09 puts at $8.50 / contract or lower
Advanced Investor Position Closing Price
Sell to Close at $19 / contract
The Summary
UBS is overleveraged and delaying an inevitable unwind. In the meantime, it is destroying centuries old customer confidence in Swiss banking.
Currently UBS is in a state of crisis. As Jim Cramer once said "Whenever you smell smoke, behind the door there is probably a giant conflagration!" The smoke is currently seeping out of UBS in the form of desperate measures to raise liquidity.
* UBS recently dumped $25B Alt-A mortgages due to liquidity concerns
“Analysts said they believed UBS had sold its Alt-A investments -- U.S. mortgages ranked between prime and subprime – to bond manager Pimco for 70 cents to the dollar, taking a deep discount on a 26.6 billion Swiss franc ($25.7 billion) portfolio.” Chris: A sure sign of cash concerns is bulk sales of loans.
* UBS still holds $400B in repurchase agreements for funding
“Analysts also said they expected the ailing bank making further writedowns on a massive 400 billion franc portfolio of repurchase agreements as it rushes to cut its exposure to the capital markets in general and to risky assets in particular.” Chris: This just shows how many assets they are holding out to avoid liquidating in an unforgiving market.
UBS tried to sell it’s Paine Webber brokerage arm to raise cash
“Swiss bank UBS, another bank suffering from the credit crunch, recently shopped its PaineWebber brokerage unit in an effort to drum up cash but failed to find the right buyer. (BAC, Wells Fargo and Barclays all declined).”
UBS needs to raise cash in a unforgiving market. There are tons competing assets sales, but all the potential customers are overleveraged and marketing the same securities themselves or prudent and choosier by the day. UBS needs to find solutions fast, while the clock on $400B in debt deteriorating in value is ticking away.
The Story
In the movie Die Hard, the evil villain says that after stealing $20m in bonds and lock safe baubles, he planned to store them in a “Swiss bank account and sit on the beach collecting 6%”. He might want to rethink that strategy.
For much of the 20th century Switzerland was considered the world’s safe haven for banking. African dictators, European despots, and Nazi war criminals all found it an oasis for savings in tumultuous times. In the latter part of the century, Swiss banking consolidated to two names, Union Bank of Switzerland and Credit Suisse.
At some point all this revere and sticky old money was not enough. The old money wanted higher returns and hedge funds came en vogue. UBS, providing the connections to the massive money of the old world, became a key prime broker to the hedge funds. Prime brokers are the home for hedge funds, housing them, executing their trades, finding investors, providing reports, cleaning up accounts, and even providing seed money and loans. This is very profitable considering 33% of volume in the market is hedge fund activity.
While times were good, the relationship was cozy. Now that the order of the day is deleveraging and the levered hedge funds, stuck in illiquid positions, are now more of a liability than an asset. The loans outstanding at UBS total more than $400B and cash on hand is $19B. Sounds impressive, but Bear had $17B on hand the day it folded. With the obvious implied leverage there is no doubt in my mind that UBS has been busy at the Fed discount window trading securities for treasuries that people will take for cash. The problem is that the Fed is lending only for 28 days. Every 28 days the value of the mortgage backed securities that UBS directly or indirectly is exposed to goes down in value. The house decline will not stop any time soon. So the predicament at UBS will continue to be more precarious as the weeks go by.
The Scorecard
Position #1: C
Direction: Short
Start Price: 27.3
Current Price: 23.78
Start Date: Jan 13, 2008
Position #2: UBS
Direction: Short
Start Price: Not reached yet
Current Price: 29.56
Start Date: TBD
Things are amiss in Gotham Citi
Quote of the Month
Proverbs 22:26-27 "26 Do not be a man who strikes hands in pledge or puts up security for debts; 27 If you lack the means to pay your very bed will be snatched under you"
Position of the Month
Citi:
Position: Short
Opening Price: Above $27
Expected closing price: Below $16
Horizon: One year
Summary:
Citi is unwinding leverage in the capital markets while facing a deteriorating consumer credit business.
Position of the Month:
The Citi is in trouble, and everyone knows it.
The previously largest bank by market capitalization in the world is trying to get hold of all the problems threatening the company. The unwinding of off balance sheet debt positions (think Enron) led to the ratings agencies attempting to downgrade to junk six of their seven off balance sheet companies. In the last minute before six of the seven SIV companies were downgraded to junk, the SIVs were adopted on to Citi’s balance sheet. What remains of the $100B of asset backed securities that Citi was caught holding the bag with, $43B of the securities still remain.
But that was the first issue. Citi seemed to lending to it’s citizens seems to be too lax. Citi also purchased two subprime insurers at the top of the market that continue to cause writeoffs as the loans deteriorate. In addition, Citi took positions is securities and derivatives that analyst William Tanona estimates gives the company 37B exposure to subprime mortgages. This issue will continue to haunt Citi as the market reprices homes from the top of the market.
The bottom line for Citi is that mortgage losses, credit losses, and derivative losses all draw cash away from the bank. Unhedged long term positions threaten to bring the banks capital ratios down below the capital requirement levels required. If the people of Citi think the bank cannot repay, they will be very likely to take their deposits elsewhere.
Ok things are bad, but what is next for Gotham?
From the transcript of the Citi 4th quarter conf call…
"The American consumer is losing net worth at phenomenal rate with the decrease in housing prices. The Case & Schiller index of home prices indicates we are only in the second year of five year retreat in home prices. Much of the consumer economy of the past ten years has relied on or was financed by the increase in home prices. As the prices fall companies like Citi will have larger and larger draws on it’s available cash from it’s consumer operations to fund it’s illiquid leveraged positions, managing bank capital ratios against decreasing asset values, and continuing losses from lax lending areas from auto loans to credit cards."
Economic Outlook:
“Pyramid schemes and chain letters collapse because there is no more credit to feed them. As the system of modern day levered shadow finance slows to a crawl, or even contracts at the edges, its ability to systemically fertilize economic growth must be called into question.”
Author William Gross, “Pyramids Crumbling”, Investment Outlook, January 2008
http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+January+2008.htm
Summary:
The current unwinding of financial markets is repricing risk from historically low levels. When price trends reach the end of a cycle and start retracing prices tend to overshoot, not revert to the mean. So we can expect significant increases in the cost of consumer credit over the next couple of years.
To support the point refer to the CFO of Citibank as reported in the New York Times (1)
“Mr. Crittenden, the chief financial officer of Citigroup, had a different message on Tuesday, as Citi disclosed an $18.1 billion write-down. He told analysts that Citi was raising rates on credit cards and tightening the amount of credit it would extend. Asked by an analyst whether credit card lending was an area where Citi might want to “pull back or increase pricing,” he responded, “All of the above.”
Crittenden continues...
"Low Federal rates of turn of the century led to a credit boom with lax lending standards. Now that lenders are getting burned, the spigot is being turned the other way. This bodes poorly for overextended consumers.
Again the NYT reports…
“Citi is not alone. While the tighter credit market has not stopped credit-worthy individuals or companies from obtaining loans, it has made loans more expensive for many of them, and left those with the greatest need for cash far less able to obtain it.”
“They are parceling out credit with a keen eye on the balance sheet,” said John Garvey, the head of the financial services advisory group at PricewaterhouseCoopers. “There is a flight to quality and a renewed focus on risk.”
(1) “An Effort to Stem Losses at Citigroup Produces a Renewed Focus on Risk” by Floyd Norris
http://www.nytimes.com/2008/01/16/business/16place.html?em&ex=1200632400&en=077a0234cedf9ba2&ei=5087%0A
Proverbs 22:26-27 "26 Do not be a man who strikes hands in pledge or puts up security for debts; 27 If you lack the means to pay your very bed will be snatched under you"
Position of the Month
Citi:
Position: Short
Opening Price: Above $27
Expected closing price: Below $16
Horizon: One year
Summary:
Citi is unwinding leverage in the capital markets while facing a deteriorating consumer credit business.
Position of the Month:
The Citi is in trouble, and everyone knows it.
The previously largest bank by market capitalization in the world is trying to get hold of all the problems threatening the company. The unwinding of off balance sheet debt positions (think Enron) led to the ratings agencies attempting to downgrade to junk six of their seven off balance sheet companies. In the last minute before six of the seven SIV companies were downgraded to junk, the SIVs were adopted on to Citi’s balance sheet. What remains of the $100B of asset backed securities that Citi was caught holding the bag with, $43B of the securities still remain.
But that was the first issue. Citi seemed to lending to it’s citizens seems to be too lax. Citi also purchased two subprime insurers at the top of the market that continue to cause writeoffs as the loans deteriorate. In addition, Citi took positions is securities and derivatives that analyst William Tanona estimates gives the company 37B exposure to subprime mortgages. This issue will continue to haunt Citi as the market reprices homes from the top of the market.
The bottom line for Citi is that mortgage losses, credit losses, and derivative losses all draw cash away from the bank. Unhedged long term positions threaten to bring the banks capital ratios down below the capital requirement levels required. If the people of Citi think the bank cannot repay, they will be very likely to take their deposits elsewhere.
Ok things are bad, but what is next for Gotham?
From the transcript of the Citi 4th quarter conf call…
"The American consumer is losing net worth at phenomenal rate with the decrease in housing prices. The Case & Schiller index of home prices indicates we are only in the second year of five year retreat in home prices. Much of the consumer economy of the past ten years has relied on or was financed by the increase in home prices. As the prices fall companies like Citi will have larger and larger draws on it’s available cash from it’s consumer operations to fund it’s illiquid leveraged positions, managing bank capital ratios against decreasing asset values, and continuing losses from lax lending areas from auto loans to credit cards."
Economic Outlook:
“Pyramid schemes and chain letters collapse because there is no more credit to feed them. As the system of modern day levered shadow finance slows to a crawl, or even contracts at the edges, its ability to systemically fertilize economic growth must be called into question.”
Author William Gross, “Pyramids Crumbling”, Investment Outlook, January 2008
http://www.pimco.com/LeftNav/Featured+Market+Commentary/IO/2008/IO+January+2008.htm
Summary:
The current unwinding of financial markets is repricing risk from historically low levels. When price trends reach the end of a cycle and start retracing prices tend to overshoot, not revert to the mean. So we can expect significant increases in the cost of consumer credit over the next couple of years.
To support the point refer to the CFO of Citibank as reported in the New York Times (1)
“Mr. Crittenden, the chief financial officer of Citigroup, had a different message on Tuesday, as Citi disclosed an $18.1 billion write-down. He told analysts that Citi was raising rates on credit cards and tightening the amount of credit it would extend. Asked by an analyst whether credit card lending was an area where Citi might want to “pull back or increase pricing,” he responded, “All of the above.”
Crittenden continues...
"Low Federal rates of turn of the century led to a credit boom with lax lending standards. Now that lenders are getting burned, the spigot is being turned the other way. This bodes poorly for overextended consumers.
Again the NYT reports…
“Citi is not alone. While the tighter credit market has not stopped credit-worthy individuals or companies from obtaining loans, it has made loans more expensive for many of them, and left those with the greatest need for cash far less able to obtain it.”
“They are parceling out credit with a keen eye on the balance sheet,” said John Garvey, the head of the financial services advisory group at PricewaterhouseCoopers. “There is a flight to quality and a renewed focus on risk.”
(1) “An Effort to Stem Losses at Citigroup Produces a Renewed Focus on Risk” by Floyd Norris
http://www.nytimes.com/2008/01/16/business/16place.html?em&ex=1200632400&en=077a0234cedf9ba2&ei=5087%0A
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