August 16, 2010

Warnings From the Past

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 9:42 PM by Robert Barone

On August 10, 2010, the Federal Reserve declared that it would prevent its multi-trillion dollar balance sheet from shrinking, in a continuing effort to spur the American economy.  The officials explained that they would take the proceeds from the maturing mortgage backed securities that they hold, and reinvest the proceeds into longer-term U.S. Treasury bonds.

It is important to understand that the monetization of debt, known as quantitative easing, is a subtle form of money printing.  The Fed assures us that it will “sterilize” the printed money in the future by selling securities back into the market, essentially soaking up cash.  They seem to be forgetting that many of the securities that they originally purchased at par are of dubious quality, and will command much lower prices when sold back into the market.  The price differential between the purchase and sale price of these bonds will eventually be the inflationary increase in the money supply.   As Government debt continues to build at unprecedented rates, the urge to print will more than likely become heightened.  The authorities will likely tell us that we have to print money and buy debt to keep rates low.  Our economy will not be able to handle high interest rates.   Can it handle large amounts of freshly printed money?

Most financial crises have been a function of debt accumulation that can’t be serviced by underlying cash flows.   Printing money has been promoted by academics and politician for centuries as a cure all for these crises.  If one reads history books, one quickly sees that money printing, in all of its various forms, has created more problems than it has solved.  It typically starts slowly, and increases as the desired results are never obtained.  As the printing continues, the value of the currency drops.  Nothing in this world escapes the law of supply and demand.  The larger the supply of money, the less the money is worth.  Purchasing power is reduced.   This loss of purchasing power is the root cause of inflation.  As inflation ramps up, the blame is laid on “greedy speculators” and “greedy businesses”.  The true cause of the inflation, money printing, is never mentioned.  The story is always the same.  Rather then add more to the discussion, I’ll let historical figures tell the tale.  I have taken it upon myself to highlight what we feel are the particularly important points in each piece.  Remember dear reader, you have been warned.

“Pamphlets continue to be issued, among them one so pungent that it is brought into the Assembly and read there.  The truth which it brings out with great clearness is that doubling the quantity of money or substitutes for money in a nation simply increases prices, disturbs values, alarms capital, diminishes legitimate enterprise, and so decreases the demand both for products and for labor; that the only persons to be helped by it are the rich who have large debts to pay. This pamphlet was signed “A Friend of the People.”   It was received with great applause by the thoughtful part of the Assembly.  Dupont, who had stood by Necker in the debate on the first issue of assignats, arises, avows the pamphlets to be his, and says sturdily that he has always voted against the emission of irredeemable paper and always will.” (Fiat Money Inflation In France, Andrew Dickson White, 1896, pg. 22)

“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency.  By a continuing process of inflation, governments can confiscate, secretly and unobserved, and important part of the wealth of their citizens.  By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.  The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become “profiteers,”, who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat.  As the inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth getting degenerates into a gamble and a lottery.

Lenin was certainly right.  There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.” (The Economic Consequences of the Peace, John Maynard Keynes, 1920, pgs. 235-236)

And as the Federal Reserve uses proceeds from printed money to re-invest in ever growing quantities of Treasury Bonds, it is important to remember the words of the former Fed Chairman, Sir Alan Greenspan.

“The holder of a government bond or of a bank deposit created by paper reserves believes that he has a valid claim on a real asset. But the fact is that there are now more claims outstanding than real assets. The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise. Thus the earnings saved by the productive members of the society lose value in terms of goods.” (Gold and Economic Freedom, Alan Greenspan, 1966)

We got into our current mess by getting into too much debt.  Instead of slowly paying our debt off and accepting reality, we going to try and print our way out of debt.  Current Fed Chairman Ben Bernanke, in his 2002 speech to the National Economist club, stated that Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.” Money printing, historically, has never been effective in bailing out debt ridden countries.  The symptoms of heavy printing have been highly disruptive, and often cataclysmic to societies.  Still, we keep on trying, perpetuating the definition of insanity.  I’ll leave you all with a few more quotes that are appropriate to this discussion.

“History repeats itself, first as tragedy, second as farce. – Karl Marx

It is absolutely impossible to transcend the laws of nature. What can change in historically different circumstances is only the form in which these laws expose themselves.” -Karl Marx

The only thing we learn from history is that we learn nothing from history.” -Friedrich Hegel

The economy is currently slowing down, and widespread deflation may still set in.  Many people are purchasing risky, long term securities in order to provide income in today’s low return world.  Others are betting on reaping capital gains if long term rates decline.  Investors must remember that Bernanke appears to be committed to stopping deflation at all costs.  Also, confidence is a fickle creature.  When change comes to financial markets, it often comes swiftly and unannounced.  It may be wise to hedge deflationary bets with some kind of inflation hedge.

Matt Marcewicz

Ancora West Advisors

August, 10 2010

The mention of securities and investment strategies should not be considered an offer to sell or solicitation to purchase securities.  Consult your investment professional on how the purchase or sale of securities can be implemented to meet your particular investment goals.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.

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August 9, 2010

Moral Hazard at the FDIC

Posted in Banking, Big Banks, Bonds, Capital, crises, Finance, investment advisor, investments, San Francisco, Uncategorized tagged , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , at 6:14 PM by Robert Barone

There has been a lot of discussion about Moral Hazard regarding the large bank bailouts (which the recent financial reform legislation apparently now has “institutionalized”).  And there has been a lot of commentary about the lack of help for America’s community institutions; in 2010 alone, the FDIC has closed 108 such banks (at least as of this writing).  It just appears to us that Washington protects the Wall Street firms to the detriment of Main Street.  We have written several blogs about this “unholy” alliance (http://www.thestreet.com/story/10771337/1/the-washington-wall-street-alliance).   Now, it appears that the FDIC, whose insurance fund was in the red by $21 billion at the end of the first quarter, has decided to become a player in the private sector by partnering with, you guessed it, Wall Street!.  This is a major strategic change in direction at the FDIC in how they deal with the disposal of troubled assets at failed institutions.  Specifically, the form of the strategic direction change is to allow a partnership with the private sector in order for the FDIC to participate in the upside potential of loan work outs and sales.  In technical lexicon, this is called an “Entity Sale” as opposed to a “Direct Sale” of the assets.

Partnering is not new to the FDIC, and it appears that the current strategic shift had its roots in the Resolution Trust Co. (RTC) model.  The RTC was the entity that dealt with the troubled assets from the S&L crisis era.  At that time, the FDIC, through the RTC, took back stock and warrants as part of their resolution in the largest failure cases of Continental Illinois and First City.  This created the public perception and significant outrage that “nationalization” was occurring; this seems eerily similar to today’s attitudes.

In one of their first forays into the entity sale strategy, the FDIC sold the assets of First National Bank of Nevada for between 30% and 50% of face value to Private National Mortgage Acceptance Company, LLC (PennyMac), a company founded by the former president of Countrywide.  The FDIC provided interest free loans to PennyMac, but kept an 80% equity stake, hoping to recover some of the losses should the real estate market turn upward.

Since the PennyMac deal, the FDIC has found it increasingly difficult to find private sector participants, so the last few deals have seen a reduction in FDIC’s equity stake to 60%.  For example, Colony Capital and the Cogsville  Group paid $445 million for a 40% stake in the assets of Community Bank of Nevada, First Bank of Beverly Hills, and New Frontier Bank.  The FDIC gave the group an interest free loan for slightly more than half of the purchase price, thus lowering the upfront cost to the group to $218 million in cash.

A July 21st news report at Bloomberg (FDIC Selling Corus Bank Loans is Bet on Failed Condos, Sterngold and Keehner) summarizes the policy shift.  “The new FDIC strategy for managing assets seized from failed banks has turned the agency into a long-term investor, making a multibillion-dollar bet on the recovery of some of the most distressed condominium markets in the country, from Miami to Las Vegas.  Instead of selling the assets to maximize cash in hand, the agency is offering its private-sector partners zero-percent financing, management fees and new loans to complete construction projects it can hold until markets recover.”  In the Corus Bank Deal, the partners, led by Starwood Capital Group, took a 40% stake in the new LLC entity while the FDIC retained 60%.  The partnership received an interest free loan for half of the purchase price.  It also received a promise by the FDIC to provide up to $1 billion in additional financing for working capital to complete the condo projects.  The private group also receives a management fee of 1% on the outstanding face value of the assets.  In order to put liquidity back into the deposit insurance fund, the FDIC sold $1.38 billion of notes backed by the partnership’s assets into the fixed income market with an FDIC guarantee.

We have several issues with this new FDIC approach:

  • First, a government agency has now become a private sector competitor with the ability to give zero interest rate loans to its partners, effectively giving these chosen ones a competitive market advantage.  These chosen few private sector partners can offer lower prices on their projects than the rest of the private sector.  Not only is this unfair, but it also puts more downward price pressure on the already strained real estate market.
  • Second, a government agency is now taking on the kind of risk normally associated with private sector capitalism.  Capitalists, of course, are looking for large returns.  At the same time, they are putting their capital at risk.  Risking capital just doesn’t seem appropriate for a government agency which is charged with protecting the public’s principal (i.e., FDIC insurance), not in risking it for outsized returns.
  • As a corollary to the above issue regarding risk, the FDIC is charged by law with resolving the problem assets in the “least cost” fashion.  Depending on what happens in the real estate markets in the future, the new approach may or may not be the “least cost” approach.

This last issue led us to examine the Corus deal more closely.  The Bloomberg article cited above provided details of the Corus Bank assets sold to the FDIC/Starwood public-private LLC.  We analyzed the possible outcomes and concluded that, only under very favorable market outcomes does the FDIC appear to come out better than if it just held on to the loans and sold them as the RTC did in the S&L crisis.

In the model discussed below, when we had to make choices about which assumptions to use, we always chose those that were favorable toward the FDIC. Here is the detail along with the assumptions:

  • The FDIC sold $4.5 billion of Corus Bank condo and other commercial real estate loan assets to the partnership for $2.77 billion, or about 61.5% of value.  The $4.5 billion of face value had already been written down by Corus to appraised value to somewhere south of $4.5 billion, but probably not to $2.77 billion.  We have no access to the written down values on the Corus books when the FDIC seized the assets.
  • Bloomberg indicates that because of the zero percent financing, the bid by the Starwood group was 20% higher, indicating that the “fair market” value was closer to $2.22 billion, or 49% of face value.  In the analysis below, we show the results for the “deal value” of $2.77 billion, as well as for the “fair market” value of $2.22 billion.
  • The FDIC advanced a $1.385 billion zero percent loan (50% Loan to Value ratio).  Then, in order to re-liquefy its balance sheet, on March 8th, it sold a note into the fixed income market for a similar sum ($1.377 billion).  That note was backed by the Corus assets and carried an FDIC guarantee.  Because this note was privately placed, there is no information available on the collateral (transparency?).  However, we have found the private placement announcements:
    • $150 million 0% coupon due October, 2011 at a discount of approximately 50 basis points (.50%);
    • $850 million 0% coupon due October, 2012 at a discount of approximately 110 basis points (1.10%);
    • $377 million 0% coupon due October 2013 at a discount of approximately 165 basis points (1.65%).

We assume that the interest rate on the note will average 2.5% if the assets are disposed of in 5 years rising to 3.5% if the term is 10 years.  This seems reasonable given the current yield curve.

  • The additional $1 billion in working capital financing to complete the condo projects is not analyzed in this model.
  • Normally, one would expect the collateral to have some cash throw off from monthly payments.  However, the assets all appear to be severely distressed, either in an unfinished stage (thus the need for additional working capital), or, if finished, with little or even negative cash flow.  As a result, we did not include any cash income to the partnership from monthly payments by the borrowers.
  • A Starwood private partner entity receives a 1% management fee based on the face value of the $4.5 billion of assets.  If nothing is sold, that amounts to $45 million per year.  The fee is paid, not to the public-private partnership, but to a separate “management” company owned by the private partners.  This is the typical hedge fund model.
  • The model assumes that the sales take place evenly over the time period assigned (e.g., 10 years).  In addition, the FDIC’s interest costs and the management fee costs are evenly amortized in the same way.  This assumption, in particular, works to the benefit of the FDIC.
  • The private sector Starwood partners’ investment is 40% of the required equity, i.e. $2.77 billion of assets less $1.385 billion of loan times 40%, or $554 million.

The tables below show the percentage of recoupment relative to the deal value ($2.77 billion) (i.e., FDIC Net/Deal Value) or the fair market value ($2.22 billion)(i.e., FDIC Net/Fair Market Value) that inures to the benefit of the FDIC over 5 and 10 year periods at various revenue realization levels relative to the deal value.  The appendix to this piece shows a complete model iteration using a 7 year time frame.

Sale Time Frame: 5 Years;   Equity: 60% FDIC, 40% Private

Sales Revenue/Deal Price 70% 100% 120% 150%
Private Partner Net Income (bill $) -0.251 0.081 0.303 0.635
FDIC Net Income (bill $) 1.533 2.031 2.364 2.862
FDIC Net/Deal Value 55% 73% 85% 103%
FDIC Net/Fair Market Value 69% 92% 107% 129%

Sale Time Frame: 10 Years;   Equity: 60% FDIC, 40% Private

Sales Revenue/Deal Price 70% 100% 120% 150%
Private Partner Net Income (bill $) -0.184 0.149 0.370 0.703
FDIC Net Income (bill $) 1.302 1.801 2.133 2.632
FDIC Net/Deal Value 47% 65% 77% 95%
FDIC Net/Fair Market Value 59% 81% 96% 119%

Observations:

  • The zero percent loan and the 1% management fee are perverse incentives from an FDIC point of view.  That is, the shorter the time frame to sell the assets at a particular price, the better off the FDIC.  But the zero percent loan and management fee make it to the advantage of the private partners to hold for longer periods of time.  The tables show that the private sector partners don’t make any money selling at fire sale liquidation prices, so it is in their best interests to wait for the real estate markets to firm up. (In the model, the private partners break-even at sale prices of about 90% of deal value.)  So far, the FDIC has done 14 such deals and is likely to do many more.  The overhang of the resulting assets, especially if banks continue to fail at their current rate, will continue to put downward pressure on real estate prices and makes even a 10 year time frame appear optimistic.
  • For the FDIC to receive the “deal price” ($2.77 billion) on a net basis, the assets would have to sell for nearly 150% of deal value ($4.16 billion) in 5 years and 160% ($4.43 billion) in 10 years.  On the other hand, if the FDIC kept the assets in an RTC type entity, it would only need to sell the assets at 100% of deal value ($2.77 billion)(plus costs).  This leads us to question whether or not this model is “least cost” to the taxpayers.
  • Said in another way, if the market does not “come back” in 5 years, but remains where it is, and the private partners decide to exit and sell for 100% of today’s deal value, the FDIC will get only 73% of deal value.  If this happens in 10 year, the FDIC gets only 65%.
  • As expected, if the ownership percentages are altered to 80% FDIC, 20% private partners, as in the PennyMac deal, the FDIC benefits at every sale price level to the detriment of the private partners.

Conclusions:

  1. Only if the real estate market recovers significantly (rising at least 50%) in the next five to ten years will the FDIC be “better off”.  It could be significantly “worse off” if the real estate recovery is modest or non-existent over that time frame.
  2. In this new “strategy”, we once again observe an “unholy” Washington-Wall Street alliance.  Large Wall Street institutions are given sweetheart deals and, as a result of such subsidy, have a significant competitive advantage over regular Main Street businesses.   If the FDIC is now giving out zero rate loans to the Wall Street entities so that they can “wait” for the markets to turn up, why don’t they just give that same zero percent financing to the institutions that they are about to seize, allowing them to count it as capital and giving them that same precious “wait” time for the real estate markets to recover? (Note: If they do this with the small banks, they don’t even need the cash – just accounting entries!)
  3. Finally, given the fact that the FDIC appears unable to structure a deal without a perverse incentive, we ask, do we really want the government in the risk/return business where poor decision making leads to loss of capital?

Robert Barone, Ph.D.

Joshua Barone

August 4, 2010

Appendix:  The Model

Sale Time Frame: 7 Years

Deal Value: $2.77 billion

Average Interest Cost to FDIC for Private Placement: 3.00%

Private Partner Ownership Percentage: 40%

Cash Invested by Private Partners: $554 million

In Bills $ except Percentages

Revenue/Deal Price 70% 90% 100% 120% 150% 160%
Revenue 1.939 2.493 2.770 3.324 4.155 4.432
Less: Loan Repayment -1.385 -1.385 -1.385 -1.385 -1.385 -1.385
Less: Management Fee -0.180 -0.180 -0.180 -0.180 -0.180 -0.180
Equals: Income to Split 40/60 0.374 0.928 1.205 1.759 2.590 2.867
Private Partner Split (40%) 0.150 0.371 0.482 0.704 1.036 1.147
Less: Private Cash Investment -0.554 -0.554 -0.554 -0.554 -0.554 -0.554
Plus: Management Fee 0.180 0.180 0.180 0.180 0.180 0.180
Equals: Net to Private Partners -0.224 -0.003 0.108 0.330 0.662 0.773
FDIC Split (60%) 0.224 0.557 0.723 1.055 1.554 1.720
Plus: Loan Repayment 1.385 1.385 1.385 1.385 1.385 1.385
Less: Interest on Note Issued -0.166 -0.166 -0.166 -0.166 -0.166 -0.166
Equals: Net to FDIC 1.443 1.776 1.942 2.274 2.773 2.939
FDIC Net/Deal Value 52% 64% 70% 82% 100% 106%
FDIC Net/Fair Market Value 65% 80% 88% 103% 125% 133%
Statistics and other information have been compiled from various sources.  Ancora West Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.

Ancora West Advisors LLC is a registered investment adviser with the Securities and Exchange Commission of the United States.  A more detailed description of the company, its management and practices are contained in its registration document, Form ADV, Part II.  A copy of this form may be received by contacting the company at: 8630 Technology Way, Suite A, Reno, NV 89511, Phone (775) 284-7778.