Saturday, February 28, 2009

The Actual Pricing of "Shovel Ready Bank" Assets

There is an article today on the actual pricing of Mortgage-Banked Securities (MBS). The numbers are scary. I want to tie it into the “Shovel Ready Bank” post from the other day.

In the post from the other day, I wrote about the disconnect between the way assets are being priced by Banks and the way they are being priced by the Markets. The Banks are pricing the high-quality mortgages in the mid-90s (90% of the maturity prices) and the Sub Prime mortgages at 100 (100% of the maturity prices).

Of all the mortgages originated since 2002, 42% of all securities have seen some level of default in their portfolios. Of the late 2005 – 2007 originations ($450 billion), $305 billion of them are in some state of default.

$102 billion have already been liquidated. The actual recover rates on defaulted paper are 32% on AAA paper (Top Quality Mortgages) and 5% on Sub-Prime (junk) paper.

Regulators and Banks pretending that assets are worth more than they are really worth, helps nobody. It actually hurts confidence and paralyzes lending. The markets figured it out long ago.

This is becoming a replay of the “Lost Decade” in Japan (1992 – 1998).

Wednesday, February 25, 2009

A Shovel Ready Bank

A buddy of mine asked be about a small bank today and I wanted to go through the numbers to illustrate the problems the banks face. I’m not going to name the bank or show a chart.

I wrote him the following –
Something isn’t working in their numbers for me. This is all from the 10Q dated 9/30/08, but you can extrapolate it into the latest 10Q which has not yet been filed.

They show Common Equity at $1.214 Billion
On 126 million shares, that is a Book Value of $9.36 per share
Yet the stock is trading at under a dollar a share.
Common Equity is essentially Assets - Liabilities

Why? Because something on the Asset side of the Balance Sheet is not properly priced and the markets know it.

Here is what I think it is –
Under Assets, you will find a position called “Securities Held for Sale, at Fair Value” $2.019 Billion

If you look at Note 4 of the 10Q, you see the breakdown and pricing of these securities.

$484 million CMOs priced at 96.4 cents on the Dollar
$745 million Mortgage Backed priced at 101 (above Par!)
$538 million Municipal Bonds priced at 100
$249 million Agency paper at 102 (implied backstop)

Some CMOs (Collateralized Mortgage Obligations) are trading at 6 cents.
Private origination Mortgage Backed Securities are trading way below Par (20 - 30 cents)
Try selling a Muni for Par right now. You will be lucky to get 68 cents.

So the disconnect between reality and the pricing of positions in the Balance Sheet is being reflected in the stock price.

The bottom line is this –
(the bank stock) is now a Call Option on a massive transfer of wealth from Taxpayer to Shareholder. That is what it would take to allow (the bank) to sell their holdings at the fantasy prices they show on their balance sheet.

If you think the Government will bail out this bank at Taxpayer expense, then buy the stock. If you don’t think so, then don’t buy it.

This bank’s “Balance Sheet” is “Shovel Ready”!

Monday, February 23, 2009

So You Had a Bad Day...

The markets rallied at the open and then got crushed all day long.

I thought the markets would bounce, so I bought a little FAS (+300% the Financial Index) for me at $4.65. It was the classic setup – the markets were testing a low, CNBC had another leak via Gasparino and Obama was set to speak in 10 minutes. So I bought FAS near the lows for the day. FAS rallied hard for about 20 minutes and then rolled over hard. I got stopped out at $4.87.

The Markets were crushed, because the government insists upon playing financial accounting games, rather than fix the obvious problems.

Tangible Common Equity
This is the new “Stress Test” that the Government will use to determine which banks are solvent and which banks are insolvent. The idea is that the value of the Common Equity (Stock) must be worth at least 3% of the Total Assets held by the bank.

Let me explain what the Government is trying to pull with Citigroup to get them in compliance with this definition, so that they can get more handouts from the Government.

Under TARP, the Government invested $45 billion in Citigroup, by buying Preferred Stock. Preferred Stock is basically a bond, so it is classified as Debt. The Government is looking to convert their $45 Billion in Preferred Stock into a pile of Common Stock worth 40% of Citigroup. The total value of Citigroup stock is now worth about $11 Billion. So the Government would get $4.4 Billion worth of stock.

Nice trade!!

The reason why they want to book this $40.6 Billion loss for the taxpayers is as follows. Converting the Preferred Stock into Common Stock increases Citigroup’s “Tangible Common Equity” ratio to a level high enough to justify the Government throwing more Taxpayer money into the sink hole that is Citigroup.

Even better, the Preferred Stock would have paid the US Government $2.5 Billion a year in Dividends. The conversion of Preferred to Common benefits nobody but the Shareholders of Citigroup.

Yesterday I wrote the following –
“No doubt there will be another round of leaks about how the banks will not be nationalized and how Timmy Geithner will invent some new math to prove that banks are indeed solvent and don’t need to be taken over or stuffed full of another $2 trillion to be able to keep their doors open under their current ownership.”

I had no clue that this was their version of “New Math”. The market crashed today, because the Big Boys know that these accounting games do not fix the real problem.

In his Press Conference today, President Obama told us how his Administration would focus on Financial Responsibility. A week after he wasted $800 Billion in Taxpayer Money, Obama told us that his new Budget would be structured under the “Pay-Go” principle, where you pay as you go. Where was his fiscal conscience last week?

The markets are sick of the hypocrites. They will keep crashing until the Government takes actions to solve the real problem – Insolvent Banks Are Not Lending Money. That has paralyzed the economy and we are now in Depression, with imploding economic activity and imploding pricing.

Is this a retest of the November Lows?

Remember how much time I spent late last year telling you not to get antsy, because I never saw a Bear Market end without a retest of the first lows? This may “The Retest” of “The Bottom” or we may just get a bounce.

Was that 100 point rally before the open all we will see for the bounce from oversold conditions? Are the Big Boys just running for the hills at any price?? Today, the gap up Open was sold hard. That is not a good sign.

I figured that 2009 would be a difficult year to make money. Because I know full well that there will be a lot of potential set ups that must be played, but only the last one will pay off in a big way.

The problem is that nobody knows which one will work. So I will buy small probing positions at logical places, with tight stop loses. This is another one of those high-probability setups. So I need to nibble a little, just in case this is a meaningful low. I bought a little SSO today (200% the S&P 500).

If the November lows fail, then potential support for the S&P 500 lies at 710, 660 and 609. It would be a selling capitulation if we reached those numbers. I will be looking to nibble there too if the set ups occur.

Sunday, February 22, 2009

Oversold and Due for A Bounce

On 2/05/2009, Senator Chris Dodd (Dem Conn) (Head of the Senate Finance Committee) told us, with a laugh, that Bank of America would not be nationalized. Then on 2/20/2009, he told us that they “may have to be nationalized for a short period of time”.

When will these guys just shut up and start taking action, executing the laws on the books. The markets are pricing in nationalization. The talk of politicians is proving to be folly and is eroding public confidence in our nation’s institutions and leadership – sort of a financial Hurricane Katrina…

Nationalizing the largest, insolvent banks is the first step in restructuring the World’s Financial Markets. That is the job of the FDIC! Their role is to protect depositors from the irresponsible actions of bank management. But they are nowhere to be found.

Counterparty Risk
Banks are afraid to lend to one another, because they know that the guy on the other side of the trade is insolvent. If the government nationalizes your counterparty or they go bankrupt, then you lose all of your money. So banks aren’t lending to one another. This has the economy paralyzed. All the talk is to try and keep confidence game going just another day longer.

The only way to get lending going again is to get the risk out of the system by removing the insolvent banks. My story has not changed since October. Unfortunantely, the economy has crated since then, as the politicians and regulators have been paralyzed from doing what is needed and right.

This week, the big boys sold banks with abandon. Take a look at the Index for the Preferred Stocks of Banks (PFF). It took out major support on massive volume. That isn’t grandma and Aunt Betsie selling, that is Fidelity and CALPERS running for the hills!
I feel bad for those little old ladies who have been chasing yield and buying Preferreds. Just wait until Corporate Bonds roll over yet again…

Very Short-Term Oversold
That said, the markets have been pounded since February 9th and they are now very stretched and can rally sharply at any time.

No doubt there will be another round of leaks about how the banks will not be nationalized and how Timmy Geithner will invent some new math to prove that banks are indeed solvent and don’t need to be taken over or stuffed full of another $2 trillion to be able to keep their doors open under their current ownership.

We may be entering another crash leg, so I want to revisit the indicators I use to determining how oversold the markets are and from where they may bounce.

Daily Moving Average Envelopes
This chart plots lines for each 5% +/- the 150-day moving average. It worked very well in the 2000-2003 Bear Market and has done a decent job defining activity of the last few months.

I use the S&P 500 Index (Cash Price, Not Futures or SPY) as my proxy for stock market activity. You can see how the S&P 500 have been bound between the -15% Line (Green) and the -25% Line (Thick Blue). See how rallies have failed at the Green Line and the 50-day (Black Line). See how selloffs have stopped at the Blue Line (Black Arrows).
30-Minute Standard Deviation Chart
I use this chart to define oversold and overbought conditions in the shorter-term. When price stretches to + or – 3 Standard Deviations from the 50-day moving average (Black Arrow), then I expect at least a short-term reversal. We are now there, so I am looking for a bounce.
A bounce from here would be normal. I think this bounce will be aggressively shorted. I think the markets are broken and the governments around the world are in panic mode. I expect MASSIVE government intervention in the next few days of trading.

I would not be surprised to see the announcement of either explicit government support of stock prices or some new multi-trillion dollar transfer of money from taxpayer to shareholder. Nothing else will stop this market from crashing.

The potential for intervention is why I am not interested in shorting. Even on a bounce.

The S&P 500 was down -38.5% in 2008. I was +2.8%. In 2009, the S&P 500 is -13.76% and I am down about -0.50% (1st Quarter Fee Included). So I am 54.6% ahead of the market the last 14 months. So I have plenty of time to wait before I deploy money into stocks again.