In other words, I am getting paid to short credit risk. The reasoning behind this trade is that I'm a bit afraid that if a good bank bought a bad bank and I was short their debt, the debt could be assumed by the buyer, making the debt worth more, even while possibly wiping out equity holders. And to short the debt of the good bank that is getting a great deal (even though I have to admit being short JPM preferred stock as it's hopelessly overvalued in my book) may not be the best way to go.

But the ones in the middle that are too big to buy and in too poor a shape to absorb a struggling bank seems the best bet. Keep in mind that this is not a bet against the common shares, just the preferred shares, as I expect that the tidal wave of issuance could "re-price" the entire sector, and in the meantime we will simply collect the "positive carry." A worst case scenario in my mind is that the entire preferred stock space is re-priced and my longs and shorts fall together. While possible, it's not the most likely scenario, but I'm prepared for such an occurrence.

FRE 8 3/8% Preferred Stock

WFC 7% Preferred Stock

What about the buyer of last resort, the Federal Reserve? The Fed releases its balance sheet weekly and below is its latest balance sheet as of March 27th. Year-over-year direct holding of Treasuries fell by a whopping $151.9 billion and were replaced with assets from the balance sheets of not only commercial banks, but also from primary dealers. This is unprecedented activity by the Fed. They used to only lend at the discount window to troubled commercial banks. And they only took Treasuries as collateral. But now they take in not only Treasuries, but agency paper, and more importantly, non agency AAA CMO’s.

We do not have a listing of the exact securities they have on their balance sheet, but if you were a primary dealer with a host of securities that were ‘hard to price’ or ‘hard to sell’ and were AAA rated, wouldn’t you hand them over to the Fed in exchange for Treasuries?

If I owned securities that were falling in value and had deteriorating credit, I would be left to sell my securities into the open market and take my loss. So "where is my bailout when I make a mistake"? It seems that the Fed, unless it's granted a lot more liquidity from Congress, may have set a rather dangerous precedent of stepping directly into what used to be a free market and now is tinkering with a financial system that needs more than a band-aid. Rather, it's in need of a tourniquet.

Condition Statement of Federal Reserve Banks, March 27, 2008

Ouch! That's My ARS!

About a month back, I wrote an article entitled Pain in the ARS. ARS, or Auction Rate Securities are now beginning to make headlines and could prove extremely damaging to investors and the dealers that sold them to investors.

ARS work in the following way. Suppose that you want to build a closed end municipal bond fund and be able to pay the broker 7% selling concession, charge 1% a year, and still pay the buyer a reasonable return. The only way to accomplish this is to leverage the fund. The fund levers up by selling ARS, or preferred stock at rates below the rates the fund earns on long term bonds purchased; essentially a "positive carry trade," and this worked for the last 20 years or so. Even though the securities have 40 year maturity dates, they are auctioned off every seven or 28 days, depending on the issue.

The securities yield a bit more than traditional money market funds and were considered "cash equivalents" when in reality they are very long term bonds that reset every so often, so long as there is a buyer and the auction doesn’t "fail" to attract enough buyers to reset the rate. What happens in a failed auction? The owner cannot get their money back from the brokerage firm—they simply have to stick it out until enough buyers are found to avoid failure.  

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