What about Ford?

A rash of news stories have focused on the resignation of GM’s CEO and the treatment of the auto makers by Washington.  It is always a challenging question to figure out if government treatment is correct (if the banking system had not collapsed would the auto have collapsed; if that is the case maybe unencumbered liquidity might make sense while if they were on the path to bankruptcy then a ch11 or forced restructuring is sensible.  But what is being missed in many of the auto stories about GM and Chrysler is that Ford is not taking any government money.  Does this mean Ford is fine?  No, they are – economically – bankrupt but they appear to trying to take care of reality by offering a debt buy back on less than par value. 

These buyback are for roughly 30 or 47 cents (see story) on the dollar – in any economic sense – is a defaulted on its debt, but it avoids the CH11 and legal fights that are sometimes associates with bankruptcy (and are very expensive).  This means that they can focus on its operations and future success instead of focusing on how to satisfy the political firestorm.  Now I’m not suggesting that it is a sure thing that Ford will not have to go through Ch11 (survive) but what they’ve done by buying back debt for cents on the dollar is an even better path than a prepackage ch11 because it is faster and cleaner (although without the pressures on GM they would have had a harder time renegotiation contract with the unions).

So why doesn’t GM do this?  The big problem is the need for ’spare’ cash; if they had some around they might pursue this but they don’t.  A second challenge with voluntary debt swaps is that of the hold out problem.  Think about it, if you had a $100 bond from Ford why would you exchange it for $40?  You would only do this if you thought you were not going to get the $100 back (and the market price was under $40).  This means that many bond holders think that Ford will not survive.  The twist is that as more of them exchange their bond the health of Ford’s balance sheet becomes better and better meaning that the likelihood that they get $100 back increases.  This means that your belief in getting less than $40 on $100 debt in Ch11 and wanting to exchange will change based on what all the other debt holders do.  In short if everyone else exchanges their bonds, you don’t want to; if no one else exchanges their bonds, you want to. 

Now this is an over simplification but hopefully you get the point.  (1) There are ways to handle firm non-financial failure well (like CH11 and even better voluntary restructuring) but (2) its complicated.

Citi: Bank Bankruptcy Done Right?

The Citi preferred for common equity swap was inclusiveof non government preferred (PRFD) capital as well.  In this way it was – in a way – a prepackaged bankruptcy which forced a subordinated owner (the  PRFD) to restructure their obligations.  In this case they took on common equity and gave up theirPRFD ownership.  It is hard to know what the market was expecting explicitly for the Citi bailout.  The pricing on the equity and preferred seemed to suggest that they would recover little or nothing but the way the deal was price in the market was good for PRFD (they rallied) and bad for the old common (they fell). 

This action gives as a case study of how to handle too big to fail failures.  Citi is too big to fail, no private entities have the balance sheet capacity to support that balance sheet and just shutting it down and selling off the assets slowly would put a hole in the credit system which would be painful.  So the governmentforced a restructuring on the company.  The old equity is nearly gone (the last in line to get paid), the PRFD (the next to last in line) exchanged theirstake for common equity.  Often in a typical CH11 bankruptcy debt holders do what the PRFD did: exchange their claim for the equity.  Why did we give the PRFD anything? Why not give the company to the debt holders (this would allow for a greater deleveraging without taxpayer capital)?  That might have worked but it involved some risk.  Who is holding the debt and what would happen to them if they had to take losses, would they collapse as well.  I still believe the knock on affect from the PRFD losses after the agencies were resecued is not well understood but the knock on affects of what happen with Lehman are.  They force private capital to go into Citi by restructuring the preferred; they did it this way (I think) because they were unwilling to risk pushing any more losses deeper into the capital structure of the financial system.  I tend to think this is wise. 

Add on comment: A number of analyst are looking at banks stocks and rating them buy/sell based on the ‘banking fundamentals’, although this is part of the equation, the thing that they should be considering is how policy will play out.  A bet on the financial system at this point seems to be more of  a bet on policy than a bet on economics and it seems like it will stay that way for some time. 

Hedge Fund Discounts

One part of the breaking down of the financial system has been out flows from hedges funds. In part this is driven by poor performance, in part due to out performance, in part due to fraud, and for other reasons. In this process number of hedge funds have limited withdraws. This has lead to an interesting fact: the secondary market for hedges funds is trading at a serious discount. The fact that people are willing to give away a beta return to offset risk is not surprising but it gives a hazy window into a couple of things.

If we assume that the discounts come from two primary sources: (1) time value and (2) the liquidation affect (forced selling of assets), you can back out what the expected downward pressure coming from liquidation sales is. Using the back of the envelope method and some assumption about the duration of the lock up, expected returns, and spreads….it looks like the implicit downward force of liquidation is ~10%. Thus if you think the valuation are not fraudulent and you think the downward force in liquidation is less than 10% then alpha might be out their in buy discounted stakes. *Admittedly this estimation requires the assumption of unobservable factor which makes it not terrible meaningful but interesting non the less.

Sovereign CDS: Do we know what we are doing?

One of my favorite things to do is look at market pricing and back out what is implied from that pricing about the future (the so called breakeven).  In practice this is not a tricky thing to do but to do it well by having the right assumptions is more challenging.  One market that has emerged in the past few years which gives market watcher like myself some new information is the CDS market. 

The CDS (credit default markets) market is a side bet on whether an issuer will default.  This side betting system does provides benefits to the market.  For example by concentrating liquidity in a standard instrument  – instead of lots of one off cash instruments – and thus generating more liquidity the cost of capital should be lower for borrowers.  But there have been concerns about the ability of the CDS market to function properly.  My impression is that when WorldCom filled for ch11 the CDS protection was much larger than the outstanding debt which could have created a debt squeeze and impaired CDS market participants view of the market as functional (Imagine if the debt rallied because shorts need to deliever it when everyone knew it was worthless paper).  In any case the event went very smoothly, as have CDS settlement on LEH and the GSEs even though they were odd.  One concern I have is that the people betting on these (or using them to hedge) don’t really understand what they are. 

I’ll admit I’m not even close to being an expert (and would love for someone to correct me if I’m wrong on this) but I don’t think the CDS market for certain sovereign CDS is that sensible.  First off try to imagine the world where the US defaults…do you expect the system to be function (the correlation between the counter-party default in the case that the US has defaulted is so high that betting for a US default doesn’t make much sense).  People will sell insurance all day on their own failure, of course no one should buy it because if they fail, they won’t pay.  Now their is a mark to market part of this but what is logic for the US CDS correlating with anything (unless you somehow know how other are trading it and can simply front run them).  (If your curious, when I wrote this, US CDS was trading at 67 bps, whatever that means). 

Ok, what about emerging market CDS (for example Mexico CDS is trading at 305 bps and was as high as 600 in mid October); they have and will default in the future without the global system collapsing.  True but you might want to read the legalize closer.  According to the Chicago-Kent Law Review, ‘absent sovereign bankruptcy, creditors facing default will have two basic ways of collecting on sovereign CDS: getting bound or not getting paid.’  I am by no means a lawyer but this means that if the country is bailed in through a ‘voluntary restructuring’ your not getting paid on the CDS (but you are losing on your bonds)…this makes the CDS a very poor performing hedge on emerging debt (and a poor means to bet on it as well).  It has an additional component that the participant has to predict, will there be a voluntary bail in.  This would impair the cash debt but would not the CDS.  I’d be very suspicious of someone thinking they can predict this and it makes a big difference because of the discrete (0/1) nature of the trigger (although – to be clear – the payout/recovery is not discrete).  If the EM CDS is being used to hedge it may put the IMF in a situation where if they want to bail-in a country they may choose not to because they are afraid of the impact on the global banking system because of CDS hedges (although I doubt they would realize this). 

On the positive side the difference between the CDS and the cash bond give me one more thing that I can interpolate market predictions from (although I have yet to establish any confidence in what it really means – I am not confident that it allows me to see the ‘true’ risk free rate, even if I account for the correlative affects). 

Update: I don’t know how close the 1995 debt ceiling crisis was to actually causing a default but from reading Rubin’s book it doesn’t seem out side of the ordinary (I’m unsure if this is right or not).  This suggest something I hadn’t thought about before that the believable yield that US Sov CDS may come from political crisis.  I doubt the traders are thinking about this but what about the lawyers?

Auto Conundrum

If I want to get a feel for how likely it is that a firm is going to fail, I look at bond spreads and then calculate the breakeven implied default rate (see note 3).  This procedure suggests that GM has a 50% chance of default.  But this method doesn’t take into account the fact that the Federal Government does not want to let the Big Three fail.  Without commenting (again) on whether this is the right decision, let’s consider what this stance does to implied calculations.  

First some background.  When the market consensus is that a firm is going to declare bankruptcy, the yield curve inverts because the bonds start trading on price rather than yield.  The price curve becomes flat (forcing the yield curve to invert) within each class of subordination, because every class will be treated the same under Ch11.

What does the auto price curve look like?  For GM it is not exactly flat.  The next to mature bonds (in 2011) are more expensive than later on bonds.  This is not only a function of market expectations that the Big Three will be subsidized (and may even make it to those bond maturity points), but also that they will likely eventual fail.

What if we assume that the congressional support package props up the auto industry for 2 years until 2011 (the next bond roll)?  In this scenario, the market implies near certainty that the companies will fail.  Looking at the following chart will explain why (it shows how many years of coupon payments it will take for today’s market value to be paid back in present value terms).  In a two-year period, I will have made back the PV of my investment in the bond based on these coupons, thus time over that is excess (better than breakeven) return.  If congress keeps the companies out of ch11 for 2 years, buyers of most of GM’s debt (I pulled the pricing mid day on 12.12) will make money even if,  the companies fail and there is no recovery (which, given the insistence on the seniority of the government loans, seems plausible – remember that being senior unsecured doesn’t help much if recovery is zero).

So on the policy side, the market is giving a vote of no confidence to the auto recovery.  From a trading perspective, an outright long in the low year to breakeven debt or long/short duration-matched bonds along this chart seems attractive (assuming you have the ability to perform trades and you are not just bleeding from deleveraging).

Side Note 1: I think it is interesting to note that even if the Big Three are not able to pay their bills over the next month (until the next congress), no one has the incentive to put them in ch 11.  Given high expectations that they will get extra money from the Federal Government, why push them into bankruptcy?  I don’t think it is obvious that it would be in any constituency’s interest to do so.

Side Note 2: One possible solution is a ‘voluntary’ bond exchange to get them to restructure outside of ch11, which could be done in coordination with the bailout.  I’m not a big fan of this as it bastardizes ch11 law and uses the political process to favor creditors, which is bad for capital markets.

Side Note 3:  Implied default rates come from bond spreads.  For example, if a bond has a spread (yield over the risk free rate) of 10% and I expect to recover 50 cents on the dollar in default, then it would take 5 years of the excess spread to make up for the 50 cents on the dollar loss if the company failed, implying a breakeven default probability of 20% (1 in 5).

Auto Bailout: Folly Squared

When policy is being created what is being thought about is how it will impact the real economy or at least that is what one would hope.  Also it is easily seen that the financial crisis which began in the Summer of 2007 has had a large impact on the real economy (which has then feed back into the financial economy).  The tragedy of this statement these real economy opportunity loses are not recoverable.  Think of the excess unemployment; every day that someone is sitting at home without a job is a day of lost labor; we don’t get that day back (and I doubt they are enjoying their time off). 

It seems in the case of the automakers policy is being crafted with the thought of politics rather than the real economy.  It is hard to know who is at fault for blocking a plan for the auto but I suspect the fault is on both sides, although likely not evenly split.  [Note: I was impressed that the President Elect Obama consulted lawyers about a pre-packaged Ch11; this would be a great idea but more on this below.  I don't think it will be done that way but it would be a wise and bold choice.]

Let’s lay out the reasonably plausible options for the auto.  First, they are bailed out by congress (of course the money is really coming from the American people) with large amount of subsidies and little or no concession but done right away.  The bad part of this plan is they are likely to continue to be uncompetitive and the problem reemerges down the road but it would help the real economy because they would go back to making stuff instead of cutting corners in order to stave off their demise.  Second, they are bailed out by the congress with some concession but done in a month or so.  The bad part is that the concession are likely to be minor and thus not enough to get them back on a competitive track and the real economy would have taken a real hit while they didn’t make autos while trying to retain cash and wait for a bail out (This seems to be the path we are on and the worst path of all).  A third choice would be a traditional ch11.  This process would help the auto maker restructure and return to long term profitability because they will be able to restructure contract on economics terms but it would also give a real whack the real economy at a time that it can ill afford to take it.  The forth option is a prepackaged ch11 where the auto would quickly emerge from ch11 with tough concession made possibly with the help of a federal negotiator.  The DIP (debtor in possession) financing, given that credit markets are not working, could be provided by the government in order to help operations during the restructuring.  Lastly some of the TARP, the treasury financial system rescue plan, could be used to provide financing for an auto loans ABS (asset backed security) purchase program.  I think this plan would give us the best shoot of providing the needed transformation in the auto industry while giving the real economy a boost. 

Look at this chart of auto securitization and auto sales to see how the credit crunch has lead to problems with auto sales.  First posted at the Council on Foreign Relation’s Center for Geoeconomic Studies. 

It seems like the path we are on of that of wait, talk and then aid.  Meaning the auto makers try to scrap by (thus less real economy activity) while they wait for the bailout.  This is a shame it likely the worst option.

Market Implication: Really?

One of my favorite activities is to look at markets and back out what they are predicting.  This is more of an art than a science because it can require a fair amount of assumptions and what I’ll call dirty methodologies in order to get at implied reality such as an implied growth rates or implied break even default rates.  But I believe it is a good practice, what it does is it allows a user to convert market prices into these numbers that have real economic meaning.  For example if I tell you that the price of a stock is 50, you cannot tell me if it is expensive of cheap (even if I tell you about the growth prospects and industry rank), but if I tell you what their implied earnings growth rate is 25% and they are a 150 billion dollar company you can guess that they are overvalued (doesn’t mean you’d make money but is suggestive).  Conversely if I told you low quality investment grade bond yields were at 10%, you couldn’t tell me if that was a good investment or not, but if I told that the spreads were 8% and the implied default rate was 16%, you would have something more tangible to think about.

So with this background in mind I ask the question: what are markets pricing?  The answer: total disaster.  The following chart shows that the low grade investment (BAA) corporate debt market is pricing in default rates that exceed the default rated during the depths of the great depression. 

Similar stories are being told by the ABX (home mortgages), CMBX (commercial mortgages), and LCDX (leverage loan markets) markets.  And the story has deteriorated rapidly (one reason why the banks have been failing so hard) over the past week.  It is worthwhile to note that this doesn’t mean that the trade (long a basket of risk assets) is one sided; there are reasons that it could get worse even if the real economy outcome is better than implied. 

So what’s the story: are we in for defaults that beat out the great depression?  I hope not, I don’t think so, but I’ve been wrong before.  So how do I explain what the markets are saying, they are broken.  The great soothsayer of the marketplace is leaving me (and you) high and dry to figure things out on my own.  There are a number of reasons for this such as the lack of balance sheet capacity, the flight to quality, the waiting syndrome, and so on but I not going to address these here.  What I would like to ask is how does one know if the market is working or not?  Using the gauge of ‘I don’t like’ or ‘I don’t agree’ with its predictions is a bad way to determine the markets degree of function.  I’ve come up with a methodology to determine, net of volatility, how well markets are functioning.  I’m going to keep to myself the details, as it really is a work in progress, but here’s the picture (higher numbers represent higher levels of dysfunction).  Maybe the flight to safety isn’t crazy after all, it’s really ugly out there. 

Auto Failures

A puzzle that is making me wonder is how what the markets are pricing about the autos going to play out.  GM has CDS spreads of above 50 point (5000 bps) while the long dated cash bonds are trading with yields consistently over 30 percent.  Whichever number you use, if you make some simple assumptions about recover rates, you soon get to an implied default rate suggesting that the likely scenario is that the major US auto firms go bankrupt in the next 12 to 18 months, if not sooner.  A similar exercise can be done by looking at the options market; it tells the same story.  This pricing makes sense with the economic picture: lowest population adjusted auto sales since WWII, frozen Auto ABS markets, and the firms saying that they may run out of cash in short order. 

What does not jive with me is how is it possible that these firm fail politically.  How is it possible that these firms will be allowed to fail when we have (1) set a precedent by injected capital into the major banks, (2) they influence large voting blocks in marginal states, (3) have across the board liberal government, (4) and have been promised large fiscal stimulus (even if this would be a very poorly designed one). 

I’m not suggesting that the sensible economic policy is to rescue the autos; it’s not (Financial Firms can’t fail because of the instant knock on affects, where as our Ch11 law is structured well enough to handle non financial failure without devastating – for the economy – effects).  A well designed prepackaged ch11 would do wonders for the auto industry (think Nabors Industries); it would allow them to work out the reality that they are broke and insolvent and then restart as new companies.  [note: for those of you not familiar with ch11, its the bankruptcy law that allows firm to continue to operate while working out their debts.  The idea is to preserve value, a recent example is Circuit City].  When they came out of this process I would expect a well structured auto business, one that could focus on making profit by selling cars instead of focusing on survival by finding cash to pay the next bill. 

So I expect that we will take short term gains and bail out the auto makers, which are not necessary to maintain stability, and either continue to have an uneconomic domestic auto industry or have poorly utilized an enormous amount of taxpayer capital.  I’d encourage our leader to target the stimulus through extended unemployment insurance which is targeted, temporary and not capital destructive but since I doubt that will happen being long the senior auto debt seem like a good bet.

Imprudent Prudent Man Rule

For those of you who have followed the financial crisis one point of focus has been the failure of the credit rating agencies; the common story sob story being, ‘I invested in triple AAA bonds and now I’ve lost everything; how could this happen.  Those credit rating agencies failed to do their job.’  I’d like to make the argument that the legal framework that gave rise to the rating agencies as a business is the problem and not the rules and regulations that the agencies where under or business practices that the agencies have used. 

Not to suggests that the structure and practices of rating agencies, such as being paid by the issuers, helped, but these only accentuated a much more significant problem that is being caused by their existence. 

People will argue that the agencies exist so that they can achieve economies of scale on investment research, which although is impart true, is not what I think the real reason is for their existence: they have been deemed the prudent man and thus many other ‘managers’ are using them to pass the buck with regards to their fiduciary responsibility.  You may have heard, ‘It’s not my fault; it was rated AAA’, coming from an office near you. 

The Prudent Man Rule states that fiduciaries should ‘observe how men of prudence, discretion and intelligence manage their own affairs, not in regard to speculation, but in regard to the permanent disposition of their funds, considering the probable income, as well as the probable safety of the capital to be invested’; this not so insightful statement puts managers in a corner where they need to find another guy whose doing something like they would like to do so they can justify themselves, or they can have no opinion at all and just pass on their fiduciary responsibilities to the prudent man. 

This leads to capital markets where money, instead of trying to determine where the best risk adjusted returns are, is looking to the next guy (the agencies) to see where it should go.  So how is the agencies being very wrong the product of this setup; its not, but the real problem is that the whole capital market ended up bring wrong not that one investor was wrong.  We need robust capital markets where savers place their capital in the hands of managers who invest based on their perception of economic principles and relationships (and thus disagreement occurs) rather than a legal framework. 

Let me suggest a replacement to the prudent man rule – call it the robust pools of capital rule – managers must provide information to their clients detailing their investment process and strategies at a level that could be understood and cover the fact that outcomes are uncertain and that all strategies have the some possibility of total loss (just varying in size) and that THEY WILL NOT OFFLOAD THEIR RESPONSIBILITY TO RESEARCH THE INVESTMENTS THAT THEY UNDERTAKE IN ENTIRETY TO A THREE LETTER SYMBOL.

When everyone started following the prudent man (note: singular) rule the capital markets stopped allocating and the prudent man rule became imprudent.