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
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.
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!
The Daily Deal has an uproarious essay on why we should not vilify bankers any more. They point out that it is just starting to get passé. New villains are needed. Their recommendation; Brussels sprouts!
Their case is absolutely compelling.
While many of you may not read ‘The Deal” on a regular basis, if at all, it is a terrifically well written “trade rag” for the finance industry. They have both a “wicked” sense of humor and social conscience in addition to being excellent reporters (Note: they assist this writer in his teaching at Morehouse College). Check out the article.
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!
To paraphrase Mark Twain, “Rumors of the demise of the homebuilding industry are greatly exaggerated”. The recently announced acquisition of Centex Homes by Pulte Homes is a bold move that speaks volumes about where the business is going. Several points worth noting about the deal include:
1) It is a stock for stock transaction-Centex directors want to capture some of the upside which is created. They are not heading for the door.
2) The synergies are huge, probably amounting to $.75-!.00 per share annually. On a net present value basis over five years, this represents between 30-40% of the purchase price.
3) The structure materially improves the pro forma company’s balance sheet
4) Centex had near term (ie next 18 months) maturities in excess of $500 million. This has not been talked about by analysts but must have been an important consideration for their management and board. The questions around the debt included:
a) Could Centex refinance all of the debt?
b) What would be the cost to refinance the debt if it could be refinanced ? Arguably the cost would have been a coupon in the mid to high teens with limited ability to call if a deal could be done? And that is a HUGE if!
c) What sort of operating constraints would the banks put on Centex in terms of revolver availability etc? Banks do not like bondholders paid out in front of them. They would have forced the issue and turned a $500million maturity problem into a portential muli-billion dollar issue. Any impairments or other issues which caused bank covenant violations would have led to truly significant problems for Centex.
d) Could the problem have forced them into some sort of bankruptcy proceeding?
This writer believes that the debt issue played significantly into Centex’s thinking. They opted to be pre-emptive rather than risk that someone would beat them to Pulte and leave them a universe of less likely acquirors, forcing them to suffer the vicissitudes of a prolonged bad debt market
5) Centex’s bonds did not have a change of control clause (“COC Provision”). This basically would allow a buyer to assume the Centex bonds as part of the transaction rather than having them “put” at 101 and forcing a major refinancing. This was a major transaction advantage to any buyer. That said, it was also something of a “wasting” asset which could be lost if Centex were to default on its bank debt and trigger a cross default with the bonds. It is very likely that Pulte viewed the lack of a COC provision as a major attraction to Centex. Centex probably viewed it as a “use it or lose it” opportunity and chose to use it.
6) Did Centex have alternatives to Pulte? Looking at the other big builders, Pulte and, to a lesser extent, NVR were clearly the most logical. Pulte had a relatively high stock price in terms of PE and multiple to book. Moreover, it only has $25million in near term maturities vs some $318million for DR Horton and over $500million for Lennar. While NVR has the industry’s most enviable balance sheet and stock multiples, it has generally operated with a “land light” strategy and high margin construction strategy. Buying Centex could have hurt their multiple and been a huge undertaking for them operationally. This was less the case for Pulte where it was much better set up to cut employees, plug Centex subdivisions into their infrastructure and play. From my soundings around the industry, Centex did not do a significant market test, opting to cut the best deal it could with Pulte and then hope that the combined entity’s stock performs.
7) Could Centex have achieved a higher price? Maybe. To do so would have involved a game of corporate “chicken” with Pulte. The odds were not stacked in their favor as most strategics (ie other builders) were not likely buyers and the size and industry precluded private equity from becoming engaged. My guess is that Pulte started at a price below book and was worked up to book value. Going above book value in this market, with attendant goodwill and impairment issues was a bet Centex could only make if it were willing to “walk from the deal” and continue on a stand alone basis. They also knew that the odds were high that their bet would be called.
8) Is this a harbinger of other deals? If so, who is next? The answer is a resounding maybe! The same issues of debt maturities, form of consideration and price will be at play. Pricing will be tricky because of all of the usual constituencies involved including common shareholders, bondholders and banks. Fair deals for all will work. Banks and bondholders do not want to operate homebuilders and, in many cases, managements own significant stock (ie Toll, Lennar, MDC, Horton, Hovnanian et al.). Land positions, size and the quality of management will also be issues
All in all, this looks to be a decent deal for Centex shareholders relative to the downside risk. They traded off a low price for their shares for comfort that they would not be crushed by their near term debt maturities. They also believe that they will still have terrific upside in Pulte shares due to the synergies and general deal structure. They are probably correct in this thinking. For the same reason, the biggest winners will likely be the Pulte shareholders
PS The bank lenders, many of whom were lenders to both Centex and Pulte, will also be very happy because they will probably be able to significantly reduce their aggregate exposure to the combined entity.
Who’s kidding who? The fact that PAC contributions fell only 6% in the first two months of 2009 vs. 2007 is remarkable. Big banks which are receiving TARP funding have been virtually out of the PAC business. Add to this the facts that businesses are facing tight liquidity, major losses and an administration espousing squeaky clean policies on political giving. Down ONLY 6% is the new up! The Wall Street Journal and others can write all they want about how political giving is way down. Anything in the range of a 10% or less decline in PAC giving says to this author that PAC giving is actually deemed as an important business priority for the givers’ employers. Anyone who has been in any significant role at a major US corporation knows that PAC giving is voluntary in name only. Whether you are a Democrat or Republican, you never want to receive a call from your boss asking why you have not given to the firm’s PAC! If employers are making such calls today, they must really mean business.
Is the Wall Street Journal in cahoots with business to mask this story or do they just not get the joke?
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:
Saturday’s Wall Street Journal has an interesting article (“Calpers Tells Hedge Funds To Fix Terms-Or Else”) which details the California Public Employees’ Pension Fund’s (“Calpers”) attitude toward hedge fund and private equity compensation. Calpers is the nation’s biggest public pension fund. It has seen its hedge fund and private equity portfolios decimated this year along with its myriad other equity oriented investments. This is necessitating a reallocation of their portfolio which will mean substantial cuts in funding for “alternative investments” like hedge funds and private equity. Calpers’ reallocation issues has done more to put the fear of God into heathen PE and hedge fund managers than would any overzealous preacher! Loss of Calpers money can put a dent into any fund’s asset base and be a harbinger of incremental losses as other funds follow Calpers’ lead. Reallocation also gives Calpers extraordinary “muscle” to demand favorable terms from those with whom it chooses to invest. As the article points out, some of the modifications in terms that it is looking to achieve include:
• Reduction in annual fees (now 2-3% on avg.) and carry from 20% to something significantly less
• Recoupment of fees paid in good years to cover subsequent bad performance
• Managed accounts solely for Calpers to reduce the impact of redemptions by other investors
• Greater disclosure of assets and potential limits to leverage
Implementation will come primarily with the deployment of new money rather than amendments of existing fund investments. While it will take some time to implement the changes desired, they will have a chilling effect on the compensation and operations of many hedge funds and PE shops. Because so many institutional fund investors follow Calpers example it is likely that some fund managers will opt for dissolution or be forced to that decision by an inability to raise adequate capital. If Calpers succeeds, the face of alternative investments will look very different in the coming years. It also won’t help the value of homes in the Hampton’s or large apartments on Park Avenue.
It is quite possible that the fund business will follow the example of Major League Baseball. Top performers like Paulson and Soros may still be able to demand their terms because of their stellar track records in the recent downturn. Others will see a dramatic change in life and pay because they did not measure up in the clutch. There won’t be many Johan Santanas or Albert Pujols in the fund world. To make matters worse, Calpers is signaling that they have no intention of spending as freely as the Steinbrenners!
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?