Market Update: 12 18 08 _ Bernanke is fighting Depression and he's not using Zoloft

Bernanke’s fighting Depression and he’s not using Zoloft. 

As we’ve moved from the summer of 2007 to December of 2008 we’ve seen a shift from “all is well” to “Katie, bar the door”.  We have seen a long string of increasingly aggressive and relentless shots fired by the Treasury and the Fed…but what are they shooting at?  To the casual observer it could easily appear that they are in full bore “reactionary” mode just hopping from one problem to the next and trying to rescue everyone they see along the way.  Up until November of 2008 when the National Bureau of Economic Research made the official declaration that we are in recession, there was still a good bit of talk about whether we’d actually post the two consecutive quarters of negative GDP growth required to hit the technical definition of recession.  The NBER came out and said it matters not…things stink so bad we’re calling it before we get the two negative quarters. 

We’ve all seen the drastic measures being taken by everyone from the Fed and Treasury, to Congress, the White House and beyond.  We’ve seen a 40% drop in the stock markets, a 70% drop in commodities prices, and as of September’s Case Shiller National Composite Index a 21% drop in home prices on a year over year basis.  We’ve seen federally insured money market accounts, federally insured corporate bonds, increases in federally insured bank deposits…at times it seems like the only thing not insured by the federal government is my truck.  We’ve seen massive capital injections at banks around the country, we got a look at the list of “too big to fail” companies and it turned out to be much larger than I suspect anyone thought it could possibly be.

The question becomes “Why?” 

Do governments do ALL of THIS to avoid two puny quarters of negative GDP growth?  I would say no…they don’t do all of this to avoid a mere recession.   Why turn so many laws of finance and economics on their heads?  Why use such vast amounts of government intervention in the free markets?  You do it because you are trying to avoid something much more sinister than two quarters of negative GDP. 

If we jump in the time machine and go back to 1933 we can listen to a highly regarded and widely studied economist by the name if Irving Fisher.  Mr. Fisher lived through the Great Depression and to this day his work on the Debt-Deflation Spiral forms the basis of many reports on the period.  In today’s market update I’m going to speed through Mr. Fisher’s work then move on to some of Bernanke’s analysis on the Great Depression and the lessons learned from that event.  I’m going to move quickly taking large strides; providing references for anyone that wants to move through the material in smaller steps.

Rather than write at length on Fisher’s work I’ll provide insight by quoting material from his paper “The Debt Deflation Theory of Great Depressions”.  I think some quotes from this work will be immediately relevant to our current situation.

Why was the Great Depression so great?

Fisher’s work centers on the interaction of over-indebtedness and deflation.  In isolation the ill effects of either deflation or over-indebtedness produce less damaging outcomes…but the two in combination form a potent brew that kills economies.  In 1933 he recognized that over-indebtedness generally occurs when there are “new opportunities to invest at a big prospective profit, as compared with ordinary profits and interest…easy money is the greatest cause of over-borrowing.  When an investor thinks he can make over 100 per cent per anum by borrowing at 6 per cent, he will be tempted to borrow, and to invest or speculate with borrowed money.  This was a prime cause leading to the over-indebtedness of 1929.”

“Just as a bad cold leads to pneumonia, so over-indebtedness leads to deflation. And, vice versa, deflation caused by the debt reacts on the debt.  Each dollar of debt still unpaid becomes a bigger dollar, and if the over-indebtedness with which we started was great enough, the liquidation of debts cannot keep up with the fall of prices which it causes.  In that case, the liquidation defeats itself.  While it diminishes the number of dollars owed, it may not do so as fast as it increases the value of each dollar owed.  Then, the very effort of individuals to lessen their burden of debts increases it, because of the mass effect of the stampede to liquidate in swelling each dollar owed.  Then we have the great paradox which, I submit, is the chief secret of most, if not all, great depressions: the more the debtors pay, the more they owe.  The more the economic boat tips, the more it tends to tip.  It is not tending to right itself, but is capsizing.”

Fisher goes on to say that “if the over-indebtedness is not sufficiently great to make liquidation thus defeat itself” then it’s not that big of a deal and we’ll have a more normal run through the business cycle.

With regard to the deflation portion he writes “unless some counteracting cause comes along to prevent the fall in the price level, such a depression as that of 1929-1933 (when the more you pay the more you owe) tends to continue, going deeper, in a vicious spiral, for many years.  There is then no tendency of the boat to stop tipping until it has capsized.  Ultimately of course, but only after almost universal bankruptcy, the indebtedness” must get smaller.  “This is the so-called natural way out of a depression, via needless and cruel bankruptcy, unemployment, and starvation.”

He concludes that had there been no massive government intervention the Great Depression “we would soon have seen general bankruptcies of the mortgage guarantee companies, savings banks, life insurance companies, railways, municipalities, and states.” 

Hmmm…anybody know of any problems in the financial guaranty companies, banks, insurance companies or municipalities?  

What’s the fix?

So Fisher warns of over-indebtedness and deflation being a bad combo.  What does he propose as the answer to this dilemma? 

“ On the other hand, if the foregoing analysis is correct, it is always economically possible to stop or prevent such a depression simply by re-flating the price level up to the average level at which outstanding debts were contracted by existing debtors and assumed by existing creditors, and then maintaining that level unchanged.” 

That is a heck of a quote in a month where we’ve seen Fannie and Freddie suggest that we can use the OLD APPRAISAL value for the house when doing a refi.  Fannie and Freddie have essentially floated a plan in which the assumed value for the home being refinanced will be the one at which it was initially contracted…bingo…right out of Fisher’s playbook for avoiding a great depression. 

Bernanke 1983

That is as brief a summary of Fisher’s work as I can provide without diluting it.  THAT leads us to a paper that Ben Bernanke wrote in 1983 titled “Nonmonetary Effects of the Financial Crisis in the Propagation of the Great Depression.”  I think the alternate title was “Bens take on the Big One” but it didn’t have an Ivy League ring to it. 

Bernanke’s paper starts off with a summary of the causes of the great depression.  Of special interest is the following quote from Ben “The disruptions of 1930-1933 reduced the effectiveness of the financial sector as a whole in performing these services (intermediation).  As the real costs of intermediation increased, some borrowers (especially households, farmers, and small firms) found credit to be expensive and difficult to obtain.  The effects of this credit squeeze on aggregate demand helped convert the severe but not unprecedented downturn of 1929-1930 into a protracted depression”.

If that doesn’t sound familiar, you must not be listening.  With that statement from Bernanke in 1983 as a backdrop it becomes startlingly clear why he is moving heaven and earth to unfreeze the credit markets.  He fears that the inability of households and small firms to get access to credit is a primary driver that can cause a recession to become a full blown depression.  

Bernanke goes on to point out the two primary components of the financial collapse in 1930-1933 were “the loss of confidence in financial institutions, primarily commercial banks, and the widespread insolvency of debtors.”

I think Bernanke got a good scare when Leman brothers failed and the money markets ran for the door.  He has been fighting a crisis of confidence at every turn since then.  They’ve insured just about everything under the sun since Lehman failed in an effort to restore confidence in the financials.  Given his statement above one can see why he attaches such importance to this.

The paper goes on to point out the many differences in the structure of the banking system between 1933 and today.  It is true that there are many important differences, but it is equally true that if you end up at a point where you have over-indebtedness plus lack of confidence in the financials and then you add deflation…it really doesn’t matter HOW you got to that point…what matters is that you are there, and according to Fisher, Bernanke, and others…you are in deep trouble.

What is Bernanke’s conclusion?

After providing page upon page of math and the assumptions used in all of the statistical models and all of the other stuff you have to include in a paper to keep the academics happy, Bernanke gets around to providing his insight on what helped to end the Great Depression.   Here again we see his words from 1983 in action in 2008.

“March 1933 was a watershed month in several ways: It marked not only the beginning of economic and financial recovery but also the introduction of truly extensive government involvement in all aspects of the financial system.  It might be argued that the federally directed financial rehabilitation- which took strong measures against the problems of both creditors and debtors – was the only major New Deal program that successfully promoted economic recovery.”

Knowing that statement above was written by Bernanke provides a good bit of color into what is going on inside the Fed.  The Chairman sees government intervention in the markets and strong action against the problems faced by both debtors and creditors as very important pieces of the solution…perhaps THE most important pieces of the solution.  Now we can look at the plans for loan modifications from a new angle.  The new Hubbard-Meyer plan calls for the government to get right in the middle of the refi business by asking the bank to take a write-down that will be shared with the government so the homeowner can refi a lower balance and reduce his monthly payment…at the same time the homeowner sacrifices appreciation potential up to the amount of the write-down.

Bernanke on how it worked:

“The Government’s actions set the financial system on its way back to health; recovery was neither rapid nor complete.”  We all read the verbiage of the FOMC statement this week where they told us rates were likely to remain exceptionally low for “some time”.  Sounds a bit like the concept in the quote above.

“Deposits did not flow back into banks in great quantities until 1934 and the government had to pump large sums into banks and other intermediaries.”  Clearly there have been many steps taken to reduce the chance of these deposits ever flowing out of the banks in the first place…two new tools created to combat this particular problem have been the new $250,000 insurance limit on interest bearing deposits and insurance on unlimited amounts of non-interest bearing transaction accounts.

Bernanke on mortgages after the Great Depression:

“Home mortgage lending was another important area of credit activity.  In this sphere, private lenders were even more cautious after 1933 than in business lending.”

“To the extent that the home mortgage market did function in the years immediately following 1933, it was largely due to the direct involvement of the federal government.  Besides establishing some important new institutions (such as the FSLIC and the system of federally chartered savings and loans), the government “readjusted” existing debts, made investments in the shares of thrift institutions, and substituted for recalcitrant private institutions in the provision of direct credit.  In 1934, the government sponsored Home Owners Loan Corporation made 71% of all mortgage loans extended.”

Bernanke spends a good bit of time in his analysis addressing the difficulty for home owners and small businesses to get access to credit.  He also assigns a great deal of credit to government intervention for alleviating that pressure.  We see many signs of this today as the TARP money is deployed and the government is pushing for banks to lend, plans are being pondered to allow the government to split losses with banks and provide loans to homeowners to help refinance, and there are potential plans allowing Fannie and Freddie to use the “old” appraised value for a home that is doing a refinance.  There are a lot of tools being brought to bear on the problems we have.  Most of these tools have their roots in lessons learned from the Great Depression. 

Bernanke’s Summary:

“Summarizing the reading of all of the evidence by economists and by other students of the period, it seems safe to say that the return of the private financial system to normal conditions after March 1933 was not rapid; and that the financial recovery would have been more difficult without extensive government intervention and assistance.  A moderate estimate is that the U.S. financial system operated under handicap for about five years (beg of 1931 to end of 1935)…this is consistent with the claim that the effects of financial crisis can help explain the persistence of the depression.”

My summary:

If I see a man with a fire hose I have to assume he’s going to fight a fire.  As I consider the totality of the government’s actions to date, I see that they are using all of the tools recommended for fighting a depression.  The only rational conclusion I can draw is that the fear behind closed doors at the highest levels is that this recession gets away from us and we slip right on into another great depression.  We clearly started out with the classic over-indebtedness of consumers, we then got our dose of lack of confidence in the financials, we then moved to consumers and small businesses having their access to credit restricted, we’ve seen deflation in asset prices and are beginning to see some small signs of deflation in general prices as well.

With that in mind I would expect to see the government do exactly what Bernanke says helped in 1933…they will be heavily involved in every aspect of this economy, especially when it comes to maintaining faith in the financial system and helping homeowners and small business maintain access to credit.

I’ve had a regional Fed president tell me recently that a depression isn’t what they’re worried about but at this point I’d have to ask “if you’re not worried about a fire…what’s with the hose?”

What does all of this tell us?

How does this information impact my investment activities today?  We know that Bernanke is not going to tolerate a crisis of confidence in the financials.  We know from reading his work on the subject of the great depression and from watching his activities over the last year that he is committed to doing everything possible to keep that problem from developing. 

Most importantly from the perspective of investing, is that many of the big financials (firms with names such as JP Morgan, GE, and Bank of America to name a few) have been given the backing to issue Full Faith and Credit paper through the TLGP program.  What better way to restore confidence in financials than to magically make them the same credit quality as the US Treasury?

Short corporate bonds from these issuers appear to have exceptional value.  The issuers have the ability under the TLGP to refinance 125% of their existing debt on a full faith and credit basis.  This drastically lowers the firms cost of debt which puts them all on a much more solid foundation (as Bernanke would like), at the same time they are receiving capital injections from the government to support them on a wider scale.  These are the biggest names in an industry that Bernanke says MUST be protected. 

They aren’t going to refinance all of the debt at one time.  There is plenty of paper trading in the secondary market that does NOT carry the full faith and credit guaranty, but this paper obviously benefits from the issuers ability to issue full faith and credit TLGP paper. 

This non-guaranteed paper is trading at huge spreads to the TLGP issued full faith and credit paper.  This leads us to ask “is it realistic that the government would be guaranteeing billions of dollars of debt for companies in the TLGP only to let them go out of business 4, 5, or 6 months or 2 years later?”

It is our opinion that the government will not allow large firms in critical industries that they are actively supporting, and to whom they are providing debt guarantees, to fail.   

Later this week and early next week I’ll be putting out a more detailed analysis of opportunities available in this sector.  To provide you with a glimpse of the value consider JP Morgan paper that is being issued under the TLGP program. 

3 year bullets from JP Morgan issued under the TLGP traded yesterday at a 1.27% yield level.

1.5 year bullets in the secondary market (the non-insured bonds) from the same issuer were at a 4.55%.

If you think the government is going to let JP Morgan (or any of the big financials) go under despite everything they’ve said and done to the contrary, then clearly the corporate bond is not a good option for you.  However, if you think the support of the US Government will allow JP Morgan to be with us in 1.5 years, then you have a huge opportunity to pick up product at much more attractive levels than are available in other sectors.  If you are of this opinion then short corporate bonds from these issuers should play some part in your investment plan over the near term. 

As a final note I’ll mention that Treasury Secretary Paulson said earlier this week that he expects no more of the large financials to fail this cycle.  He believes that the combined efforts of the Fed, the Treasury and central banks around the world will enable all firms with systemic risk to remain viable.

Short corporate bonds from these issuers offer a great shelter from the storm of low yields we are experiencing currently.  If you need to see levels on these today just shoot me an e-mail, otherwise look for further analysis to be forthcoming shortly.

 

Market Update: 12 10 08 Congress scares me

This morning we’ve got CSPAN on in the background to keep up with the latest house hearings on the TARP program. Each time a congress person speaks I’m reminded of why our problems are going to be with us for a while. Here is a big part of the problem...I heard a politician say the following:

“the problem is that to date the Treasury hasn’t come up with a loan modification program to help worthy borrowers stay in their homes.”

This congress person is one of many that are in a position to influence the course of this “financial rescue/bailout/TARP boondoggle/yard sale/circus” and they don’t even understand that WORTHY borrowers don’t need loan modifications. Worthy borrowers can manage their finances, worthy borrowers pay you back, worthy borrowers honor their commitments. I heard a lot of talk in those hearings from politicians telling banks how to run their shop. I heard no mention of credit quality from those that are pushing banks to deploy the TARP money in loans. The rhetoric is essentially “we gave you this TARP money now you need to go lend it out in the same manner that got us into this mess. Loan it to anybody…give people more loans and credit cards regardless of whether they can pay you back.” I find it disturbing…we just turned off the TV.

Asking congress to fix the financial crisis is like asking the trash man to do brain surgery (no offense to any sanitation engineers that may be on this distribution list).

What’s available?

As I look across the short end of the yield curve I see lot of products trading at yield levels lower than one-quarter of one percent.

Fed Funds 6 basis points (per Bloomberg)

1 month T bill 2 basis points

3 month T bill 1 basis point (yesterday this was a negative 1 basis point)

1 year T bond 46 basis points

On the short end banks have been buying a lot of seasoned MBS paper at great spreads. Short corporate bonds with “A” or better ratings that have also received government support are trading at very high spreads to Treasuries and offer a great alternative to Fed Funds. We’re seeing 3 to 6 month paper in this sector trading anywhere from 3% to 7% (these are the same companies that are CURRENTLY issuing FULL FAITH AND CREDIT PAPER under the TLGP program!). Agency Callable bonds in the 1 to 3 year range are trading from 1.3% to just over 3.00%.

On the longer end, seasoned 20 year SBA paper has been in high demand due to the full faith and credit guaranty, monthly cash flow, and wide spreads. One additional benefit is that the cash flows on SBA paper are driven by different factors than MBS cash flows, which provides a nice bit of cash flow diversification for those that already have a high concentration of MBS in the portfolio.

There is a brand new bond available to you…Full Faith and Credit Corporate bonds issued through the TLGP program. These are corporate bonds that are 20% risk weighted that carry the explicit full faith and credit guaranty of the US Government. The TLGP Full Faith and Credit guaranty runs through June of 2012. If you buy bonds that mature on or before that date you have the same credit quality as a US Treasury bond. Two examples are:

Regions Bank 3.25% due 12/09/11 offered at approximately a 3.13% yield. That is 200 bps over the 3 year Treasury…on a full faith and credit, 20% risk weighted, corporate bullet.

Suntrust Floating rate bond due 12/16/10, full faith and credit, floats at 3 month Libor +65 bps…currently a 2.09 yield (109 bps over Target Fed Funds).

What to watch for:

Spreads on Agency bonds over Treasury securities have been widening since May. This spread widening is the reason the Agencies haven’t been able to call a lot of their outstanding debt. In a more normal market the Agencies would have had a tremendous opportunity to refinance a large percentage of their outstanding debt by calling bonds and re-issuing them at lower rates. Spreads have begun to tighten recently and we’ve already seen an uptick in called bond activity. With Treasury yields at 60 year lows it won’t take much in the way of spread tightening on Agencies to unleash an avalanche of called bonds. We have analytics available to help you monitor bonds that are likely to be called based on current rates. If you’d like to monitor your potential cash flow volatility with this report just let us know and we’ll get you set up.

After reaching a crescendo in November, MBS spreads have tightened dramatically over the last few weeks. The Treasury and the Fed are committing a lot of resources to drive spreads on MBS product lower. The graph below shows the benchmark 15 year current coupon MBS yield as a spread over the 5 year Treasury. That spread has collapsed from 311 basis points in mid-November to 210 basis points this morning. The long term average spread on this index is around 125 basis points. There is still room for more spread tightening as we move through this crisis toward a more normal market.

The Fed Funds futures market continues to price in a 100% chance of a 75 basis point cut at the December 16 FOMC meeting…this would put the target rate at 25 basis points. The Fed will pay you the target rate so you could get that level from them…correspondent banks will likely be paying far less. If you’re looking for places to keep short term liquidity…Fed Funds will likely remain the least attractive option.

If you have any questions on this material or if there is anything I can be doing for you just let me know.

Market update: 12 9 08 - 3 month T-Bill yields go negative

You’ll see from the screenshot below that the 3 month T Bill is trading at a yield of -0.01%. This means that if you give the government $1,000,025.56 tomorrow…in three months they’ll give you back $1,000,000 even. Don’t all call me at once to take them up on this deal…I couldn’t handle the call volume.

Fed Funds futures are currently indicating a 100% chance of a 75 basis point cut in the overnight rate which would take us down to 25 bps. Most correspondents are paying far less than the current target rate of 1.00% as it is…I can’t wait to see what they offer when the target rate is down to 25 bps. One small comfort is that Fed will pay you the target rate for funds you deposit with them.

A very attractive alternative to Fed Funds at these levels has been short, high quality corporate paper. There are plenty of financial firms that have paper trading in the secondary market with very short final maturities and very wide spreads to Treasuries.

Issuers like Bank of America, Goldman Sachs, JP Morgan, Morgan Stanley, American Express…these are issuers that are currently issuing FULL FAITH AND CREDIT PAPER via the FDIC program.

This FDIC program presents us with a great opportunity. You can buy secondary paper from these issuers that wasn’t issued under the FDIC plan at much higher yields. Part of the yield difference is attributable to the fact that the secondary pieces do not carry the full faith and credit guaranty. Part of the difference is due to the inefficiencies that popped up in the money markets when the normal buyers in that market ran to the short end of the curve (see the negative yield on the 3 month bill above).

So there are now short maturities available at very wide spreads from issuers that have the US Government propping them up with liquidity injections and new debt guarantees.

As we see these short bonds with A or better credit ratings, government provided capital, and government backing of their new issue debt we have to ask…is it reasonable to believe that the government would do all of this to keep this firm in business, and then let it fail in the next four months?

If you have an interest in seeing short, high quality corporate bonds with high spreads to Treasuries to use as a Fed Funds alternatives just let me know and I can get you on the distribution list.

Market Update: 12 8 08_Non-Performing Assets comparison

So did you hear the big news on Friday? Yep…OJ finally got some jail time. Oh yeah, and Initial Jobless claims came out about 200,000 higher than the estimate. TWO HUNDRED THOUSAND HIGHER THAN THE ESTIMATE of 335,000. I was on the road last week, and when I checked the news I thought it was a misprint or that my eyes were going bad. It is difficult to recall a number that outran the survey by that amount…especially a big important number like that one. The number was so bad that it surpassed the worst expectations of all 73 of the dismal scientists surveyed.

Fridays report brings the number of job losses this year to 1.9 million. Last year you could look around and find plenty of people saying that we weren’t likely to have a recession and that if we did it would be a mild one like the 2001 recession. I’m looking around now that we’re “officially” 12 months into this thing and I can’t find any of those folks. The length of the average recession in the US in the post WWII era is 10 months. The 2001 recession lasted 8 months. We are 12 months into this one, we appear to still be headed downhill, and we’re speeding toward the 16 month record of the 1981 to 1982 recession that most economists have been using as our worst case benchmark. 2008 has been an exceptionally volatile year but at this point it looks like 2009 is shaping up to be the one everyone remembers.

533,000 people lost their jobs last month. That ripple effect from a number that big will have far reaching and long lasting effects throughout the economy. Those are 533,000 Americans that may have credit card balances, that may have auto loans, home loans, home equity lines, they used to spend money going out to eat, going on vacation, buying (insert your holiday here) gifts, and they just lost their jobs. The numbers show that the average American has very little in savings, and with all major stock indices down they will have a far smaller cushion to land on if they have one at all.

I spoke with a number of bankers last week and while many are wrapping up a decent year in 2008 they are all looking at 2009 with a bit more caution. Loan problems are popping up everywhere. Problem loans are now a topic of conversation at banks almost everywhere. As I sat in the airport on the way home I got to thinking about problem assets this recession vs the 2001 recession. I thought it might be interesting to look at Non-Performing Assets as a percentage of Total Assets over the two time periods. Saturday afternoon I only had two things on my schedule…to give my 100 lb dog a bath which he sorely needed, and to put together an analysis on Non-Performing Assets across two recessions. How hard could it be? The dog turned out to be the easier job.

I thought the best way to show the data would be with the heat maps below. These allow me to show activity by regions (by county in this case). Below you will see two maps. I took data for the current recession (4^th Quarter 2007 through 3^rd Quarter 2008) vs the 2001 recession (I used 4Q 2000 through 4Q 2001) and I plotted the CHANGE in Non-Performing Assets as a percentage of Total Assets for all commercial banks in the country for which I had data. All in all we’re talking about 6,087 banks for the 2001 recession and 6,984 banks for the current recession.

The first thing I noticed when doing the math was the absolute range of values for NPA’s between the two periods. In 2001 the worst bank in the pool had an 18% increase in NPAs and the best bank reduced their NPA’s by 8%.

Over the course of the current recession the worst bank (worst that is still filing call reports) had an increase in NPA’s of 31% and the best bank had a reduction of 38%. The magnitude of the changes is enormous.

The averages provide an alarming contrast between the two periods. The average INCREASE in NPA’s at banks in 2001 was 0.09 as a percentage of Total Assets. In the current recession that has ballooned to 0.81…that is an 800% increase from the 2001 number.

You’ll notice in the first map that there were not a terribly high number of banks that saw more than a 4% increase in NPA’s in 2001 (dark red areas). Much of the country was unchanged to improved (light blue areas) or had only modest increases in the NPA’s (light pink areas). There were some areas that saw NPA’s increase by 1% to 4% but they were in pockets separated by great distance and didn’t seem to follow any pattern.

By contrast the second map below virtually explodes with concentrations of dark pink (1% to 3% increase in NPA’s) and dark red clusters (NPA increases over 4%). Clear trends of very poor numbers are immediately evident this time. The west coast, the southeast, the rust belt, and many places across the middle of the country are struggling with NPA’s.

What makes this picture worse is that we appear to still be on the way down with the economic data showing no signs of improvement over the near term. Against this backdrop one begins to see the urgency at the Fed and the Treasury.

I hope you find the data below useful. If you have any questions on this material just let me know.

Market Update: Citigroup gets rescued

When I was a kid and I did something stupid (yes…that was known to happen) my dad would ask me “if everyone was jumping off a bridge would you do it too?” There is a long list of financial firms that could have benefited from that rhetorical line of questioning over the last few years. Maybe there is a spot on Citigroup’s board for my dad. If I know him I bet he’d ground them getting in this much trouble.

Citigroup has become the latest bail-out benefactor. The US Government has given them $20 Billion in capital and has committed to $306 Billion of guarantees to backstop their troubled investments. As part of the deal, Citi is issuing $27 Billion worth of preferred shares to Uncle Sam with an 8.00% dividend. The Government also gets warrants enabling it to buy 254 million shares of Citi at a strike price of $10.61 which in theory should allow the tax payer to profit if the plan works. Payment of dividends is limited to 1 cent/share over the next three years, a significant reduction from recent dividend levels. Regulators were concerned that depositors may begin a run on the $2 Trillion institution and upset the “stability” of the financial system. We’re now to the point where it would be more surprising if someone DIDN’T get rescued than if they did.

The asset guarantee portion of the agreement has Citi soaking up the first $29 Billion worth of losses on the troubled assets, after which the government takes 90% of the losses and Citi takes the remaining 10%. Unlike some of the other bailouts…nobody at Citi is required to lose their job. Nobody at the TOP that is..Citi announced last week that they’d be firing 52,000 people…THOSE people will lose their jobs…but the Treasury plan replaces nobody in senior management.

Here is a look at what Citigroup shareholders have had to look at over the last few months:

In addition to covering losses at Citigroup, the Treasury said they would cover anyone who lost money on the Philadelphia Eagles yesterday. They cited the fact that the market mechanism for the Eagles winning the game had broken down (Donovan McNabb went 8 for 18 with two interceptions and a fumble) and that they had to step in to keep the $500 million gambling market from collapsing. If people lost money on the game then the short term pool of liquidity that funds gambling operations across the country might shrink drastically and we can’t have that. Additionally the Treasury is considering guaranteeing credit card purchases of Christmas, Hanukah, Kwanza, and New Years gifts made between today and January second, as well as guaranteeing purchases of any big ticket electronics items made with Home Equity withdrawals over the same time period.

Fed Funds futures continue to price in a 100% chance of a 50 bps cut at the 12/16/08 meeting.

Despite being a short holiday week we actually have a pretty full calendar of economic data. Below is a list of what’s on tap. These releases will be watched with great interest as we move into December.

If you have any questions or if there is anything I can be doing for you just let me know.

Market update: 11 20 08 late afternoon....RECORD MOVE ON THE 30 YEAR BOND

 

 

I’ve been trying to write an update on the 30 year Treasury for the better part of an hour…I can’t get it done because every time I grab the screen shot the long bond jumps another quarter of a point.  I started this process when the 30 year was up about 5 points.  I looked around the office and nobody could remember the long bond being up 5 points in a single trading session…if it’s not a record it has to be close because nobody can remember the last time it happened.  I grabbed the screen and then it was up 5.5 points, then 6, then it kept going…currently the 30 year Treasury bond is up almost 9 points.  There is no story yet on what is causing the rush to the long end, but have no doubt that the 30 year is moving like a rocket.  As I type it’s now up over 9 points.  When I get some news I’ll pass it on…9 points in a single session has to be in record territory.  It is now yielding 3.44%. 

 

 

 

 

 

Below is a graph of the yield on the 30 year Treasury.  It opened this morning at 3.87%....it is now trading at a 3.44%.  I’ll update as things develop.

 

Steve Scaramastro

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Market update: 11 20 08 Initial Jobless Claims blow through the estimate

Initial Jobless Claims were expected to post a 505,000 level today…the number we actually got is 542,000. Continuing Claims were also released at higher levels than expected. The Philadelphia Fed Index for the second month in a row posted a very negative number. This index tracks manufacturing trends in the Philadelphia Federal Reserve District. This is a diffusion index so any number below 0 indicates contraction, conversely any number above 0 indicates expansion. Last month this index posted a very disappointing number…it did the same this month. The survey expected the Philly Fed to post a -35 but we actually got a -39.

Treasuries are running like a greyhound this morning pushing yields lower across the length of the curve. Starting on the short end of the curve you’ve got a one-month bill yielding 3 basis points, If you don’t like that you could stretch out and get a 1.00% yield on the current two year Treasury, and if that doesn’t float your boat you can score a whopping 3.20% on a 10-year Treasury.

Oil is down over $3.00 today and is teetering on the $50 mark. It has traded with a $49 handle today.

JP Morgan is quoted in an article this morning forecasting Fed Funds at ZERO in the next few months. I’ve attached the article and inserted it at the bottom of this e-mail for reference.

Today GMAC joins the list of “people that make bad decisions that then apply to become a bank holding company and probably will get permission to do so”. They applied this morning. Additionally word JUST ran across the screen from Senator Bond that a bipartisan group has agreed on an aid plan for the automakers…watch for this to develop.

After thinking about how wrong the Fed and Treasury have been since this meltdown began I went back to the summer of 2007 and pulled a few quotes from them that capture their outlook at the time. Our view at the time was much more negative than theirs and it seemed like they were doing more cheerleading than analyzing. So below are some quotes from both of them, followed by graphs of several key economic data that show what actually happened.

From the FOMC statement in August of 2007:

“Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.” 10 days later they changed their mind and cut the discount rate in an intermeeting cut and changed their outlook to “downside risk to growth”.

From the US Treasury economic update for August 2007:

“The U.S. economy and the job market are healthy, with sustained job growth, low unemployment, and rising wages. Solid fundamentals will support continued growth in household spending and business investment." Assistant Secretary Phillip Swagel, August 3, 2007

Since that time:

-Initial Jobless Claims have risen 67%

-GDP growth is down 105%

-Philly Fed Index is down 624%

-New Home Sales are down 40%

-the yield on the 5 year Treasury is down 122 bps

It does not comfort me that these are the same people that are making the decisions on spending Federal money that will decide how much my taxes will go up.

I got to thinking about this recently and I came to two potential solutions. Option 1 is I become a pirate…I hear there is good money to be made, plenty of opportunity, and apparently very little risk involved.

Second is that I stay here, pay a lot more in taxes but I petition the government to even the playing field. If the government wants to raise my taxes and use that money to keep paying a guy in Detroit $80/hr to install tail lights on SUV’s, and to pay for a subprime borrower on the coast to keep his house, then I think I should get some benefit from that. After all, why should my standard of living drop so that the irresponsible party can keep their standard of living? I propose that everyone that has their taxes go up because of this debacle gets assigned an autoworker and a subprime borrower. Each year the autoworker that gets my taxes has to drive me to the coast for a month while I vacation in the house of the subprime borrower that got the other part of my tax increase. The subprime guy will essentially be running a bed and breakfast type operation while I’m there…cooking…cleaning the room…basic hotel stuff. If either of these parties get tired of the arrangement they can agree to send back my taxes and I’ll go away. I see this plan as more fair than the current direction we seem to be heading.

I’ve attached below graphs of some of the key economic indicators that I discussed above.

If you have any questions on this material just let me know.

Below is an article from Bloomberg this morning that quotes JP Morgan as saying the Fed will likely take Fed Funds to zero very shortly.

Nov. 20 (Bloomberg) -- The U.S. Federal Reserve will probably cut interest rates to zero percent over the next two months to staunch deflation, according to JPMorgan Chase & Co.

The Fed will lower borrowing costs by 50 basis points at each of the next two policy meetings on Dec. 16 and Jan. 28, JPMorgan economist Michael Feroli wrote in a note to investors yesterday. The central bank will hold rates at zero for the rest of 2009 to prevent prices from spiraling down as companies cut jobs and banks reduce lending, stifling spending, Feroli said.

The Fed may not be the only central bank to begin offering free money to jolt life into their recessionary economies and keep prices rising as the 15-month credit crisis deepens. The Bank of Japan cut its benchmark rate to 0.3 percent last month, and the European Central Bank has signaled it's ready to lower rates further after two reductions in the past six weeks.

U.S. consumer prices plunged 1 percent last month, the most since Labor Department records began in 1947, the government said yesterday. Some Fed members indicated a willingness to cut rates to spur growth and keep prices from falling, according to minutes from the last Federal Open Market Committee meeting that were released hours after the price report.

``Taking the target rate to zero percent would not be costless for the Fed,'' Feroli said. Public confidence may drop ``if there is a perception that the Fed has `run out of ammo.'''

Fed officials cut their forecasts for inflation and growth at the Oct. 28-29 meeting. Some members saw a risk that the inflation rate will fall below the Fed's objective of ``price stability.''

Feroli said cutting the key rate to zero from the current 1 percent wouldn't exhaust the central bank's tools. The Fed could become ``more aggressive'' by purchasing the debt of Fannie Mae, Freddie Mac and other government-chartered mortgage financing companies, Feroli said.

``The path of least resistance may be for the Fed to first communicate to the markets that the nature of the current economic woes should keep rates low for an extended period,'' Feroli said.

To contact the reporter on this story: Jason Clenfield in Tokyo at jclenfield@bloomberg.net

Last Updated: November 19, 2008 22:35 EST

FW: Market update: 11 20 08 Initial Jobless Claims blow through the estimate

Initial Jobless Claims were expected to post a 505,000 level today…the number we actually got is 542,000. Continuing Claims were also released at higher levels than expected. The Philadelphia Fed Index for the second month in a row posted a very negative number. This index tracks manufacturing trends in the Philadelphia Federal Reserve District. This is a diffusion index so any number below 0 indicates contraction, conversely any number above 0 indicates expansion. Last month this index posted a very disappointing number…it did the same this month. The survey expected the Philly Fed to post a -35 but we actually got a -39.

Treasuries are running like a greyhound this morning pushing yields lower across the length of the curve. Starting on the short end of the curve you’ve got a one-month bill yielding 3 basis points, If you don’t like that you could stretch out and get a 1.00% yield on the current two year Treasury, and if that doesn’t float your boat you can score a whopping 3.20% on a 10-year Treasury.

Oil is down over $3.00 today and is teetering on the $50 mark. It has traded with a $49 handle today.

JP Morgan is quoted in an article this morning forecasting Fed Funds at ZERO in the next few months. I’ve attached the article and inserted it at the bottom of this e-mail for reference.

Today GMAC joins the list of “people that make bad decisions that then apply to become a bank holding company and probably will get permission to do so”. They applied this morning. Additionally word JUST ran across the screen from Senator Bond that a bipartisan group has agreed on an aid plan for the automakers…watch for this to develop.

After thinking about how wrong the Fed and Treasury have been since this meltdown began I went back to the summer of 2007 and pulled a few quotes from them that capture their outlook at the time. Our view at the time was much more negative than theirs and it seemed like they were doing more cheerleading than analyzing. So below are some quotes from both of them, followed by graphs of several key economic data that show what actually happened.

From the FOMC statement in August of 2007:

“Nevertheless, the economy seems likely to continue to expand at a moderate pace over coming quarters, supported by solid growth in employment and incomes and a robust global economy.” 10 days later they changed their mind and cut the discount rate in an intermeeting cut and changed their outlook to “downside risk to growth”.

From the US Treasury economic update for August 2007:

“The U.S. economy and the job market are healthy, with sustained job growth, low unemployment, and rising wages. Solid fundamentals will support continued growth in household spending and business investment." Assistant Secretary Phillip Swagel, August 3, 2007

Since that time:

-Initial Jobless Claims have risen 67%

-GDP growth is down 105%

-Philly Fed Index is down 624%

-New Home Sales are down 40%

-the yield on the 5 year Treasury is down 122 bps

It does not comfort me that these are the same people that are making the decisions on spending Federal money that will decide how much my taxes will go up.

I got to thinking about this recently and I came to two potential solutions. Option 1 is I become a pirate…I hear there is good money to be made, plenty of opportunity, and apparently very little risk involved.

Second is that I stay here, pay a lot more in taxes but I petition the government to even the playing field. If the government wants to raise my taxes and use that money to keep paying a guy in Detroit $80/hr to install tail lights on SUV’s, and to pay for a subprime borrower on the coast to keep his house, then I think I should get some benefit from that. After all, why should my standard of living drop so that the irresponsible party can keep their standard of living? I propose that everyone that has their taxes go up because of this debacle gets assigned an autoworker and a subprime borrower. Each year the autoworker that gets my taxes has to drive me to the coast for a month while I vacation in the house of the subprime borrower that got the other part of my tax increase. The subprime guy will essentially be running a bed and breakfast type operation while I’m there…cooking…cleaning the room…basic hotel stuff. If either of these parties get tired of the arrangement they can agree to send back my taxes and I’ll go away. I see this plan as more fair than the current direction we seem to be heading.

I’ve attached below graphs of some of the key economic indicators that I discussed above.

If you have any questions on this material just let me know.

Below is an article from Bloomberg this morning that quotes JP Morgan as saying the Fed will likely take Fed Funds to zero very shortly.

Nov. 20 (Bloomberg) -- The U.S. Federal Reserve will probably cut interest rates to zero percent over the next two months to staunch deflation, according to JPMorgan Chase & Co.

The Fed will lower borrowing costs by 50 basis points at each of the next two policy meetings on Dec. 16 and Jan. 28, JPMorgan economist Michael Feroli wrote in a note to investors yesterday. The central bank will hold rates at zero for the rest of 2009 to prevent prices from spiraling down as companies cut jobs and banks reduce lending, stifling spending, Feroli said.

The Fed may not be the only central bank to begin offering free money to jolt life into their recessionary economies and keep prices rising as the 15-month credit crisis deepens. The Bank of Japan cut its benchmark rate to 0.3 percent last month, and the European Central Bank has signaled it's ready to lower rates further after two reductions in the past six weeks.

U.S. consumer prices plunged 1 percent last month, the most since Labor Department records began in 1947, the government said yesterday. Some Fed members indicated a willingness to cut rates to spur growth and keep prices from falling, according to minutes from the last Federal Open Market Committee meeting that were released hours after the price report.

``Taking the target rate to zero percent would not be costless for the Fed,'' Feroli said. Public confidence may drop ``if there is a perception that the Fed has `run out of ammo.'''

Fed officials cut their forecasts for inflation and growth at the Oct. 28-29 meeting. Some members saw a risk that the inflation rate will fall below the Fed's objective of ``price stability.''

Feroli said cutting the key rate to zero from the current 1 percent wouldn't exhaust the central bank's tools. The Fed could become ``more aggressive'' by purchasing the debt of Fannie Mae, Freddie Mac and other government-chartered mortgage financing companies, Feroli said.

``The path of least resistance may be for the Fed to first communicate to the markets that the nature of the current economic woes should keep rates low for an extended period,'' Feroli said.

To contact the reporter on this story: Jason Clenfield in Tokyo at jclenfield@bloomberg.net

Last Updated: November 19, 2008 22:35 EST

Market Update: 11 19 08 Consumer Prices are falling like a barrel of oil

Treasuries are rallying this morning on a host of news showing more indications of a slowdown and lack of inflation. The 10 year Treasury is yielding 3.45% currently.

The economic news is driving things this morning. You’ll see from this morning’s release calendar that everything economic indicator came in lower than the survey expected. Consumer Prices fell by a full 1.00% last month. That is the largest single drop since record keeping began in 1947. The large drop in oil prices is largely responsible for this decrease. Over the course of about six months the headlines have moved from screaming about inflation to talk of disinflation to speculation about deflation.

Housing starts and Building Permits were both lower than expected and Mortgage Applications were down 6.2%.

Fed Funds futures are now pricing in a 100% chance of at least a 50 basis point cut at the Dec 16 FOMC meeting. 90% of the probability is placed on a 50 bps cut, the remaining 10% is placed on a 75 bps cut. The 75 bps cut scenario being assigned any probability at all just happened this week.

Below is a quick review of oil prices and the more broadly based Goldman Sachs Commodities Index to give you an idea of how far these prices have dropped. Over the summer the headlines were all printing that oil was going up to $200 a barrel…what a difference a global recession makes. OPEC has been frustrated by the decline as cuts in production (market manipulation) have failed to support the price of crude. One thing is for sure, oil under $50 a barrel is going to put the squeeze on Christmas budgets for terrorists everywhere. In fact it’s gotten so bad that this week those pirates had to choose between doing the normal plunder and pillage for cash and gold, or supporting the price of crude by taking supply off the market…ultimately they went with the oil thing and hijacked a Saudi tanker.

Below is the CPI data going back to 1947.

That’s all for now. MBS spreads remain attractively wide, short maturity corporate in the financial sector continue to see strong demand as many have so much government backing that they couldn’t fail in the next 6 months if they tried. We continue to see a longer line of players line up for free tax-payer money. GM, Ford, and Chrysler will be the immediate names you here…behind them is a growing list of states and municipalities that are screaming that they want some of your money too…beyond that look for headlines about more hedge funds collapsing (I love it when that happens because we see lots of cheap bonds as they struggle to save themselves)…and somewhere in the middle of all of that we’ll get a really good look at consumer spending as the day after Thanksgiving is traditionally a very busy shopping day…if the consumer doesn’t show up we could start seeing a lot more stress at small businesses around the country.

If you have any questions on this material just let me know.

Market Update: 11 14 08_ Advance Retail Sales fall off a cliff

We got another dose of poor economic data this morning, this time in the form of Advance Retail Sales. The survey expected a -2.1 number but we actually got a -2.8. The combination of tighter credit, high debt loads, no savings, mounting job losses, and scary news everywhere you turn appears to have affected the consumer. They’ve got bills they can barely pay with the check they get from the job they might lose, their 401k is now a 201k, many are upside down on their house, and they are headed into the Christmas season like an addict passing the crack-house on the way to rehab. How will the consumer make it through the holiday season without charging big screen TV’s, laptops, iPhones, and all sorts of imported electronics?

It occurred to me recently that Congress may have just reached the same level of delusion under which the US consumer has been operating for the last few years. I hear elected officials in the news telling banks how to lend. They want banks to just start lending out the TARP money, and to lend it out quickly, with no mention of credit quality. It’s almost as if members of Congress don’t realize how this mess happened. In an environment where marginal credits are becoming terrible credits Congress is pushing banks to ignore prudent lending standards, disregard their fiduciary responsibilities to their shareholders, and keep feeding the cycle where you make loans to people that you know can’t pay you back in the hopes that it will all work out somehow. I don’t know that I can find a group of people more out of touch with reality currently than our Congress. I’m going to track down Baghdad Bob, he would be a great spokesperson for them.

We’ve been saying for a while that we expect the 10 year Treasury to remain in a volatile range around 3.70% and that’s what we’ve been seeing. Big swings both ways with a tendency to settle in around 3.70%. This week has been no exception. The 10-year Treasury traded off yesterday despite the fact that Initial Jobless Claims pushed to highs they haven’t seen since 2001. Today the Advance Retail Sales numbers undid much of yesterday’s move in Treasuries. Fed Funds are currently trading at 25 bps.

Fed Funds futures continue to price in a 100% chance of a cut at the December meeting with 74% of the probability placed on a 50 bps level for the overnight rate after the Dec 16 FOMC meeting. Bernanke’s recent comments acknowledge that monetary policy actions thus far have not reduced the strains in the markets. He further stated that central banks will remain coordinated in their monitoring of developments, and are resolved to take additional measures if necessary.

With Advance Retail Sales dropping by the largest amount since the data series was created in 1992 I thought it was an opportune time to take an historical look at some of the recent as well as upcoming economic data. Below you’ll see a graph of Advance Retail Sales going back to the start of the index in 1992. I also plotted the 30, 60, and 120 day moving averages. You’ll notice that the giant drop off on the far right takes us into new territory. The prior low in late 2001 was associated with the last recession dated by the NBER (National Bureau of Economic Research) March 2001 to November 2001.

After I looked at this series I pulled up the economic releases that we have on tap for next week. I took several of those indices and plotted their long term performance versus all recessions since 1960 (as dated by the NBER). Below is the economic data release calendar for next week. I pulled several items from this list and plotted their long term history versus all recessions since 1960 (as dated by the NBER). I think this provides some color as to where this economy is currently. What the charts don’t reflect is that these numbers are developing against a backdrop of a global liquidity crisis.

Initial Jobless claims were released yesterday at 516k versus an expectation of 480k. The graph below indicates that jobless claims are pushing into levels that are historically associated with recession. The red dots indicate recessions and the red circle highlights the most recent reading.

Next week we get a look at Industrial Production which measures real output as a percentage of real output in the base year (2002). The graph below shows the month over month change in Industrial Production. The red dots indicate recessions and you can see that this index is clearly moving into a bad neighborhood. We get our next look at Industrial Production on Monday the 17^th.

Below is a graph of the Philadelphia Fed Index. This tracks manufacturing activity in the Philadelphia Federal Reserve district. The next release is on Thursday the 20^th. Again the red dots correspond with recessions, the red circle indicates the last reading.

So that’s a quick review of where things are this morning and what we have on tap next week. Spreads on many products continue to be very wide, offering great opportunity to grab some yield before all of the TARP money is deployed. As the TARP plan progresses and banks begin receiving and deploying that capital in leverage programs we expect to see tremendous pressure on spreads.

If you have any questions on this material or if there is anything I can be doing for you just let me know.

Treasury rolls out the TARP

Change at the speed of Paulson

 

The banking landscape is changing and one thing is certain…we’re all going to have to move fast to keep up.  The Treasury department is rolling out the TARP (not a red carpet but hey…this is the government and a TARP will have to do). 

 

The TARP program is designed for the express purpose of injecting capital into the banking system to stabilize it and promote confidence therein.  This is no small program…starting with the initial $250 Billion it will literally change the look of the banking landscape. 

 

The first round of this program saw $125 Billion in capital distributed to the big nine: JP Morgan, Bank of America/Merrill Lynch, Citigroup, Wells Fargo (includes Wachovia), Goldman Sachs, Morgan Stanley, Bank of New York, and State Street Bank. 

 

The Treasury is very aware of the fact that some stigma might be attached to anyone that approached them for capital, so they forced these nine banks to take the money whether they needed it or not.  The goal here is to establish confidence and if everyone is doing it nobody can be singled out as weak for participating.  The remaining $125 Billion will be distributed to “qualifying US Banks”…this is where you come in. 

 

You may remember from our Nordic Banking Crisis review a few weeks ago that capital injections are part of the model that the government will use to get us out of this financial crisis.  All in all it’s a pretty good plan…as we’ll see it’s really good if you’re a community bank looking to boost earnings.

 

There are a lot of details to cover, but to get the ball rolling we’ll look at the big picture first.  We are dealing with a VERY compressed time frame for making decisions on this matter.  The deadline to apply is November 14^th.  That means you have to know all there is to know, educate the board, reach a consensus, fill out the application, and have it submitted in about 2.5 weeks.  That doesn’t leave a lot of time for scheduling committee meetings.  To help out in this regard we have scheduled two webinars that you can use to educate all key personnel on the details of the program and we’ve created all the analytics you need to illustrate how the program would apply to your bank.

 

So given that quick introduction lets dig in…the clock is ticking.

 

What’s a bank to do?

 

Every bank should consider participating in the US Treasury Department’s TARP Capital Purchase Program Senior Preferred Stock and Warrants (“TARP Preferred”) and here is why.

 

• The Treasury TARP Preferred is the cheapest source of capital - by a long shot.  Warren Buffet got a 10% interest rate and warrants equal to the amount invested in his deal with Goldman Sachs.  The TARP Preferred will cost you 5% with warrants equal to 15% of the amount invested.  There is no private capital available at these levels.

• The capital can be used to offset loan and security losses, merger and acquisition considerations or for balance sheet growth using securities in the short-term and loans longer term.
• The break-even point for leveraging the TARP Preferred is approximately 4 times at a spread of 150 basis points. The TARP Preferred is typically non dilutive to current shareholders at this level of levered asset growth.

• You do not have to be a troubled institution or have troubled assets to apply for the TARP Preferred.
• You can apply first while you review the terms of the program.
• The deadline to apply is November 14TH.
• The Treasury will not report applicants, only approved institutions.
• You can withdraw your application if you find the terms unacceptable. 

• Non Public Banks are eligible - Private and Sub S terms from the Treasury department are expected any day now.

 

The TARP preferred is a cheap source of capital, not a cheap funding source. To overcome the cost of the TARP Preferred, leverage will be necessary to blend the cost of the TARP Preferred with lower cost wholesale funding from the FHLB.

 

Attached is an analysis of the US Treasury Department’s TARP Capital Purchase Program Senior Preferred Stock and Warrants (“TARP Preferred”) on your institution using call report information. This model is flexible and can customized to show many variations.  In its current form it provides a very useful “big picture” look to use as a starting point for analyzing how your bank can maximize the potential of the TARP Preferred program. 

 

For a typical bank if TARP Preferred Stock equal to 3% of risk-weighted assets were issued the treasury would have a minimal effective ownership interest. The Treasury effective ownership interest for your institution can be found in the attached analysis.

 

The break-even point for leveraging the TARP Preferred is approximately 4 times at a spread of 150 basis points. In other words, the model suggests that the TARP Preferred should not be dilutive when asset growth of four times the amount of the TARP preferred is achieved. This can be done short term via security purchases with the cash flow from the securities used to fund loans. 

 

We believe the 150 basis point asset growth spread can be achieved. As an example 15-year MBS are trading at historically wide spreads, and offer an excellent opportunity to lever the TARP Preferred capital. Over time as an institution has the opportunity to fund loans, the cash flows from the MBS can fund the loan demand. We believe that to maximize the benefit it is important to purchase securities to lever the TARP Preferred before MBS spreads tighten to historical levels.  The Treasury Department will issue a total of $250 billion of TARP Preferred. If this $250 billion is levered at 10 to 1 it represents purchasing power to buy $2.5 Trillion worth of GSE debt.  The total MBS debt guaranteed by FNMA and FHLMC is roughly $5 Trillion, so the potential for bank purchases fueled by the TARP Preferred could tighten spreads dramatically. Currently MBS Spreads on 15yr paper are historically wide, at approximately 298 basis points over the 5-year treasury compared to a weekly average spread of 117 basis points over a 5-year period. If spreads tighten just 100 basis points the approximate gain is 4% on discounted seasoned 15 year MBS.

 

The attached model assumes that asset growth via loan funding and securities earns a yield of 5% against blended FHLB advances costing approximately 3.5% producing a spread of 150 basis points.  Given the volatility of the markets the spread will change from day to day and can be modeled for you given your asset liability and risk return profile.  We can model the asset growth using the mix of loan funding and asset purchases you deem appropriate for your institution.

 

We strongly suggest you consider applying for TARP Preferred capital.  This is one of those times in history where time is of the essence.  Banks have roughly 2.5 weeks to get the board and management educated on this program before the window shuts.  The big banks were told that if they didn’t participate in the program at the start then they would be locked out in the future…there would be only one chance to take the money.  It is imperative that at the very least you take a studied approach to this topic.  The deadline to apply is November 14, 2008.

 

Because this is such a timely and important topic we are hosting a webinar October 30 at 12:00 noon Central and again Friday October 31 at 12:00 noon central time.  This is the perfect time to get your board and senior management up to speed on this issue.  They can dial in from where ever they happen to be and get all the information they need to make informed decisions.   We are available on an ongoing basis to address analytical needs in support of this process.