Time to look at Financials?

November 30, 2007

Here’s my simplistic take on what’s going down at E*Trade:

E*Trade starts out as a discount online broker. They decide to create a bank once they realize they have easy access to cash deposits sitting in customer brokerage accounts. To make some money on these deposits, E*Trade Bank “reached” for yield by buying some sub-prime mortgages. (Banks make money by having a positive cost of carry on their assets. In other words, the bank pays depositors 5% on their money and lends it out at a higher rate of 6% or so, for a positive spread of 1%)

For a bank, customer deposits are liabilities. Loans – whether in the form of mortgages, investments in bonds, etc – are assets. Banks are required by regulators to keep a certain amount of net capital, or money held in reserve to pay back its liabilities (customer deposits). To illustrate, let’s say a bank accepts $100 in customer deposits. To be well capitalized, they should have about $110 of assets, which should be more than enough to pay back all the depositors when they demand their money back.

The problem at E*Trade is that they invested their $110 of assets in risky securities such as sub-prime mortgages. Now those assets might be worth only $90. So the bank actually has a negative book value – it doesn’t have enough assets to cover its liabilities.

However, as AccruedInt points out today, just because a bank has negative book value, it doesn’t mean the company is worthless. If investors are willing to bolster the capital of the bank, it can keep operating:

You are never bankrupt as long as investors are willing to keep funding you. In other words, running numbers and coming up with a negative net worth doesn’t necessarily equal insolvency. If so, the U.S. Treasury would have been bankrupt a long time ago.

So if an investor comes in with $20, the bank now has $110 in assets again and it can continue to operate. Plus, in the case of E*Trade, it also has a great online brokerage business which certainly has value. At least that’s what Citadel (hedge fund) must think. Today they announced a $2.55 billion deal to save E*Trade. From the WSJ:

Citadel’s Mr. Griffin, 39 years old, is confident the worst scenarios are already priced into the securities of a number of financial companies. That view extends to a $3 billion portfolio of E*Trade’s mortgages and other securities, which Citadel now has agreed to buy from E*Trade for $800 million. Citadel also is injecting $1.75 billion into E*Trade, in exchange for 10-year E*Trade notes that pay it 12.5% interest and shares boosting its stake to almost 20% of E*Trade’s stock outstanding.


As I mentioned in my 3Q portfolio review, I have stayed clear of financial stocks this year. At some point, though, it will make sense to buy. While I certainly don’t think we’ve seen the worst of the credit crunch, it’s possible that most of the future bad news is already priced into stocks and bonds of these companies.

Plus, nobody wants to see these companies fail — not the Dept. of Treasury, not the Fed, and not investors.

Perhaps this is overly simplistic, but it seems to me that as long as E*Trade doesn’t fail, the stock will go higher.

What do you think? Use the comments to let me know!


Why Deflation is a greater threat than Inflation

October 11, 2007

The United States and Canada are tremendously wealthy countries. Geographically, we have assets that China would do anything to obtain: vast amount of high quality land suitable for growing way more food than we need, plenty of water, lots of natural resources and commodities, and plenty of space to spread out. Politically, we are also extremely lucky: we have governments that are rock-solid-stable, honest law enforcement, strong private property laws, and low levels of corruption. The social dynamic in our countries is great, too. People here generally do not try to screw over their neighbors to get ahead; instead of trying to bring others down, we work hard and emulate them in order to achieve success.

We also have extremely productive economies. Since we have plenty of food to eat and it hardly takes anybody to grow it, what’s everyone else supposed to do with themselves? To fill this void we have a dynamic economy that creates an endless amount of goods and services we can buy.


Why do we consume so much and save so little?

The reason we consume so many services and so much stuff, is because we are optimistic about the future: it is ingrained in our national culture to be consumers: work hard, make money, and have babies. Also, we have confidence that things will be even better tomorrow than they are today. Instead of saving 10% of my income, I’m going to take an expensive vacation and buy the iPhone because I will have a better job and make more money next year.

We have good reason to feel this way: since WWII, the United States has experienced phenomenal economic success. We have enjoyed booming asset markets, huge job creation, strong foreign appetite for our debt, and a strong dollar. What if something happened that caused a shift in this optimism? The result might be higher savings rates and necessarily a reduction in aggregate demand.


The FED is afraid of a Japan-Esque-Deflationary-Slump

Japan went through a tremendous boom in the 1980’s. The economy, along with asset prices expanded at an amazing pace. Turns out, a lot of this growth was a bubble and when it crashed in the late 80’s, the hangover that followed was severe. After people lost so much money in real estate and the stock market, their national appetite to consume decreased and their national savings rate went up.

Japan is similar to the US in that they are a very productive society: plenty of food, water, health care, and shelter for all. So when everybody decided to save instead of spend, the economy stagnated for ten years. Prices for goods and services stayed the same or even declined over this period. Despite massive injections of liquidity, negative real interest rates, and tons and tons of freshly printed money, people just didn’t feel like consuming. On top of this, Japan has a rapidly aging population and low birth rates.

All things being equal, one could argue that a deflationary period is a good thing. But a deflationary/stagnant economy is hardly consistent with the United States’ role as an economic and military empire. Deflation is also a worst-case-scenario for a debt-laden society at both the consumer and government level. Deflation increases the real size of our liabilities because the liabilities grow in size relative to incomes and the general price level.

And here’s the real reason why we should be scared to death of deflation: the demographic time bomb the US faces sometime between the years 2015 and 2040. We face massive — and totally unfunded — future liabilities in the form of Social Security and Medicare. The only way we have a hope of paying for these is if economic growth is robust in order to keep tax revenues flowing to the government.

If something were to happen, such as a housing crash, which caused people to change their positive expectations for the future, people might choose to save instead of spend. Faced with high taxes (to pay for “entitlements”: interest on the national debt, Social Security & Medicare), people might stop working so hard and the economy would slump.



Credit Crunch

August 21, 2007

In my post An End to the Debt Bubble, I tried to organize my thoughts and present the big-picture synopsis of the events leading to the current market turmoil.

Over the last few days, just about every newspaper, blog and pundit has opined about the “credit crunch”. So, in the spirit of everybody else is doing it so why can’t I?, here’s my interpretation of what’s going down.

What Makes a Credit Crunch?
In a functioning market, there is a buyer for every seller. When you want to buy or sell GE, MSFT, or a T-Bill, there is usually always someone to buy or sell it to you.

Credit crunches and financial panics happen when buyers disappear, or when banks are unwilling to lend money to good credit risks. In the fixed income markets today, there are no buyers, at any price, for even the highest quality mortgages.

If a bank writes a mortgage greater than $417,000, they cannot sell it to anybody, so they have to keep the loan on their books. (High quality mortgages under $417,000 can be sold to Freddie or Fannie) Over the last few years, there have always been plenty of buyers of high quality mortgages – in today’s market, there are none. Thus, if banks can’t sell their loans, they are severely limited in the new loans they can write.

The crunch is not limited to mortgages. The market has broken down for any instrument that is not an obligation of the US Treasury. In fact, many money market funds, which typically hold all manner of high quality paper, are now exclusively buying T-Bills and not buying any commercial paper. For paper that still is trading, spreads have risen, making the prospect of selling more expensive.

Liquidity Crisis, NOT a solvency Crisis:
A typical Mortgaged Back Security will be a package of many different quality mortgages. As a simple example, it might have 75% prime, 15% Alt-A, and 10% subprime. As an absolute worst-case scenario, let’s assume that all of the subprime and Alt-A loans in this MBS default. So, instead of trading at 100, the bond is now worth something like 75 cents on the dollar. If the market were functioning as usual, there would be investors willing to buy the MBS at a price somewhere around 70-75. The owner of the MBS would certainly take a loss, but at least he/she could sell it to raise cash if needed. In the current market, there are no buyers at all and the few that are out there bidding very low – 45 or 50 to continue with this hypothetical example.

What is the Fed doing about this?
Essentially, the Fed and other central banks around the world are providing liquidity. Through their open market operations they are lending money to banks and accepting high quality mortgages and commercial paper as collateral. In effect, trying to function as the market would normally. This is not a bail-out – the Fed is not actually buying any loans, let alone anything even remotely related to subprime.

For sure, the Fed walks a tight rope when it pumps liquidity into the system because it can encourage risk-taking behavior and lead to inflation, etc. Here’s an interesting quote from Brian Wesbury, in today’s WSJ Op-Ed page ($link):

The best the Fed can do is to stand at the ready to contain the damage. In this vein, their decision to cut the discount rate and allow a broad list of assets to be used as collateral for loans to banks, was a brilliant maneuver. It increases confidence that the Fed has liquidity at the ready, but does not create more inflationary pressures. It was a helping hand, not a bailout.

It also buys some time, which is what the markets need. Every additional month of payment information on mortgage pools, and every mortgage that is refinanced from an adjustable rate to a fixed rate, will increase certainty and provide more clarity on pricing.

Even though many, including Alan Greenspan, continue to argue that the excessively easy monetary policy of 2001-2004 was necessary, it was this policy stance that caused the problems we face today. The current financial market stress is a result of absurdly low interest rates in the past, not high interest rates today. In fact, current interest rates are still low on a both a nominal and real basis. Cutting them again causes a further misallocation of resources, and makes the Fed an enabler of the highly leveraged.

Similarly, even very easy money today can’t put off the day of reckoning for subprime mortgage holders who bought homes with no money down and thought interest rates would stay low forever. It can’t help overly leveraged investors who thought they were getting risk-free 20% annual returns. Providing enough liquidity to allow markets to function, while keeping consumer prices as stable as possible, is the best the Fed can do. It should be all we really ask.

An End to the Debt Bubble?

August 17, 2007

Credit Crunch
Run on the Bank

Sub-Prime Meltdown

Housing Bubble

Central Banks Inject Liquidity

These terms are being thrown around left and right these days and I’ve read and talked so much about it that my brain is about to explode from serious information overload. Here’s my attempt to present the big-picture synopsis of what’s been happening.

Part I: How We Got Here:

Low Interest Rates:
Starting in 2001, after the dot-com crash and 9-11, the economy was teetering on the edge of recession. To stimulate economic activity, the Fed began to lower interest rates. From the corresponding chart (Bankrate.com), we can see that interest rates across the whole economy fell dramatically.

Along with lower interest rates — beginning with those set by the Federal Reserve — there was also a dramatic increase in the money supply.

Since interest rates are lower, demand for money will be higher. The Fed sees to it that money will be available through its “open market operations.” Most often, the Fed will engage in repurchase agreements (repos) with the money center banks (Citibank, JPMorgan, Bank of America, etc.). Essentially a repo transaction is when a bank deposits collateral (loans) at the Fed and receives cash in exchange. This cash is then lent to the bank’s customers who are eager to borrow money at low interest rates.

The other option is for the Fed to buy Treasuries from the banks (outright purchases). The Fed buys Treasuries with freshly printed currency, thus dramatically increasing the money supply. As I understand it, the Fed rarely does this because it is considered more permanent and it can be highly inflationary.

Over the past few years, the Fed was not buying US Treasuries but our foreign trading partners certainly were!

In 2006, the US trade deficit was nearly $764 billion: the US bought $764 billion more stuff from the rest of the world than the rest of the world bought from us.

What happened to all of those dollar bills sent to our trading partners? A great deal of them found their way right back into the USA through the purchase of US Treasuries and T-Bills. Consider the massive foreign currency reserves held by the Chinese government: as of June, 2007 they stood at nearly $1.4 trilion. Of this amount, it is estimated that the vast majority is held US Treasuries and other USD debt instruments.

And let’s not forget that the US was not the only country with a stimulative interest rate environment. Interest rates and availability of loans from Japan was another hugely stimulative factor.

Increased Risk Appetite:
With so much money available at such low interest rates, the collective risk appetite of market participants across the globe increased. All of this newly created money had to flow somewhere. Because of China’s willingness to produce consumer goods at such low prices, the increased money did not, by and large, slosh into the prices of consumer goods. Instead it sloshed into asset prices: bonds, stocks, commodities, wine, art, and especially REAL ESTATE.

The new money certainly helped to push home prices higher. The other major factor was the increased risk tolerance and demand for risky loans. Wall Street banks created new “structured products” which were sold to investors all over the world. Leveraged products such as CDO’s & CMO’s were created and promised increased yield with low risk to investors. These products contained lots of subprime and Alt-A mortgages yet they managed to receive AAA ratings from S&P, Moody’s & Fitch.

Typically, banks are very careful about who they lend money to because they want to get paid back. In this latest cycle, the borrower’s ability to repay was irrelevant because the mortgage brokers immediately sold the loans to Wall Street. Because of these new products and the strong market to sell them into, Wall Street had a voracious appetite for risky home loans.

Yesterday’s WSJ has a must-read free article about a family in California who bought a $567,000 house with a combined income of $90,000, and NO-MONEY DOWN. Their mortgage was an interest-only, adjustable rate mortgage. At the start, their yearly payments on the loan were $38,400. After a reset which is coming shortly, the mortgage will cost them $50,000 per year. It doesn’t take a financially sophisticated person to realize that this mortgage is totally unaffordable!

But it’s OK because housing prices only go up, right? Wrong – the price appreciation in many neighborhoods was driven by the hysteria and availability of easy loans. Without that, prices must fall.

To be continued…