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In going through the financial news stories on various sites tonight, this one from the NY Times struck me as particularly insightful.  Lets see what they have to say about the state of the financial institutions….

The story starts with this: Somehow, $4.4 billion just evaporated at Merrill Lynch. Less than two weeks ago, Merrill Lynch valued the toxic mortgage investments on its books at $11.1 billion. Now, it is selling those investments for $6.7 billion — and financing most of the purchase to boot.

So two weeks ago, Merrill Lynch claimed that the value of their mortgage holdings (the bad ones anyway - they haven’t disclosed all of them) were worth $11 billion.  Today they’re supposedly worth only $6.7 billion.  That’s $4.4 billion utterly gone, destroyed by the decrease in value of the underlying assets.

I say “supposedly” because you haven’t heard the best part yet - Merrill is financing $5 billion of the sale of these assets (which are worth 40% less than two weeks ago) to Lone Star Funds.   I can’t find where I read it right now, but I think Merrill owns a big part of Lone Star Funds.  If this is true, they’re selling these toxic CDO’s to themselves in order to get them off the books.  Not good.

Here’s something from FoxNews on the story:  Lone Star Funds, a Dallas-based distressed-debt investors based run by John Grayken, will acquire asset-backed securities with a nominal value of $30.6 billion for $6.7 billion. The sale will help cut Merrill’s exposure by $11.1 billion from its level on June 27, leaving $8.8 billion of these securities on its books.

That’s 22 cents on the dollar.  The NY Times story linked above puts it into perspective: Executives at Citigroup, JPMorgan Chase and Bank of America began reviewing the bundles of mortgages, known as collateralized debt obligations, or C.D.O.’s, that their companies hold on their books. Those companies may have to lower their valuations, and take additional charges, if their assets are similar to those sold by Merrill.

Of the companies they mentioned, I personally think Citigroup is the one most likely to pull a Bear Stearns and disappear.

The NY Times story also said: Still, financial stocks rallied on Tuesday, as investors hoped the deal at Merrill signaled the troubles plaguing banks’ balance sheets might be coming to an end.

Anyone want to bet on that?  How many times are these analysts going to say that the troubles are over, that this is the kitchen sink quarter, that this must be the bottom?  I can find dozens of examples over the past 10 months.

In just one month, Merrill had to drop the value of some of their CDO’s from $30.6 billion to $6.7 billion.  What does that say about the honesty of their accounting?  Damn near everyone knew they’d have to write these assets down last year - but Merrill tried to delay their day of reckoning.

Regardless of the way the market reacted today, there’s no way Merrill is worth more today than last week.  But that’s what the stock price says.

I am forced to conclude that many investors are stupid, that they are betting on a short term gain, or that they are smoking crack - because the numbers just don’t add up.

If I’m right Merrill (which closed today at $26.25) will be lower a week from now after investors have had time to understand what this really means for Merrill.  Bank of America ($32.22) and Citigroup ($18.46).

One of these days I’ll have the guts to short individual stocks and make some money off of these things that should be obvious to everyone, but I’m chicken.  I have no position in any of the stocks mentioned in this post.

There’s a lot more to say regarding the market and financial stocks, but I’m calling it a night.  Stay tuned.

gk

I have a “My Yahoo!” page setup with a couple of portfolio’s, one to view the funds I have available in my 401k.  The other has a few stocks that I own in various accounts, such as the kids college funds, a Roth IRA, and a small “play” account.  The second portfolio also has a few stocks that I’m interested in, plus the major indexes so I can tell at a glance what the market is doing whenever I’m interested.  So with one click on a favorites button, I can see what’s happening during the day.

With the Fed due to announce on Thursday, I was was curious to see how the markets would react, so I checked my custom Yahoo! page several times during the day.  It never fails, when the Fed does ANYTHING, the markets react big time - the only question is will they go up or down? 

All morning the market was down slightly, 30 to 40 points most of the day.  When the Fed announced at 2:15pm, there was an instant surge up, with the Dow up as much as 200 points very briefly.  Then the news hit about Financial Guaranty Insurance being downgraded from AAA to AA.  Stocks immediately took a nosedive, and ended the day right about where they’d been until the Fed announcement - down about 40 points.

In case anyone is wondering why a downgrade of a fairly insignificant bond insurer caused such a downturn, I’ll try to explain it as I understand it. 

Bond insurers do just what their name suggests - they insure corporate and municipal bonds.  It’s an important function which allows corporations and municipalities to sell their bonds at a lower rate than they might get based on their own rating.  For example, lets say that Memphis needs a new sewage treatment plant at a cost of $100 million.  They don’t have $100 million laying around, so they need to borrow it - but (lets assume) they already owe $200 million for other projects, and there is some doubt that they will have the money to repay the sewage bonds on time.

The city of Memphis might be able to sell their bonds at a 10% interest rate (all these numbers are 100% made up - they’re for example use only!) on their own, but if the bonds are insured by a AAA rated insurance agency, they may be able to sell them at a 6% rate - which saves the city a LOT of money on a 20 or 30 year bond.   Let’s assume that the insurer also insured other debt instruments, such as mortgages, derivatives, and CDO’s (Collateralized Debt Obligations), as most of them do in order to have a broader customer base. 

Now what happens when the bond insurer doesn’t have enough money to pay off the claims they’ve insured?  Those city of Memphis bonds were that were yielding 6% because they were insured by a AAA rated (investment grade) insurer, are suddenly being guaranteed to be repaid by a AA (”less than” investment grade) insurer.  The bond ratings are only as good as the insurer, so guess what happens?  Yup, the rate goes up to match the increased risk.

Note that this doesn’t affect bonds that have already been sold.  The people who have bought them will be repaid on time, and at the going rate when they were purchased.  The problem is that very few people actually hold onto bonds for the whole term - they sell them on the secondary market in order to free up their money for something else; buying a home, car, sending little Sally to college, or to move the money to something that they think will give a better return.

In other words, bonds are traded almost like stocks, and almost as often.  When you have a bond fund in your 401k and you move money in or out of it, someone is buying and selling those bonds, be they government bonds as in the example above, or corporate bonds, or maybe even someones mortgage.  So, if I owned a $1000 city of Memphis sewer bond yielding 6% and I wanted to sell it to get my money out, no one in their right mind would settle for a 6% return because it’s no longer investment grade (AAA) rated.  They will demand a higher interest rate to compensate for the increased risk.

You need to realize that the interest rate doesn’t actually change, the price of the bond changes instead, which is effectively the same thing.  If the price I sell the $1000 bond at is $900 instead of $1000, the effective yield to the new owner (assuming it’s a 10 year bond) is 6.667% instead of 6%.  And it yields 7.454% if they hold it for the full 10 years to maturity.  At least that’s what the calculator at http://www.moneychimp.com/articles/finworks/fmbondytm.htm says.  Your mileage may vary. 

The thing to keep in mind is that as the bond is worth less on the secondary (reseller) market, the effective interest rate goes up.  The opposite is also true - if the price of the bond is worth more, the interest rate (yield) goes down.  That’s why Treasury bonds (which are backed by the US Government and your tax dollars) are considered a “safe haven” in times of turmoil.  More people want them because they are the safest investment you can make, so the price goes up.  Simple supply and demand.

Now back to the Memphis sewer bond.  If the insurance company is now rated lower, those sewer bonds are now riskier, so they drop in price.  No one wants to buy or trade them anymore.  The secondary market has dried up, and (since I can’t sell them and do something else with my money) we have a credit crunch.  I can’t invest that money in a new business, I can’t invest that money in the stock market, and the asset I paid $1000 for is only worth $900, so I can’t borrow as much using that bond as collateral.  My net worth has also decreased by the amount that the bond has dropped in value.

Extrapolate this out.  Instead of an individual owning  one or two bonds, imagine that I’m an institutional bank or investment company, such as Bear Stearns.  I have billions of dollars in bonds - both government and corporate - that I own as assets.  In order to get a better return for my shareholders, I’ve borrowed against those assets (just like you or I might take out a second mortgage using our home as an asset) and invested the borrowed money in the stock market, or other places where I think I can get a better return on my investment.  

Overnight my assets  have dropped in value by a good percentage just because the insurer of my AAA rated bonds was rated one notch lower.  What happens?  Since I’ve borrowed against the assets which have dropped in value, I suddenly owe more than what the assets are worth - just like if I’m “upside down” on my car loan or mortgage.  I can’t sell it for what I owe on it, so I’m stuck with something that’s worth a lot less than I owe. 

This is happening at most of the major banks and investment companies all at the same time - the credit crunch “crunches” even tighter.  No one will buy my assets for anything near what I owe on them, so I owe a lot more overall than what what I’m worth.   What can I do?  There are three ways to approach it:

1)  I can ‘fess up and admit that I owe a lot more than my assets are worth.  I produce a quarterly earnings report that shows how much my assets have fallen in price.  That’s what the major investment banks have been doing.  That’s essentially what happened when Merrill Lynch “wrote down” $7.9 billion in the 3rd quarter.  The same for when CitiGroup reported $18.1 billion in write offs.  And when UBS writes down $14 billion, and when (pick your bank writes down billions more).

2)  I can pretend everything is fine and do nothing.  I can say that everything is coming up roses in my report, and everyone believes me.  After all, there really isn’t a loss until you sell the asset for less than you paid for it.  But that’s a house of cards, just like if you or I were upside down on our car loan.  You have to keep making the payments long after you’ve paid what it’s actually worth.   But you can’t sell it and you can’t borrow against it.  Your money is locked up and unavailable to loan to anyone else.

3)  I do what most banks and investment company are doing - at least in my opinion.  I combine the previous two methods.  I write down some assets, but I don’t dare write down all of them that are affected - because that would make it clear that my prestigious company is nothing but a house of cards.  But eventually I will have to come clean and fess up, because the stuff I’ve invested the borrowed money in (mainly other peoples debt obligations) isn’t going to pay enough for me to keep making my payments on the original loan (bond) that I bought.

That’s basically what’s happening in the markets right now - but it’s actually 10 or 100 times worse than this.  That’s because banks and investment companies don’t do what I described above - they do it times 10 or 100.  No one really knows the real numbers, but it goes something like this:

I get a sub-prime home loan from a local bank at a ridiculously low teaser rate that resets in 2 or 3 years.  My local bank doesn’t want to wait that long to get their money back, so they sell my loan to someone else.  The company who purchases my loan (at a discount) also wants to use their money for other things, so they bundle my sub-prime loan with other (mostly prime, but a mixed bag) loans and bonds and sell it to someone else.  My sub-prime loan is a very small part of the overall loan, so you’ll probably get most of your money - if not all of it - back at this point.  Besides, this company paid an insurance premium on the whole thing (it’s actually broken up into “traunches” at this point, but that’s another subject) to be insured by an AAA rated bond insurer.

But the company who now “owns” your AAA rated sub-prime mortgage also wants to get higher returns than the discounted teaser rate (here’s where your super low ARM for the first 3 years hits everyone else) they are getting on paper, so they again bundle it with other loans and bonds, and sell it to someone else.  After all, it’s investment grade AAA rated (and because of the discounts in price every time it’s sold) lot’s of pension funds and other conservative investors will buy it for the nice interest rate they’ll receive.

And the returns will only get better as the teaser rates adjust!  That’s assuming that I can pay my mortgage after my rate resets anyway.  If I can’t, the whole house of cards falls down.  My loan is bundled with hundreds or thousands of others at this point, so if I default on the loan (that I can no longer pay because I was stupid and bought more house than I could afford) it affects the whole bundle.  The owner of that bundle has to take a write off for the amount of my loan - so that AAA rated insurer has to pay up for my non-payment.

But guess what?  How was that AAA rated insurer making money?  By investing their capital into AAA rated debt instruments - thats’ right, the insurers assets are in the same (or a derivative) of the same AAA rated securities that they’re insuring.  So they can’t pay up, because the sub-prime mortgages that they own as assets aren’t making their payments either.

The same debt has been resold over and over.  The same debt has been counted as an asset by 3 or 4 or 10 different companies - because it’s been leveraged multiple times.  An example of leverage is when I buy a stock or bond “on margin” from my broker.  In effect, I’m borrowing money from my broker based on nothing but my guarantee to repay them when the asset goes up in value.   But because my neighbors’ house has also gone down in value (because of the foreclosure on my sub prime loan) none of these leveraged assets are worth what they were. 

The biggest problem is that NO ONE KNOWS where these sub prime mortgages are today.  They’ve been bundled with other prime loans, sold as CDO’s, used as assets against leveraged loans, etc.  No one wants to purchase them so the price keeps falling.  And as the price of a bond (or any other debt instrument) falls, the interest rate goes up.

So regardless of what the Fed does with interest rates, real rates are going up right now.  And the value of all those “assets” held by banks and investment companies is going down.  I think it’ll take years for all of this bad debt (and the subsequent write downs) to work their way through the system.  I don’t know who, when, or where, but I think more than one major bank will fail.  Its’ assets will be bought by another bank and/or the government, but the end result will be the same.  We’re borrowing money to pay back borrowed money.  At some point this always fails.

Personally, I think we’re in for a repeat of the late 1970’s, with high interest rates, little to no growth, and higher inflation.  Because of all the leveraged debt, I think the true picture will only be clear years from now.  Some are saying that we’re entering a deflationary period.  It could be, but my money is betting that “you ain’t seen nothing yet” regarding write downs and losses.  When this house of cards comes down, no one will want the dollar, so it’ll inflate dramatically - especially if the Fed keeps lowering rates and effectively printing more money.  It’s simple supply and demand, and we’ve got way to much supply right now.

This post ended up being a stream of consciousness type of post.  I had one point in mind (the importance of bond insurers) when I started, but it morphed into the other types of debt that make up this house of cards.  It’s way longer, and much more rambling than I originally intended, but hopefully it will provide some insight.  As always, if you spot a factual error, please let me know so I can correct it.  My intent is to enlighten, not to obscure.

gk