Traderbill’s Financial Markets Weblog

Solvency: The ability of a corporation to meet its long-term fixed expenses and to accomplish long-term expansion and growth.

…TB has referred to the current situation alternatively as a liquidity crisis and a credit crisis. In the past week or so he has seen this described as a solvency crisis. For the Administration it has become a credibility crisis. Today we will examine the layers and how we got to where we are today.

1. Credit. For 25 years we have been told that we, as individuals are creditworthy. Some of us were and some weren’t but being a democracy we blurred the difference. Let’s go back another decade and notice how we saw the gasoline credit card morph into the general credit card which could be readily used for most transactions…except food which was a no-no because as Mork of Mork & Mindy fame would say, ”it’s too hard to repossess.” Home buying was not easy: 10% down was the minimum and the banks wanted 20% down for the best rates and they also wanted to see the source of the downpayment…did mom and dad give it to you gratuitously or was it a loan? Auto loans expanded and GM and Ford credit became huge in the traditional realm of banks.

Creditworthiness became a moving target along the lines of “we finance what we sell.” This was largely a function of the rising inflation in the 70’s and 80’s brought on by Johnson’s ‘guns and butter’ approach to the Viet Nam war which produced huge deficits. Buy it now because it will cost more tomorrow made sense in those days but that produced a lack of discipline so that after Paul Volcker killed inflation in a painful experiment we continued to buy now…not because it was cheaper, we wanted it now. Like anything it is the desire to own something that produces satisfaction when you acquire it and that quickly fades as we look at the next new thing that we ‘gotta have,’ even though we really don’t. Does anyone else remember the US chastising the Japanese for not consuming enough…as if they needed two TV’s in an 800 square foot home…after all, we did! Imagine what would have happened had they followed our government’s advice…they would be worse off and probably where we are approaching today.

We have foregone savings (after all we had it in stocks…oops, they crashed but we still had our homes and they didn’t…till now), and ridiculed people who keep money in savings accounts. Banks were morphed into financial supermarkets with the 1999 repeal of Glass-Steagall, and with that there credit standards declined more…and they already had in the 1980’s rush for credit card accounts. Thanks to a 1978 Supreme Court ruling that national banks could charge any interest rate, all state laws went off the books or were revised up to insane levels that were more like loansharking…but at least they didn’t break your kneecaps. In fact, you could file bankruptcy and pick up a credit card application on a table at the rear of the courtroom…true story! People had 5, 10, TB even saw a guy on People’s Court who had 50.

Homes became ATM’s and thus even more attractive as the values started rising…move in and six months later take a vacation and buy that BMW you always wanted…that too with no money down, better yet lease it. But now that the cycle has turned people are finding the ATM closed, the money spent and unavailable, locked in the lease, having their mortgage reset, and not able to get new credit let alone another car lease.

TB predicted when GM and Ford were doing all those 5 year 0% leases mainly on big SUV’s that there would be problems and as gas prices rose the value of those they plummeted in value…these were the first upside down loans where you had to pay up to get out of it. Want to take over someone else’s lease? They are all over the lot now but of course you will be on the hook if they don’t pay up, unless they can qualify and if they can why do they want to take over yours?

TB can still hear Larry Kudlow and Brian Wesbury chortling about how stupid and blown out of proportion the subprime mess was…and both are clinging on in the belief that the economy is coming back despite all evidence to the contrary. Either a total lack of understanding of the derivatives market or just ‘dissing’ it

Now we see that subprime delinquencies have extended to Alt-A mortgages that are variable and now to prime (imagine the guy who bought a tract home in Vallejo and put down 10-20% while everyone else went subprime…he has now lost all his equity and then some and still can’t sell if he has to)…yet we are continually told that people who have owned their homes for five or six years are OK, they may be but most likely aren’t if they availed themselves of extracting their home ‘equity.’ Some of this was frivolous (vacations, cars), and some was to improve their homes, normally a good investment, and some were required due to a lack of pay increases or one person losing a job, or for medical expenses. So we have no idea how the person who has owned a home for six years is really doing…none…and we can’t judge by their lifestyle, the car they drive or how they spend their leisure time…it is all a blur.

We are now seeing the crisis extend to home equity and former Fed governor Lawrence Lindsay who wrote a book on the crisis said this morning on CNBC that auto loans are next…add to that credit cards. TB was discussing this the other day…what choice does the holder of the second have…other than to pick up the first mortgage…and that would prove futile. Already we are seeing people make their car payment (you need transportation) and credit cards (you need gas and to eat), and forego their mortgage payment as it takes about 15 months to get you out of the house and if for some reason you are doing better and make it up, all will be forgiven…probably without penalty…but don’t bet on that.

2. Monolines. After the subprime losses came to light…and by the way they will not peak until about midyear but you won’t know about it with the banks because they will report as they become delinquent so it will be the second quarter of next year at least before we know the extent of the damage to them, whereas we probably no the damage to brokers now just not how they will dig their way out. Had monoline insurers done what they do best (and the rating agencies done their jobs), insure states and municipalities who didn’t need it in the first place…and as a side effect destroyed the incentive to analyze credits by the buyers of these securities…rather than branch out into insuring credit derivatives that reached massive proportions we would not be at this juncture. Without the insurance, the auction rate securities market is a shambles because the brokers who act as issuing agents have their capital so impaired that they cannot do what they have done consistently since 1984…support their own auctions by buying back any excess paper…this is the unthinkable (over that 23 year period there were less than 50 ‘failed’ auctions. Now, we are routinely seeing more than 500 in a single day). since he has been buying ARS, around 1990, by carefully choosing the securities he bought, he only had one ‘failed auction’ and that worked out with a month or so. Currently he has had four different issues called and redeemed by issuing bonds and will undoubtedly see more called as he does not buy or hold any of the exotic varieties. Also, his have had reset rates from as low as 4% tax free to as high as 12% (Dallas Fort Worth Airport to avoid a cap of 7.25% just issued bonds yielding over 6%), but sadly some issues have yielded less than 2% due to formulas and some do to caps during a computation period are at ZERO with no ability to get out of the securities…TB was shocked to learn this.

There are only two times a year (normally) where liquidity is an issue for ARS: yearend, and April 15th. At yearend the rates rose modestly as they always do but in January they didn’t come back down. Suddenly, there was no out from the auctions except by luck. Fortunately, on the good issues, people are getting wise to the situation and some buyers are coming in and thus providing some measure of liquidity, yet, yesterday, TB attempted to put back 300M of an issue and only got rid of 25M despite being a buyer of $100M on the other side so that should give you some idea of the ratio of buyers versus sellers.

After NY State started going after the monolines it appeared a solution would be in place within weeks or a month or so…perhaps due to the Spitzer scandal you don’t hear a peep anymore…in something that has reached crisis proportions. TB had to sell some bonds yesterday to raise cash for an account. He had issues with guarantees by AGS, MBIA and AMBAC. Before putting them out for bid he discussed with a salesman who listed priorities as shown above so he didn’t sell any of the AMBAC. These were not crap, but good solid stand alone credits. He got terrific bids on both securities but one broker would not bid the AGS even though it is the strongest of the insurers…in other words they will only bid the insurers they know completely. Again, this is unheard of.

TB also heard from an investor in a pool of asset backed securities…collateralized loans which TB has said were trading cheaper than junk bonds of the underlying issuer. When he saw the collateral he was shocked by the ratings and also that issues maturing within a month were marked at less than 90% of their face value. This, folks, is a credit crisis…and if nobody wants this paper which is most likely money good, how is a company supposed to finance its operations? How is an investor to get the money necessary to continue to finance his investments?

3. Solvency. As the above statement suggests, credit (caused by a failure of the monoline insurers), has created a liquidity crisis, which has in turn created a solvency crisis. Perfectly good companies do not have access to the capital markets (CIT can no longer issue asset backed commercial paper and had to resort to its bank lines…for how long before they must restructure their debt?). Investors are more willing to buy less senior junk bonds than collateralized loans of the same company. At the least this raises their borrowing costs and at worst can render them insolvent. So far we have addressed only large public companies, but what about smaller ones…and small banks who are being squeezed as rates are cut but they must maintain deposit rates to hold on to customers even as the big commercials bid up for those deposits. Small businesses rely on credit card financing not bank lines…and their credit is being cut. TB told of a small private bank that had its corporate credit card limits cut by AmEx to $5,000…in total. How can a business operate on this…and there was no reason for the cut. John Mauldin wrote recently of when he was a young man and had a small but profitable business that was growing and financed by a bank. Suddenly, and without reason the called his loan. He didn’t have the money to pay it back but could…they went so far as to call his mother demanding payment or they would take him to court. When he heard this he shut down the business in order to repay the loan…is this what we are coming to? Have an unused home equity line…read your contract…they can reduce it at will if your credit or the value of your home declines…so don’t count on that as a backstop. You have just seen what is happening from top to bottom and it brings everyone’s solvency into question…there are no guarantees of liquidity…hence Treasury bills at 1%.   

4. Scary.  This was not meant to be entertaining and might be frightening but was prompted by the different conversations yesterday with experienced investment professionals with three separate areas of expertise that TB has known and respected for more than ten years and the fact that all were concerned, to put it mildly, about the current situation. Never in his 38 years experience has TB ever seen this level of concern and each of the conversations resolved around corporate credit that has been eroded due to the insurance crisis impacting the liquidity and borrowing ability.

TB has continually said that you cannot solve a problem until you identify it. TB has identified it, the government knows the problem (yet Economic Advisor to the President Ed Lazear continued to say this morning that they see just a slowdown with the consumer bringing us out of it in the second half of this year!), and only Ben Bernanke, who does understand it, is doing anything about it. Thankfully, he, not good times Alan, is the Fed Chairman, but what a mess he inherited. The answers are not and will not be simple but they must be found before our standard of living erodes further.

TB remains bearish on stocks…and watch out for the ides of April as the tax date approaches and people who had short term investments to pay their taxes are forced to sell stocks…the only ’liquid’ assets available to them. Why do people persist in saying the bottom is in?…it isn’t.