Monday, February 23, 2009

Hussman Pivots

In his latest weekly commentary ("The Economy Needs Coordination, Not Money, From the Government"), Dr. Hussman seems to pivot a little on a couple of positions he took in his last market commentary (from which we excerpted in this post, John Hussman on "How to Climb out of a Global Financial Hole"). Last week, Hussman wrote this about Citigroup and some other large banks,

The government should continue to provide capital directly to large, diversified financial institutions which remain solvent but have some impairment to capital. Preferred stock is a reasonable form, though a high (possibly deferred) yield to the government is preferable to a low one (Bagehot's Rule[1]). Tight restrictions against using taxpayer capital for compensation and bonuses are certainly appropriate. These institutions include major banks like Citigroup, Bank of America, Wells Fargo, J.P. Morgan, and others, which appear to be experiencing pressure not because of insolvency, but because of uncertainty about potential future loan losses, and the ongoing availability of publicly provided capital.

Market action over the last week seems to have prompted a different view of Citi from Hussman today,

Take a look at Citibank's balance sheet as of the third quarter of 2008. The company had about $2 trillion in assets, versus about $132 billion in shareholder equity, for a gross leverage ratio of about 16-to-1. That's not a comfortable figure, because it indicates that a decline of about 6% in those assets would wipe out Citibank's equity and make the bank technically insolvent. Unfortunately, we saw credit default spreads screaming higher last week, while the bank's stock dropped below $2 a share, so evidently the market is deeply concerned about the possible immediacy of that outcome.

Instead of the government providing additional capital to Citi, now Hussman favors a sort of receivership,

But keep looking at the liability side of Citibank's balance sheet. There is over $360 billion in long-term debt to the company's bondholders, and another $200 billion in shorter term borrowings. None of that is customer money. That puts the total capital available to absorb losses at $132 + $360 + $200 = $692 billion, which is about 35% of the $2 trillion in assets carried by Citibank. That's a huge cushion for customers, who are unlikely to lose even if Citibank becomes insolvent. Should that occur, the proper response of government will not be to defend Citi's bondholders at taxpayer expense, but rather, to take Citi into receivership, wipe out the shareholders and most of the bondholders, and sell the assets along with the liabilities to customers to another institution.

On the broader point of dealing with foreclosures, Hussman still highlights the need for government coordination and the creation of PARs (proper appreciation rights) to compensate lenders for writing down the principal amounts of mortgages, but takes a slightly different tack on the issue of mortgage "cram-downs". Last week, Hussman wrote,

The most direct method of intervening is at the point of foreclosure through the courts. One way of doing this would be to give judges the ability to write down principal, and to assign the balance as a deferred “property appreciation right” (PAR) to the lender.

And this week, Hussman writes,

If you simply let bankruptcy judges push down principal values with no other recourse to lenders, you undermine the basic principles of contract law that underpin our economy. If you provide government funds to reduce the mortgage principal of some homeowners, with nothing for those who have played by the rules, you create huge inequities and incentives for good homeowners to go delinquent.

It may be that Hussman is being consistent here, i.e., that he's OK with allowing judges to reduce the principal on mortgages provided they compensate lenders with a PAR equivalent to amount the principle was reduced. Perhaps Dr. Hussman will clarify this next week. I suspect, though, that if the government facilitated a market for PARs (as Hussman recommends), most lenders would write down their mortgages in return for PARs voluntarily.

The chart above, which was included in Hussman's column, illustrates a point Hussman made about the steep recent decline in S&P earnings (earnings have historically grown 6% from one cyclical peak to the next cyclical peak).

No comments: