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VIDEOBuyouts, Bifurcation, Bailouts and Bankruptcy
By
Bennet Sedacca Dec 10, 2007 12:28 pm
Artificially delaying the natural business cycle will create a more horrific final event.
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3) Bailouts
Ever since the stock market bubble began in 1995, and money supply and credit growth took flight, we have had to increasingly bail investors out. In 1997, we had a currency crisis that first spooked investors that the world’s markets were becoming increasingly intertwined, a trend that has only increased as nearly one half of a quadrillion dollars of derivatives have been created worldwide since then. Yep, half of a quadrillion dollars - that is not a typo.
In 1998, it was Long Term Capital Management (LTCM) which was one big, unregulated, leveraged mess, but thankfully an isolated player. Then, the tech bubble blew apart and you would believe that lending standards would improve and credit growth might slow, but no. We have become so addicted to debt that, like someone addicted to heroin, we must produce ever-increasing debt each day to keep the levered mess afloat. This debt has to be serviced, meaning that we still have to pay the interest charges.
What do you get when you add loads of new money, loads of new credit, moral hazard cards, poor lending standards and a housing bubble? A really, really big mess. Since 2006, 200 mortgage lenders have folded up shop, and I suspect that one day we will see a big one go, possibly Countrywide Financial (CFC). Just taking one look at Countrywide’s balance sheet makes me want to curl up in the corner with a blanket.
Many of the housing related companies in portfolios are already technically bankrupt. This leads to more bailouts. The US Fed and European Central Bank (ECB) pump the system full of fresh money daily just to stop the systemic risk from taking over, but I believe it is inevitable. Regarding the Bush/Paulson sub-prime bailout, I feel bad for the folks that need bailouts. I feel bad that they borrowed more money than they should and that they were taken advantage of by predatory lending practices that still exist today. Then again, I respect those that have prudently managed their finances, lived within their means, saved money and didn’t take second and third mortgages to pay for expensive toys and wonder why they must pay for the mistakes of others.
When I make an error or buy a security that falls in price, I am not saved by Mr. Paulson and the Fed. Where is my check? While being interviewed by Fox Business News Friday at Festivus, I was asked about the fairness of the bailout. I responded that not only is it unfair to prudent investors, it is contractually unfair to investors on the other side of the trade who are holding adjustable rate debt they had purchased, expecting a high coupon in 2008 and 2009. These investors should not be bailed out for taking excess risk any more than the people that took the loans, but in a democratic society, they should at least receive the contractually obligated coupon income they are due for taking the risk of buying sub-prime assets in the first place.
As a frequent buyer of Ginnie Mae and Fannie Mae Adjustable Rate Mortgage securities on behalf of myself and my clients, I fully expect Ginnie Mae to pay me a higher coupon if interest rates rise and to pay me a lower rate if interest rates fall. This risk is contractually stipulated up front and we pay certain prices based upon some simple interest rate assumptions. If Congress will bail out sub-prime borrowers, will they also bail out FHV/VA borrowers if their interest rate rises? If they do, is it possible that my bond can only fall in coupon? Surely, some of the FHA/VA loans will experience higher default rates if rates rise. Does this mean that Ginnie Mae can simply tell me “Too bad, Mr. Sedacca, we are going to penalize you and your investors so that the borrowers can lock in a lower payment”?
If this bailout passes, and the SIV (structured investment vehicle) bailout passes, I may have to re-consider my entire investment philosophy. If poor choices are not met with consequences, then my investment philosophy needs to be redrafted. Borrowers that lied about their income and balance sheets should suffer the naturally occurring consequences. And certainly, those lenders that were predatory should be fined and/or closed down. Banks and dealers that improperly priced their mortgage related bonds should now feel the consequences of their actions. But this bailout has gone one step too far, and we cannot go down this road indefinitely. There will likely be a day in the future when a problem becomes too large to bail out.
4) Bankruptcy
While studying macro-economic theory for my major in college, we were taught about the ‘business cycle’, a simple concept. During boom times, lending standards become too easy, which encourages borrowers to take on excessive risk and become a prime candidate for economic failure. This is how ‘Social Darwinism’ works. After an economic downturn ends, lenders tend to be rather cautious about their lending standards as they have most likely been recently stung by recent delinquencies on their lower quality loans in the end of the previous cycle.
You might call it LIFO lending (last in, first out). The loans that were made at the beginning of the cycle, which had better higher standards to begin with, tend to withstand an economic downtown much better. The increased defaults that are now occurring are a direct result of lending standards having deteriorated to such a low level and with so much leverage attached. The financial alchemy that created all of these low standard derivatives is beginning to evolve into a credit unwind 'on steroids.' The credit unwind is likely to last longer and cut deeper into the economy than most expect. It sounds cold-blooded and heartless to say this, but those that overspent and overleveraged should go bankrupt. That is how cycles are supposed to work.
I will be spending quite a bit of time researching bankruptcy over coming days and weeks in order to be prepared of how to deal with the next wave of defaults. Yes, there will be another wave of defaults. This view explains why I continue to avoid most credit risk and will continue to focus on quality until all of the credit problems are known and I am adequately compensated for risk. This philosophy has served my investors well during this credit crisis and I look forward to the day when the coast is clear to once again take risk.
Bailouts delay ‘Social Darwinism’ and the natural business cycle. Artificially delaying the cycle will create a more horrific final event. This is a dire situation, but there continue to be opportunities in this market environment. I will continue to look for value in the credit and equity markets as they present themselves, as in the case of the Fannie Mae and Freddie Mac Trust Preferred shares.
Positions in FNM, FRE Trust Preferreds.
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