Two straight days of (in)digestion

Good Evening: Departing from recent form, our capital markets spent a lot of time churning during the past two days. Trying to digest various bits of positive and negative news, investors received a touch of indigestion for their efforts. All things considered, however, it could have been worse as our markets continue what Jim Grant likes to call “the value restoration process”.

One of the most positive pieces of recent news affecting the markets came out Wednesday night in the form of a very strong earnings report from Apple. AAPL jumped 10% in after hours trading and lifted our stock index futures going into Thursday morning. The news flow turned decidedly more negative prior to yesterday’s open, however, when jobless claims spiked back toward 600,000 and housing starts fell to the lowest level on record (see Merrill’s take in “Dave’s Top 10” below). Prices for new homes also fell, but while the housing data is definitely a short term negative for our economy, it should also be construed as a longer term positive. Now that starts are running below the rate of new home sales (for now), the important process of soaking up excess inventory can finally begin. And, since conventional mortgage rates are now below 5% (or even 4% — see below), housing can now start to bottom out as inventories get worked off. It will take time — months, not weeks — but cheaper prices and lower mortgage rates should eventually do the trick.

Yesterday also saw companies as varied as Microsoft, Fifth Third Bank, and Aflac all report earnings misses. There were other disappointments, too, as well as fresh worries about the U.K. and European banking systems, but the markets held in fairly well considering the preponderance of negative news. Friday had no economic releases to deal with, but Google reported a decent quarter last night and finished 6% higher today. On the other end of the earnings spectrum, GE reported a poor quarter even as it insisted it would try to hold on to both its AAA rating and its large dividend. I may not have attended a fancy business school, but one does not need an MBA to see that Jeff Immelt will have to part with one or the other (and perhaps both — see below). GE’s bonds already trade on a par with companies sporting ratings 5 or so notches lower, and the stock market is forecasting a dividend cut into the price of GE’s common equity. GE finished down 10.5% today, which leaves its stock within shouting distance of single digits.

During both Thursday’s and Friday’s trading sessions, the major averages opened with a swoon and spent the rest of the day trying to recover. Thursday’s efforts fell short, while stocks did manage to finish on the positive side of mixed today. The Dow transports (-2.2% today) still can’t get out of their own way, but Google did help lift the NASDAQ by 0.8%. The other averages finished somewhere in between and the indexes all fell for the third straight week. Stocks seem to be gearing up for another retest of the November lows, but the last hour rallies of late muddy up the picture as to timing. Treasurys represent another murky market, and bond prices continued to retreat both yesterday and today. Yields backed up between 8 and 16 bps as next week’s supply of bills and notes looms in the windshield. The dollar gave ground on Thursday before finishing flat today. Commodities rallied during this same period, and the CRB index gained 2.5% over the two sessions. I would like to note that precious metals and their associated equities shined brighter than almost any other market during this holiday-shortened week.

President Obama and his Treasury Secretary appointee, Tim Geithner, are none too pleased with Wall Street. The shenanigans foisted upon Bank of America by John Thain and others at Merrill Lynch prior to the closing of their recent merger has set tongues-a-wagging in Washington (see below). With the regulatory climate in D.C. turning chillier than a Chicago winter, I’m hoping someone in either the White House or Treasury Department will consider creative solutions in lieu of simply imposing a set of stifling regulations on Wall Street. My “matching gift” idea for the TARP is one such proposal, and I’ve seen some other good ideas bandied about in recent days. I’ve received a lot of positive feedback about my idea, as well as some pointed questions about how a matching program with the TARP would actually work. The following represent a set of sample transactions that I hope will provide readers with a little more clarity as to how my proposal works:

Let’s assume a $100 million bonus pool, and let’s use ABC bank as our candidate bank.
1. ABC has on its books a $200 million mortgage-backed bond (bond X) for which it paid a par amount of $200 million.
2. ABC has written down the value of this position twice and now marks it at a value of 120 million (i.e. a price of 60 on the bond)
3. The ABC bonus pool manager (with oversight by the independent directors on the ABC Board) decides to buy 50 million in face value of this bond for the same price (60) where it’s now marked, costing the pool $30 million (50mm face x .60 price). The bonus pool now receives the bonds and pays ABC bank $30 million in cash
4. The TARP, a separate fund owned and controlled by Treasury, now does the exact same trade with ABC bank. TARP pays $30 million in cash to MS, and receives $50 million in face value of bonds in return
5. The TARP would double these amounts if the matching was done on a 2-1 basis — paying $60 million for $100 million face amount of bonds

+ Benefit to ABC bank: between $60 million and $90 million in fresh cash and most of these bad bonds on its books are now gone (either 1/2 or 3/4 of the total position — the rest stays on the books and remains marked at 60). ABC is now free to make new loans or investments
+ Benefit to ABC bank bonus pool: if the bond recovers in value, then employees actually make money in this pool that vests over time) If the bond loses money, then tough toenails for them
+ Benefit to the TARP (taxpayers): if bond recovers in value, then taxpayers make money. If bond loses money, then at least TARP (us) doesn’t lose as much as if they bought all the bonds on its own, since the employees had to eat some (1/3 or 1/2) of the same bad securities.
+ Benefit to the TARP (taxpayers): Requiring that the bonus pool chooses the price ensures that senior management and their bonus-eligible employees will have their interests aligned with those of taxpayers
+ Benefit to the financial system: With freed up capital, ABC bank (and, presumably, all participating banks) can now do other deals or lend to other clients, which will help get the financial system moving again.

Let me be clear: ALL banks taking TARP funds would be REQUIRED to join this plan, but all pools of money remain separate. ABC bank and the other banks will have their own balance sheets, the employee bonus pools will be held on a different balance sheet, and the TARP will stay in Washington. The only thing moving around will be the money and the bonds, but it will all be pretty easy to track.

One final point to make is that this requirement to have the employee bonus pool take a stake in their firm’s loans/investments could survive beyond the TARP. One of the biggest weaknesses of the securitization process is that the banks processing the loans or creating fancy structures is that they don’t have any stake in the outcome — they just take fees. By making them buy a piece of each deal they originate (or having the bonus pool do so), it would have the positive impact of making them do deals more carefully in the future.

— Jack McHugh

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Dave s Top Ten.pdf

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