Banking on value: the explanation
Roughly a month ago, almost as it happened, I put out a post entitled Banking on Value, which opened:
Ten days ago, the Federal Reserve made a bet that economic students will be studying for decades.
Under Ben Bernanke, the Fed pushed $200 billion – that’s your money and my money – into the global capital markets pot, in effect making a bet that assets the market won’t buy have the value their originators say they do.
I returned to the subject in greater detail over at Recap’s workout group, where once a month we publish State of the Market, whose most recent issue deals with this topic in depth:
The financial coup of the new century
The revolution that occurred over the Saint Patrick’s Day weekend of March 15-16 was quiet, swift, and decisive – so much so that even today the major media do not realize just what’s happened.
To secure financial liberty, we have to take a financial risk
In funding JPMorgan’s hasty adoption of Bear Stearns and backstopping the major banks, the Federal Reserve (with the support of four other global central bankers) called a halt to the runaway markdowns plaguing our industry, by allowing the beleaguered institutions to pledge – not sell – their complex if illiquid assets in exchange for cheap short-term Federal cash.
In so doing, the Fed’s move changes the rules for every major institution in ways that will permeate all asset classes, including residential rental.
While technically oriented readers or practitioners are urged to read the whole thing, for ordinary folks, here’s the shorthand version (profusely illustrated):
It takes years to create a weekend crisis
“In case of crisis, dial 1-800-FED-CASH”
Though coups, even financial ones, happen in a twinkling, the conditions enabling them take longer to arise. This one’s origins start with Sarbanes-Oxley ….
Sarbanes-Oxley, otherwise known as Sarbox or SOX, imposes substantial new diligence and reporting requirements (including, for example, that the CFO and CEO are personally liable for material misstatements on financial statements, which concentrates their minds wonderfully). It’s led to a healthy focus on the accuracy of financial reporting, even as in doing so it’s imposed meaningful new accounting and internal compliance costs on public companies.
Many of my friends complain about Sarbox, and in idle moments I do too, because its costs are entirely visible and immediate, its benefits unquantifiable and deferred. That’s true of all regulation, I think; initially the industry goes bonkers at the added burden, but with automation and routine, costs decline gradually. Meanwhile ecosystemic benefits accrete. So even though I’d like to see Sarbox dialed back in a few places, overall I’m glad it’s in place.
Still, the increased scrutiny places public companies at a disadvantage:
What do you mean I’m at a disadvantage now?
Widening the information asymmetry
The capital markets have an intrinsic information asymmetry – private companies (not listed on stock exchanges) need not report their earnings, whereas public companies (whose shares trade on exchanges) are required to fess up quarterly.
Okay, I did it – I fudged the earnings
Private equity has the luxury (or license) to think longer-term, and has been using that to advantage, as I reported in Press De-REIT and Barbarians at the REIT. Private equity also has a faster OODA loop, and used that greater speed to grow:
This mattered less when the public companies were dominant, but private equity grew into giga-funds by exploiting the public markets’ unforgiving punishment of underperforming publics.
Because Sarbox makes the inner workings of public companies more transparent, and requires them to report more frequently, it creates information asymmetry, an edge whose value rises rapidly in times of turmoil:
When spreads exploded last August, the trading values of complex assets plummeted, and just as the bankers returning from vacation were coming to grips with this, FAS 157 took effect in October.
That’s what we call “exploding spreads”
I warned about this when it happened, in State of the Market 1: Will the Capital Shakeout Hit Multifamily?
For most companies, the day of reckoning comes at quarter’s end: September 30. Are the positions impaired, and if so, by how much? Normally one looks to recent trades, but these assets are customized and may not have any recent activity. A market trained to solve its bad positions by selling them goes into a tizzy when there is no one to buy – must the assets be marked to model, or marked to bottom?
Many markets for highly complex positions either froze or were overwhelmed by sellers swamping buyers, leading to cliff-like drops in price (even if not in ‘intrinsic value’).
Though the herd be observant, it is not always quick to think –
Why think when you can graze?
– rendering it vulnerable to predation.
Private equity’s wolf pack on the prowl for over-levered public entities
Adding to the public entities’ besieging was the legacy of a hyperactive market in complex instruments. What with put and call options and many layers of CDO’s and similar derivatives, it became possible for private entities (immune to FAS 157 fluctuations) to make huge, flash-mob-type bets that a particular public entity would fail. The volume is by no means limited to the target’s market cap; in fact, the aggregate betting can be 10x or 100x the market cap.
One single trader shorting a highly levered public entity is like a lone wolf taking a run at a caribou.
You smell earnings down, cash exposure?
If the target reacts – by selling positions, or getting new financing – those bets may fail. The wolf trots away and eyes another caribou.
Come on, boys, they raised capital from a sovereign wealth fund
If the target is slow to react, the adverse bets multiply –
I think he can’t make his margin calls
– the wolves start running as a pack –
The short-term lenders have called their lines
– and if for some reason the target can’t raise its liquidity, then the financial press piles in,
Rumors of massive shorting
– the stock flutters and dives, and the by-now-wounded caribou cannot escape.
Which divisions can we divest quickest?
This was brought home to me, quite remarkably, in a mid-October conversation with an investment banker of my acquaintance: “my bank is making huge bets that AMBAC’s going down.” Two weeks later, their stock dropped 70%.
This sequence – pick a target, run at it, see if you can devour it – has gone on now for six months. The caribou could be MBIA or AMBAC, Bear Stearns or WaMu. In some sense, the caribou deserved to be run at, for they had grown fat with easy browsing – creating or investing in large portfolios about which they knew too little and which they were unprepared to asset-manage. If the target couldn’t dodge and maneuver (as Countrywide did with Bank of America), it’s overtaken and consumed.
The only ones enjoying the last six months have been the wolf pack, for whom the plains were filled with bewildered caribou –
Who can we run at next?
– but in early March things got completely out of hand. Banks, under pressure to raise cash, began offering GSE securities (Fannie Mae and Freddie Mac) for sale, not because they wanted to divest, but because these securities, sheltering under the umbrella of a government charter, are perceived as universally liquid.
Liquid they were … but with everyone wanting to sell them, and few people wanting to buy, the prices dropped, proof – if proof were needed – that the markets’ mania for liquidity had reached absurd points.
Panicking? Who’s panicking?
Then came Bear, about which I’ve already posted. With any luck I’ll also be able to post on the cut-and-thrust of that remarkable weekend, citing the Fed’s Congressional testimony.
It’s a gargantuan bet, and the more I think about it, the more convinced I am it will work.
Why the world will turn
“Markets are driven on the 80/20 rule: 80% greed, 20% fear,” somebody quoted to me a couple of weeks back. “Money’s not gone; money is on strike.”
Holding out for higher rates!
A quarter of a trillion dollars, which the Fed has just put into the system, is a big deal in itself. Even bigger is that this move signals a
S-P-E-N-D
Markets figure things out quickly, and this market has. Post-Bear, there’s a time to convert the pricing advantaged derived from artificially low public-entity prices into long-term positions in these undervalued assets and entities. Only a few days after the Fed’s move, private equity investor TPG agreed to put $7 billion into WaMu in exchange for a large ownership stake – an ownership stake four times as large as TPG would have received had it made the investment twelve months ago, before WaMu’s share price start falling.
Time to convert liquidity into equity
Write a comment