1-2 Knockout

Heidi Montag Will Be the Next Secretary of The Treasury or: How We Are All (even more) Royally F&cked

John McCain, cleverly disguised as his non-existent daughter, recently met up with das-uber annoying wannabe-celebutard Heidi Montag to discuss her views on a variety of important topics (Yes I just linked to The Superficial, yes I know I'm gay, yea yea).  Our strategically-placed stalker source tells us items on their agenda included a lengthy debate on the relative merits of silicon vs. saline, but things really got heated when Heidi mentioned the economy.  Our first inclination is that this must have been some sort of subconscious Freudian slip or yet another unfortunate case of a (quasi-)celebrity parroting something she saw scrolling across a TV out of the corner of her eye.  But, according to our informant, before Montag could snap back out of fembot mode (if such a thing is even possible), "McCain" had already devolved into a state that can only be described as TIMMMMAYYYYYY!!!!!!!!!!! (not that Timmmayyyy). 

After reviewing spy footage of the event, we're not entirely sure whether the cause of "McCain's" sudden shift in behaviour was due to hearing Montag say the word "economy" - a mind-boggling occurrence for sure - or merely the mention of the word itself. 

We've Seen This Before

Hey, remember the time large financial entities, implicitly backed a market's liquidity?  The whole problem was created by a duration mis-match between assets and liabilities.  To "serve their clients", provide "temporary relief" and mainain an "orderly market in times of strain" the banks backstopped the rollovers when the regular buyers ceased to come back for more.

I remember.

It worked for awhile.  Until it didn't.

Just a thought.

Credit Crisis Contagion Kills Celluloid

Thanks, I know, amazing title, right?

Anyways, the credit crisis has struck another victim (from the FT):

The credit crunch has hit home in Hollywood after Paramount Pictures, which has released a string of hit movies this year, was forced to suspend plans for a $450m film financing.

The studio has been working with Deutsche Bank on a financing that would have provided funds for up to 30 films, including possible blockbusters such as the sequel to Transformers and a new version of Star Trek.

However, Deutsche has decided to close its film finance unit and concentrate on other areas. With the Paramount deal proving difficult to close because of a market-wide lack of enthusiasm for the senior debt component of the deal, the financing has effectively been left in limbo...

...While Deutsche’s decision to close its film unit is a blow for Paramount, the films affected by the deal are still likely to be released as scheduled.

But if the studio fails to revive the deal with another bank it could force Paramount to seek funds from Viacom, the media conglomerate that owns the studio, to produce the titles. This would expose the company to greater financial risk if the films fail to perform as expected.

Well Thank God We Have the GSEs!

It seems to me that there are exceedingly few government entities that actually do what they were set up to do.  Whether through the law of unintended consequences, politically motivated 'drift', or just plain failing management, these agencies pervert their 'jobs' on a regular basis.  For a case in point I give you the Fannie Mae "who we are" write-up.  Emphasis is mine; my snide comments are in blue italics.

Fannie Mae provides stability, liquidity, and affordability to the nation's housing finance system under all economic conditions. Well, thank god we have the GSE's to provide "stability, liquidity and affordable houses".  Without them we may find ourselves in a housing/credit crisis, too few homes on the market (sarcasm), and expensive (yet declining) houses.  We are a shareholder-owned company with a public mission. "We privatize the profits, and socialize the risk just as Moussilini would have wanted."  We exist to expand affordable housing (unless congressional pressure tells us we can't let house prices fall) and bring global capital to local communities that give the most money to congress in order to serve the U.S. housing market help incumbents get re-elected.

Fannie Mae has a federal charter and operates in America's secondary mortgage market to ensure that mortgage bankers and other lenders have enough funds to lend to home buyers at low rates. Seeing as how we had more money flowing into the RE sector than we knew what to do with (that's how you get a bubble), at rates too low to compensate for the riskiness of loans, what problem did this solve again? Our job is to help those who house America.

Fannie Mae was created in 1938, under President Franklin D. Roosevelt, at a time when millions of families could not become homeowners, or risked losing their homes, for lack of a consistent supply of mortgage funds across America.  This line should read "we now have the honor of being the first of the Socialist New Deal programs to fail, but you should expect the others to follow suit shortly.  Go us!"

The government established Fannie Mae in order to expand the flow of mortgage funds in all communities, at all times, under all economic conditions, and to help lower the costs to buy a home. HAHA! "at all times, under all economic conditions"  Well, it seems like the GSE's lent when the private market was functional and lending, but now, when we "theoretically" (open to debate) need the new loans for stability FNM and FRE are unable to provide them.  Phew, what would we do without all their help.

In 1968, Fannie Mae was re-chartered by Congress as a shareholder-owned company, funded solely with private capital raised from investors on Wall Street and around the world. Unless they need my capital.

Fannie Mae has a unique duty to the public it serves -- and the private investors that fuel its service -- to be a model company focused on service, reliability, and value. No comment.

Like all who participate in the housing market, Fannie Mae has a responsibility to help home buyers, homeowners, and communities through market challenges. We believe in the long term health of America's housing market. The nation is growing and that growth will bring a renewed demand for housing and for responsible, sustainable mortgage lending. Fannie Mae will be there to help meet America's changing housing needs.  We'll see, won't we.

It's also important to note that, by definition, to provide "low cost" loans means providing loans that are not expensive enough to cover their risks.  If the loan rate was enough to cover those risks and a profit margin they loans would cost exactly what the market charged.  Suffice it to say, the GSEs are performing EXACTLY AS SHOULD HAVE BEEN EXPECTED.

Bondholders 2 - Taxpayers -365,743

Generally companies facing insolvency don't see their debt climb...

NEW YORK, July 11 (Reuters) - Debt of Fannie Mae and Freddie Mac  soared in their best one-day gain in history on Friday amid speculation that a government takeover of the housing giants would make the bonds more like ultra-safe U.S. Treasuries...

...But that also means a credit-quality downgrade for U.S. Treasury debt, which slumped, investors said.

Thank god I get the junk Fannie and Freddie trade in for the t-bills.

UPDATE: In you haven't seen it, i present to you the first page of any Fannie Mae prospectus (emphasis theirs!):

Fannie Mae Guaranty

We guarantee that the holders of the certificates will receive timely payments of interest and principal. We alone are responsible for making payments under our guaranty. The certificates and payments of principal and interest on the certificates are not guaranteed by the United States, and do not constitute a debt or obligation of the United States or any of its agencies or instrumentalities other than Fannie Mae.

Thanks, Comrade Paulson

Over at Naked Capitalism, Yves Smith laments over William Butler's "characteristically colorful" piece "Time for comrade Paulson to pull the plug on the Fannie and Freddie charade".  Yves regrets Mr. Butler beating him to the punch over the backdoor socialism movement underway here in America.  It is a topic i have opined on numerous times, but never with the clarity of thought Mr. Butler or Mr. Smith provide.

"But Buiter's beef isn't the operation of the GSEs but the philosophy behind them, the hydra-headed and not fully visible ways the US has socialized real estate (did you know about the Farm Credit Banks, for instance?). He provided a good summary of the history and dramatis personae."

Read both editorials.  They are incredible.

Enjoy your weekend and take a shot (or down a fifth) of Jack for me while you ponder the impending downfall of the American financial system--you've got a front row seat.

(hat tip - ep)

 

Setting the Record Straight: Taxpayers Are NOT Funding JPM's Buyout of Bear Stearns

Since news of its imminent collapse and the actions of the Federal Reserve to prevent it, much of the criticism heaped upon JP Morgan’s takeout of Bear Stearns has revolved around whether it amounts to a taxpayer-funded bailout of Wall Street. Countless media reports would have their readers believe that this is indeed the case, but I have yet to read a single compelling explanation of how exactly this is the case. It does not take much effort to stoke the populist fire by quoting anonymous sources or citing vague ‘reports’ supporting this conclusion. To date, not a single account I have read attacks the crux of the matter, which is to explain the mechanisms, or under what circumstances taxpayer funds were, or could be used to fund the transaction.

I’ve scoured information on the Federal Reserve’s website and spoken with respected authorities on the subject, none of which suggest that taxpayers are footing the bill for the transaction. The likelihood that taxpayer funds will every be used at all is slim-to-none. One source I spoke with, a respected Finance Professor (of Markets & Banking, among other subjects) went so far as to say that he doesn’t expect either JPM or the Fed to take any significant loss as a result of the Bear deal when all is said-and-done.

Before anyone jumps down my neck, let me elaborate.

Two weeks ago the Fed released its quarterly update of the collateral pledged against its loan to JPM was marked down to $28.9 Bn from ~$30 bn when the loan was first made. Maturities on the assets pledged extend out 10-20 years or more, according to what I’ve seen, although the Fed is relatively mum on the exact composition of the portfolio.

To illustrate what would happen in an extreme case, lets consider a semi-arbitrary situation in which the default rate on the pledged assets is 100% (which is very unlikely, baring global financial catastrophe or something on that scale), with zero recovery on any assets, spread out evenly over 15 years. In this example, these are not simply mark-to-market accounting losses (how they’ll actually show), but economic losses, just to illustrate the point. In this example, the Fed will have to absorb ~$2bn per year over that 15 year period, a figure which may seem extreme, but as I’ll explain, is relatively insignificant in the grand scheme of things.

In “Purposes & Functions of the Federal Reserve”, pp. 11, it states:

The income of the Federal Reserve System is derived primarily from the interest on U.S. government securities that it has acquired through open market operations. Other major sources of income are the interest on foreign currency investments held by the System; interest on loans to depository institutions; and fees received for services provided to deposi­tory institutions, such as check clearing, funds transfers, and automated clearinghouse operations.

“Ok, BFD, so what?” you say. Relax my young padawan, for the truth shall set you free:

After it pays its expenses, the Federal Reserve turns the rest of its earn­ings over to the U.S. Treasury. About 95 percent of the Reserve Banks’ net earnings have been paid into the Treasury since the Federal Reserve System began operations in 1914. (Income and expenses of the Federal Reserve Banks from 1914 to the present are included in the Annual Report of the Board of Governors.) In 2003, the Federal Reserve paid approxi­mately $22 billion to the Treasury.

In 2007 this number was $38.7bn, up from $29.1bn in 2006 (pp. 360 of the report). Even if we take the low number from 2003, the $2bn annual loss from the above extreme example would only represent less than a 10% hit to the funds contributed to the Treasury by the Fed.

For those who still don’t get it, let me explain. While the Fed is funded and overseen by Congress, it is “private within the Government;” it is effectively a self-funded entity operating as a “private” organization within Government. The loan extended by the Fed to JPM (via Maiden Lane, LLC) was a direct extension of credit from the Fed’s balance sheet, not from an appropriate of taxpayer monies, which so far as I can tell, would have required specific Congressional action.

When this information is taken in its entirety the only possible “hit” to taxpayers would be a budgetary shortfall resulting from poor budgetary planning (e.g. if the budget was based on receiving X dollars from the Fed, only to actually receive X minus whatever “loss” the Fed absorbed from collateral losses in the Bear collateral). Even in this situation, taxpayers still are not actually funding any part of the transaction, only the foregone funds – which were never a certainty to begin with – of the difference between the estimated Fed contribution and its actual contribution in a given year.

May I be missing something (or potentially many things)? Absolutely. But all research I’ve done suggests that one thing is certain (or at least as certain as anything can be these days): Taxpayers are NOT funding the purchase (“bailout,” whatever) of Bear Stearns.  Until, or unless someone can provide clear, factual support that this is not the case, journalists, pundits, and even those of us on The Street need to resist the urge to propagate the unsubstantiated claims of those who cannot or will not back up such claims.

I'm Moving to Guatemala

Not that this is news to anyone who, uh, actually reads the news, but the two men running for President of the U.S. are, how to put this gingerly, economically retarded.

Karl Rove did a piece in the WSJ yesterday, calling out these two pandering politicos on their blatant b.s., the most painful example of which may be the idea of taxing "windfall" profits (of course, avoiding any discussion of what, exactly, constitutes said "windfall".  Not to go off on a rant here, but wtf is up with the wind references, "windfall", "headwinds", etc?) 

Rove accurately points out that margins for the current corporate pariah du jour, oil/energy companies such as Exxon Mobil, are amongst the slimmest in any industry.  So, if these populism-promoting politicians aren't defining windfall profits by margins, they must mean by sheer size, right? 

Wrong. 

It's not the profit margin, but the total number of dollars earned that is the problem, Mr. Obama might say. But if that were the case, why isn't he targeting other industries? Oil and gas companies made $86.5 billion in profits last year. At the same time, the financial services industry took in $498.5 billion in profits, the retail industry walked away with $137.5 billion, and information technology companies made off with $103.4 billion. What kind of special outrage does Mr. Obama have for these companies?

It's one thing when the most liberal senator on Capitol Hill blabbers incoherently about things which he clearly does not understand (as a matter of fact, its pretty much par for the course, no?), but when a so-called "Regan Republican" like John MCcain allows himself to sound similar ignorant, its a sign that we're all in serious trouble.

This past Thursday, Mr. McCain came close to advocating a form of industrial policy, saying, "I'm very angry, frankly, at the oil companies not only because of the obscene profits they've made, but their failure to invest in alternate energy."

So yea, about the title of this post.  I'm not kidding.  When the next leaders of the free world (ha!) not only say stupid things, but I fear, will actually follow their rhetoric with action, bad things will happen.  Very bad things.

(Mis)Adventures in Myopia

We're all supposed to 'know' that investors are myopic, that they tend to focus on the present and very-near future while ignoring the long-term.  While this may be a convenient assumption in modern finance, it behooves the prudent investor to look beyond the 'now', so-to-speak, beyond the hype, to find attractive long-term investment success.  Unfortunately, this approach seems to be about as popular as Nick Hogan at a MADD conference.  The sheer amount of evidence is staggering, but I'll keep it light and let Bloomberg do the work:

Retail sales in the U.S. rose twice as much as forecast in May as Americans snapped up electronics, clothes and furniture, evidence that they aren't hoarding their tax-rebate checks or using them just to pay for gasoline.

``It's just amazing -- the American consumer's resilience in the face of everything negative,'' Stuart Hoffman, chief economist at PNC Financial Services Group Inc. in Pittsburgh, said in an interview with Bloomberg Television.

Yes!  Long live consumer whoredom!  Maybe we can spend our way out of this 'recession' after all, no?  Hell, the S&P Retail Index is off its year lows (although well-below its highs), and, as Bloomberg points out, retail sales were up TWICE as much as expected!!!  The rest of the article above takes this tone, that the worst of our problems are already behind us.  But, lest we prematurely jump to any conclusions, the very last paragraph reminds us of that which so many seem to be overlooking:

The bulk of the tax rebates will probably be spent from July through September, giving third-quarter growth a lift, before the economy decelerates again in the last three months of the year, the Bloomberg poll also showed.

Oh.  So they're saying that, Aeropostale isn't going to keep increasing same-store sales 20% every quarter? That people are going to have to decide between filling the tank in their Escalade or buying a new XBox?  HOGWASH!  I bet next you're going to try to tell me that defaults on auto and other consumer loans are on the rise, ha!  Rubbish!

And so, sarcasm aside, despite what by all measures is an inevitable storm of difficulties for the economy - especially the consumer discretionary sector - the S&P is already up almost 10% from the lows reached only 3 short months ago.  It seems daily, the so-called pundits, experts, and talking heads in the media are trying to convince us that the worst is already behind us, that the economy is strong.  It is certainly possible that we may be further along towards absorbing the negative affects of the subprime mortgage fiasco, but we've only begun to scratch the surface of the secondary and tertiary effects of a slowing, or receeding economy.  Trading in November, 2008 CBOE Volatility Index (VIX) options strongly support this thesis, as there is massive open interest all the way up to $37.50, implying that some market participants are seriously hedging their bets (or betting outright) should things tank over the next 2 quarters.

It seems, especially in the retail and discretionary sectors, that results have been heavily influenced by the receipt of tax refunds and "stimulus" checks.  While most of the relevent data has yet to come out, early indications suggest that consumers were spending more of their "free" money at the malls, instead of paying off their ever-increasing debt load.

Higher commodity and energy prices, ever-increasing consumer (and government) indebtedness, and a generally downward turning business cycle do not bode well for the state of the U.S. (nay, Global) economy in the itermediate-term.  Unfortunately, it seems that our human nature (or the nature of crowds), the predisposition towards unbridled optimism - even in the face of mounting evidence to the contrary - has been, and will continue to overpower logic and reason. 

Only time will tell, but as I write this and overlook the menacing clouds hovering over the East River, I can't help but think of the storm cloud of consequences from our irresponsible and short-sighted decision-making, threatening the economic well-being of the entire Country as a whole.  Hopefully I'm just letting my predisposition towards cynicism get the best of me, but until I see substantial evidence that my worst fears are only that, I'll be cautiously taking the other side of your long America trades. 

Disclosure: Anal_yst is short Aeropostale, but really long America (at least in heart, but less in portfolio, or something).  Anal_yst is not a creative writer (clearly).

Said Nextel, "Let Them Eat Cake"

Over at tech uber-blog Engadget, there is an interesting story that Sprint/Nextel waived early-termination fees (the other ETF) for Government employees/agencies.  This is especially interesting, since Chris Cox, chairman of the FCC is trying to push the mobile carriers to come to some sort of agreement to chill out with the ridiculous ETFs.

Thats all well-and-good, and I'm sure theres some yet-to-be-explored angle there, but I'm more interested in the discussion that followed in the comments section on Engadget.  As could be expected, many decried the CRAZY early termination fees as usurious extortion by the carriers.  Some tried (and failed) to kind-of explain, but even the most 1/2 hearted attempts fell on deaf ears.  I also tried (and failed) to lend some reason to the debate, but the kind folks at Engadget refuse to recognize my logon/password, even though I copied it directly off the automated confirm sent to my email when I first signed up.  Alas, I shall not be ignored!

I put together a quick & dirty (spreadsheet ) to illustrate a simple example of the cell phone retail business model, but to summarize, it goes something like this: 

• Step 1. Subsidize cost of phone (i.e. sell as loss-leader)
• Step 2. Amortize the loss/make $$ by locking customers into long-term contracts.
  • Step 2.5. Charge mucho dinero to customers for walking away from said contracts.

Now, some people have a hard time with these fees, which can be as much as $250 (if not more).  My first reaction is generally somewhere along the lines of, "READ THE CONTRACT BEFORE YOU SIGN (idiot)."  Of course, we all know the average person's ability to read (nay, comprehend) contracts is not so good ("hey, who wants a no-doc, stated-income jumbo option arm mortgage?"), so this response is pretty much a waste of breath. 

In reality, people need to understand that they simply cannot have their cake (i.e. affordable handsets) and eat it too (no/low early termination fees). Thats just how the world works.  Deal with it.

In this example, I assumed a 2-year contract period, on which the carrier takes a loss (subsidy) of $200 on the handset at purchase, a contract costing $50 monthly, and an annual interest rate of 9% (semi-arbitrary).  The NPV to the carrier over the life of the contract is about $900.  However, if there we assume a hypothetical situation where there is no early-termination fee and the customer were to cancel after only 12 months, the NPV drops down to about $375, almost a 60% drop in profit.  To the layman, this may seem silly, as the company is still 'making a profit', but that only captures a small part of the picture, running a mobile communications company is an awfully expensive proposition.  Thus, the "profit" generated by long-term mobile contracts enables the company to conduct business, that is, it doesn't simply trickle down to the bottom line uninterrupted.

We'd be delusional, of course, to expect every Joe and Jane Doe understand the complex business model of a wireless carrier, and we'd be similarly delusional to expect the fervor surrounding early-termination fees to die down any time soon. 

Lets assume that the FCC and the carriers come to some sort of agreement limiting the ETFs, avoiding the possibility that Cox & Crew will bow to the anti-capitalist cries from the masses and mandate they be eliminated entirely.  How, then, will the carriers account for the increased uncertainty of future cash flows from service contracts?  One thing is certain:  The carriers are absolutely not going to roll over and play dead.  I'd imagine they'll play ball, so-to-speak, and give up some restrictions on early-termination, but where they're losing money (and the attendant certainty of that money) they'll make up for it elsewhere.  I'd expect they'll keep up with the practice of heavily subsidizing handsets as their main sales driver, and reducing ETFs should definitely increase sales, as people can upgrade their phones more often. 

Its important to keep in mind that not only are the carriers losing out on previously-certain future cash flows, but they'll also suffer a hit to their gross margins as higher handset sales directly increase their CoGS.  To offset this, I'd expect the carriers will increase the cost of service contracts to even-out the PV calculation, and changing the structure (i.e. tenor) of the service contracts they offer.  I think the most obvious solution is that there will be a shift towards 1-year contracts, reducing the likelihood that a customer will switch carriers or upgrade their phone before the contract expires. 

Of course, the trade off is that the shorter-duration contracts will most likely cost more per month than the traditional 2-year variety, but as I said, you can't have your cake, and eat it too.