Port Authority: You overconfidence is your weakness
Fleckenstein Shutting Down Short Hedge Fund
Costco: "The kid’s sitting in the cart, and she sees a guy carrying a 19" flatscreen, and she goes, ‘Look! He has a tiny one!’ and the guy looks at her, looks at the box–I’m not making this up — and goes and puts it back, and picks up a 23" flatscreen… And so I turn to the guy with two 42’s in his cart who’s helping a woman put a 37 in her cart…"
There’s been some very good commentary in recent days about whether a reduction in mortgage interest rates might help boost house prices. Counterintuitively, the answer seems to be that there’s a good chance it won’t:
A 2006 study of mortgage rates and New York City housing prices going back to 1975 by Lucas Finco of Quadlet Consulting found no correlation between lower mortgage rates and higher housing prices, or vice versa. "The relationship between mortgage rates and home prices is pretty obscure," says Jack Guttentag, a professor emeritus of finance at the Wharton School of Business.
James Hamilton, a professor of economics at the University of California, San Diego, says he used to think that lower mortgage rates were responsible for rising home sales in the first half of this decade, and for that reason he projected home prices would rebound in 2007. He now says rising home sales were the result of deterioration of lending standards and not lower mortgage rates. "I was wrong. The real story with home sales has to do with the availability of credit," says Hamilton. "And credit is tight now."
Calculated Risk gets a bit wonkier: yes, he says, lower mortgage rates help tilt the balance of the rent vs buy calculation. But:
Landlords, already struggling with high vacancy rates and falling rents, would probably lower their rents further and make the rent vs. buy decision more difficult again. So lower interest rates might not boost demand very much, it might just lead to lower rents.
My feeling is that lower mortgage rates do feed through into higher prices in an up market. It wasn’t all that long ago that we were all bombarded with the advice to "buy the biggest and most expensive house you can afford" — since houses always and everywhere rise in value, that’s just a way of maximizing your net worth. Clearly, the lower that mortgage rates go, the more house can be bought with a monthly dollar of mortgage payment, and during the bubble, people were putting every last penny they could scrounge into their mortgage payments.
Now, however, things have changed. For all that a few brave souls are poking their heads above the parapet and wondering whether it’s a good time to buy, there has been a dawning realization that maybe a strategy of deliberately maximizing your mortgage payments might have a certain amount of downside. In other words, we’ve gone from:
to:
In this new world, lower mortgage rates might just allow people to buy property which was formerly just out of their grasp. But that’s a marginal effect, and lower prices would be more effective at that anyway. If people stop buying houses on the outer edge of affordability, then I see very little way in which lower mortgage rates are going to feed into higher house prices.
(HT: Kiviat)
On April 3, 2007, Sam Zell was triumphant. The headline in the WSJ was "Zell Wins Tribune In Bid to Revive A Media Empire", and the story was accompanied by a dot portrait of a happy, smiling grave-dancer.
Today, the headline is gruesome: "Tribune Prepares for Bankruptcy Filing". And even Zell’s dot portrait seems to have got the memo, despite the fact that most of the shares in the company are actually owned by Tribune’s employee stock ownership program, rather than Zell himself.
First Pandit, now Zell — can’t we find anyone willing to smile for the WSJ any more? Yes we can!
The wsj.com home page today features, prominently, an article on fund manager Ken Heebner, who’s long bank stocks, and I can’t for the life of me work out what it’s doing there. Heebner was a media star back when he was outperforming massively, but his fund has lost more than half its value so far this year, and in any case it’s impossible to mirror what he’s doing because, as the article itself notes, Heebner is known for his "rapid portfolio turnover". In other words, you might be able to go long with him right now, but you’ll never know when he’s exited that position and moved on to something else.
I fear that this article will steer some retail investors into buying bank stocks — it is in the Personal Finance section, after all. And bank stocks, as we all should know by now, are very dangerous things. The WSJ should be providing less adulation of fund managers in general, and of Ken Heebner in particular: it does no one any good.
For really lazy journalism, however, you need to turn to the WSJ’s glossy magazine. I’m surprised at this: it comes out so infrequently that you’d think its editors have the time to really check things over. But turn to the article about hard-core adventure travel — things like six-day, 155-mile races across the Egyptian Sahara:
“Lately, the hardest thing for us has been keeping authentic adventure travel distinct from mainstream tourism,” says Chris Doyle of the Adventure Travel Trade Association, who estimates world-wide spending on real adventure-travel packages at $75 billion to $150 billion a year.
Let’s put those numbers in perspective: according to its annual earnings report, Walt Disney’s global revenues from all its parks and resorts in fiscal 2008 totalled $11.5 billion. So I’m pretty sure that Doyle was talking in millions, not billions: 10,000 people each spending $10,000 will add up to $100 million. Which means that the WSJ is three orders of magnitude off.
Alternatively, check out the little maps that accompany the little article on hot winter spots around the world. The magazine’s editorial staff is based in New York, and its editor, Tina Gaudoin, is an Englishwoman who has only recently moved here from London. So you’d think they’d be able to get those two cities right, at least. Think again: the New York map places the new Giorgio Armani Store, which is going to open on 5th Avenue and 56th Street, about 20 blocks north of that, on a residential stretch of the avenue abutting Central Park. And the London map places Somerset House somewhere in South Kensington — about three and a half miles from its actual location on the Strand.
Of course, people aren’t going to use those maps literally, to find the places in question, especially since that Armani store isn’t even scheduled to open until February. (What it’s doing in this issue of the magazine I have no idea.) But there was clearly a lack of attention to detail here.
But the worst offender of all, this weekend, is not WSJ but rather the NYT’s T magazine, and specifically a section called The Must Haves. What are this season’s must-haves?
On what planet is a $54,200 watch a must-have? In which economy does a $2,295 handbag qualify as cheap? I don’t know the answers to those questions, but with a bit of Googling I can tell you what "price on request" means: $126,700. And no, there’s no bling — it’s even got a rubber strap. But there is a tourbillon, which is French for "utterly useless widget which adds an extra zero onto the price".
I know that lead times for these magazines are long, but we’ve been in recession for a year now. And these kind of prices don’t generate escapist reveries, they generate revulsion and disgust. I’m sure the editors don’t care what I think, but maybe we can hope that the advertisers will start phoning up the NYT and asking them to tone things down a bit. The New York Times Company needs T magazine, which is probably its most profitable arm — it simply can’t afford this degree of cluelessness.
Update: It turns out that there’s no shortage of industry associations willing to peg total adventure-travel expenditure in the tens of billions of dollars. So WSJ wasn’t making a billions-for-millions mistake, it was just making a don’t-stop-to-think-if-the-number-makes-any-sense mistake. In order to get to Doyle’s numbers, I’m pretty sure you have to start including things which most of us would consider "mainstream tourism", like Scuba diving or renting 4-wheel-drive vehicles — things which are a world removed from the subject of the article. Which is weird, ‘cos that’s exactly what he says he’s trying not to do.
Bank of America’s Merrill Takeover May Be Tough Deal: Great quote on Ken Lewis: "The companies he’s been acquiring all make sense strategically, but the timing and price almost always seems to be off."
Trump Sees Act of God in Recession: Which is why he reckons he can get out of paying Deutsche Bank $40 million he owes them. For good measure he’s also suing them for $3 billion, and threatening to sue the NYT as well.
Workers Give Up: And U6 is now 12.5%.
Bubbles in Prices of Exhaustible Resources: Bubbles in wine prices: very old wines, in particular, go up in price even when no one’s drinking them any more.
As I suspected, CDS collateral has a lot of complexities that I didn’t get to last time round. So with many thanks to my commenters and also to David Felsenthal of Clifford Chance, here’s more: on questions of buyers posting collateral, whether rehypothecation is allowed, and whether all the collateral being posted is causing a major liquidity shock. As ever, the mistakes are all my own.
First, do buyers of credit protection ever have to post collateral? The easy but unhelpful answer to this and all questions is that it depends on what is negotiated in the CDS contract. But if you take a normal CDS issued under the ISDA Master Agreement with few modifications, then yes, in many cases the buyer of protection does need to post collateral if the contract moves against them.
In practice, however, this is rarely a big deal. For one thing, spreads have been moving out, not in — which means that buyers of protection have generally been making money, not losing it, on a mark-to-market basis. But also there’s a limit to how much a buyer of protection can lose: if there are "points" up front then that money has been paid already, so a buyer’s only liability from then on in is the insurance premiums they have to pay every six months. Those payments are senior unsecured liabilities of the buyer, but if the seller of protection is worried about them, then they can ask for collateral to secure the upcoming payment. Normally the collateral requirement doesn’t exceed one payment.
Most of the collateral being posted goes the other way: from the seller to the buyer. And the big question there is whether the buyer can use that collateral in the normal course of business — rehypothecation, it’s called — or whether it just needs to sit there in the bank account, untouched.
The ISDA Master Agreement allows it both ways: it’s basically a check-the-box thing. Brokers nearly always want to allow rehypothecation of the collateral which has been posted to them, but any client can ask for rehypothecation to be "turned off" very easily. The more rehypothecation that’s going on, the less of a liquidity problem that brokers will have when they’re posting and receiving collateral every day: if they allow rehypothecation, the same collateral can effectively be used on lots of different contracts at once. But we’re moving towards a world where the brokers’ clients are increasingly concerned about the brokers’ own credit risk and are therefore more wary of allowing rehypothecation.
Historically, brokers sometimes negotiated CDS contracts with their hedge-fund clients whereby the hedge funds would need to post collateral if the contracts moved against them, but they themselves did not need to post collateral unless their credit ratings were downgraded. At this point, however, pretty much everybody is posting collateral, with the exception of Berkshire Hathaway, partly because the brokers did get downgraded.
Because the brokers tend to prefer to allow rehypothecation, most CDS contracts do allow it. (I was wrong about that last time round.) That minimizes the liquidity problems associated with lots of collateral needing to be posted at once, but it also introduces the risk of exactly what we’re seeing with Lehman Europe: counterparties being unable to retrieve collateral from a bankrupt broker because it’s been rehypothecated many times over.
Moving forwards, brokers may well start quoting two different prices for CDS: one for a contract with rehypothecation allowed, and the other one with it banned. Less likely is another proposal which has been mooted: that of holding the collateral at a third-party custodian such as Bank of New York.
The one thing I’m still very unclear on is how much total collateral is tied up in one form or another right now — and whether that amount is big enough to cause serious liquidity problems in the financial system. Obviously the numbers for AIG on its own are enormous, partly because it only ever sold credit protection and never bought any. But outside AIG and other formerly triple-A insurers, is CDS collateral significantly decreasing the liquidity available to investment banks? My very vague gut feeling is that the answer is no, but I might well be wrong about that.
Update: Alea points to an ISDA press release from April putting total collateral in circulation at end-2007 at $2.1 trillion, up sharply from $1.3 trillion at end-2006. Yikes! It’s not clear whether there’s any double-counting going on thanks to rehypothecation; for liquidity’s sake, I hope there is.
Update 2: I’ve now received a copy of the actual ISDA report; in fact there’s even double-counting without rehypothecation:
The objective of the ISDA Margin Survey is to estimate the
importance of collateralization in the market and not simply to estimate the value of assets used as
collateral. The Survey therefore tracks the gross amount of collateral–defined as the sum of all
collateral delivered out and all collateral received in by Survey respondents–and does not adjust
for double counting of collateral assets. Double counting takes at least two forms. The first occurs
when one Survey respondent delivers collateral to or receives collateral from another respondent.
The collateral assets in this case are counted twice, once as received and once as delivered. The
second source of double-counting is collateral re-use–sometimes called rehypothecation–in which
collateral is delivered from one party to another, then delivered to a third party, and so on. A single
unit of re-used collateral may consequently be counted several times by the Survey as the collateral
progresses down the chain of parties re-using it. But because each re-use represents the securing of a
separate and distinct credit exposure between two parties, we believe it is valid to count the collateral
as many times as it is used. If in contrast the objective were simply to measure the value of assets
currently in use as collateral, it would then be necessary to adjust for double counting.
Who can get a 123% loan-to-value mortgage these days? George W Bush, that’s who! He’s just taken out a $3,074,239 loan from Community National Bank in Midland, Texas, to buy an 8,500 sqft bungalow in Dallas which was appraised at $2.5 million earlier this year. It’s a big loan for CNB, which has total loans outstanding of just $310 million, according to the FDIC.
The mortgage has a four-year maturity, which is a little odd, but presumably Bush reckons he’ll make enough money in that time on speaking fees and book deals that he should easily be able to repay it by then. I wonder what interest rate he locked in.
Today’s 8,000-word dose of schadenfreude is here, courtesy of Michael Shnayerson and Vanity Fair. All the bankers laid low by ill fortune you could ever want!
Still, a look at the real-estate "bargains" shows how much further there is to fall: a Greenwich home which sold for $11 million after being listed at $19.9 million; a Hamptons rental for a mere $250,000, down from an intial asking price of $500,000. Yes, just for the summer. People are still mentally pricing off the highs: enormous numbers seem positively reasonable when they’re much smaller than they were a few months ago.
Last night I ate at a very expensive new downtown restaurant; it was packed. Maybe people feel that spending a few hundred dollars on dinner doesn’t make a difference when the big problems are with seven-figure salaries and mortgages. Or maybe they’re simply more likely to order the $50 wine than the $2,000 wine, and that way they can get most of the benefit at a fraction of the former cost. But I do still get the feeling that people need a little time to unwind from the culture of excess; that right now they’re just looking for cheaper flat-screen TVs, as opposed to not buying a new TV at all.
On the other hand, I do think that there’s a solid future ahead for the likes of Vanity Fair, at least. It always catered more to those who would dream of spending millions of dollars than it did to that select group who actually do. And now the dream is stronger than ever, not despite but because of the recession. There’s always a bull market in escapism when the economy turns south.
The recession might be one year old already, but as anyone can see from this morning’s payrolls numbers — much worse than even the pessimists expected — it’s still getting worse, and there’s certainly no end in sight. Once upon a time, this was a financial crisis; at this point, as Brad DeLong notes, we’ve entered a fully-fledged Great Recession.
Every time I remark to Barry Eichengreen about the disjunction between the intensity of the financial crisis and its limited transmission to the real economy, he says "just wait." I guess we can stop waiting.
The base-case scenario now has to be that things are going to get worse before they get worse. We had a long run up, and we might not see any economic growth until GDP has fallen a lot — 5% or so. As a result, spending tens of billions of dollars on a Detroit bailout now feels increasingly like trying to catch a falling knife: my feeling is that the Zandi estimate of the cost of the bailout — $75 billion to $125 billion — is probably far too low. If we’re going to be spending 12-figure sums, we should do so strategically, and not get rushed into it because things are urgent now. Pretty soon, a lot of other things are going to be urgent, too.
Remember that GM is warning of a couple of million job losses should it be forced into Chapter 7 liquidation — something the government is almost certainly going to prevent one way or another. But even without those job losses, the US economy shed over half a million jobs in November alone. And the employment bloodbath is only beginning.
How do we get out of this mess? I have no idea. But I do know that anybody still hoping for a swift bounce back is looking increasingly delusional. As we saw this morning, the probability of downside surprises is much greater than the chance that we’ll get any good news any time soon.
The Auto Industry As a Play: A wonderful summation of what is wrong with Detroit.
Staff Keeps Neuberger After Deal Falls Apart: Essentially buying the liability-free shop, which was meant to be worth $8 billion, for nothing.
Central banks need a helicopter: They should be able to print money and just give it to consumers. But how to do that, in practice?
Citigroup Needs to Confess Its Writedowns Now: It might start with that $40 billion of "goodwill" it has on its balance sheet.
The Class of ’99: Where Are They Now? Looking at what’s happened to banks’ market capitalization over the past 9 years.
Geithner May Seek to Push Bair Out After Clashes During Crisis
The Moral Hazard of Underwater Stock Options: Joe explains vega.
Harvard Endowment Down 22%: "Two ‘lost years’ is not a big deal if you’re 372 years old and consider yourself immortal."
Music and the Market: Song and Stock Volatility: The negative correlation between BPM and the VIX.
Singapore Strikes Again: The WSJ shows how to deal with Singapore’s courts. FT, take note.
The money talks: Financial literacy, in practice.
Times Extra has launched, and it’s even less impressive than I’d feared it would be. This is not, by a long shot, the ideal newspaper site, which leads with its own content where that’s strong and which links to the best of others’ content where the newspaper is less strong. Instead, we have a site which:
All of these are niggles, however, in contrast to the biggest problem of all: the Times Extra links are automated! I’m sure that’s great news for Blogrunner, a technology the NYT acquired and now is putting to use. But it completely defeats the purpose of putting external links on the home page to begin with.
There’s a reason that the top dog at any newspaper is called the editor: the first and most important function which newspapers perform is to edit out the noise and serve up what’s most germane. And nowhere is that function more important than the front page, which is essentially a second round of editing giving you just the handful of the top stories of the moment. Installing automated links destroys that hugely valuable editing function.
So much as I would love to see external links on the nytimes.com homepage, I’m actually glad that they’ve buried this function, because the current implementation is horrible, and I for one won’t be availing myself of it. I just hope that this isn’t an elaborate plan to allow them to say "well, we tried external links and it didn’t work". Because this isn’t even close to what such an experiment would look like.
Why would anybody invest with Jim Simons? Everybody knows where his love and attention and money is concentrated: in the $8 billion Medallion Fund, which charges 5-and-44 but which in any case is closed to outside investment and basically just runs the money of current and former Renaissance employees. It’s up more than 58% this year.
On the other hand, if you’re not a current or former Renaissance employee, your choices are limited to the Renaissance Institutional Equities Fund (down 14.8% this year) and the Renaissance Institutional Futures Fund (down 15.6%): it seems that relatively little of the Medallion stardust has settled on the newer franchises.
The problem of course is one of incentives. When you consider how much personal money he has in Medallion, it’s easy to see how Simons would have every incentive to concentrate on Medallion to the detriment of RIEF and RIFF. People invest in them all the same, much as they buy mass-produced Shun knives when they can’t get a Bob Kramer original. But they can’t be very happy with the results right now.
Reader Dennis Mangan emails asking how and where firms post collateral in the CDS market. It’s a good question, and the answer can get as complicated as you like. But here’s a short(ish) answer.
Most of the time, collateral requirements are governed by the standard ISDA master agreement, which covers the majority of CDS contracts: we’ll assume that you’re not buying your credit protection from a triple-A-rated insurer, or anything like that. Instead, let’s keep it simple, and assume you’ve just bought credit protection on IBM from Goldman Sachs.
Every day, the value of that CDS contract is marked to market. If it’s worth more than you paid for it, you’re in the money. And for every dollar that you’re in the money, Goldman Sachs deposits one dollar, in cash or Treasuries, in a bank account in your name. If the value of the CDS contract falls, Goldman can withdraw money from the same account.
Note that it’s always the seller of credit protection who has to post collateral: if you bought protection, you have a fixed obligation to pay Goldman Sachs a certain amount every six months, and that doesn’t ever change. But if you have been both buying and selling protection on various credits with Goldman Sachs, it’s entirely kosher to net things out. If Goldman needs to put up $10 million of collateral to you, and you need to put up $9 million of collateral to Goldman, then that works out with Goldman just putting up $1 million of collateral to you, and you putting nothing into Goldman’s account. These bilateral netting processes are not to be confused with the multilateral compression processes, which can end up changing your counterparties, just not your net exposures.
What are you allowed to do with the money in your bank account? Can you use it as collateral with other counterparties, in a process known as rehypothecation? Normally, no — but there are exceptions, as hedge funds doing business with Lehman Brothers Europe found out. The collateral might be in your account, but it’s not there for spending: it’s there to protect you against your counterparty going bust. If that happens, the CDS contract is closed out, and you get to keep the collateral.
Thanks to Nishul Saperia of Markit for helping me out with all this — any errors are entirely mine and not his. Do be sure to read the comments, too; I’m sure they’ll explain where I’ve gone wrong.
Daniel Solin has a column at BloggingStocks extolling the virtues of index funds, which is all well and good. But the argument he uses to get there is odd:
All information about listed companies is public. It is widely and instantly disseminated. This information is studied by millions of investors, who establish the price of a given stock based on this data.
Many of those looking at this data are professional analysts. They are well trained in finance and have access to powerful computer programs that assist them in crunching the numbers.
There is one piece of information they don’t know: tomorrow’s news.
Future events move stock prices. The market has already discounted for current news.
This is a very strong version of the efficient markets hypothesis, and anybody with an eye on the stock market’s massive swings of late know that it’s bullshit. Stocks move all over the place on no news at all, every day.
But you don’t need to believe in the efficient markets hypothesis to come to the conclusion that investing in index funds is a good idea; you can think that even if you’re a strong believer in alpha. Solin himself demonstrates that:
Of the 500 companies that made up the S&P 500 in 1957, only 74 of them were in the index in 1997.
Here is the real kicker: Only twelve of those companies outperformed the S&P 500 index in the period from 1957-1998.
The fact is that the S&P 500 itself outperforms the market, largely thanks to its survivorship bias. If you can buy an index fund and keep track with the S&P 500, you’re ahead of the game already. If you think that you can outperform the S&P 500, you’re basically saying that you have truly extraordinary alpha-generation abilities. Most people are happy to admit that they don’t have those abilities — and that’s a much easier way of getting into index funds than feeling that you need to buy in to the EMH first.
Barbara Kiviat understands, I think, why Chicago sold off its parking meters on the cheap:
Chicago hadn’t raised rates on some of its meters in 20 years–there’s a lot of value to be had by the person who doesn’t fear getting voted out of office. Chicagoans, used to paying 25 cents an hour downtown, will see the rate go up to $1 an hour next month, and to $2 an hour by 2013. That doesn’t make for a happy populace, but still, isn’t that something some brave Chicago politicians could have done all on their own, without giving up the rights to an asset that’s apparently worth $1.2 billion?
The simple answer is "evidently not": if Chicago’s parking meters are still charging just 25 cents an hour, then the political obstacles to raising that rate are clearly enormous.
Chicago’s mayor, Richard Daley, is absolutey on the side of the angels when it comes to green initiatives, and nothing would be greener than managing to reduce the amount of auto traffic downtown. Unfortunately, that hasn’t happened yet — Chicagoans are more attached to their cars than ever. And so maybe this parking-meter initiative is the municipal equivalent of a CEO hiring McKinsey to come in and recommend job cuts: it’s a way of doing what needs to be done while somehow managing to blame someone else.
In any event, Chicago should get much more than $1.157 billion in benefit from this deal. Underpriced on-street parking is the bane of many large cities’ existence: it results in a huge amount of needless congestion as drivers circle around endlessly, looking for a spot to park. I wouldn’t be at all surprised if the benefits from lower congestion are larger than the up-front cash that Chicago is receiving.
Lou Jiwei, the head of China’s CIC sovereign wealth fund, is saying some interesting things:
“Right now we do not have the courage to invest in financial institutions because we do not know what problems they may have,” Mr. Lou said as part of a panel discussion on the second and final day of the Clinton Global Initiative conference here.
Asked whether China might pursue economic policies aimed at saving the world, Mr. Lou said that the country’s leaders had a narrower focus. “China can only save herself because the scale of China is still rather small,” he said, adding that while China has more people than any other country, economic output is still low enough that the Chinese economy is not yet big enough to have a big effect on the global economy.
“If China can do a good job domestically, that is the best thing it can do for the world,” he said.
The first comment is definitely smart. Back when CIC was taking stakes in the likes of Blackstone, the world was more easily comprehensible than it is now. When financial stocks started plunging last year, it was easy to expect that a liquidity injection could get them back to what then was seen as "normal" but now is seen as bubble levels. Now, no one knows what "normal" is going to be, going forwards, or even whether the global financial system is solvent. So staying away from financials right now, especially when it comes to their equity, seems like a good idea.
Lou’s also right that the best thing China can do for the world is to just keep on growing domestically.
But as for the idea that the Chinese economy is not yet big enough to have a big effect on the global economy — well, that’s just silly. There’s a very good chance that right now, with Europe and the US in recession, all of the increase in gross world product can be accounted for by the amount China’s GDP is rising. Without China’s growth, the world would be in a much more dire place than it is now.
Yes, there’s a limited amount that China can do singlehandedly. But then again, there’s a limited amount that anybody can do singlehandedly: European stock markets seem decidedly underwhelmed by this morning’s massive coordinated rate cuts, and US markets even more so. China might feel "rather small" these days in terms of what it can achieve — but I can assure Mr Lou that policymakers everywhere else have much the same sentiment.
Is a bankruptcy for GM not only an option, now, but a necessity? At least one of Bloomberg’s interviewees thinks so:
The Democrats’ goal of preserving a U.S. auto industry is not doable without a bankruptcy, said Lynn LoPucki, who teaches bankruptcy law at Harvard University and the University of California at Los Angeles.
“A workout requires everybody’s agreement,” he said. “If I own bonds, GM can’t force me to take less than 100 cents on the dollar outside of bankruptcy court. Bankruptcy is the only thing that can work because GM and the government need the ability to force people to go along with the plan. Paying everyone in full is prohibitively expensive.”
This is exactly the question that I was asking Troy Clarke about yesterday. Of course any company can offer to its bondholders some kind of debt-for-equity swap at any time: Aiden, in the comments to that blog, mentioned Foster Wheeler and AbitibiBowater as precedents. But given the enormity of GM’s debt obligations, and the strong temptation for any bondholder to attempt to free-ride on a bond swap and get paid out in full after everybody else takes the offer, what would the chances of success be?
There is another precedent, however: the Chrysler bailout of 1981. That bailed in bondholders without formal bankruptcy, so it can be done. Does anybody know what the formal mechanism was in that case?
Update: A GM spokesman just emailed me the company’s official take on this question, which does seem to point in the direction of some kind of debt-for-equity swap:
Our plan is to convert $62B of debt to approximately $30B in outstanding debt. About $20B of the current liability is the present value of obligated payments to the UAW VEBA (the health care costs that the UAW is about to pick up).
A bankruptcy would not provide any assurances to bond holders, who could likely end up receiving minimal value for their claims in a bankruptcy. In fact, the bonds are already trading at these levels (pennies on the dollar). We believe that the capital restructuring approach outlined in our Plan would provide the best avenue to return value to bondholders by providing them an option to take a restructured stake in a viable entity in return for their current securities.
We have successfully and recently executed similar transactions, for example a pair of debt for equity exchanges in September in which we exchanged $500 million of convertible bonds into equity. We believe there is appetite by debt and bond holders to pursue this course of action, and are in discussions with our advisors to develop the best structure with the best probability of success. Finally, we believe the involvement of a federal oversight board, will help to facilitate the process.
Viacom’s announcing that it’s cutting 850 jobs, or 7% of its workforce, at a cost of between $400 million and $450 million. Which, if you do the math, works out at about half a million dollars per job reduction.
You think that’s mostly the writedowns of "certain programming and other assets"? I’m not so sure, after bumping into my neighbor yesterday, who had a massive grin on his face after walking into Viacom HR and walking out with a severance package of 24 months’ pay. If that offer’s extended to Viacom employees generally, they might well find themselves with a too-many-voluntary-redundancies problem.
(HT: Wiesenthal)
Update: Viacom spokesman Jeremy Zweig just sent me a note saying that "the significant majority of the charge mentioned in the release is related to the asset writedown, not severance".
Securities lending starting to dry up a little? Worries about counterparty risk are infecting the repo markets.
Brown unveils mortgage help plan: The UK plan to prevent foreclosures: deferred mortgage interest, no reduction in principal.
When Reactionary Goldbug Austrian Plumber-Economists Attack!!
Gordon, Darling: A sign in a Reykjavik shop window. (Background here.)
And finally, wakeboarding in Piazza San Marco.
Eliot Spitzer is blogging! Or he has a column at Slate, anyway:
For years, we have accepted a theory of financial concentration–not only across all lines of previously differentiated sectors (insurance, commercial banking, investment banking, retail brokerage, etc.) but in terms of sheer size. The theory was that capital depth would permit the various entities, dubbed financial supermarkets, to compete and provide full service to customers while cross-marketing various products. That model has failed. The failure shows in gargantuan losses, bloated overhead, enormous inefficiencies, dramatic and outsized risk taken to generate returns large enough to justify the scale of the organizations, ethical abuses in cross-marketing in violation of fiduciary obligations, and now the need for major taxpayer-financed capital support for virtually every major financial institution.
This is quite right. Spitzer doesn’t explain how we can undo what we have done — he prefers to say that we should never have allowed ourselves to get into this situation in the first place, which is true, but not particularly helpful. But he does seem to think that the big banks should be broken up:
Imagine if instead of merging more and more banks together, we had broken them apart and forced them to compete in a genuine manner. Or, alternatively, imagine if we had never placed ourselves in a position in which so many institutions were too big to fail. The bailouts might have been unnecessary.
This is the diametric opposite of the US government’s present strategy, which is to encourage consolidation at almost any cost. The problem is that breaking up banks is non-trivial, to say the least. And breaking them up into pieces small enough that they’re no longer too big to fail — that’s really hard. The fact is that many consumers want their bank to have a global presence, and a large number of the rest want at least a national presence. And it’s pretty much impossible for any bank to be in many states at once without being too big to fail.
I can’t, off the top of my hand, think of a single country which has an efficient banking system and which doesn’t have banks which are too big to fail. The fact is that bank failure is always a systemic risk — and even if no bank is too big to fail, there’s a good chance that they’ll all be making more or less the same loans, which means that collectively they’re all prone to fail at the same time anyway. That’s what happened in the S&L crisis, here in the US.
The answer, I think, is not breaking banks up, but rather regulation with real teeth. Is that possible? The case of Spain seems to imply that it might be. But the US, of course, isn’t Spain, and we’ve never had tough regulators here. Spitzer made his name by stepping in as New York attorney general where the regulators feared to tread: he knows this better than anyone. Which is maybe why he reckons that only breakups will work.
I recently withdrew money from an InTrade account I’ve had for some years. The total cost of withdrawing the money was $53.10: A $20 fee to InTrade for "processing the bank wire", a €10 ($13.10) wire-transfer fee to National Irish Bank, and a $20 fee to Bank of America, the intermediary bank via which the money arrived in my Citibank account. If Citi had charged their customary $25 incoming wire fee, the total would have been $78.10.
You need to have a very large balance at InTrade, or an incredibly successful trading strategy, to make trading there worthwhile if it costs the best part of $80 just to withdraw your money. And prediction markets need a critical mass of users, otherwise they die. InTrade, for one, can count me out.
After reading through GM’s restructuring plan, it strikes me that the $18 billion loan from the government is only the beginning of the money that GM is asking for. Take a look at page 11:
GM’s Plan
includes, and is conditioned upon, significant sacrifice and deleveraging of GM’s balance
sheet…
GM will immediately engage current lenders, bond holders, and its
unions to satisfactorily negotiate the changes necessary to achieve this capital structure.
And what does GM’s balance sheet look like after all this sacrifice and engagement? Total debt has been magically reduced from $62 billion to $30 billion. In other words, the government might provide $18 billion in new money, but GM’s creditors are going to be asked to provide $32 billion in debt relief.
I spoke this afternoon
to Troy Clarke, the head of GM’s North America business, and he said that roughly half of the renegotiated debt would come in the form of lower contributions to the trusts run on behalf of GM workers by the UAW — the so-called VEBA contributions. But yes, the other half of the debt restructuring would involve bondholders.
Which means that GM is going to ask bondholders to voluntarily give up $16 billion of future income as part of this plan, and it’s not going to have a bankruptcy court giving it any muscle to help it do so. Is this even possible? Clarke’s not a financial expert, and couldn’t give me much in the way of detail on whether GM’s bonds have any provisions which might facilitate a bond restructuring outside bankruptcy. I’m hoping to hear back from someone else within GM on this subject. But Clarke did say that the bond restructuring was "a necessary and critical element of the plan", and that he would be fine with the government making its own aid conditional on such a restructuring going through.
In fact, the plan is in many ways a fill-in-the-blanks document — something Congress can pick up and run with, rather than simply approve. It doesn’t suggest an interest rate for the government’s loans, or suggest how much government aid could come in the form of preferred stock. It clearly sees a government role in terms of bullying bondholders into giving up that to which they are contractually entitled, however: "Oversight Board involvement may be necessary to be successful," is the way GM puts it. What bondholders will think of this, and whether they will have any ability to hold out and free-ride on everybody else, remains to be seen.
Clarke did reiterate to me, unsurprisingly, the "bankruptcy is not an option" mantra, saying that a large part of the reason for the fact that GM’s sales fell more than those of the auto industry as a whole last month was that would-be buyers were put off by even the possibility of bankruptcy. Is that true? Probably. Is it surmountable, especially with a government guarantee on GM’s warranties? Yes, I think so. It’s got to be no harder than restructuring bonds outside bankruptcy while retaining some stake for shareholders, in any case.
Let’s put this in perspective, shall we. Yes, a 22% drop in 4 months is pretty gruesome. But Harvard’s endowment is still ginormous, by any standards, even those of the relatively recent past.
Here’s how Harvard’s endowment has grown of late; the chart’s taken from the last annual report and therefore doesn’t show the most recent decline.
By the standards of this chart, Harvard’s endowment is still comfortably in the crimson. A 22% drop from $36.9 billion puts it at $28.8 billion, roughly where it was in 2006. And nobody thought that the Harvard endowment was in any trouble in 2006.
It’s true that Harvard has become increasingly reliant on its endowment for income of late: while the endowment contributed just over $1 billion in 2006, that number grew to more than $1.6 billion in 2008. But as that growth shows, there’s no particular reason why the endowment’s contribution to Harvard’s budget should be any fixed percentage of its total value. With the endowment still comfortably over $20 billion, it can easily afford to spend a few billion more over the next couple of years and remain big enough to support the university in perpetuity.
To put it another way: if you’re big enough to lose $8 billion on mark-to-market investment losses, you’re certainly big enough to find $1.6 billion to spend on your stated purpose of helping to run the university. Obviously, Harvard would prefer it if the endowment had gone up rather than down. But the fact of its decline is no reason for panic.
What does AIG have in common with the auto industry? Beyond bailouts, of course. One answer is that public shareholders are really part of the problem, rather than part of the solution.
In a publicly-listed company, management works, first and foremost, for shareholders. At AIG, the incentives are even more skewed: the CEO, Edward Liddy, is working for $1 a year — plus a large slug of equity.
And so we end up with a situation where Liddy wants yet another AIG bailout, this one to reduce the amount of interest that the company is paying to the government, leaving more money for shareholders. It’s similar to GM’s protestations that bankruptcy is not an option — but management would say that, because they work for shareholders, and shareholders would get wiped out under any bankruptcy proceedings.
The problem is that these companies are insolvent, and shareholders should be wiped out, sooner rather than later. But because they’re still hanging on by their fingertips, they’re refusing to accede to the inevitable. The value of their shares is minuscule, but because they control the management of these multi-billion-dollar companies, they’re a massive obstacle to any sensible reorganization.
At AIG, Treasury is at least the single largest shareholder, and should tell Liddy to shut up: his job is to manage the company, and if he doesn’t want to do that for $1 a year, he should resign, or renegotiate his contract. His job should not be to try to maximize the value of the rump equity held by himself and other shareholders: this is just another situation where minority shareholders really don’t have much in the way of rights, and have to go along with whatever the majority shareholder wants — even if the majority shareholder is getting lots of interest on preferred stock investments and the minority shareholders aren’t.
At GM, Congress should provide financing within a Chapter 11 bankruptcy, and get the shareholders out of the way that way. Once it’s already in Chapter 11, management can hardly continue to say that bankruptcy is not an option. And shareholders won’t have a significant seat at the table any more, which will reduce the number of stakeholders who need to be placated.
The WSJ reports:
In the past several days, congressional representatives have met with bankers and bankruptcy experts to discuss the possibility of a so-called prearranged bankruptcy for either GM or Chrysler, these people said.
One idea that emerged from the talks would have the U.S. government put up as much as $40 billion to fund reorganizations under bankruptcy for GM and Chrysler, these people said.
Let’s do it, and end the tyranny of the shareholders, and of the managers who work for them.
Update: Some great comments below. Apparently boards do start having fiduciary obligations to non-shareholders when a company enters the "zone of insolvency". (But hasn’t GM been there for many years now?) And dWj comes up with a wonderfully wonky slogan: "You want moral hazard, give control of a company to a class of people who are longer vega than they are the value of the company." There’s a line to whip out at your next dinner party.
Peter Fisher was, until 2004, the Treasury official in charge of bond issuance. So when he says that Treasury should start issuing 100-year bonds, it’s worth paying attention.
"If you issued a 100-year bond and had principal and interest pay down smoothly over the last 50 years, you create a great borrowing device for the Treasury that would let us move this hump of borrowing over the generational retirement that’s coming up," Fisher, managing director and co-head of fixed income at BlackRock in New York, said in a Bloomberg Radio interview.
Ah yes, Social Security. I remember that; I suppose it makes sense to start thinking about funding it now, while Treasury rates are uncommonly low.
That said, however, I’m not a fan of Fisher’s idea. Have a look at David Merkel’s list of US government obligations which trade very wide to Treasuries — and note that the spreads involved are only getting wider. Anything which is illiquid, and anything which needs to be explained, trades at a significant discount. Any century bond would fall into that category — especially if it had some weird amortizing structure where principal was paid down over the second 50 years.
If Fisher had dealt with international rather than domestic finance, he would remember the Brady market, which was full of weird and wonderful sovereign debt instruments, foremost among them the Brazilian C bond. I once, for no particular reason, tried to find out exactly how the C bond was structured, and asked a bunch of people who actually traded it for a living. None of them could tell me. Unsurprisingly, Brazil’s plain-vanilla global bonds traded at much tighter spreads than its Brady bonds, and a lot of investment banks made a lot of money in the late 1990s structuring swaps whereby Latin American countries issued new global bonds and bought back the Bradies which nobody wanted or understood.
The Treasury market has no interest in trading anything clever — that’s one reason why TIPS are trading at such ridiculous levels right now. Investors in Treasuries know what they want, and that’s large, liquid issues of bullet bonds at round-number maturities like 10 years. Even the 30-year long bond is out of favor these days.
In any case, Treasury has its hands full these days funding TARP, and whatever stimulus plan is going to be enacted sooner rather than later. Social Security may or may not be a problem in the long term, but it’s relatively low on the list of priorities right now.
