Thursday, October 2, 2008

betting on the wrong horse

I have criticized the "bailout" plans for many reasons, so why stop now?

it suffers some basic philosphical problems, as I have mentioned -- such as being a confused muddle of capital-injection and price support.

furthermore, as I speak to credit-market watchers, I have also come to believe it will ultimately fail because it bets on the wrong horse.
my plan is radically different: instead of buying distressed mortgage securities that no one wants to touch with asbestos gloves, THE GOVERNMENT SHOULD BUY STRAIGHT CORPORATE DEBT. many ordinary companies that never committed any subprime sins are now facing a complete liquidity paralysis. this could cause them to freeze up, stop paying each other and lay off millions of americans. to prevent this 1931-style event from occurring, I say the government should intervene in this market. unlike mortgages, it can still be saved.
let's start by looking at some of the damage that has occured in just the last 2-3 weeks. while things were shaky before, I think many people don't realize that september 2008 was probably the worst month in the post-depression history of the U.S. credit market. (it was the worst month in the history of the long-running lehman credit index, based on excess return.)
everyone knows mortgages were in trouble, but this month, serious damage was done across the board:
look at the bonds of a nice solid credit like AT&T:

or tech giant cisco:

price declines like this for solid investment-grade bonds are simply unheard of.
these are companies that can weather economic downturns and generate vast amounts of free cash flow to service their debts. yet their bonds have gotten crushed. and, it's important to note that this didn't happen at the other moments of panic, such as march or july. something is different this time.
let's look at a company that's less fortunate than AT&T or Cisco: Pilgrims Pride, a much lower-quality credit. like their chickens and cows, they've gotten slaughtered as they struggle to renegotiate bank loans:

now, these are all companies with thousands of employees. they had nothing to do with mortgages, yet they are suffering. the real danger right now is that the spreading credit crisis will bring down thousands of other solid companies that "did nothing wrong". it's looking increasingly likely this might happen.
the next chart shows the rate at which these very companies borrow money under 30-day "commercial paper" programs. these are essentially very short-term bonds that companies normally roll over every month as part of the normal course of doing business. (kind of like ordinary people use credit cards so you don't have to always have the cash available at the moment you spend.) almost no one ever talks about the CP market because it's usually an extremely boring place where everything functions smoothly. let's look at the interest rates investors are demanding on CP (30 day non-financial A2/P2):

I also included the federal reserve's overnight target interest rate. under most normal circumstances, these two rates follow each other pretty closely. the spread between the two is now flirting with 4 full percentage points, an unheard-of level. it's too bad the data only goes back 12 months, but I am sure that's the highest level in at least the last 10 years, judging by comments many in the market have made to me.

the biggest concern is that debt is piling up and not getting refinanced. companies issued a mere $72bln across the american debt markets in September... that's 66% lower than a year ago, according to dealogic.. august and september are the first months since at least 2005 with total debt issuance below $100bln. in other words, this market is shutting down...
similar things are happening in the municipal market, according to a banker in that sector I spoke with today. ordinary companies and municipalities have TENS OF MILLIONS OF EMPLOYEES who would be hurt if they can't issue bonds to rollover debt.
let's look at another chart... this one compares the average Baa-rated corporate bond to the 10yr Treasury yield... another example of "spread".. when it goes up, it's bad.

at the far right, we see a huge spike to the place where we are now. this is near all-time highs reached in late 2002 or the early 1980s... it's not significantly above those highs, so it's not that big a deal, right? wrong... a couple of very important things are different now.
in both previous cases, the spike in yields happened deep into a recession, or after many many companies had already gone bust. for instance, in 2002, enron and worldcom had both failed and the overall default rate was more than twice the current level. in 1982, the economy was in a severe recession after paul volcker raised interest rates to kill inflation.
in october 1982, the economy had lost jobs over the previous 14 months before the Baa-10yr spread peaked.

in october 2002, most of the job losses had already occurred and the economy was already beginning to rebound...

in contrast, this time, it occurs after only 9 months of job losses ... and the losses this year have been much less severe. (I am assuming september, which comes out tomorrow, will be negative.) and, we're still not even officially in a recession.
in both previous cases, this spike in spreads came at the very tail end of slowdowns as months of defaults worked their way through the system. this time, it's happening at the very start of the contraction.. which means it will only get worse.... the global economy is only now really slowing down... usually defaults are a lagging indicator.
furthermore, in both previous cases, spreads had been climing slowly over several years. that means companies had time to adjust to the higher rates and they weren't planning to have cheap debt financing. this time, the change has been sudden and jarring and will be a severe shock to many companies that are accustomed to easy credit.
even those these companies didn't commit the sins of subprime, they are feeling the pain as the entire financial system shuts down. as I discussed previously, banks don't want to lend to each other, companies are giving each other less credit and asking for payment more quickly.
now ordinary companies that did "nothing wrong" like issue subprime mortgages are getting punished.

instead of helping them, henry paulson wants to prop up the failed mortgage market. somehow he thinks if we buy a bunch of bad mortgage bonds, we will make it easier for companies like GE and Pilgrim's Pride to roll their debt. at least that's the argument.... "main street needs the financing system to work again."
to me, this is simply too indirect. instead, I propose that paulson use his money (I mean "my/your money") for something a little more useful: buy corporate debt.
I think the government should step in and say "we will not allow innocent companies to go bankrupt because of the collapsing mortgage market." he should establish actual government levels were certain kinds of debt "should trade". he should say the government will ensure that BBB debt trades at +300bp, AAA at +100bp, etc. he should establish some clear bands and say the government will be a buyer in both the primary and secondary market to provide support.

he should also offer to buy commerical paper and municipal bonds under a similar arrangment.

of course, this isn't how free markets work, but we are beyond that at this point.

everyone I talk to now describes a seizing up of the corporate-bond market. many companies have maturing debt. normally they would issue new bonds... now investors won't buy any sort of new issuance at all because they insist on huge price concessions. and, if price concessions are made, it will depress the value of bonds they already hold. it's a vicious circle that is killing the bond market.
this doesn't have much to do with the mortgage market. but in many ways, that is my point. I think the mortgage market is already too diseased to be saved. almost every security in that market was priced with 2 fundamental assumptions in place:

1-houses never lose value

2-you can always refinance

neither of these scenarios are true anymore, so these bonds will wind up being close to worthless. it's better to just accept that now and to move on. the next step is to prevent the damage from spreading to the rest of the economy. and spreading is exactly what it's done over the last 2-3 weeks.

imagine our credit system was once a normal, healthy person. at some point in 2005 and 2006, he was bored with living the normal life, so decided to try heroin. being discreet, he shot it up between his toes.
it felt great at the time, and he didn't think twice about the fact he used a dirty needle.
by 2007, it started getting red and swollen. but then a doctor gave him some tylenol and told him not to worry about it.
by early 2008, the lower half of his foot was purple and black. again the doctor came and told him the problem was contained and gave him more tylenol. this time he also rubbed some neosporin on it and nodded reasurringly.
by july, his entire foot was swollen and gangrenous, but the doctor again assured him his health was sound. after all, this doctor was tenured at princeton.
but now it's september and the infection has spread halfway up the leg and the patient is suffering a fever of 103. he's so delirious he can't remember his own name.
again the doctor tells him we can stabilize the situation.. it will only have a small cost... and congress needs to approve it first....
ok, enough of the anology... the point is clear. at this point, the only way to save the patient is to tie a turniquet at the knee and just saw the rotting leg off. if not, it will only be a short time before the infection spreads to the rest of his body and finishes him off.

that's what we need to do in the credit market. we need to draw a line around mortgage assets -- like a turniquet -- to keep them from infecting the rest of the patient.
we must give credit investors confidence the problem will not spread from mortgages to other assets. that's why I say the government should become an active player in the non-mortgage credit market. it should be buying corporate debt to put a real floor under it.
(interestingly, the Fed may be doing a poor man's version of what I suggest.. today's balance sheet release by the Fed indicates it dramatically increased its loans to banks at the same time that commercial paper balances plunged by more than $90bln. what's happening is that companies unable to borrow in the CP market are drawing on bank lines, and the Fed is supporting those same banks with its own lending facilities such as the asset-backed commercial paper money market mutual fund liquidity facility and the Primary Dealer Credit Facility.)
my plan of buying corporates would make investors realize THESE ASSETS are not going to become toxic as well. it would restore confidence and allow companies to do essential things like roll over their debts, pay employees and pay each other. and, I think it would cost a lot less than $700bln, given the fact that these corporate bonds do not have real inherent problems -- they are being disrupted by market conditions.
nouriel roubini says we need to triage the banks to decide which will survive. I find that even a little off the mark.. I think we need to do the triage at the asset level. all of the banks face problems of different degrees, but we must not forget that banks themselves are nothing more than portfolios of assets. you cannot save the banks if its assets become toxic.
unlike prof. roubini, I am not a big student of international banking crisis. but I question the idea that the government should take over the toxic assets. he says it will prevent the infection from spreading, but I don't think there is a clean way to do this... furthermore, not only will it be a waste of money, but everyone else in the credit market will be on pins and needles waiting for the market to come back to life. imagine that.. for months, as the government buys up these assets, everyone will be waiting for the liquidity to trickle-through ... during that time, companies will be shutting down, firing workers and leaving vendors unpaid.
I think it's better to make clear to the market what kinds of assets CANNOT fail. that would be like issuing a giant put under 90% of the economy. I think it would be much easier, much more direct, less expensive and IMMEDIATELY EFFECTIVE. corporate issuance could come back and the pressure would be removed from the CP market overnight.

for another example of how non-mortgage credit is under pressure, consider these huge price declines in the last 2 weeks for normal bank loans from B of A and S&P Leveraged Commentary & Data:

note that even during the telecom/utility debt crisis of 2002, these loans didn't drop anywhere near these current levels. one thing I worry about, although am not sure will happen, is that this may trigger an entirely new round of writedowns in the Q3 earnings season that's about to begin...

another advantage of my plan is that I think it would put the government in a much better position to make a profit than it would buying toxic mortgage securities.

I think the $700bln paulson plan is government thinking at its worse. many people have observed that government allocates resources in the opposite method of the private sector: when a program is struggling, it gets more money. if it succeeds, no one thinks about it. in private companies, those areas that are most successful and most profitable get the most attention and follow-on investment.

yes, this is not a totally fair comparison, because the government does some activities that no one else wants to do and don't generate "profits". but it does reflect the basic problem with government as an allocator of resources... without the profit motive, there is no institutional incentive to succeed.

these mortgage bonds are failing. instead of trying to drive them back up in value, we should look to prevent them from infecting others. we shouldn't reward failure with money. corporations are much healthier and much more important to the long-term health of our economy and employment. they should be rewarded.

No comments: