On April 14 we posted a discussion entitled “How Deficits Are Financed Does Matter”
(see link below). We pointed out that the government was missing an opportunity to finance its deficits and stimulus measures at once in a lifetime 30 year long term rates in favor of cheaper short term levels. We suggested that that rate rises were inevitable, could come quickly and that waiting would have significant incremental costs to the US taxpayers as well as US corporate debt issuers whose bonds are priced at a spread to US Treasuries. The analogy of Americans who are using ARMs rather than financing long today is an apt comparison that most Americans can readily comprehend. They would not do what the Treasury is doing!!
At the time of our April post, 30 year Treasuries were trading at approximately 3.6%. Today 10 year treasuries are at 3.93% and 30 year Treasuries are now at 4.69%! A 100 basis point or 30% rise in six weeks is bad news. Worse yet, the 10 years are only at that level due to intervention by the Fed and treasury to keep yields below 4%.
That 100 basis point swing alone would result in an annual financing cost of an incremental annual cost of $10billion on $1trillion of debt. Even if we were to just finance for 10 years rather than the previously suggested 30 years, the cost would be $3billion more annually than had we financed for 30 years 7 weeks ago. To make matters worse, Brazil and Russia are making serious noises about dumping upwards of $10billion in treasuries in favor of new IMF bonds. This could be a leading example for other foreign governments to diversify their foreign reserves away from US Govt. obligations. India and China frequently follow in tandem with the actions of Brazil and its Central Bank wizard, Henrique Meirelles. The cost to taxpayers and US corporates would be huge and could significantly impair prospects for economic recovery.
I find it tragic that a socialist nation like Brazil is exhibiting far more economic discipline in financing its deficits and managing its reserves that the United States.
They are not confused between acting in their economic best interests vs. using the Treasury or Central Bank as an instrument of social policy. Likewise, they are very careful to evidence a strong respect for lender rights and the rule of law as it impacts their access to the capital markets.(
Add to these problems is the fact that investors at home and abroad are increasingly worried about the US Government’s lack of respect for the rule of law regarding lender rights in bankruptcy (e.g. GM and Chrysler). America won’t go the way of Weimar Germany but stagflation (inflation without growth) is a real possibility. Savings will be diminished and businesses will become less and less competitive globally. As an investor, government policy leads me to buy mostly foreign securities and inflation hedged companies with assets like oil and iron ore. As a card carrying Democrat, I am troubled for my country’s economic future. We can and must do better.
Follow the links below for copies of prior posts on financing the Treasury and Brazil’ Central Bank President
Greg Mankew, former economic adviser to President George W Bush and currently an economics professor at Harvard, had an interesting article in yesterday’s New York Times entitled “That Freshman (economics) Course Won’t be Quite the Same.” In it he suggests that recent economic events necessitate the inclusion of four new topics into an introductory college economics course:
1) The Role of Financial Institutions-
“The current crisis has found financial institutions at the center of the action. They will have to become more prominent in the classroom as well.”
2) The Effects of Leverage-
“If housing prices (and other leveraged assets) have fallen only 20%, why did the banks lose almost 100% of their money? The answer is leverage, the use of borrowed money to amplify gains and, in this case, losses…there is no doubt that its effects have played a central role in the crisis and will need a more prominent place in the economic curriculum.”
3) The Limits of Monetary Policy-
“When the economy suffers from high unemployment and reduced capacity utilization, the central bank can cut interest rates and stimulate demand…what would happen if the central bank cut interest rates all the way to zero and it still was not enough to get the economy going again? …The Fed is acting with the conviction that it has other tools to put the economy back on track. These include buying a much broader range of financial assets than it typically includes in its portfolio. Students will need to know about these other tools on monetary policy.”
4) The Challenge of Forecasting-
“Students should understand that a good course in economics will not equip them with a crystal ball. Instead, it will allow them to assess the risks and be ready for surprises.”
While a terrific list and spot on in its insights, one may argue that it is not sufficiently inclusive. This author and sometimes finance professor would add four incremental topics for consideration:
1) The Globalization of Credit Markets and Economies-
Globalization has changed the game significantly and reduced the power of any one nation or region’s central bank to solve a crisis by itself. Today, America’s largest creditors include investors from around the world. Similarly, economic demand is global. When America reduces consumption of Chinese goods, both nations have a problem. It is exacerbated globally when the Chinese then reduce their purchases of Brazilian iron ore, Middle Eastern oil and products from other parts of the world. The impact of this ever increasing economic interdependency must be studied by even an introductory economics student.
2) The Impact of Debt Instruments on Every Day Life-
Forty years ago, few Americans carried credit cards, had variable rate mortgages or leased automobiles. There were minimal securitizations of debt instruments and, as Greg Mankew points out, leverage was substantially less a factor in the US or other economies. Today such financing vehicles are ubiquitous. The internet and saturation advertising by entities like Di-Tech.Com and others have encouraged even the least credit worthy consumers to become part of the game. Investors from around the globe, from Atlanta to Reykjavik to Beijing have become part of the global investment community directly or through mutual funds, hedge funds, their employer’s pension funds and even money market funds. Unlike the past, when primarily the “investor class” and marginal workers were those at risk, now almost everyone is exposed and has suffered. Issues of regulation and general investment risk/appropriateness are now important to most Americans. Education about these investments becomes essential to one’s economic well being.
3) Deleveraging -What it Means-
Just as Greg Mankew is correct in his point that we need to understand the impact of leverage, students will need to know a great deal about the methods and the impact of deleveraging. A simple explanation is that, if not done carefully, it can be as painful as drug withdrawal for a heroin addict! Deleveraging in its simplest form means reducing debt. While easy to comprehend in concept, the implications of how it is done can vary significantly. Today we are witnessing the ramifications of lenders demanding repayment and foreclosing on mortgage loans. Similarly, when banks seek to reduce leverage by not renewing credit lines, this can strangle a business’ operations and potentially lead to bankruptcy, investor losses, job losses, negative growth etc. Raising equity to reduce debt may be a possible solution; however, it is easier said than done. It requires available capital and a positive investor view toward risk. Recently we have seen the US government play an important role as a “last resort” source of capital for deleveraging to stabilize our financial institutions. Arguably the actions of TARP, including direct equity infusions, have restored investor confidence and facilitated over $50 billion in new equity offerings in the month of May. Learning from these lessons and understanding the successes and the failures should benefit our understanding of how to deal with 21st century economic crises.
Unlike any time in the last seventy years, bankruptcy has become a major risk factor in the US and global economies. While US laws are seemingly well established, and based on legal precedent, the rules of the road are now changing dramatically. US government intervention in the bankruptcy of Chrysler and the possible fall of General Motors is changing everything. Heretofore senior secured lenders had priority claims over junior creditors. Now, in part as a result of its equity ownership and capital support of US banks through TARP, the government is negating or minimizing such claims in favor of less senior lenders and unions. The ramifications of this activist approach raise many issues which may help or hurt the restoration of a major American industry, economic order and the vibrancy of the American capital markets. Regardless of one’s views, the actions and impacts must be studied carefully to provide a basis for prudent investing and to understand economic forces in our changing world.
It has been suggested by some that “education is wasted on the young.” In the case of the study of economics, this is hardly the case. Just as our parents learned economic lessons from the Depression, tomorrow’s leaders must learn from the new issues and actions of today. For Boomers, regardless of educational background or age, a refresher course based on current economic events would also be a welcome development!
To paraphrase Mark Twain, rumors of the demise of Ford and the major homebuilders is greatly exaggerated. While GM, Chrysler and a number of private builders are in or near bankruptcy, some of their larger public competitors are evidencing something even more significant than rising stock prices. They are raising significant amounts of capital!!
New capital is significant in many ways. It can allow companies to refinance maturing debt, reduce leverage and facilitate growth. Most important, it requires investor confidence. Raising new capital can only be accomplished when large groups of investors simultaneously commit to buy a company’s debt or equity securities. It is axiomatic that this is a formidable task if a company’s viability is in doubt. We are increasingly starting to see new capital commitments becoming the new “Good Housekeeping Seal of Approval”. They can signal that investors believe that a good company in a troubled industry should survive. The capital commitments often assure this inevitability and lead to post financing price increases from the abyss.
In the last few weeks we have seen the following financings for Ford and a group of large Builders:
Issuer Amount Security
Ford $1.6 bil equity
Toll $400mil bonds
Ryland $230mil bonds
Lennar $400mil bonds
Horton $450mil converts
Lennar $275mil equity
In the wake of these financings, including those who issued equity or converts that diluted existing shareholders, the newly issued debt and equity securities are trading at generally higher levels. While not necessarily a guarantee of long term success for the issuers, it has to be construed as a near term positive for both equity and debt investors. All have already registered gains in companies which the market sees as improved risks.
In a larger sense, the ability of companies in weaker industries to access the capital markets is a very positive indicator for a broad based recovery and further market advances. Six months ago Ford was a supplicant at TARP’s table. Today it is viewed as the long term winner in the US auto industry. As recently as three months ago, few would have made any bets on even one US homebuilder being able to access the capital markets for the foreseeable future. The foreseeable future is NOW!! Four builders have successfully financed and the securities issued are all trading at premiums.
Virtually all experts agree that the opening of the capital markets is essential to the end of the recession. The ability of Ford and the larger builders is a clear and significant harbinger of a major market opening. Like Mark Twain, the demise of the markets and the dire prospects for Ford and the large public builders was greatly exaggerated!
PS It is also very interesting to note that Citibank sole lead managed all of the builder financings. Their ability to execute such transactions also suggests that their demise as an underwriter may also be overstated.
Harvard Law School Professor Mark Roe made some extremely thoughtful observations in a Friday “Op Ed” piece in the Wall Street Journal (“A Chrysler Bankruptcy Won’t Be Quick”). Central to his discussion are the following key questions:
• Are Chrysler’s secured lenders receiving fair value for their claims as is their legal right in bankruptcy?
• Was the 70% lender vote to accept $.32 on the dollar valid or was it coercively tainted by government influence on banks who had received TARP funds? The law requires a 2/3 vote of secured creditors to accept a settlement. TARP banks make up the vast preponderance of the lenders who accepted the govenment’s proposal. Non-TARP lenders can reasonably ask if TARP lenders would have voted to accept if the government did not have an ability to influence their operations.
Professor Roe makes it clear that there is a reasonable basis for lenders to resist the settlement “mandated” by the Obama Administration. If so, creditor claims may make the final outcome less than clear and the process long and contentious.
What is not said but also must be considered is the generally heavy hand of the government to obviate the contractual rights of secure lenders. This does not begin to address the issue of unions gaining majority control of the Company.
The overall process raises significant and pernicious issues for our national economic future. If lenders rights are not protected, the appetite for U.S. corporate debt will diminish significantly. This will have severe adverse implications on economic growth, employment and our national standard of living. We have already seen how unilateral government interference has caused a significant measure of investor reluctance to play in TALF programs to buy “Toxic Loans”. The Chrysler bankruptcy could make matters worse. Fears of government intervention against indenture terms will not necessarily be reduced by higher interest rates, though higher rates will be one possible outcome. They will more than likely result in reduced lending until fears abate. The government will find that it has a hard time forcing lending by any institution that it does not control (ie foreign banks etc). If the over arching goal of Treasury policy is to get credit flowing, the government’s role in Chrysler is a major step backward.
Just as the American government was wrong in condoning torture against the laws of the nation and the civilized world, so too are actions which disregard freely negotiated loan terms which are critical to financing American industry. If we learned anything from the disastrous policies of the Bush administration, we need to understand and believe that our laws can’t be selectively followed or enforced.
When Winston Churchill lost the Parliamentary election of 1945, his wife advised him that it was “a blessing in disguise.” His response was that the blessing was “very well disguised!” Many recently laid-off young bankers and college seniors who are NOT receiving investment banking jobs are feeling a lot like Churchill in 1945.
Unlike Churchill, the blessing may be closer to reality than they realize. As a long time investment banking group head, recruiter and, for the last two years, a college finance professor, I have seen far too many bright young twenty year olds pursuing a false dream on Wall Street. The allure was the trappings of the job, not the experience or nature of the work. High compensation, an exciting life style, prestige, material possessions and other superficialities were part of a bargain made in exchange for 100+ hour work weeks, sublimination of personal creativity, foregone time with friends and, at times, abuse by obsessive compulsive ego maniacs who may have suffered similarly and view mistreatment of junior bankers as an outward sign of their power and success.
The real question is whether investment banking is what they really want(ed) to do or whether it is just a means to achieve the fruits of a Faustian bargain. Was or will it be worth it for them? Will they be happy? Will they even last long enough to achieve the fruits?
For a few, the answer is yes. They will be either the lucky or those who genuinely enjoy the challenges and sacrifices attendant to the career. They will tend to be people who possess various requisite skills and aptitude for specific jobs on the “Street.” Facility with numbers, problem solving talents and an enjoyment algebra and statistics are crucial prerequisites for success at virtually any Wall Street position. Knowledge of psychology, legal concepts, salesmanship and recognizing recurring historical patterns are also important. An entrepreneurial spirit, a proven ability to recover from severe setbacks and a desire to make money are a must for all.
Sadly, the last point is probably the only common thread with the vast majority of young Wall Street job seekers and the freshly unemployed. Few actually would ever see the relevance of most of the skills enumerated above except maybe for the quantitative aspects and regrettably, few would ever mention a love of algebra or statistics less they be viewed as “geeky” or unsophisticated.
Typical arguments made by “twenty-somethings” when seeking investment banking jobs include variants of the following:
• “I am really a hard worker and love putting in 100+ hour weeks as a “work unit”
• “I have always received top grades and have never been anything but the best academically”
• “I know what it takes to be a success and I have it”
• “I have always wanted to be an investment banker”
Too infrequently asked or sincerely answered are questions like:
• Would you work 100+ hours per week as a banker next year if your pay were to be $20,000 per year with no bonus and limited economic upside?
• If you have never experienced a serious setback in life or evidenced an ability to recover from adversity, why should one believe you can do so in a high pressure and now low paying job?
• What does it say about your intellectual curiosity or self realization that the only thing you ever wanted to be is an investment banker? Explain why this will still be the case in a low pay environment
• When asking about skills to be an effective banker, see how many, if any, cite knowledge of legal concepts, historical methods, psychology or even statistics, algebra and salesmanship
The point to glean from such questions and observations is that the preponderance of the 35-50% of the classes at Princeton, Harvard, Yale or any other college that now seeks Wall Street jobs are not appropriate candidates regardless of their inherent intellect. They would likely be happier in other pursuits if they could only get over trappings of Wall Street. Sadly, many recruiters have been as misguided as the students in recognizing this verity or in selecting appropriate candidates.
The good news is that the allure and job availability are now significantly diminished. Only those who “really” want jobs, regardless of compensation, are likely to land such positions. Ridicule of bankers, a scarcity of positions and limitations on economic upside will do much to reorient thinking.
Where will the young people go for employment? Is it really a blessing that they won’t be on Wall Street?
It will be a blessing if the students and newly laid-off exercise self realization and pursue jobs which excite them because of the content rather than the compensation or perceived prestige. It will be a blessing if they experiment, explore and take chances pursuing dreams rather than dollars. Who knows, maybe some would be bankers will instead join the Peace Corps, start a business, become teachers, coaches, artists, work with autistic children or even become community organizers. Most importantly, maybe they will find satisfaction and happiness doing something because they enjoy it. They may even find a great truth to be that enjoyment and happiness with one’s job can lead to significant career success. History would suggest that this is what happened to Barack Obama, Bill Gates and Bill Belicheck. None can argue that they pursued traditional jobs or were the highest paid when they left college. They were bright, hard working and blessed because they sought careers doing what they enjoyed when they were young!
The attached article from the New York Times provides further insights on this topic:
Note: While the author did spend a significant number of years on Wall Street, he was a history major who liked algebra and statistics and remained a practicing Democrat to the chagrin of his loyal clients. His immediate post college years included selling advertising, travel to Brazil without a job in pursuit of adventure and an around the world trip mostly by public bus. He arrived on Wall Street in the sustained and severe downturn of the late 1970s and early 80s with 20% interest rates, low salaries and minimal bonuses. He stayed because he enjoyed the work, liked the clients (despite their political predilections)and was excited by the markets. Eventually the compensation got better and he did not complain!
Today is Tax Day all over America. Unlike our current Secretary of the Treasury, more than 65% of all Americans now have professionals prepare their tax returns. With incomes down, few if any capital gains to offset losses and a $3,000 limit to investment losses against non-investment income, tax returns have become less complicated for a lot of people. As I have talked to friends, family and acquaintances ranging from my 89 year old mother (living on a fixed income) to former students in their first year of work, they all have had a similar complaint: the tax preparation cost me as much or more than I saved.
Perhaps Tim Geithner’s do-it-yourself plan was a harbinger of today’s lament!!
In any case, as is almost always true, the Wizard is a source of great wisdomon this subject!
Fortune magazine’s Allan Sloan poses some excellent questions and raises some ugly issues in his piece “Structuring the Treasury’s bet for a Long-Term payoff.” His central thesis is that the Treasury makes a mistake financing the majority of its new debt in the short term debt markets at .2% today rather than locking in long term (30 year) rates at about 3.6%. It is his belief that long rates are likely to rise as the US deficit increases. While he makes no judgment on the merits of a deficit driven stimulus plan, financing such long term deficits in the short term markets may make the near term savings extremely expensive in the long run.
Rates may rise regardless of what action the Treasury takes today, however, the actions taken today may make tomorrow worse than it need be. Rising rates are usually what happens when business conditions improve from recessionary levels. Financing an increasing deficit in the short term market today exposes the Treasury to greater refinancing risk in the future in what most likely will be a higher rate environment. Laws of supply and demand will also have an impact on the US Treasury’s cost of capital. The larger the amount to be financed, the more leverage the buyers will have in terms of rate demands. The Chinese are already talking about holding less dollar debt. Is this a precursor for a “Sino-Hold-Up” that would make John Dillinger proud? While there is still faith in the United States Treasury, that faith could have an unattractive price tag attached!
The implications for a rise in long term rates and strategies to minimize the long term interest cost do more than just add varying levels of incremental debt to our national balance sheet. Corporate bonds are usually priced on the basis of a “spread” over Treasuries. Higher Treasuries, regardless of the maturity, mean higher corporate borrowing costs unless spreads decrease; the exact opposite may happen in a rising rate environment. Weaker and smaller less-than-investment-grade companies can expect to be hit the hardest. In a worst case scenario, it is possible that no spread would be sufficient to compensate investors. To put hard numbers to this, in today’s market, B rated companies’ 8-10 year bonds are trading in the 14-15% range. Similar bonds of BB rated businesses are in the 10-12% range. Were ten year Treasury rates to rise 2.5-3% and spreads to remain constant, the cost of ten year bonds for B rated businesses would rise to 16.5-18% and BB rated bonds to 12.5-15%. Any upward movement in spreads would make rates higher, taking them to potentially prohibitive levels. Though such rates would not impact the cost of pre-existing bonds, they would be a severe impediment to the refinancing of maturing bonds and/or to finance growth or capital projects.
Dick Cheney was famous for saying that “deficits don’t matter.” Time will tell if he was right. What is for sure is that how deficits are financed can make a big difference!
As my mom often tells me, “many a truth is told in jest”. Tom Toles captures the estate tax argument in a cartoon. What is hard to believe, in times like these, is that there is substantive Republican discussion about the estate tax. For those in the Republican leadership who have gripes about the $7million limit before taxation that President Obama proposes, they and their constituents should be happy if they can still pass that level of tax free capital to their children. They may not realize that many who might have been able to do so can no longer do it due to the financial crisis. Likewise, when they had a chance to increase the limit, they overreached and sought to completely eliminate it on a permanent basis. Fighting over this issue now raises a serious issue of certain leaders’ priorities in a conflagration!
A quick look at the first quarter ’09 Underwriting revenue statistics released today by DealLogic suggests that Underwriting may not be such a big source of increased profitability for banks. While total proceeds raised increased 27% from $1.344 billion to $1.707 billion, industry wide fee income was down 11.9%. The results were far worse for a number of the former industry leaders whose liquidity and stability are in question.The differences are, in part, explained by the fact that there was less activity in the higher margin areas of equity and less than investment grade debt issuance. More interesting is a look at the underwriting revenues of individual banks. Only Deutsche Bank and Royal Bank of Scotland posted increases in underwriting revenue. Names like Citi, Goldman and BofA did not fair well at all. If Citi and BofA are going to have up first quarters, it won’t be from underwriting. Citi’s first quarter revenues were down 31.3% and B of A’s declined a whopping 56%. The mighty Goldman Sachs fell from third to tenth on the League Table and saw its underwriting revenues fall 45%, which was worse in total dollars and percentage terms than even Citi’s results.
The changes probably reflect a few things. First, the more stable banks, like JP Morgan and Deutsche, are likely to be the leaders going forward. While Citi and BofA were still marginally ahead of Deutsche, their precipitous declines point to an issuer abandoment trend that may not be quickly restored. Were it not for a few old relationships, which probably meant joint books on the right and conferred less real revenue than DealLogic thinks, they would likely be behind Deutsche. Second, were it not for major refinancing by investment grade names, who were taking advantage of market windows and proactively moving to protect their balance sheets, revenues would have been much worse for everyone. These event phenomenons, if true, may not be indicitive of great ongoing revenue streams. Third, Goldman’s fall off reveals just how dependent they really were on equity and less than investment grade issuance. In the last few years they evolved into a higher risk shop dependent on proprietary trading and investments together with higher margin and risk underwriting.
Perhaps the Obama administration need not worry about legislating bank compensation. Decining Underwriting and other bank revenues may do the job for them!!
Bank Underwriting Revenues First Quarter 2009 v 2008 may be found below:
The same guy who says that the Obama Administration should be spending trillions more on everything does not like the government’s plan to liquify toxic bank assets. He also seems to hate the capital markets. I guess he thinks that the incremental trillions he wants us to spend come from the printing press rather than the global markets.
What is the real source of his problem? He is is a truly smart guy but today’s piece in the New York Times really lacks clarity. His article “The Market Mystique” fulminates on multiple topics but never really specifies the underlying sources of his problems.
He clearly sees a need for more regulation of markets and then grudgingly admits that the Obama Administration is moving to significantly increase regulation. He dislikes markets and won’t come to grip with the fact that they can’t be ignored. He seems to forget that even in his favorite generation, the fifties, the government used markets to finance its operations. Maybe he thinks that in that era, America was like the Fonz and always had money but did not have to do anything to get it! Only the Fonz failed to realize that there is no free lunch.
It is less clear what Krugman wants other than for banks to admit that the assets have a low value. The argument comes down to what is fair value. If banks follow Krugman’s draconian solution, it could be Lehman redux, unless mark to market rules are eliminated, which his logic would argue against. Forcing big markdowns triggers capital inadequacy issues and, probably, government takeover (s) of some big banks. In this scenario, the FDIC gets to own the assets and probably lots more as a result of a collapse in market confidence (remember what happened when Lehman fell). The government would have to step in and, like it or not, figure out how to finance everything it acquired. It would have to go to the markets. The fellows who make up the markets might not have a Krugmanesque point of view (those Chinese fellows, in particular, have no sense of humor when it comes to losing money in American assets). The elegant thing about the Geithner plan is that it does not deny the valuation issue and provides government funding. The difference in the plan versus Krugman is that it does it by attracting outside capital and reigniting trading in the assets. Krugman’s plan lays it all on the government’s shoulders to finance after triggering a very negative series of events. We saw this with Paulson at the helm. do we want to watch it again?
Paul, please take a bite of a reality sandwich. You can’t avoid markets so use them for our benefit. Obama, Geithner and equity investors get the joke. Why can’t you?