Sunday, 28 September 2008

Thoughts on the Bailout and Other Things

By now you've probably read umpteen articles about the proposed bailout of US financial institutions. Rather than waste time on the political sideshow playing out on Capital Hill, I would rather talk about the viability of the plan and what it means for investors.

Put simply, the plan proposed by Hank 'containment' Paulson and 'Helicopter' Ben Bernanke, is for the US government to buy troubled assets from banks and then resell them at auction.

The $700 billion amount you see floated about in the media is just the amount that can be held at any one time. Thus it could be significantly more than that, expectially if as proposed, they start buying up commercial real estate loans, credit card debt, auto and student loans.

There is understandably much opposition from the US taxpayers to such a huge amount of their tax dollars being used to pay for problems created largely by Wall Street. I know there are plenty of other parties who share some of the blame but lets avoid playing the blame game for now.

Also working against the plan was the poor attempt at marketing it by Paulson and Bernanke who basically asked for a blank check. Their excuse being that financial armageddon was imminent. There is something eerily similar about the fear-mongering of this event and that of the need to invade Iraq because of the WMD's that turned out not to exist.

In fact, in the little over a week since the prediction of worldwide financial meltdown, we have Goldman Sachs get private equity infusions and Washington Mutual get taken out by JP Morgan who was then able to get a $10 billion dollar equity raising away to pay for it.

So it seems the private sector is not as moribund as some would have us believe. However, we also should not ignore the severe stresses in the credit markets. As mentioned on Wednesday the credit markets are a better gauge of financial distress than the equity markets.

    The chart above comes courtesy fo John Maudlin and shows the TED SPREAD in the last week has hit levels not seen since just prior to the equity market crash of 1987. According to Bennet Sedacca at Minyanville, the credit markets are virtually closed:

    Welcome to the credit market, folks - it's officially closed. After Lehman, Fannie Mae (FNM), Freddie Mac (FRE), AIG (AIG) and Washington Mutual (WM) debt and preferred holders have been unmercifully tossed under the bus so Jamie Dimon can be given banks, do you really think many want to get in front of this train wreck?

    Me thinks not.

    • For what it's worth, I was just offered Wachovia (WB) 5.8% hybrids at $0.10 on the dollar, and I passed. A block of 30-year Wachovia paper just traded at $0.35 on the dollar. This is not preferred stock or hybrid, folks, this is subordinated debt.

    • Washington Mutual sub paper? $0.01 on the dollar. This is what a credit rout looks like. And until this ship is righted, watch out.

    • There are others trading similarly, like Morgan Stanley (MS) and, while I have no positions, it's quite interesting to watch.

    • So the few that can raise capital, like JPMorgan (JPM) and Goldman Sachs (GS) will survive, but many failures lie directly in front of us.

    • Many regional banks are likely next.

    So there are very legitimate causes for concern but there are also signs that the market is sorting itself out. As usual, choices are rarely a simple case of black or white, there are various shades of grey. However, whether the bailout plan is needed seems to be a moot point. As I write it seems an agreement, at least in principle, has been reached.

    So what does it mean? US taxpayers should understand that whatver the final amount to be spent, that it is not going directly down the drain, the government will recoup some, if not the majority (and some even say more than) the intial outlay. However that still doesn't make it any more palatable.

    The theory behind the plan is that by removing bad assets from banks' balance sheets, it will free them up to resume lending again. That sounds good in theory but will it work? Will banks just resume lending to one another? This is my biggest doubt about the plan.

    I think a lot depends on what price the government pays for the assets. It's clear from Bernanke's discussion of what he called 'hold to maturity price' and 'firesale price' that the government will pay somewhere in between.

    However it also depends on the specific institution. If a bank is on the verge of bankruptcy, has not been writing down the assets to firesale prices and the price paid by the government is less than that on the company's books, the subsequent capital hit the company takes may be enough to tip them into bankruptcy.

    Conversely, if some institutions have been aggressive with their marks (and I doubt there has been many of those), they may not have to write off any capital. The problem is that the government will auction these securiites and whilst the price eventually realised may be good for one company, it may be lethal for another.

    Thus uncertainty remains around who can be trusted to lend to, or put another way, who is solvent. Hence why back in January I said the bigger issue was solvency not liquiditiy. If financial institutions are unsure of who is going to make it, they will continue to be reluctant to lend and thus the credit markets will remain under stress.

    If instead the government identifed those institutions who they would put capital into and support, and then those they think will go belly-up, then that would remove some of the uncertainty. Then there is the question of how exactly do you value these assets. A bunch of mortgage backed securities might not be too much trouble but how about a CDO squared?

    From the latest read the bailout plan seems to have attracted a few additions such as limits on executive pay and equity participation by the taxpayer. Still there are scores of financial commentators who think the plan is a dud. Time will tell. But it seems it will be passed in one form or another.

    Assuming that it goes ahead in its current form, what does it mean for equity investors? Initially we can expect equity markets to rebound sharply as confidence returns, credit spreads should narrow but still remain elevated.However as time goes on, I think the difficulties as outlined above in implementing the plan will become evident.

    Also, A few themes that I identified almost a year ago continue to play out. The economic backdrop continues to deteriorate. There is only a few permabulls left now that would claim the US is not in recession. Also growth is slowing considerably in Europe and now even in asia.

    Corporate profit margins are contracting from record levels and earnings estimates are being revised lower. Research in Motion (RIMM) being the latest market darling to disappoint on their outlook for the fourth quarter, causing the stock to plunge -27% on Friday.

    My take is that the intial euphoria over the bailout plan could push the equity markets sharply higher, it could last a few days, weeks or even months. However the economic fundamentals coupled with gloomier corporate profit outlooks and the realization that the bailout plan is not a panacea for all that ails the US economy and global financial markets, will reassert itself and the stockmarket will eventually find new lows.