John Hussman's Latest: "Money Doesn't Grow on Trees"

From Dr. Hussman's latest market commentary, "Money Doesn't Grow on Trees":

On the BofA/Merrill Lynch deal:

[I]nstead of Merrill Lynch's bondholders taking a loss on their bonds, or swapping their debt for BofA equity, those bondholders will now be made whole for all of the losses that Merrill incurred, with 100% principal and interest, right alongside of the bondholders of BofA that are being protected. That's what these bureaucrats want during their stint in government service, that's how they advise our elected officials, and then their revolving door takes them right back to Wall Street.

On what it would take for the banks to earn their way out of their losses:

[T]he earnings to recover the losses have to come from somewhere, which implies a redistribution away from where they were going before. Really, money doesn't grow on trees. We've got an economy running with outstanding debt of about 350% of GDP. Even a moderate percentage of that as loan losses will represent a significant share of GDP. To reallocate enough funds to fill that hole, we would have to keep deposit rates near zero, and corporate lending rates high, so that financial institutions would earn a persistently wide spread, or “net interest margin.” Over the short-term, that's what's been happening, so ironically, banks are more “profitable” today than they probably will ever be. Unfortunately, that “profitability” is an artifact of a) unsustainably wide net interest margins, and b) a failure to adequately book losses, at the encouragement of government bureaucrats.

[...]

In order for U.S. financial institutions to earn their way out of the losses, they will have to accrue and retain an amount on the order of 25% to 35% of GDP. From where will they reallocate that amount?

[...]

If banks were able to sustainably charge high interest rates on loans and pay low interest rates on deposits, the earnings of the banks would come at a cost to what would otherwise have been retained: corporate earnings and private savings. Essentially, savers will earn less, and corporate borrowers will pay more. To accrue 25-35% of GDP to cover the debt losses (which is a mainstream estimate, not a worst-case by any means), you would have to persistently depress non-financial corporate profits and personal savings by about 25% for well over a decade.

As Dr. Hussman goes on to reemphasize, this is a high price to pay to provide 100% protection to the bondholders of poorly-run financial institutions.

Andy Kessler on the Fixing the Banks

From his op/ed column in yesterday's Wall Street Journal, "Why Markets Dissed the Geithner Plan":

Mr. Geithner wants to "stress test" banks to see which are worth saving. The market already has. Despite over a trillion in assets, Citigroup is worth a meager $18 billion, Bank of America only $28 billion. The market has already figured out that the banks and their accountants haven't fessed up to bad loans and that their shareholders are toast.

[...]

Mr. Geithner should instead use his "stress test" and nationalize the dead banks via the FDIC -- but only for a day or so.

First, strip out all the toxic assets and put them into a holding tank inside the Treasury. Then inject $300 billion in fresh equity for both Citi and Bank of America. Create 10 billion new shares of each of the companies to replace the old ones. The book value of each share could be $30. Very quickly, a new board of directors should be created and a new management team hired. Here's the tricky part: Who owns the shares? Politics will kill a nationalized bank. So spin them out immediately.

Some $6 trillion in income taxes were paid by individuals in 2006, 2007 and 2008. On a pro-forma basis, send out those 10 billion shares of each bank to taxpayers. They paid for the recapitalization.

Each taxpayer would get about $100 worth of stock for each $1,000 of taxes paid. Of course, each taxpayer has the ability to sell these shares on the open market, maybe at $40, maybe $20, maybe $80. It depends on management, their vision, how much additional capital they are willing to raise, the dividend they declare, etc. Meanwhile, the toxic assets sitting inside the Treasury will have residual value and the proceeds from their eventual sale, I believe, will more than offset the capital injected. That would benefit all citizens, not the managements and shareholders who blew up the banking system in the first place.

Richard Pzena's Picks For 2008

Hat tip to GuruFocus poster Abeck for this Barron's interview with Richard Pzena dated December 31^st, 2007: "Opportunity Amid the Ruins". Excerpt:

Barron's: What is your downside risk [of holding Citigroup]?

Richard Pzena: There is some short-term downside risk. Looking out three years-plus, you have a really spectacular risk/reward trade. The odds that Citigroup sells for less than 30 in three years are very low, and the odds of it selling for substantially above that are very high.

Barron's: Do you feel the same about other banks?

RP: Bank of America [BAC] is the same story. They are going through a downturn, so they're going to have losses and provisions. We're estimating earnings of $3.70 a share for 2007 and $4.10 for '08. Right now, people aren't buying banks because the next quarter might be bad. Whenever investors become hypersensitive to the next piece of information, value opportunities arise.

You have to have a strong stomach to do this. I always joke about it, but the most common question we get from clients in any market environment is "don't you read the paper? How could you possibly do this, given what is going on?" And the response is, these shares don't trade at these valuations unless this kind of stuff is going on. If this proves to be fatal to Citi or Fannie or Freddie, we'll get killed. If it proves not to be fatal, as we suspect, then over the long term we're going to make a lot of money.

The article included this table listing Pzena's six stock picks (Fannie, Freddie, Citi, BofA, Alcatel-Lucent, and Capital One) and their prices as of the end of 2007.

The photo above, of Richard Pzena, is from the Barron's article linked to in this post.

"Unable to Read the Air"

In yesterday's Financial Times, letter writer Takashi Ito introduces a Japanese idiom to describe ousted Merrill Lynch CEO John Thain's recent behavior:

Sir, The hot new word in Japan is “KY”. An abbreviation for “kuuki-yomenai”, it literally means unable to read the air. For an ex-Goldman Sachs partner, John Thain was astoundingly KY. He decorated his office as he laid off Merrill Lynch employees, and then he asked for a $10m bonus when the whole country had turned against excessive executive compensation. There was also the little detail that his company was not doing that well.

The height of his KY was the fact that he was buying company stock the day before he was ousted!

Now a true believer (in Goldman superiority) may say that he was buying stock because he knew his departure would ignite the share price, but I am not willing to give Mr Thain that much credit. Anyway, the stock dived on the news.

How Tight are Goldman Sachs Alumni?

That question occurred to me when reading William Cohan's evisceration of Bank of America CEO Ken Lewis in yesterday's Financial Times ("The tattered strategy of the banker of the year"). In that piece Cohan wrote,

[W]hen he announced the Merrill deal, Mr Lewis boasted that he was able to move so quickly because his adviser, the ubiquitous private equity expert, Chris Flowers, had already done the due diligence on Merrill’s books and pronounced them much improved since John Thain, Merrill chief executive, took over at the company a year ago. With Mr Flowers’ apparent blessing, Mr Lewis agreed to pay billions of his shareholders’ money for Merrill’s worthless equity and in the process absorbed billions of dollars more of its debt on to his balance sheet at par. While Barclays was buying Lehman Brothers’ US assets for pennies on the dollar and Jamie Dimon at JPMorgan Chase had done pretty much the same in his acquisitions of Bear Stearns and Washington Mutual, Mr Lewis was paying retail prices for companies that had already been remaindered.

Now, not surprisingly, Bank of America’s shareholders are paying the price. Since Mr Lewis agreed to the Merrill deal during the fateful weekend of September 15, Bank of America’s stock has crashed to about $7 per share, down a whopping 80 per cent from the $34 a share the stock was trading at the day before the Merrill deal was announced, and 40 per cent so far in 2009. Bank of America’s total market value is now less than the $50bn it offered for Merrill’s stock last September.

Perhaps because Goldman Sachs alumni are ubiquitous in high finance, Cohan didn't note that J. Christopher Flowers is a Goldman Sachs alumnus, as of course is John Thain. One would think that, as an adviser to Bank of America, Flowers had a fiduciary responsibility to objectively conduct his due diligence on Merrill's books; perhaps Flowers did, and the math whiz was simply off by a wide margin. In any case, the result is that one Goldman Sachs alumnus (Thain) got to sell his new firm for what appears now to be an inflated valuation, thanks to an analysis done by another Goldman Sachs alumnus (Flowers).

Back to Cohan on Lewis:

Mr Lewis’s end cannot come quickly enough. There really is no excuse for his decision to do these ego-driven deals at the prices he did them. It is one thing to feel the need to do one’s patriotic duty; it is quite another to miss the mark so completely at the expense of your shareholders. It was probably just a matter of time, anyway, before he joined the other former “bankers of the year” such as Ken Thompson (2005), former chief of Wachovia, and Kerry Killinger (2001), former chief of Washington Mutual, on the junk heap of history.

The photo of Flowers above comes from Cityfile.

A Difference Between the Dot-Com Bust and the Real Estate Bust

During the dot-com bust, the bag holders were, for the most part, individual retail investors -- average Americans, who bid up the price of Internet stock IPOs. Investment banks collected huge fees on those IPOs, regardless of how the companies they brought public performed. In the wake of the real estate bust and the related credit crunch, the biggest bag holders have been on Wall Street: Lehman and Bear Stearns -- two firms that survived the Great Depression intact -- gone, nearly all of their respective CEOs equity stakes wiped out; the country's largest broker/dealer, Merrill Lynch, forced into a sale to Bank of America; etc.

That's something I've thought about as I watched Congressman after Congressman rail against Wall Street in yesterday's hearings while lamenting the plight of his average American constituents.

More Sunday Night Excitement

A lot of news for a Sunday Night:

- Lehman Brothers is filing Chapter 11.
- Bank of America is buying Merrill Lynch.
- The Fed is expanding the types of collateral it will lend against to include equities.
- AIG is planning asset sales to raise capital as part of a massive restructuring.

I wonder if at some point it might make sense for the Federal government to create its own vulture fund with one or two hundred billion dollars and start buying up distressed mortgages and mortgage-backed securities at steep discounts. Maybe that would put a floor under the prices of some of the complex assets derived from mortgage-backed securities, and if the Feds buy these securities at steep enough discounts, they might turn a profit on them when the credit markets revive. Just a layman's thought. Perhaps professional pundits will offer better suggestions.