Tuesday, December 16, 2008

"2008-Breaking Out the Bailouts"

Looking back on a historic year for financial markets and capitalism.

Bear Stearns

Date- March 14, 2008

Structure- Initially, Federal Reserve backed 28-day emergency loan to Bear Stearns. Subsequently, firm sold to JPM for $2 per share in conjunction with a $29billion non-recourse loan for illiquid mortgage assets. Offer later raised to $10 a share by JPM.

Logic- Since this was the first bailout the logic was that the fed needed to intervene to preserve the orderly functioning of financial markets. The initial loan was provided to stem the run on Bear as counterparties were pulling assets. It would then appear that the fed being concerned with a “moral hazard” argument pressured Bear management to find a buyer or face bankruptcy. Though when you consider the non-recourse loan JPM got, I have to believe the fed was not planning on letting bear go under and would have extended them more time had JPM not balked.

Message to Private Capital- Mixed. Initially, somewhat harsh as fed’s focused on moral hazard issue. But the raised JPM offer tempered this. As this was the first bailout, regulators believed that focusing on systemic risk was their top priority and thus very little attention was given to a potential banking sector panic.

Date- Sep 7, 2008

Structure- Placed into a conservatorship by FHFA. Treasury was then issued senior preferred stock and warrants that represented 79.9% stake in the equity of both entities. Treasury announced that they were willing to commit up to $100 billion in capital to each entity. Common and preferred dividends suspended. This bailout came on the heels of a failed backstop attempt by Treasury in early July.

Logic- After failing to restore confidence with a backstop guarantee, the government was forced to address the systemic risk posed to the housing market by a potential GSE failure. With outstanding obligations of almost $5 trillion the main concern was maintaining the orderly functioning of the agency debt market, and Fannie and Freddie’s ability to provide housing credit. The massive capital commitment was designed to instill confidence in anyone holding agency debt or GSE backed paper. As far as this is concerned, the government achieved their objective.

Message to Private Capital- Very harsh. Common equity was effectively wiped out by massive dilution, and the preferred stock was crushed by the subordination and suspension of dividends. Many critics have pointed (see GaveKal’s “Unintended Consequences of Mr. Paulson”) out that terms of the GSE bailout provided the catalyst for a mass-exodus of private capital from the financial sector. A move that would result in the bankruptcy of Lehman, the BAC/Merrill merger, several bank failures, and the conversion of all remaining investment banks into bank holding companies.

Date- September 16, 2008

Structure- Federal Reserve Credit Facility of $85 billion in exchange for warrants amounting to79.9% of total equity. Subsequently modified to include additional $37.8 billion facility from the NY FED, and then a $40 billion preferred investment via TARP. The TARP investment reduced the initial central bank facility to $60 billion. Term of credit facility was initially LIBOR +850 BPS. TARP modification reduced this to LIBOR+300 bps for borrowed funds.

Logic- AIG failure posed massive systemic risk to financial markets. Outstanding Credit default swaps sold by AIG on cdo’s meant there was tremendous counterparty risk in the event of an AIG default. Bankruptcy could cripple the financial system, and thus was not an option. Lack of liquidity triggered by loss of AAA rating meant AIG needed immediate cash infusion to post margin requirements. FED took initiative.

Message to Private Capital- Initially very punitive. Equity holders effectively diluted to almost zero by government warrants. Though subsequent modifications and TARP investment have somewhat blunted this move, message is still quite harsh. This bailout was about avoiding market disruptions and not about preserving confidence in financials. (That is if you believe the two can be effectively separated)

Date-September 25, 2008

Structure- FDIC led secret auction. Bulk of banks assets including branch network, secured debt, and all deposits sold to JP Morgan for $1.9billion.

Logic-Unsecured senior creditors were subordinated to depositors to protect FDIC Insurance Fund from taking a potential crippling hit. Clearly, the focus here was on protecting depositors and stopping the 1907 style run on bank deposits.

Message to Private Capital- Punitive. Equity Stakeholders pretty much wiped out as surviving holding company filed for CH11. Also, WAMU board had no say in sale as regulators held auction without their approval.

Date- September 29, 2008

Structure- FDIC ordered sale to Citigroup. Wachovia was ordered to sell itself to Citigroup for $2.1 billion. Deal was backed by Treasury and the FED and in exchange for the purchase Citi losses over $42 billion on Wachovia’s loan book would have been absorbed by the FED. In exchange for this backing, the FED would receive $12 billion in preferred stock. Retail brokerage arm and asset management unit were not part of the deal and would remain independent.
Subsequently, sold to Wells Fargo for $15.1 billion on Oct 3 in a board approved deal. No federal assistance required.

Logic- It would appear regulators panicked once Wachovia’s deposits started to fall fast as the financial crisis spread and thus took the forced sale initiative as a step before receivership. What happened afterwards is still murky, but it would appear that the situation wasn’t as bad as initially thought and that the Wells Fargo deal for the whole company could not be ignored. Though it is perplexing how this deal even happened with Citi receiving govt approval for the initial purchase.

Message to Private Capital- Mixed. Shareholders would have been left with about 1$ but the brokerage business would have remained separate so the deal was not as nasty as WAMU. However, when you consider that the board was allowed to pursue an alternative solution, even after the govt forced bailout, that ultimately added shareholder value has to viewed as a positive, as wamu’s board was left completely in the dark and ultimately rendered useless.


Date- October 14, 2008

Structure- The Treasury Asset Relief Program was born out of the Emergency Economic Stabilization Act of 2008 which was initially passed by Congress(Oct 3) as a means for Treasury to provide economic relief via the direct purchase of distressed assets that were infecting the US banking sector. The program was modified before it was implemented into a direct equity purchase vehicle by which the Treasury has taken stakes in the US financial sector through the purchase of senior preferred shares. The shares pay 5% cumulative dividend for 5 years at which point they reset to 9%. The treasury receives warrants for common stock amounting to 15% of senior preferred stake at a 20day trailing strike price.

Logic- US Financial Stocks started imploding despite the Congressional approval of the TARP bailout. Treasury was basically forced into a corner as European governments took the lead by taking direct equity stakes in their banks. U.S. had no choice but to abandon their proposed toxic asset relief program. This moved was designed to stop a banking sector panic. It worked temporarily, however, within a few days financials resumed their painful slide and more federal intervention would end up being required.

Message to Private Capital- Supportive and encouraging. Govt is willing to step in and shoulder some of the de-levg pain. Treasuries stakes were at very low costs to the banks and current stakeholders and potentially high costs to the US taxpayer. These deals could have been much more punitive, but considering the state of affairs the government was trying to avoid an all out collapse of the financial sector. Thus, TARP was turned into a stock market support program as systemic risk had turned into systemic failure. Treasury probably hoped this move would put a floor on bank stocks and bank runs.


Date- November 24, 2008
Employees- 300,000

Structure- $306 Billion Asset Guarantee to be split between TARP, FDIC, and Federal Reserve Non-recourse loan in exchange for $7billion in preferred stock. Also, US Govt ups preferred stake via TARP to $45 billion by agreeing to purchase $20 billion more. Citigroup agrees to exec compensation restrictions and dividend restrictions and provides the US Govt with $2.7 billion in warrants with a $10.6 exercise price.

Logic- Citigroup shares were free-falling for five straight days despite the initial $25 billion TARP investment and thus the government was forced to act. Investor confidence was at critical levels, and thus something needed to be done to resolve the too big to fail question regarding Citi and their massive balance sheet.

Message to Private Capital- Extremely equity supportive. Treasury and Fed broke from past practice of punishing private capital at the expense of tax payer funds. The city deal was set up in such a way to make the actual equity recover as the government ownership stake was kept very small and also set at a much higher valuation then the prevailing market price. It would appear the goal here was to throw free money at anyone willing to get back into financial stocks with the hope that the sentiment impact would ultimately offset any taxpayer costs. Could be argued as an attempt to correct the Lehman blunder or the GSE/AIG precedent.

"Bush's Last Chance"

"We've already stepped forward and made enormous concessions," UAW President Ron Gettelfinger said Friday at a news conference. "But as we made it clear ... , we were prepared to make further sacrifices. But we could not accept the effort by the Senate GOP caucus to single out workers and retirees for different treatment and to make them shoulder the entire burden of any restructuring."

President Bush has one last chance to salvage what little shred of credibility his administration has left. He has presided over the worst collapse in U.S. history (politically and economically). A collapse that can be largely blamed on the government’s failure to effectively regulate private enterprise and mitigate economic risks. The UAW is playing a game of chicken with the rest of the country. They know that everyone now believes that an auto-industry bankruptcy is off the table. Thus, they are only willing to concede what little they feel they need to give up until a deal is done. Naturally, from a bargaining perspective this is not shocking, as they know the only outcome they fear will ultimately be avoided. So, why be the first to cave? In a worst-case scenario, the concessions that are being asked of them will be forced upon them by the government or a judge, and thus the current leadership will never have to take the blame for what will amount to life changing wages for hundreds of thousands of union workers. Best-case scenario, you get the money and only have to give up very little in the immediate term thus postponing the eventual reckoning for a later date.

It is for this reason that I think it is about time for the President to take charge and make a difficult decision. Will Bush stand firm, or will he usurp congress and allocate TARP(sect 102 limits the funds to financial institutions) funds to the auto industry? Reagan was willing to use drastic measures when the Air Traffic Controllers Union wouldn’t budge. This president should do the same. The solution is simple. Force the UAW and the Big Three to enter into a binding agreement under which the parties agree in principle to accept any future restructuring that is deemed necessary by and independently appointed “car czar” or committee. In exchange for this agreement, the government will extend temporary credit throughout this transition period that will allow the automakers to sustain their operations. The big three will agree to this agreement, if the UAW balks, dissolve the union under an executive order.

Btw- the trading in the common stock of gm is complete and utter nonsense. These shares represent an interest in a company that is no longer a going concern. How we get there is inconsequential. The new equity when and if it ever emerges from government control will represent a stake a very different company. That is the only way gm survives. The debt is worth cents on the dollar and the stock is worth zero. Any day is a good day to short this stock.

Thursday, December 11, 2008

"Guaranteed Grief"

Crack Down on Guarantees!

The one thing that stood out the most to me 6 months ago was the seeming limitless amount of firms offering guaranteed investment returns. To me this was a tell tale sign of a boom town market that was headed for trouble. Sadly, we have yet to see a crackdown on these “guarantees”. Today, I received an email from a friend regarding a “Buy Back Investment Consortium” being proposed by a real estate agency. According to the email(which I did btw confirm by calling the real estate agent), Smith and Ken “have taken away the uncertainty and are offering a guaranteed profit on your investment within 6months of 30%.” I do have to admit these marketing ploys are impressive. The words “Buy Back Investment Consortium” even caught my attention. Here is how it works. You put up what amounts to 10% down on a developers project. In return, Smith and Ken will give you post-dated checks repaying your investment and also entitling you to 35% return for the 6-months of your investment. Minimum amount you can put up is 100,000 aed. The current max is 18,000,000. Presumably this is because they have raised 22,000,000 of the 40,000,000 they are seeking(the project is valued at 400,000,000). Pretty straight forward. Smith and Ken raises 40,000,000 for the developer which can than market and launch their project. The developer than sells the units off-plan and at a decent markup and thus can buy-back the property or in effect the 10% down payment you provided them because it has swapped that down payment out with one from a purchaser. The developer in question in this transaction is M-Holding which the UAE property development arm of the Mundia Group. M-Holding has recently launched two executive tower projects in Ajman. Based on the success of these launches they acquired 15 plots of land from Dubai Investment Real Estate Company(DIRC) for 615 million aed(in July of 2008). Their goal is to develop a 3billion aed freehold community in Mirdiff. Seems pretty sensible. So, then why can’t the developer come up with the money needed to market this project? There are really only two answers to this question.

1) The developer has the funds but doesn’t want to take the risk and thus would prefer to pass it onto investors

2)The developer doesn’t have the funds.

My guess is their previously hot Ajman project is seeing more than its fair share of problems and this is now compounding the problem of what was probably a gross overpayment for land in Dubai this past summer. Thus, I do not see how this buy-back will ever be accomplished. The developer can claw back 8% of the funds from sales for their operations. That is supposedly how they intend to pay you back. If we take the 40 million and add the 35% promised return, we get 54million in cash outflows that will need to be made between the end of month four and the end of month 6. With the 8% claw back(not sure if they are right on this my impression was that RERA is allowing roughly 5% of the escrow funds to be used for marketing, broker fees, and disbursements) that means they need to come up with some serious sales to unlock the funds needed to pay you.

RERA’S Interpretation of Trust Law No 8. Of 2007

1. Payments will be managed on the following basis:

§ Installments will be made to the contractor of the project according to the agreement between the project consultant and the bank.
§ 5% of the sum will be given to the developers for marketing and other miscellaneous purposes.
§ Installments could be taken from the account if the sufficient funds were available for the completion of the construction of the project for the which the account has been opened.

Smith and Ken’s QA

2. Why does the Developer need to borrow cash?

With the trust account laws in Dubai, Developers have to have the funds in place in order to build their projects without using the purchaser's funds, and can no longer use the money from purchasers until the project is complete. They can, however, claim back a percentage of the money once the project has been launched which calculates to around 8% of the value of the project. In order to launch the project, the Developer needs money, and with their money tied up in escrow accounts(what money are they referring to here…this makes no sense) they can't launch. Hence the creation of the Buy Back facility providing the Developer with the cash to launch, releasing further funds, allowing/enabling the Developer to pay the Buy Back within either a 6 or 12 month timescale.

Doesn’t make much sense does it? The funds they need are for marketing and launch, which theoretically should produce sales, which then will lead to funds in escrow as trust law requires each project to have a separate escrow account. So, what additional funds are going to be released? Are S&K referring to other projects in which their money is tied up? To come up with 54million through the 5% release the escrow account needs to have 1billion aed in it. So, that is a pretty weak explanation. My guess is they are treating this as a free ride. They have bought the land and the only way to make any money of it is by launching a project. So, they cut a deal to come up with the funds for launch knowing that once they have a launched project that is generating some sales they can more easily fund their ops. If they are dead wrong, well then the land goes to Smith and Ken at a fraction of what M group paid for it. Seems sweet for S&K, but then again I am sure the details here are not as clear as we think. But in this market you never know.

Ironically, the notable headline of last week was angry investors looking for Imran Khan of Al Barakah Investments, who has failed to deliver the 50% returns he promised more than 100 investors who made down payments on Ajman and Dubai projects. Mr. Khan has presumably defaulted on his post dated checks and is now seeking time to repay these investors. In an emailed statement he says and I quote, “I am out of touch with the outside world and the real estate market in Dubai for more than a month now. Due to the above, I am not in a position to make a realistic forecast of the future.” I guess Mr. Khan is learning the hard lesson that actual returns can and often do vary greatly from expected or anticipated returns. Had he done just a little bit of reading before he formed his investment firm he would have known that promising or guaranteeing returns via post-dated checks to investors could end up very badly for him. He goes on to say that he “deeply regrets the we are in this unfortunate situation..I never expected the real estate market to come to such a standstill.”

But Mr. Khan isn’t the only person at fault here. Investors who were willing to put up money thinking there was such a thing as a guaranteed 30%-100% return in a six month time frame should have known better. Enter irrational exuberance and the madness of crowds. If people were willing to spend 20x their annual salary or the equivalent of 12 acres of land for one tulip bulb in the 1600’s, we should not be shocked by their willingness to put up money for a piece of property. This is why we need regulators to step in and create as many possible obstacles to stand in the way of self-destructive human behavior.

I am not calling for mass regulation, but rather just some level of oversight that prevents irresponsible behavior like the aforementioned “guaranteed” profit schemes. The people or entities propagating these schemes could be fairly characterized as reckless or even moderately deceptive. If you wanted to take it to the next level you could argue that some of them were being fraudulent as they knew that ultimately what they were selling was a ponzi scheme(which btw we’ve had a few of the plain vanilla variety in the UAE and Middle East in general over the past couple of years) that would leave some investors hanging dry. A good first step might be that RERA prohibits any marketing in which profits are guaranteed to investors or forces any marketing material to contain a disclaimer warning investors that actual returns may differ from anticipated returns.

It would be a step in the right direction for this market and would ultimately give other investors confidence that precautions were being taken to look out for their interests.

Wednesday, December 10, 2008

Regional Rental Inflation in a Global Deflationary World

On a side note, I’d like to throw in my two cents on the rental inflation argument made in the real estate report I referred to in my last post. According to the Khaleej Times (http://www.khaleejtimes.com/DisplayArticle08.asp?xfile=data/business/2008/December/business_December225.xml&section=business), the report stated that the “continued pick up in the rental market will prop up Dubai property prices with no signs of rental inflation slowing down with demand growing in outskirts like Jebal Ali and the Dubai-Abu Dhabi corridor”.

I do not buy this argument. To say the least the authors appear to be very static with respect to their assessment of the local market. I understand the tried and true argument of rents rising as end users switch from buying to renting in a typical real estate market. However, this argument does not strike me as very persuasive when it comes to Dubai properties. Why? Well, to put it simply this is not a true end user market, at least not yet. Most renters in Dubai were not choosing between owning a unit and renting one when the real estate market was booming. In fact, the actual demand/supply imbalance in Dubai and lack of available housing was largely being driven by hoarding of properties by investors parking money in local real estate with no intention of renting out the units. The incentive to rent a unit, floor, or recently completed building is not very high when you can sell it in a matter of months for a 30% premium or 150% realized gain if you were typically geared. Furthermore, rent controls in a booming real estate market provide a significant incentive for land lords looking to cash in on the boom to treat their properties like stocks and just hold them for capital appreciation, as an unrented unit is easier to sell in an economy with rampant inflation and negative real interest rates. So, if a 2000 sq ft 3br was renting for 350,000 aed a year in July when the prices in Downtown Burj Dubai were as high as 3500aed/sqft, I do not believe the rent on this unit is not going to come down significantly. Yes, the rental yield may rise, but the absolute rental price will fall as the selling price declines drastically from the July peak. There have been a few units in southridge listed for around 1600-1700 per square foot. Current rents being demanded for these units are between 180-210k per annum. This implies rental yields of over 7%. Personally, I believe yields will fall below 5% as rental supply starts to dwarf demand, but at even a 5% yield the asking price should be closer to 120-140k. Thus, the prospects for rental inflation in Dubai are in my view next to nil, particularly in the midst of a global deflationary shock.

"Deflation, Dubai, and GCC Growth Revisited"

There is a somewhat cautiously optimistic report out today saying that the temporary sting in the UAE property market is likely to be short lived. First, I would like to say that I hope this report is right, and I want to commend the authors for providing us with something potentially uplifting in the midst of all this gloom and doom. However, I do have to question exactly what it is they are basing this view on beyond mere wishful thinking.

The three major trends of the last 24 months have not only slowed and changed course but they have utterly imploded.

They are:
1) Dubai’s booming Real Estate Story
2) The GCC’s booming Oil Story
3) The overall boom in emerging financial markets

All three of these interconnected broad investment themes have slowed, reversed direction, and then proceeded to fall off a cliff in a matter of four months. The real estate story in Dubai was for the most part a function of themes two and three as the Emirate managed to leverage the surrounding wealth in the region and boom in emerging market real estate investing to fund its aggressive development. However, investors are not stupid, and foreign flows don’t find their way into a region whose major revenue source declines 73% in 5 months. The health of the real estate market in the UAE, if health is measured by a consistently upward sloping price graph (I would tend to disagree with the view of price as a determining factor but I’ll save that for another blog), is directly tied to the price of crude. This is a harsh reality that people in this region still have a hard time accepting. While I will concede the progress has been made with respect to diversifying the economies of the oil producing GCC nations, the reality is that they have for the most part barely scratched the surface. 2008’s record surpluses will turn into current account deficits at current crude prices. All things being equal, when you factor in the accumulated wealth during the oil boom this is not exactly a disaster, as the GCC should be better off than most other emerging economies. Problem is all things are not equal. The region has massive infrastructure plans that were predicated on a sustained oil driven liquidity boom. The marginal liquidity coming in was quickly being soaked up by future long-term investments. This means that liquidity at the margin needed to stay positive to sustain the increasingly ambitious plans of regional developers. Why? Well, simply put your ability to finance future growth plans through external capital inflows becomes seriously impaired when creditors and investors believe that your revenue growth has peaked. In most cases, you can dodge an economic shock if this scenario plays itself out gradually. However, if your major revenue source and liquidity provider collapses in a matter of months you will most likely find yourself in difficult situation. For Dubai, and several other GCC nations, the situation is exacerbated by the fact that they were operating a two pronged economic growth strategy. Not only were they borrowing against the future to fund massive and rapid current infrastructure projects, (I.E. building a long lived asset like a global city in a matter of five years with significant short-term funding) but they were also using accumulated wealth and borrowing against their future anticipated wealth to fund external acquisitions to complement their strategic vision and diversify their economies.(Think Sovereign stakes in pretty much every global financial company you can name, stakes in the likes of MGM, land mark real estate in N.Y. or London, football clubs in Europe, home builders in California, semi conductor makers, automobile companies, and ports) Thus, a global financial collapse coupled with a oil price implosion is going to pose a considerable challenge for the region, as both prongs of the economic development plan take a hit. Growth plans will need to be reined in, businesses re-sized and difficult decisions will have to be made with respect to foreign asset allocation.

I didn’t think oil would reach $147 and I also never thought it would hit $60 in a few months let alone the $40 it is at today. However, I am not going to plan my investment strategy under the assumption that the price of crude will rebound 100% in the next 4 months, and I assume the powers at be won’t be doing the same. Oil is an enigma and I have given up trying to come up with a fair price for it. All I know is that the world definitely relies on it, it has been at the heart of every major conflict over the last 100 years, and the West has always gone to great lengths to control it. Therefore, I won’t rule anything out with respect to the recent crazy price swings. But at the same time, I think one needs to be realistic about what impact a depressed oil price of even 6 months is likely to have on this region.

In my humble opinion, the real estate market will most likely follow the equity markets and oil market with respect to its correction. This is the most probable outcome. Many people will argue to the contrary, but I have hard time believing that this will be the case. If Emaar shares can fall 80% and crude can decline 70% then I see no reason to believe that very leveraged residential property won’t meet the same fate. History has proven that the belief that any one investment can be “unique” or “safe” is a complete and total fallacy that holds up only until conventional wisdom provides evidence to the contrary.

Keynes once stated that an

“investment becomes reasonably ‘safe’ for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are "fixed" for the community are thus made "liquid" for the individual.”

When the convention is broken in a matter of months an investment is no longer perceived to be reasonably safe, as the investor has just witnessed a period in which he did not have sufficient time to revise his judgment and alter his investment. This is the problem with bubbles, and right now, we are getting a nasty dose of the illiquidity that comes with a breakdown in conventional wisdom.

My Top Five Ways to Ride Out the Global Economic Crisis

1) Cryogenically freeze yourself. Set the time lock for five years and hope that by the time you thaw aggregate demand has finally caught up with aggregate supply at an equilibrium point that can sustain your desired standard of living.
2) Hop on a plane and hope that you manage to find your way to the “Island”. There you can spend the majority of your time trying to figure out what the Dharma Initiative is while you dodge “the others”. If you are lucky, the time warp phenomenon will allow you to skip several years of economic malaise at the cost of no more than one year of your natural life.
3) Give up on capitalism and senseless
4) wealth accumulation and join the Peace Corps
5) Become a Buddhist monk and spend the next five years focusing on your spiritual self
6) Find and Ivory Tower that is willing to let you inside its walls.