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
Tuesday, December 2, 2008
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.
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?”
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.
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.”
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.
Friday, August 22, 2008
Fannie, Freddie : Beyond the Balance Sheets
1 Kings 19:11-13
“The LORD said, "Go out and stand on the mountain in the presence of the LORD, for the LORD is about to pass by."
Then a great and powerful wind tore the mountains apart and shattered the rocks before the LORD, but the LORD was not in the wind. After the wind there was an earthquake, but the LORD was not in the earthquake. 12 After the earthquake came a fire, but the LORD was not in the fire. And after the fire came a gentle whisper. 13 When Elijah heard it, he pulled his cloak over his face and went out and stood at the mouth of the cave.”
The story of Elijah is a spiritual example of how investors need to demonstrate discipline and discernment. Each of the seemingly apocalyptic events that occurred in front of Elijah could have caused him to react prematurely or fear something not worthy of fear.
On a much more worldly level, such is the case with Freddie Mac (FRE) and Fannie Mae (FNM) preferred shares. In the past few months, the din of negative assessments of the GSEs situation has been deafening. Stories of representatives of foreign sovereign financial institutions calling Paulson himself to explicitly guarantee the US government financial backing for the FRE and FNM are accepted as truth. There has been an unprecedented selling of FRE and FNM preferred share securities, over $12B worth, in just a few weeks. For any smaller or non-government entity, this would be a sign that the corporation was worth no more than junk.
Even more telling is estimates regarding the net worth of GSEs. By many mark to market measures, there is negative net worth to the organizations. No one really disputes this, but many market participants expect that this is grounds to seek bankruptcy proceedings for these entities. The roar of the critics and investors disillusioned by the state of the credit markets expecting honest reporting and vindication for predictions of this outcome of easy credit is deafening.
Yet this is all noise. The authority, the US government has completely different agenda. The US government must maintain the stability of the US and implicitly the US housing and credit markets. The calculation of the net worth of FRE and FNM completely discounts the goodwill value of having a government organ able to keep mortgage markets from freezing up completely and starting the economy in a free fall. To the government, FRE and FNM are one of the few remaining levers to keep the markets moving. How much is that worth? In a whisper, that value is beyond the value of any bailout cost in dollar terms.
Why keep value in the preferreds and even the common then? Scream any profanity appropriate about how unfair it is for investors not to pay for their faith in insolvent corporations, but what about the intangibles? The biggest currency the US government has right now is faith that it is a good place to invest and that it will pay whatever debt is owed. A tremendous amount of the preferred securities were purchase based on the implied backing of the US government. To repudiate that assumption at this point will to risk total loss of faith in the US government as debtor. How much is that worth?
Why hasn’t the authority spoken to revive faith in these institutions and let all this noise come out speaking of their demise? In the financial classic “"Manias, Panics, and Crashes: A History of Financial Crises" the author, Kindleberger, explores how financial crises unfold and what is the options of those seeking to alleviate the crisis. A reviewer gives a synopsis of Kindleberger’s conclusion…
“What, in the end, is Kindleberger's moral? …. The solution, he believes, lies in having a lender of last resort. The trick, of course, is to avoid moral hazard and prevent the public from gambling due to the reassurance of a lender of last resort. The answer is ambiguity: the lender can come in and save the day but investors should never be certain that help is forthcoming."
Elijah never knew how many dramatic events would occur before he would hear The Lord speak. Such is the case with FNM and FRE, there is no motivation for the government to establish a floor because of the risk of inspiring moral hazard in the market is too great.
In the end, some time soon the cacophony of market opinions will subside and the market will realize that FNM and FRE serve a purpose much larger than just what balance sheets suggest. Then, at that grand final moment, the authority in this matter will honor the faithful.
Disclosure: Lockstep Investing is long FRE Y Series and Z Series preferreds
Lockstep Proposed Position: Buy FRE Y Series preferreds below $9 / share.
“The LORD said, "Go out and stand on the mountain in the presence of the LORD, for the LORD is about to pass by."
Then a great and powerful wind tore the mountains apart and shattered the rocks before the LORD, but the LORD was not in the wind. After the wind there was an earthquake, but the LORD was not in the earthquake. 12 After the earthquake came a fire, but the LORD was not in the fire. And after the fire came a gentle whisper. 13 When Elijah heard it, he pulled his cloak over his face and went out and stood at the mouth of the cave.”
The story of Elijah is a spiritual example of how investors need to demonstrate discipline and discernment. Each of the seemingly apocalyptic events that occurred in front of Elijah could have caused him to react prematurely or fear something not worthy of fear.
On a much more worldly level, such is the case with Freddie Mac (FRE) and Fannie Mae (FNM) preferred shares. In the past few months, the din of negative assessments of the GSEs situation has been deafening. Stories of representatives of foreign sovereign financial institutions calling Paulson himself to explicitly guarantee the US government financial backing for the FRE and FNM are accepted as truth. There has been an unprecedented selling of FRE and FNM preferred share securities, over $12B worth, in just a few weeks. For any smaller or non-government entity, this would be a sign that the corporation was worth no more than junk.
Even more telling is estimates regarding the net worth of GSEs. By many mark to market measures, there is negative net worth to the organizations. No one really disputes this, but many market participants expect that this is grounds to seek bankruptcy proceedings for these entities. The roar of the critics and investors disillusioned by the state of the credit markets expecting honest reporting and vindication for predictions of this outcome of easy credit is deafening.
Yet this is all noise. The authority, the US government has completely different agenda. The US government must maintain the stability of the US and implicitly the US housing and credit markets. The calculation of the net worth of FRE and FNM completely discounts the goodwill value of having a government organ able to keep mortgage markets from freezing up completely and starting the economy in a free fall. To the government, FRE and FNM are one of the few remaining levers to keep the markets moving. How much is that worth? In a whisper, that value is beyond the value of any bailout cost in dollar terms.
Why keep value in the preferreds and even the common then? Scream any profanity appropriate about how unfair it is for investors not to pay for their faith in insolvent corporations, but what about the intangibles? The biggest currency the US government has right now is faith that it is a good place to invest and that it will pay whatever debt is owed. A tremendous amount of the preferred securities were purchase based on the implied backing of the US government. To repudiate that assumption at this point will to risk total loss of faith in the US government as debtor. How much is that worth?
Why hasn’t the authority spoken to revive faith in these institutions and let all this noise come out speaking of their demise? In the financial classic “"Manias, Panics, and Crashes: A History of Financial Crises" the author, Kindleberger, explores how financial crises unfold and what is the options of those seeking to alleviate the crisis. A reviewer gives a synopsis of Kindleberger’s conclusion…
“What, in the end, is Kindleberger's moral? …. The solution, he believes, lies in having a lender of last resort. The trick, of course, is to avoid moral hazard and prevent the public from gambling due to the reassurance of a lender of last resort. The answer is ambiguity: the lender can come in and save the day but investors should never be certain that help is forthcoming."
Elijah never knew how many dramatic events would occur before he would hear The Lord speak. Such is the case with FNM and FRE, there is no motivation for the government to establish a floor because of the risk of inspiring moral hazard in the market is too great.
In the end, some time soon the cacophony of market opinions will subside and the market will realize that FNM and FRE serve a purpose much larger than just what balance sheets suggest. Then, at that grand final moment, the authority in this matter will honor the faithful.
Disclosure: Lockstep Investing is long FRE Y Series and Z Series preferreds
Lockstep Proposed Position: Buy FRE Y Series preferreds below $9 / share.
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