Unintended Consequences.... Oops
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2008-09-09 07:52 by Karl Denninger Ignore this thread
Unintended Consequences.... Oops

As noted yesterday, the first was the triggering of a "credit event" for Fannie and Freddie CDS.

Now for most of these swaps, this is a non-event. That's because most of them are physical delivery - you sell protection on a bond, it triggers, you must deliver the money but the buyer must deliver the bond. Since the bond is trading at par (it didn't default) the buyer delivers, and you pay him. You then sell the bond. Whoopie.

However, some CDS are fixed-price cash-settled. Those are bad news, because they triggered and you now owe the buyer money, and get nothing in return. The guys writing those are (mostly) hedge funds, and they looked like "the ultimate safe money play." Ha! It will be interesting to see who manages to get dirt-napped out of that...although we'll probably see it by implication and "odd" moves in the markets rather than an explicit announcement. This morning we are seeing some indications of this in FX and commodities, particularly Gold. Expect more of this in the coming days, with indicators that are usually reliable in the market going on "tilt" from time to time.

The more serious problems that this bailout creates are in the commercial real-estate, non-agency market and the preferred-stock issue arena.

You can best characterize what this did tothose areas of the market like this:

That would be "done", as in well-done.

If you're a bank or other financial and need to issue (or have outstanding) preferred stock, you've got a problem - a serious problem. The Federal Government just declared out loud that it will declare that stock essentially worthless any time they think there's an accounting irregularity, and they will value things as they - not GAAP - sees fit.

Here's what happened to you if you held just one of the many series of Fannie Mae preferred (the others are all essentially identical)

How about that - $13 to $2.50 in one fell swoop.

That's an instantaneous 80% loss.

Now think about this from the perspective of, say, Lehman. You have a capital problem. You'd like to go out and issue some preferred stock - essentially a junior debt issue, where you pay interest in exchange for money, and perhaps its convertible into common stock at some point in the future.

However, you have a bunch of Level III assets, which might include mortgage bonds - not Agencies, but private-label stuff and commercial real-estate backed.

As a potential buyer of these securities, are you going to take this sort of risk? Remember, Fannie and Freddie did not file bankruptcy; even in a bankruptcy, you'd likely get something as a preferred stockholder!

But in this case you got essentially nothing as a result of an (arguably) unlawful "taking" of your ownership interest in the firm!

My opinion? This move just destroyed all preferred stock issues going forward for financials in the United States.

The second area of "unintended consequences" is in the area of commercial and private-label mortgages. These now are severely disadvantaged - much more so than they once were.

The bad news is that historically, commercial real-estate always follows residential down the toilet by 12-18 months, and this time around, during the boom, the "cap rates" that deals were getting done at were arguably insane, with absolutely zero comfort level in terms of excess cash flow.

As a result I believe the short of the century is to be found in commercial real estate - right here, right now. SRS is a double-inverse fund that unfortunately suffers from skew to an extreme degree as a result of the violent moves in the underlying it tracks (IYR, more or less), and IYR is both hard to borrow most of the time and PUTs tend to be expensive, so playing this is a bit difficult.

However, this doesn't change the reality of things, which is that in my view commercial real estate is in an enormous amount of trouble, and so are the banks that have over-reliance on it in their lending portfolios.

While you're at it, consider the non-agency (private label) mortgage market. Think west-coast (in particular) lenders with big Option ARM exposure. These guys are toast. WaMu, for exampleis trading today as if an FDIC takeover is imminent; the October $2.50 PUTs have traded over 10,000 contracts (as of 9:25 CT)against an O/I of 27,813 this morning - clearly, someone thinks they're a big fat zero between now and October expiration and is willing to shoot a decent wad at that bet.

Finally, we have a curve problem. For banks to be able to generate sustainable profits they need a stable and positive-sloping yield curve so they can "borrow short and lend long", and have a solid ability to hedge off interest rate fluctuation risk.

The problem with all these "stick saves", especially the ones that encumber the public balance sheet, is that they destroy this stability and lead to extraordinary violence in the yield curve. This makes hedging off interest rate risk increasingly difficult to do with precision, and when you're wrong in this area you tend to get rammed. In addition it makes hedging off prepayment risk (convexity) difficult with accuracy, since these sorts of moves change the velocity of refinance activity to an extreme degree. This is extraordinarily un-helpful to the bank profit environment, and does not bode well for financials in the medium term.

So yesterday we saw lots of "cheering" that "the bottom is in."

Uh, no folks. The bottom is not in. Once again we have seen the government intervene to produce a false bottom, and once again, it will not hold.

Government intervention does not produce sustainable bottoms in the market. Only actual wash-outs do that, and those don't come with the government's heavy hand sticking traders into the wood chipper feet-first.

All the latter does is shred confidence in the markets, because without those traders in the pits to provide liquidity, you've got no market at all.

The government may think that its job is to make sure markets "always go up", but this is as stupid as believing that houses "always go up." Its an impossibility, and by violating those traders who make correct bets on a repeated basis, you carry them off on their shields one by one, thinning the liquidity you need for a vital and efficient market.

Repeatedly, we have seen the government do this, in the 2000-03 recession and now during this one. This sort of "sticksave" nonsense produces lots of high-fives among the Cramerites and folks in Washington DC, but in reality what it produces is a lot of broke guys on the floor in NY and Chicago, and those folks are the ones that we all depend on to have liquid, vital capital markets.

The font of these individuals and businesses continues to narrow, and today, post-bailout, we can remove those investment and commercialbanks who need to issue preferred stock, along with the commercial real estate folks, and the floor traders who had the Chrysler Building inserted into their butts by the government - again -Sunday afternoon. This reduces total liquidity available in the market, which means the violence of moves is likely to increase, not decrease, and the risk of severe overshoots in both directions (up and down) goes up instead of down.

If the goal is to reduce volatility and stabilize the markets, this sort of "sticksave" does the exact opposite.

Leave it to government to get it exactly backwards - that's one thing they're very good at.

Now, as to "how to stop this crap", its really quite simple.

Remove your money from the banks.

Seriously.

Folks, how many of you have a few grand laying around in a bank? Why? Do you not have room for a small safe at home? Get one, bolt it to the floor, cash your paycheck (or withdraw it immediately if direct-deposited) and pay with green, dead Presidents for your purchases. Screw the debit-card nonsense.

This does two things, both positive for you (and negative for the rapists who got us into this mess):

  • You can't get hit with an overdraft fee on your debit card if you're not using one. And boy, do banks love those fees!
  • The banks can't make money using your money by loaning it out at interest.

They're not paying you jack in interest these days to use your cash anyway, so why are you letting them have it? For most "Joe Sixpacks" who live more-or-less "hand to mouth" there is no reason to leave any material amount of money in a bank. You get paid nothing (or close to it) to have it in there, but they use your money to make lots of cash, and on top of it, you're exposed to insane fees any time you (or they) make a mistake.

If you have a LOT of money, open up a Treasury Direct account and stick it in there. Keep a bank account but keep only enough in there to keep it open, and never use it (you need the linkage for Treasury Direct); there are banks almost everywhere that will let you have a zero-cost checking or savings account so long as you don't process many transactions through it.

Tell the banks to go to hell the easy way.