Tuesday, 18 March 2008 01:00

On the insolvencies of non-bank financial institutions

My blog has been quite popular as of late,
most likely because it may appear to some that I have a crystal ball.
My last 5 or so warnings have resulted in 50 point or so price drops in
the shares of the companies in questions. Let me be both modest and
honest. I am not that smart and do not have a crystal ball. There is a
simple premise behind all of this that allows me to understand what is
going on, but this premise does not get any press play and is not
harped on by the analyst community. Many major players in our financial system are simply insolvent.
Plain and simple. The liquidity issues that you see are simply a result
of that insolvency, not a cause. When you lever up on assets at the top
of a bubble and that bubble pops, you become insolvent, delevered or
not. If forced to delever, the balance sheet insolvency now becomes an
income statement insolvency as the cash outflow outstrips the cash
inflows, but it all stems from the original balance sheet insolvency -
not the other way around.

Borrowing more money, no matter what the
terms, will not aide you in your dilemma. That is, of course, unless
you can borrow large amounts of that money quickly on non-recourse
terms. But that is not really borrowing money, it is someone giving you
money with the option to pay it back.
It is the equivalent of a straight bailout, isn't it? That is what just
happened last weekend, which leads me to the next paragraph...

I have been alleging that many investment banks, monoline insurers, home builders and commercial banks are effectively insolvent. Nouriel Roubinin wrote an accurate piece on the topic.
Between that and the the five or six major analytical pieces that I put
together, I believe a pattern emerges (please take note of the dates
the pieces were written and the share prices at the time of the post).
I believe the pattern is indisputable. You could have made a fortune on
the short side of these analyses, and you could have lost a fortune on
the long side, just ask the employess and shareholders of Bear Stearns,
Ambac, MBIA, Lennar, etc. My condolences go out to the rank and file
employees of all of these companies whose savings have been lost in the
share price devalution. Hopefully, there is a lesson to be learned

More on Insurers and Insurance

More on Commercial Real Estate

More on Residential Real Estate

More on Investment Banks

As you can see, the path was not impossible to determine as
practically all of these companies shared the same catalyst to their
downfall - excessive leverage at the top of an asset and credit cycle
bubble. Now, the Fed is attempting to lend directly to institutions
that it has no jursidiction over. If I am not mistaken, the Fed's
balance sheet is only good for $400 billion dollars or so. There are a
lot of potential "runs on the non-bank" coming down the pike, enought
to drain the coffers. This is an ingenious, albeit very risky endeavor.
Moral hazard abounds. I know the Fed believes that they have nixed the
moral hazard argument in the butt by wiping out the Bear Stearns
shareholders, but this is an imperfect argument. The shareholders have
to approve this $2 buyout deal, and $2 is low enough to risk a battle
with the Fed and their agents. This is a major flaw in the plan that I
see as coming back to bite the markets. If this happens when the next
shoe drops, I can see the Fed getting overwhelmed.

As an investor and analytical pundit, I will be looking for the next
shoe to drop, which I believe I have found. I will keep you posted.

Last modified on Tuesday, 18 March 2008 01:00


  • Comment Link Reggie Middleton Tuesday, 18 March 2008 23:21 posted by Reggie Middleton

    Shuttle, I gave my opinion on the banks in the other thread. Look at the comments list on the left.

  • Comment Link Reggie Middleton Tuesday, 18 March 2008 23:20 posted by Reggie Middleton

    I don't trade in and out of positions. It doesn't work for me. I hold a well researched position through thick and thin. A very good example of this Bill Ackman and his 5 year short of the monolines, which made him over half a billion dollars (amortized, that is only $100 million per year, but that still ain't bad ;D). Investing, not trading. The key is to research it well and get in very cheap with money you can afford to lose, then dig in and stay there until your investment thesis either pans out or does not pan out. Either way, it takes time. My numbers are multiples, several times over, of what many of the so-called smart money guys at many name brand prop desks are, primarily because I don't need to show positive results every quarter. My only mandate is to make lots of money and not to lose any of my principal. Real simple.

    Yesterday was a trading opportunity, even for me who is not a trader, but today was a day to look for cheap bearish positions since everything was shooting up. It is hard to do since it is counterintuitive, but it is the way I operate.

    The more traders go in and out of positions and cover shorts from weak hands, the more valuable my position are since the volatility usually increases the value of my holdings.

  • Comment Link George Hadley Tuesday, 18 March 2008 22:49 posted by George Hadley

    Reggie - many thanks again for all your information, which is first class. What do you think are tha chances of possible runs on the commercial banks as happened with Northern Rock in the UK. Please keep up the excellent work on this forum.

  • Comment Link Matt McClure Tuesday, 18 March 2008 19:49 posted by Matt McClure

    I agree; I like the new formatting. :)

  • Comment Link M M Tuesday, 18 March 2008 19:13 posted by M M

    I like the new format and layout. Easier on the eyes.

  • Comment Link ken Tuesday, 18 March 2008 17:42 posted by ken

    I told you guys you had to be nimble on those shorts. I knew it was a market bottom as that VIX never lies. Did I go long Lehman? No. That big money that did must have had some solid information that there was absolutely no danger besides the CEO coming out and saying there was no danger. Rising tide lifts ALL BOATS - even the ones you don't want it to. I heard today that some of the big short positions on MS were being covered. Is it possible the FED has changed the equation with its recent dealings?

  • Comment Link shrek Tuesday, 18 March 2008 11:29 posted by shrek

    Great job on the blog. Your conclusions on why certain institutions are going to fail and simple, concise, and accurate. I think the federal government is going to end up with trillions in bad securities and we are going to eventually see unemployment around 12 percent. The fed is already setting the stage for the US taxpayer to monetize trillions in bad debt. It will not be a pleasant time.

  • Comment Link fdh Tuesday, 18 March 2008 07:07 posted by fdh


    June 8 -- Amid growing concern about the housing market's reliance on subprime loans -- those made to people with poor credit -- the Dow industrials plunge 198.94 points, or 1.5%, to 13266.73. Treasurys see some of their sharpest losses in years, pushing the yield on 10-year notes up to 5.10% amid simmering inflation jitters.

    June 13 -- U.S. bond yields hit a five-year high as investors continue to sell Treasurys, with the yield on the benchmark 10-year note rising to 5.249%.

    June 14 -- Bear Stearns reports a 10% decline in quarterly earnings as the mortgage market shows signs of cracking. Chief Financial Officer Sam Molinaro says, ``We are impacted in a weaker mortgage market until that industry turns around.''

    June 18 -- Reports say Merrill Lynch seized collateral from a Bear Stearns hedge fund invested heavily in subprime loans.

    June 22 -- Bear Stearns commits $3.2 billion in secured loans to bail out its High-Grade Structured Credit Fund, says company's troubles are "relatively contained."

    June 22 -- Blackstone Group's initial public offering is priced at $31 a share, raising as much as $4.6 billion; the next day, on the first day of trading, the stock jumps 13%.

    June 23 -- Bear Stearns agrees to lend as much as $3.2 billion to one of its two troubled hedge funds.
    June 28 -- Federal Reserve policy makers, on the second day of a two-day meeting, announce the key federal-funds rate will remain unchanged at 5.25%.

    July 2 -- BCE Inc. agrees to be acquired by the investment arm of Ontario Teachers' Pension Plan, Providence Equity Partners Inc. and Madison Dearborn Partners for $32.6 billion. It is the largest private-equity buyout in history.

    July 9 -- After a series of setbacks, including the collapse of an internal hedge fund, Swiss financial firm UBS removes Chief Executive Peter Wuffli. Marcel Rohner, the deputy CEO and head of private-banking and wealth-management operations, succeeds him.

    July 13 -- The Dow Jones Industrial Average surges 283.86 points, or 2.1%, to a record 13861.73, its biggest gain in nearly four years

    July 14 -- Oil climbs to almost $74 a barrel. The Dow industrials hit a record for a second straight session, rising 45.52 points to 13907.52 despite a jump in oil prices.

    July 17 -- Bear Stearns tells clients that the assets in one of its troubled funds are essentially worthless, while those in the other are worth 9% of what their value was at the end of April.

    July 20 -- The Dow industrials cross the 14000 milestone for the first time by rising 82.19 points to 14000.41, lifted by IBM's strong earnings

    July 25 -- Countrywide Financial says profit slipped 33%, dragged down by losses on certain types of prime mortgage loans. Countrywide slashes its 2007 earnings forecast, citing expectations of "increasingly challenging" housing and mortgage markets

    Aug. 1 -- Bear Stearns's two troubled funds file for bankruptcy protection and the company freezes assets in a third fund.

    Aug. 5 -- Bear Stearns Co-President and Co-Chief Operating Officer Warren Specter resigns. Alan Schwartz becomes sole president. CFO Molinaro takes over co-COO role.

    Aug. 6 -- Bear Stearns sends letters to clients reassuring them the company is financially sound. "Rest assured, Bear Stearns has seen challenging markets before and has the experience and expertise to serve you and us well," the firm says.

    Aug. 6 -- Warren Spector, Bear Stearns's co-president, quits, becoming Wall Street's highest-profile casualty in the burgeoning subprime-lending fiasco.

    Aug. 7 -- The Dow industrials surge 286.87 points, or 2.2%, to 13468.78, as investors aggressively bet ahead of the Federal Reserve meeting

    Aug. 10 -- Fallout from the credit crisis intensifies, triggering injections of cash by the U.S., EU and Japanese central banks, among others, and sending the Dow industrials plunging 387.18 points to 13270.68.

    Aug. 11 -- The Dow industrials drop 212 points during the session before recovering to finish down 31.14 at 13239.54.

    Aug. 16 -- The Dow industrials tumble 167.45 points, or 1.29%, to close at 12861.47 and extend the previous day's 207.61-point fall.

    Aug. 18 -- The Fed cuts the discount rate, or interest charged on loans it makes to banks and other depository institutions, to 5.75% from 6.25%.

    Aug. 23 -- Bank of America acquires a $2 billion equity stake in Countrywide in a bid to bolster the confidence of creditors and investors in the mortgage lender

    Sept. 12 -- Crude rises 74 cents to a record $78.23.

    Sept. 19 The Fed cuts the federal-funds rate, the benchmark target rate for overnight lending between banks, by half a percentage point to 4.75%

    Sept. 20 -- Bear reports 68% drop in quarterly income. The company's accounts slipped by $42 billion between the end of May and the end of August.

    Sept. 21 -- Gold soars to a 27 1/2-year high of $732.40 a troy ounce on combination of a weak dollar and increasing inflation fears

  • Comment Link Brad Gunter Tuesday, 18 March 2008 07:06 posted by Brad Gunter


    Love your work.....keep up the GREAT analysis and posts. Wish I had taken your advice on Jan 27th to short BSC when it was >$90.....might have enough money to see my TarHeels in the Final4 (hope they make it). Anyway, if we get a nice run up over the next several days (Fed rate cut induced), what names will YOU be looking to short into the rally. Thanks again for everything.

  • Comment Link fdh Tuesday, 18 March 2008 07:05 posted by fdh

    Oct. 1. -- UBS says it will write down as much as $3.41 billion in fixed-income assets, including securities tied to subprime mortgages.
    Oct. 2 -- The Dow industrials surges 191.92 points, or 1.38%, to 14087.55. It was the average's 55th record finish in the previous 12 months, surpassing 14000.41 in July.
    Oct. 12 -- A deal-inspired rebound in the technology sector helps stocks and the Dow climbs 77.26 to 14093.08.
    Oct. 16 -- Citigroup posts a 57% drop in profit, as the bank is hit with write-downs tied to mortgage-backed securities and loans to fund deals that were delayed
    Oct. 17 -- Morgan Stanley laid off about 300 bankers after revenue from sales and trading in credit markets in its third quarter plunged to $260 million from $1.3 billion three months earlier. The bank also wrote down more than $1 billion of loans for leveraged buyouts.
    Oct. 18 -- J.P. Morgan Chase's net rises 2% to a record $3.37 billion as CEO James Dimon's plan to slash costs and invest heavily in technology appear to pay off amid the credit crunch.
    Oct. 25 -- Merrill Lynch posts a $2.24 billion loss as a larger-than-expected $8.4 billion write-down on mortgage-related securities leaves the firm with its first quarterly deficit since 2001.
    Oct. 27 -- Countrywide Financial posts its first quarterly loss in 25 years on about $1 billion in write-downs.
    Oct. 28 -- The Federal Reserve cuts interest rates by a quarter point to 4.5%
    Nov. 3 -- Gold futures climb 1.9%, or $15, to $805.70, the highest level since January 1980, on inflation fears.
    Nov. 4 -- Citi's CEO Charles Prince resigns. Vikram Pandit, head of its investment-banking business, is named chief executive.
    Nov. 8 -- GM posts a $38.96 billion loss due to a tax-credit write-down, one of the biggest quarterly losses for a U.S. company.
    Nov. 14 -- Bear Stearns CFO Molinaro says the company will write down $1.62 billion and book a fourth-quarter loss.
    Nov. 15 -- Merrill names John Thain, the chief of NYSE Euronext and a former Goldman Sachs executive, as its new CEO, as the board seeks steady leadership in the wake of inner turmoil and risky expansion.
    Nov. 24 -- Crude hits a record $98.18, its high for the year, amid forecasts of higher output and cold Northeast weather.
    Nov. 27 -- Citigroup, seeking to restore investor confidence amid massive losses in the credit markets and a lack of permanent leadership, receives a $7.5 billion capital infusion from the investment arm of the Abu Dhabi government.
    Nov. 28 -- Bear Stearns lays off another 4% of its staff, two weeks after cutting 2% of its workforce.
    Dec. 11 -- UBS announces write-downs of $10 billion, becoming one of the biggest casualties of the U.S. subprime-mortgage meltdown. The disclosure comes as the Swiss bank receives an $11.5 billion capital infusion from Singapore's investment arm and a Middle Eastern investor.
    Dec. 12 -- The Fed cuts interest rates by a quarter percentage point to 4.25%, the third reduction since August, and leaves the door open to further cuts.
    Dec. 12 -- The Dow industrials plunge 294.26 points, or 2.1%, to 13432.77, as many investors hoped for a half-point cut.
    Dec. 20 -- Bear takes $1.9 billion write-down. CEO Cayne says he'll skip his 2007 bonus.
    Dec. 20 -- Morgan Stanley posts a $3.59 billion loss, its first quarterly deficit in 21 years, amid a $9.4 billion write-down on its mortgage assets. The firm receives a $5 billion investment from a Chinese fund in exchange for a 9.9% stake. Chinese buyers spend $29.2 billion acquiring foreign companies, outpacing for the first time foreign buyers that have invested in China.

  • Comment Link fdh Tuesday, 18 March 2008 07:03 posted by fdh

    Time line of events for those who chipped in late.....
    Jan. 7 -- Bear Stearns CEO Cayne retires under pressure. President Alan Schwartz takes over.
    Jan. 10 -- Merrill is expected to get $3 billion to $4 billion, much of it from a Middle Eastern government investment fund. Citi could get as much as $10 billion, likely all from foreign governments.
    Jan. 15 -- Financial stocks swoon as economists predict the U.S. economy will slip into recession. President Bush unveils a $150 billion stimulus plan.
    Jan. 21 -- While U.S. markets were closed for the Martin Luther King Jr. holiday, major indexes fell 7.2% in Germany, 7.4% in India and 5.5% in Britain.
    Jan. 22 -- Fed policy makers make the single deepest cut in the interest-rate target in more than two decades: a three-quarter percentage-point cut in the target for the federal-funds rate, to 3.5%.
    Jan. 24 -- Congress and the White House hammer out an economic stimulus package that would put $150 billion into the hands of consumers and businesses while seeking to revive the market for large mortgages.
    Feb. 15 -- Subprime woes spread to a broad range of assets, including certain kinds of municipal debt.
    Feb. 26 -- Federal Trade Commission Chairman Deborah Platt Majoras announces she will resign next month
    Feb. 27 -- Oil futures soared to a record all-time settlement above $102 a barrel, bolstered by the dollar's slide to new lows
    Feb. 27 -- Gold settled at $958.20 after a record high of $960 overnight on the New York Mercantile Exchange.
    March 3 -- Crude-oil futures on the New York Mercantile Exchange touched $103.95 a barrel in intraday trading before settling at $102.45. Oil has now surpassed its longstanding April 1980 record, when adjusted for inflation to January 2008 dollars, of $103.76 a barrel.
    March 3 -- Gold inched closer to the psychologically important threshold of $1,000 an ounce, hitting an intraday high of $986.90. Gold is still less than half its inflation-adjusted peak of $2,239.67, hit on Jan. 21, 1980.
    March 10 -- Market rumors say Bear may not have enough cash to do business. "There is absolutely no truth to the rumors of liquidity problems that circulated today in the market,'' Bear says.
    March 10 -- Broker-dealer Lehman Brothers announced a fresh round of layoffs totaling 5% of its workforce, or 1,425 people.
    March 11 -- The Dow Jones Industrial Average rocketed 416.66 points, or 3.6%, to 12156.81
    March 12 -- Bear CEO Schwartz goes on CNBC to reassure investors his company has enough liquidity and he is "comfortable" it turned a profit in the fiscal first quarter.
    March 12 -- Crude-oil futures sprung to a fresh record at $109.92 on the New York Mercantile Exchange after gliding as high as $110.20 a barrel.
    March 13 -- Some gold futures hit the much-expected $1,000-an-ounce price.
    March 14 -- The federal government and J.P. Morgan Chase bail out Bear. The company says it sought the emergency funding after realizing it would not be able to keep up with a spike in demand from lenders.
    March 16 -- J.P. Morgan announces it has acquired Bear Stearns for $2 per share, or about $236 million.
    March 17 -- Swiss banking giant UBS reduces its balance sheet by some $520 billion, or 20%, from last year. The dollar weakened to its lowest point in more than 12 years against the yen, to below ¥96 to the dollar. The 13-nation euro traded as high as $1.5905, a new record, before dropping back slightly to $1.5761

  • Comment Link eh Tuesday, 18 March 2008 06:28 posted by eh

    If BSC had assets of real, hard value, then why didn't they sell them, perhaps even at an attractive discount, in order to provide the liquidity they needed? Surely someone would have stepped up for a bargain like that, and this would have been better than rolling over for JPM for less per share than it would have cost to buy a hot dog out on the street.

    This is a reasonable question with no good answer other than the usual: a 'liquidity crisis' brought about by risk aversion. Which we are all supposed to believe.

    Lack of transparency is still a big problem in all of this.

  • Comment Link Mark Edmunds Tuesday, 18 March 2008 06:28 posted by Mark Edmunds

    I have never had the patience to follow up, but it would be interesting to perform or see a forensic analysis after the fact of this and other bailouts. For example, did the firms that bailed out LTCM ultimately lose money, do OK, or earn a windfall in unwinding LTCM's positions?

  • Comment Link Mark Edmunds Tuesday, 18 March 2008 06:23 posted by Mark Edmunds

    The following link discusses "Four Signs Financials May Be Bottoming." I am not sure I agree with the thesis, and three of the four reasons were not particularly persuasive. But I found reason #3 very funny and mildly compelling:

    "The sell-side analysts becoming very bearish on the financials after being largely bullish a year ago."


  • Comment Link alan dutch Tuesday, 18 March 2008 06:22 posted by alan dutch

    reggie could you look into your crystal ball and pick 5 numbers between 1 and 56 and one number between 1 and 46 for my MegaMillions ticket this week? a guaranteed winner...thanks!

    oh and can i thank you for your excellent work, it was one of a few things that persuaded me to sell a large holding in a certain brokerage stock just a month ago prior to the meltdown, saving me a small fortune, and also on the back of your work i made some healthy money shorting GGP and other CRE guys and also CTX and a few other homebuilders...you the man!

  • Comment Link Reggie Middleton Tuesday, 18 March 2008 05:30 posted by Reggie Middleton

    That is the conclusion that I came to as of January with access to limited data. It appears that I MAY have been wrong in light of recent events. There are some contingent liabilities on the books that led some to believe the $2 share buyout would fly. In addition, the other firms that looked at BSC didn't bite. I don't know if it was political, but it appears that some believe the risk outweighed the reward.

    Remember, I spent money to lock in profits at $35, and had no idea that it would drop as far as it did. I am taking all of the new market info for valuation of other assets though. Bear was apparently in worse shape than I thought, and I think I was the most bearish on Bear than any other bear in this bear market (try and say that 3 times, real fast). After looking at PMI's results and the fact that Citadel, et. al. passed on Bear after seeing th books (this is at less than 1/8th what it was trading at last year, and they still passed on the opportunity), as bearish as I am, it appears I may still be too optimistic. I will keep this in mind as I digest the results of the I banks that report this week.

  • Comment Link Mark Edmunds Tuesday, 18 March 2008 04:50 posted by Mark Edmunds

    If memory serves me, in one of your earlier Bear Stearns analyses, you arrived at an adjusted book value of $36. Presumably, this represents the difference between the fair value of assets and the fair value of liabilities. Is this correct?

    If so, doesn't this mean that Bear was "solvent" (in that assets would fund liabilities if allowed to run off over time) before the liquidity crisis forced Bear to the brink of bankruptcy?

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