When Dragnet’s Sergeant Joe Friday asks for “Just the Facts,” the Treasury’s Fact Sheet: PUBLIC-PRIVATE INVESTMENT PROGRAM is hardly comforting. While many of the facts are obscure or still to be determined, the banks and insurers don’t appear to be the targeted beneficiaries in the framework presented. If they participate at their low stock prices and capitalization, they will be the chumps with further asset markdowns and common stock dilution.
On both the legacy loan and securities programs the participating selling banks and insurance companies will have to issue warrants to the Treasury. And in the legacy loan program, the published documentation does not specify that the selling financial institutions can set the minimum bid they will accept.
My initial conclusion is that these programs have been designed to entice private investors (read hedge funds) to buy assets difficult for financial institutions to value or sell. Whether the target assets are toxic or just mispriced is a matter of opinion. The overriding reason the Treasury wants to rid banks of legacy assets is to avoid the Japanese syndrome of zombie banks. Our large banks claim they are not zombies, but even if the Treasury disagrees what is the bank’s incentive to participate?
Let’s compare the two programs. The starting point in the loan program is for banks to submit a pool of loans for the FDIC to evaluate, while the securities program starts with an approved manager creating a fund. Next in the loan program, the FDIC determines the leverage ratio it will guarantee (up to 6 to 1) and holds an auction. The second step in the securities program is for the fund manager to raise private capital. The Treasury will match the private capital raised with an equal amount of equity. The winning bidder in the loan program then must select an approved fund manager and post 50% of the required equity, the Treasury using the TARP to fund the other 50% of equity.
Now for the leverage acceleration: The winning bidder in the loan program must now sell the FDIC guaranteed loans. The FDIC will be charging a fee for its guarantee and the fund’s assets will serve as its collateral. The documentation does not state whether the FDIC guaranteed debt will be recourse or nonrecourse.
Juicing up the securities program is far less risky to investors: The Treasury will offer senior debt funded by the TARP to increase leverage up to 400% of equity. The debt will be nonrecourse, but all other terms are to be determined later. Then the afterburners could be turned on with the Federal Reserve’s TALF program. After all this the securities fund is ready to start buying RMBS, CMBS and ABS. The document emphasizes legacy non-agency residential mortgage backed securities – the best source for toxic waste. Geithner should have consulted with the masters of the EPA superfund.
The fund investors are open to substantial political risk in both programs, and many loose ends in the securities program related TARP loan terms. But overall the Treasury sees the risks of scaring away investors greater than scaring away the selling banks. Thus the Treasury is bending over backwards for investors. The FDIC appears to be more cautious in its generosity.
On the other hand the risks to banks and other sellers are substantial. The FDIC appears to want to run an absolute action. The sellers can’t specify a minimum price. This form of price discovery is too risky for banks in terms of further mark to market write downs. Thankfully the securities program provides for negotiation.
Maybe the reason the Treasury is giving all the incentives to investors is because regulators believe that they can “encourage” reluctant banks to participate. Is it possible that these programs are tied into the stress tests? Let’s hope that the government does not strong arm banks like Bank of America (BAC), Citigroup (C) and Wells Fargo (WFC) into participating. Imagine issuing warrants at the current stock prices. The banks would be far better off working through the mortgages themselves.
It is ironic that the FDIC is giving 100% debt guarantees in its program while not extending the same protection to bank depositors.
Disclosure: Author is long BAC, C and WFC.
No Incentive for Banks in Geithner’s Public-Private Program
Americans Travel the World for Affordable Healthcare
While we hear endless stories of Canadians coming to the US to avoid waiting for noncritical operations, Americans are starting to look abroad for affordability. The New York Times “Finding Affordable Health Care in Foreign Hospitals” tells the story of an early retiree from Bank of America (BAC) with a $10,000 deductible health insurance plan.
Ben Schreiner, a self described 62 year old former executive, priced a double hernia operation at $14,000 in local hospitals. Trying not to spend his entire deductible, he settled on Costa Rica for $3,900. Our medical tourist was satisfied with the results.
If even the skills of a bank executive are no match in negotiating medical costs or effectively shopping the American healthcare market, none of the rest of us stands a chance. That’s why President Obama sees no future in “consumer driven” high deductible plans.
The most interesting aspect of the article was not the quality of care or cost savings available outside the US, or even the potential risks of receiving care abroad. My interest was on Ben Schreiner himself and why a former Bank of America executive is carrying a $10,000 deductible policy. Did he think that he could wing-it until Medicare without incurring substantial medical expenses? Did he do a cost-benefit analysis, concluding he could easily absorb $10,000 in medical costs? Or was a $10,000 deductible policy all he could afford after medical underwriting at his age?
Unfortunately, the Times article focused primarily on the process for planning an out of the country medical procedure. And Ben Schreiner did not discuss the economics of or any constraints imposed on his choice of health insurance plan. Whatever his reasoning, for any American to be limited to such poor coverage is unconscionable.
Let’s examine the rhetoric in medical tourism. There have been stories over the last two decades of American medical tourism for cosmetic and elective procedures. Basically, procedures not ordinarily covered by health insurance. At the same time, “horror stories” of desperate Canadians coming to the US for what turned out to be non-life threatening operations. So whether the motivations are financial or convenience, no one appears to be traveling for a life or death medical procedure.
The stories of Canadians suffering a few weeks of pain while waiting for an operation don’t make my heart bleed. I have yet to hear of a Canadian that suffers under the stress of a $10,000 deductible. Remember that only financially able Canadians can come to the US for care.
When former executives either cannot or will not get adequate health insurance, current executives should beware of having their companies stand in the way of letting anyone at any age buy into government sponsored “Medicare for All.”
Disclosure: Author is long BAC.
Government Created the AIG Bonus Firestorm it Claims to be Reacting To
Do you believe that the government created the firestorm on AIG bonuses to deflect anger against its own failed rescue attempt? After Congressional anger over no end in sight to the AIG bailout and demand to know which counterparty firms actually benefitted, the Administration partially capitulated. They allowed AIG to release the beneficiary names, and then set forth with a massive deflection campaign.
President Obama, Treasury Secretary Geithner and Federal Reserve Chairman Bernanke conspired to shift the focus from Goldman Sachs (GS) and other large recipients of the AIG bailout back to AIG itself. First, the Fed Chairman gave us his YouTube moment al la CNBC Jim Cramer’s “they know nothing” and Rick Santelli’s staged follow on. Bernanke’s “nothing angers me more than AIG” and “I’ve more than once slammed the phone down” are just as disingenuous. This was followed by the President’s carefully orchestrated response “ordering” the Treasury Secretary to do everything short of breaking contracts to stop the bonuses.
What Congress and the American people really want to know is why the rescue is not working. The answer sheds light on objectives that were never disclosed in the AIG rescue. Gretchen Morgenson’s New York Times column “At A.I.G., Good Luck Following the Money” explains that the government did nothing to mitigate or contain AIG’s obligations to post collateral or covering 100% of its guaranteed investment contracts and securities lending repayments.
The government created a new precedent with AIG, protecting the value of the counterparty's securities. Through AIG's negligence in promising collateral, the government provided more than a guarantee of principal and interest payments.
I can understand the desire to make municipal purchasers of GIC whole. There might even be an argument that securities lending partners should not take a haircut, but the government using AIG as a conduit to protect the capital position of other financial institutions is unconscionable. If the government believed it was a just cause, than the objective should have been revealed and promoted from the start. Instead the government promoted the punishment of AIG and created plans intended to lead to its destruction.
I doubt whether many Americans actually care about the AIG bonuses; they simply want to know if the government will ever get its money back. In this regard, I believe that most American are curious as to when the government will allow AIG to closeout its toxic obligations and start operating in way that will make the taxpayers 79.9% equity position worth something.
Even the common folk know that the AIG businesses can’t be sold to pay back the government, so the only hope is to maintain AIG as a going concern. To be successful with AIG, the Administration needs to finally start negotiating in AIG’s favor with its counterparties. Otherwise the skeptics will be right and there will be no end in sight.
Disclosure: Author is long AIG.
AIG Bailout Empowers Class Action Lawsuit Against MBIA
Dow Jones Newswires is reporting that Aurelius Capital Master Ltd., Aurelius Capital Partners and funds owned by Fir Tree Partners have a class action lawsuit to prevent the splitting of MBIA (MBI) into separate subsidiaries insuring government and structured product debt. The MBIA plan, endorsed by New York State's Insurance Superintendent Eric Dinallo, would capitalize the new government insurer with $5.4B in cash and transfer all existing MBIA municipal policies. At the same time Reuters is reporting that 15 financial institutions are meeting with Dinallo today to complain that split would adversely affect CDS they wrote on securities wrapped by MBIA.
The complaint alleges the split would deplete capital and income from municipal bond insurance from backing structured products, “leaving some $241 billion of policyholders stranded in a denuded insurer that will be unable to meet its obligations as they come due." Further, certain mortgage backed securities wrapped by MBIA have "tumbled in value by approximately 40%," since the split was announced.
To my knowledge MBIA never insured the value of any security and never committed to post collateral on structured products. But, the government’s actions to make AIG’s (AIG) counterparties whole have empowered investors insured by MBIA to extend their reach. The argument that the split reduces the value of the insurance they purchased and subsequently the value of the underlying structured products has little merit since most banks have already written down the value of the wraps to zero anyway.
The case for a reduced ability to pay claims might have merit, but the negative effect on related CDS written by third parties only comes into play with public policy. The Federal Reserve and the Treasury have placed great emphasis on the system risks inherent in CDS. However, this is a public policy directive and should not add to the obligations of the bond insurers.
The counter and more important public policy need is for restoring an efficient municipal bond market that insurance from Ambac (ABK) and MBIA (MBI) would provide. Only these two companies have the operational infrastructure to support the small issuers that Warren Buffett would not.
Good public policy should never insure the value of any security, only the payment of obligations. But even government policy that virtually guarantees the payment of financial institution debt at the expense of common shareholders actually promotes systemic risk. Holman W. Jenkins, Jr.’s opinion piece in The Wall Street Journal “Buffett's Unmentionable Bank Solution” states:
“Yet the truth is, you get little or no moral hazard bang from punishing bank shareholders. Equity investors, by definition, accept the risk of losing 100% of their stake in return for unlimited upside. Go ahead and wipe out shareholders: Markets will turn around and create the next 50-to-1 leveraged financial institution as long as the potential return outweighs the risk.
The only real fix for moral hazard, in some future regulatory arrangement, would be truly to dispel the belief of bondholders and uninsured creditors that they will be bailed out.”
In summary, MBIA should not be held responsible for third parties losing confidence in its insurance or any related consequences of that lack of confidence. Seeking protection for a drop in value of CDS not written by MBIA is certainly is a far stretch.
Disclosures: Author is long ABK, AIG and MBI.
US Needs to Convert from a Consumer to an Industrial Economy
The New York Times’ “Conflicting Signals About the Chinese Economy” reports that Chinese exports fell 25.7% last month, yet China is still trying to stimulate its industrial economy. At the same time Federal Reserve Chairman Bernanke is about to embark on a $1T program to expand consumer credit. American consumers are balking at both, while defiantly increasing their savings rate to a near term record 5%.
The coordinated world economic plan appears to be focused at the American consumer pulling all nations out of a near depression. But fundamental changes will prevent this from happening. First, as reported by The Wall Street Journal’s “Lean Factories Find It Hard to Cut Jobs Even in a Slump”, American factories are running so efficiently that foreign low cost labor is becoming far less relevant than factories being close to their customers. Second, the cost of transportation and long lead times often outweigh labor savings. Third, consumer deleveraging is leading to less predictable consumer spending patterns. Factories will need to prepare for small runs, higher levels of customizations and unpredictable reorder patterns.
The long production cycle, just-in-time manufacturing model exemplified by Toyota (TM) is now dead. China just does not realize this yet. Local highly flexible manufacturing will replace the lethargic dinosaur logistics and sourcing that signifies the Chinese-Wal-Mart (WMT) model of today. How much longer can Macy’s (M) order 9 months in advance for Christmas?
What’s even more disturbing is that the Fed is depending on a narrow slice of consumers to restart our historic consumer economy. Just like I wrote in "Fed Pushes Housing into Stronger Hands", the Fed is now trying to push consumer credit into the strongest hands. The TALF program is seeking triple-A rated securitizations targeted at consumers with FICO scores exceeding 660. These are the more responsible consumers that are deleveraging now and strengthening their balance sheets. Making auto loans available to these consumers is like “pushing on a string.”
The whole focus of pushing money into strong hands to stimulate the economy is flawed. Alternatively, promoting investment into long-term flexible manufacturing assets might not stimulate the economy as fast. But, at least we will begin the difficult transition back to an industrial based economy. The service based economic model of the last few decades was merely a charade for foreign financed drunken consumer indulgence.
America’s future is extremely bright for industrial process and control manufacturers such as Eaton (ETN), Ingersoll-Rand (IR), Parker Hannifin (PH) and Rockwell Automation (ROK).
Disclosure: Author is long IR.
Presidents Obama and Bush – Different Objectives, Same Results
President Bush thought common shareholders in financial institutions should be massacred to preserve Darwinistic capitalism. President Obama thinks the evil ones should suffer for their crimes against the people. Both Presidents wanted to preserve the sanctity of debt holders, for they are a tool to expand credit and reflate the economy.
The only difference appears to be that Obama is being more forceful in expanding mortgage modifications and refinancing; something Bush only paid lip service to. Both are pretending that they can hold down mortgage rates for a protracted period of time, and both have so many caveats in their mortgage plans that few will actually benefit.
The similarities become highlighted in the treatments of AIG (AIG) and Citigroup (C) and the cascading effect of diminished common shareholder confidence. Neither President wanted to pressure counterparties to negotiate their collateral terms with AIG. Both Presidents thought AIG’s counterparties such as Goldman Sachs (GS) and Merrill Lynch (BAC) should be made whole, at the same time that Ambac (ABK) and MBIA (MBI) were able to commute certain CDO insurance contracts at a discount. Although AIG foolishly agreed to post collateral if their credit rating dropped or their underlying insured securities lost value, the Presidents saw more benefit in preserving the value of credit insurance than AIG’s equity. Therein lays the underlying problem with the bank rescue efforts of both Presidents.
Neither President wanted to take a majority equity stake in Citigroup, but they did not want to promote its common equity value either. Now the cascading effect is not only being felt in Bank of America (BAC), but also in the previously thought to be strong JP Morgan (JPM) and US Bancorp (USB). The Presidents did not have the political strength to convert the Treasury’s Citigroup preferreds at a price high enough above market to instill confidence. While the Treasury’s new stress test is purported to be focusing on TCE, they are doing nothing to stop the decline in the value of the “E”.
Realistically, there’s not much more common equity the Treasury can take without bank common stocks being deemed worthless. Between the TARP warrants and Citigroup preferred to common equity conversions, even the value of bank preferreds is even being called into question. But as long as major bank runs have subsided, the Administration seems satisfied to let stock prices approach zero. After all, Citigroup depositors did not react like National City (PNC), WaMu (JPM) and Wachovia (WFC) depositors.
Bernanke was wrong when he said stock prices do not matter as long as depositor confidence remains. President Obama needs to be bold enough to convert the remaining TARP preferreds to common equity at a price high enough to truly stimulate a recovery plan in bank stocks.
Disclosures: Author is long ABK, AIG, BAC, C, MBI and WFC.
“Uniquely American” is Code for Killing Healthcare Reform
Just like “All American” type gal-Friday or receptionist was code for discrimination in employment advertisements a few decades ago, so is “Uniquely American” code for preventing a Medicare for all government option for individual health insurance. Opposition politicians have uniformly adopted the need for a uniquely American approach to healthcare reform when the “this is not the time” delaying campaign failed to gain momentum.
President Obama responded to the calls for delay by light heartedly saying it is not the time for healthcare reform during good times, bad times, peace times and war times. It is never the right time regardless of the economy. The President also recognized that private insurers feared competing with a government run plan, but did not concede. The President called for a prominent role for private insurers while not allowing them to promote the government option as a path to Canadian and European style healthcare. Both sides excelled at fine tuning their rhetoric.
Everyone fronted a positive attitude at Thursday’s White House Healthcare Summit. The private insurers agreed to eliminate their underwriting practices if everyone was mandated to carry health insurance, and the government subsidized the purchase of insurance from only private carriers. Doctors and Hospitals did not want a further “cram down” of reimbursements from an expansion of Medicare to people under 65, but claimed they wanted to be part of the solution. Pharmaceutical company supported politicians were concerned about comparative drug benefits without adequate clinical studies. Everyone had a positive-but attitude.
I was enthusiastically surprised with Obama’s determination to pass healthcare reform this year. He clearly stated that now is precisely the time for change and that the country does not have too much on its plate. Now that delay is not an option, all the players are jockeying for position and the President is giving them enough rope to hang themselves before he moves in for the kill. Perhaps I was wrong in underestimating Obama’s political savvy and determination on healthcare. Previously I believed that only Hillary Clinton had the will and perseverance to make it happen.
I wrote previously that private health insurers will have a difficult time justifying their value, but at least they’re making a valiant effort. They appear to be selling a delicate mix of fear and optimism to both politicians and the American people. Bloomberg’s “GE, Siemens Will Fight Obama Plan to Cut Costs of MRIs, X-Rays” reports that General Electric (GE) wants to be anything but subtle in fighting the reduction in superfluous medical imaging. GE is mounting the political fight of its life to protect more than half of its 17.4B healthcare revenue. GE is risking tarnishing its good boy image by not learning from the more savvy attendees of the healthcare summit.
Most stakeholders are showing great skill in their efforts to derail the healthcare reform process. They all “want” reform with caveats. While none wants to concede any profits, they have yet to show investors how they can profit under an inevitable alternate reimbursement structure. The private healthcare industry is still pretending that they can defeat the President.
Disclosure: Author is long GE.
Investment Bank Concentration brings Fee Leverage
Bloomberg reports in two articles, “Goldman Sachs, JPMorgan Increase Rights Offer Fees” and “JPMorgan Said to Reap $5 Billion Derivatives Profit” the benefits and risks of fewer and larger investment banking operations. Goldman Sachs (GS) and JP Morgan (JPM) and eight other underwriters increased their fee for the HSBC (HBC) rights offering to 2.75% from the 1.75% fee charged to Royal Bank of Scotland (RBC) by Goldman, Merrill Lynch (BAC) and UBS (UBS). Fees have increased from an average 1.9% to 2.9% to compensate the underwriters for the risk that the offerings won’t be completely sold and they are stuck with inventory. The investment banks are taking advantage of limited capacity to raise risk related fees.
It is clear to see the advantage of the elimination of the Lehman capacity and reduced competition of the Bear Stearns and Merrill mergers for the remaining banks. But, the further concentration of risk is an impending danger sign. JP Morgan is reported to have earned $5B of its $5.6B profit in 2008 from trading over-the-counter fixed-income derivatives. Much of the derivatives were related to its $132B of corporate debt underwriting. Additional volume came from the fear of counterparty risk in competitors. This flight to quality is not considering that JP Morgan has accumulated $87.7T in outstanding OTC contracts. That is more than the balance of its nearest two competitors combined, Bank of America (BAC) and Citigroup (C).
As LTCM taught us long ago, portfolio management of risk can collapse based on unforeseen events. And the monolines and AIG (AIG) taught us that counterparties are not always reliable, even if JP Morgan’s book is perfectly matched. Interest swaps and foreign currency exchange fees rose 60% in 2008 as spreads widened. This leads me to be concerned that CEO Jamie Dimon is chasing fees. Dimon is filling a vacuum and temporarily reaping the rewards. These rewards are supporting WaMu integration and other empire building.
The question remains, is the government supporting the formation of a new investment banking bubble on the shoulders of Goldman Sachs, JP Morgan and Morgan Stanley (MS)? These appear to be the last true investment banks left standing. It seems that the regulators are granting a lot of leeway in OTC contracts, one of the few remaining high profit investment banking activities. If the country was alarmed by the concentration of risk in AIG and the cost of unwinding it, think about a huge multiple of that contained in a limited number of investment banks.
Federal Reserve Chairman Bernanke spoke of the need for regulators to review and approve new financial products, in answer to a Senator’s question. The discussion related to the complexity and risks of the financial alchemy of the last decade. He was eluding to the FDA’s model for approving drugs before they can be marketed and sold, including defining the target audience and delivery method. This was a complete break from Greenspan and Paulson, who advocated experiment first and cleanup later.
In summary, Bernanke is now leaning toward financial product standardization while reluctant actually regulate risk reduction. Bernanke is still not ready to truly force the remaining investment banks to recognize the black swans. With Bernanke’s need to need hang on to the failed securitization model of the past, he still refuses to let banks go back to basic conservation banking under the utility model.
Disclosure: Author is long AIG, BAC and C.
Private Health Insurers Race to Justify their Value
The New York Times “Health Insurers, Poised for Round 2” examines the differing approaches of two of the largest private insurers to their potential disintermediation with President Obama’s healthcare reforms. Aetna (AET) is focusing on creating value through better employee health management for its large corporate clients. 20% of Aetna’s staff is dedicated to information technology and 20% are clinicians. This leaves only 60% to non-value adding sales, underwriting and administration. UnitedHealth Group (UNH) is concentrating on incubating additional services such as consulting to doctors and hospitals, and directly providing health services through acquisitions like Sierra Health Services. Sierra Health Services is Nevada’s largest physician group.
While most large private insurers have had some success in negotiating discounts through their large networks of doctors and hospitals, these efforts have been no match for escalating costs. The HMO revolt of the 1990’s led the insurers to stop fighting costs and just raise premiums. It’s no secret that the recession has only exasperated the affordability of the products the insurers sell. The market share of commercially insured dropped from 78% to 68% over the last two decades, with 46M uninsured. The Times did not define what percentage of commercially insured was purchased risk-based insurance versus corporate self-insurance.
Aetna CEO Ronald A. Williams is embracing the new reality with statements like “we have to transform the system” and “there’s a huge opportunity.” UnitedHealth CEO Stephen J. Hemsley is far more sanguine with “open to reform” and “the issue is around how.”
Both companies have been feeding off the Medicare and Medicaid trough since 2003, with UnitedHealth accumulating 1.7M Medicare Advantage members. Now President Obama says that Medicare Advantage seniors are no healthier than others and wants to reign in the cost of the program. Both companies are profitable, but profits are shrinking and government pressure to lower costs is only likely to increase. Lower reimbursements from the government and shrinking private membership do not spell a bright future.
The companies could probably muddle through for a few more years if not for the possibility of Medicare open to all (under 65) and guaranteed issue for private insurers. The health insurance industry is concerned that Medicare has an unfair cost advantage and therefore could offer lower premiums. Secondly, they say mandated coverage for all is necessary to support guaranteed issue. The insurance industry does not say whether a mandate is required to widen the risk pool and prevent gaming the system, or is just a way of calling President Obama’s bluff.
During the Democratic primary campaign Obama pledged only to institute a mandate for children, not adults. Playing games with the mandate could be an unwise industry delaying tactic. It would be far wiser to let the government assume more risk, than trying to unravel the reform process over mandates.
Paying for effective clinical management might be a service the government is willing to buy. But selling risk-based business has fleeting value when medical underwriting is outlawed and you’re competing with the government for customers. Basically, insurers will have to become highly efficient administrators and chronic disease care managers to add any value. IBM’s (IBM) Dr. Paul Grundy doesn’t believe the insurers are either now. They “don’t have a clue about providing what we really want to buy.” IBM wants cost effective care to help employees be more productive and live longer.
Let’s say Medicare for all becomes a reality in the near future; where does that leave the private insurance industry? The low hanging fruit would certainly be subcontracting portions of the administration from the government and providing supplemental coverage to consumers and corporate clients. On the administrative front, a great deal of horse trading has yet to take place on whether the private insurers will assume risk and how the risk should be compensated.
The more interesting space is supplemental insurance. This experiment might start being played out in the State of Washington. Washington is approaching a vote on a "Guaranteed Health Benefits" plan which would provide catastrophic coverage for medical costs over $10K to all residents via a payroll tax. Employers and consumers would have to purchase coverage for routine care in addition if they desire. Both policies would be administered by a single private insurer for each resident.
I believe that in a Medicare for all world, the free market for supplemental care could be even more robust and profitable than in the current medically underwritten world. The private insurers should concentrate now on the delineation point between coverage that can be purchased from Medicare and supplemental coverage purchased from private insurers. Standards will need to be set for deductibles, co-pays and co-insurance.
Fear not and resist not private insurers, you will actually get richer selling a new suite of services and risk mitigation to government, employers and consumers. Just think about private insurers selling coverage for drugs that the government does not consider cost effective or to move to the head of the line for rationed noncritical operations. It’s time to enthusiastically embrace the future as your current business model is dead.
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