As a follow up to Note 15, this week banks in the US issued $23.8 Billion more in FDIC (taxpayer backed) debt. This is on top of the roughly $17 billion issued last week. The total amounts exceed the reserves the FDIC has in the bank. Looking at where other debt is trading for major banks, the FDIC (the taxpayer) is subsidizing each bank (B of A, GS, Morgan Stanley, JP Morgan, etc.) by approximately 300 basis points.

First off, Happy Thanksgiving to you and yours!

Last week Goldman Sachs became the first “bank” to float a bond issue guaranteed by the FDIC.   A look at the weekly debt issues from the Financial Times shows US banks springing back into action, all issuing FDIC guaranteed debt. As I can tell, these are the first bond issues of any major financial institution in Dollars since Lehman’s declaration of bankruptcy.

(For the purposes of this post, all noted bonds sold close enough to par that coupon yields as first order approximations for true yields will suffice. Sorry Professor Jenter!)

• Goldman Sachs issued $5 billion due in June 2012 yielding 3.25%
• Morgan Stanley issued $2.25 billion due in Dec 2010 yielding 2.90% and $2.5 billion expiring in December 2011 3.25% and $1 billion due in June 2011, half of which has a known floating rate of   1 month LIBOR plus 74 bp.
• JP Morgan issued $5 billion due in December 2011 yielding 3.125% and $1billion due in December 2010 with floating rate interest of 3 month LIBOR plus 50bp .

Thanks to the FDIC guarantee, the yields on these bonds are very low, making them very favorable for the issuing banks. Yet the FDIC has only $34.6 billion in funds for this purpose or general insurance on accounts up to $250,000.

I would argue the FDIC’s funds are too small to take on insuring now larger accounts as well as guaranteeing bank bonds. So, the taxpayer is on the hook for  $16.75 billion of new bank debt.

Let’s put that amount in perspective.

• GM, Ford, and Chrysler are asking for $25 billion
• The net CDS exposure on GM and Ford amounts to $9.6 billion
• As I wrote in Note Four A, as part of the TARP program, the tax payer is due to receive roughly $18 billion in dividends from the first $250 billion the Treasury is injecting as preferred equity capital into these same banks.
• John McCain railed against earmarks all campaign long. President Elect Barack Obama said earmarks amount to $18 billion a year.

Further, it is important to compare the incredibly low yields on these bonds:

• In the week of November 7, 2008 Ireland, a sovereign euro denominated nation that stated it would guarantee all deposits from six of its largest financial institutions, sold 4 billion of euro debt, due in November 2011, yielding 4.0%

And during the Year of Cheap Credit, Fall of 2006-Spring of 2007 (without any FDIC backing)

• In September of 2006, Goldman Sachs issued 750 million euros due in October, 2021 yielding 4.75%
• In September of 2006, Citi issued 1.25 billion euros due in October, 2013 yielding 3.95%
• In February of 2007, three banks no longer in existence in the same form issued long duration debt:

1. Wachovia issued 1 billion euros due in February 2014 yielding 3 month Euro LIBOR plus 15 bp.
2. Lehman Brothers issued 1 billion euros due in March, 2019 yielding 4.625%
3. Merrill Lynch issued 1 billion euros due in February , 2012 yielding 3 month Euro LIBOR plus 18 bp.

Side Note: it is amazing reviewing that year of cheap credit how few bonds were issued in dollars relative to Euros and Sterling. It made me believe Mayor Mike Bloomberg was right to worry New York was losing out as the capital of global finance.

IN SUM: This is new uncharted waters for the US Taxpayer. What if one of the banks uses the funding to underwrite new acquisitions that create “synergies” resulting in laid off workers? What if the funds are used  to lever up a commodities bet? I do not believe banks raised enough capital to make single bets of that systemic threatening magnitude, but the overall point is this:

• In large part, banks and autos are short term inelastic industries. Without a bank, its hard to save currency and its hard to do commerce. Without a car in the USA, its hard to travel from point A to B.
• There are plenty of foreign banks and plenty of foreign car companies.
• I reckon between the FDIC, Treasury and Fed plans, we are spending close or guaranteeing close to $2 trillion, ~15% of GDP, for our private sector banking industry. While congress has made “noises” on insufficient bank lending, there is no plan attached to this funding. Yet produce autos and ask for $25 billion, you’d better have a plan.
• Bottom line for CEOs learning how to manage through a future crises: It sure pays to be the industry first in line for help.

Is the liquidity crunch over?

Here is my thinking:

Let’s review treasury rates (aka, the “riskless” rates) for the US and UK over the next six months. According to the Financial Times data on November 14^th, 2008:

• US treasuries set to expire in six months yield 87 basis points (Deflation).
• UK treasuries set to expire in six months yield 199 basis points (who knows)
• One British Pound today is worth 1.4827 US Dollars
• One British Pound’s worth in six months as of today’s spot forward is 1.4807 US Dollars

The rates for sovereign taxpayer debt and the interlinking value in currency should display the differences in risk of each country.

• $100 invested in US treasuries vs. $100 invested in UK treasuries and converted at the corresponding spot and forward rates should yield the same rate of return.
• Converting $100 to pound equivalents, investing in UK treasuries, and returning those pounds to US Dollars six months from now returns a dollar more (.98 US cents) in value.

In normal times, no way. Someone in any trading house would be looking for the “blips” to quote Michael Lewis from Liar’s Poker. Here are a two observations why this opportunity exists today:

• As discussed in previous posts, we’ve witnessed massive flight to quality recently, as capital has left emerging markets and safe harbored itself in US Treasuries
• The REPO market continues to be stressful. Again, as discussed in previous posts, the lack of shorting treasury opportunities has caused massive spreads differences in otherwise equally risky cash flows.

What is interesting though is that the link between currency and risk still exists for the most part. For the UK though, that means its current treasury yields are tied far more to the US and the Dollar than they are to their own interest rate policy (currently at 3.00%). While the Bank of England has been aggressive in rate reductions, its own government bonds in no way reflect this.

Remember the good old days of 2006-07?

On a random January 17th, 2007 3-Month LIBOR was 5.36%. Yet two treasuries were bidding 4.91%. The Fed Funds target rate was 5.25%. In short, spreads were short.

More amazing were Emerging Market Bonds and the market’s confidence in sovereign performance.

• On that same January 17th, 2007, the Ukraine’s debt expiring in June, 2013 was priced only 1.35% higher than US government bonds of the same duration.
• South Africa was only 0.97 basis points more and
• Russia, the country that would 18 months later invade Georgia, had debt set to expire in March, 2030 only 100 basis points more than the US treasuries.

(sigh)

The picture is significantly different today.

• At market close on November 12th, Ukraine’s debt noted above is now 18.13% more than US treasuries.
• South Africa’s is 6.61% greater .
• And Russia’s debt is 5.45% higher.

Why?

Current Account Deficits are the place to look.

• Ukraine: At the end of 2006, 3.71% of GDP. Today,  the IMF estimates it is 7.2% of GDP
• South Africa: At the end of 2006, 7.26% of GDP. Today,  the IMF estimates it is 8.0% of GDP
• Russia: At the end of 2006, it had a surplus of 9.50% of GDP. Today,  the IMF estimates it had dropped to 6.4% of GDP.

In general, owing more to debtors outside your own walls creates one of two possibilities:

1. Default (as in the case of Argentina)
2. Currency devaluation, which when importing basic staples or other durables, causes inflation, making the bond payments less valuable

But further, this massive spread increase could also be caused by a flight to “quality” of US Treasuries. Capital is simply skittish of anything but the US Taxpayer. Which, at this point, should give us all pause.

Regardless, the bailout the G1, G3, G7 are trying is crimping the ability for emerging markets to raise capital, increasing strain on IMF funding and solvency.  Crowding out 101 is in effect.

In yesterday’s Financial Times, an article appeared on Ireland’s increasing yield to would be investors of its sovereign debt. While France and Germany’s two year bonds trade at 2.83% and 2.52% respectively, Spain and Italy’s two year bonds trade 3.13% and 3.38% respectively, Ireland had to offer 25 basis points more than average European Yields.

In today’s Financial Times, further evidence of sovereign debt problems as emerging markets are having a harder time raising funds. Most countries signaled out are running high current account deficits. Translation, the sovereign currencies are poised for a revaluation, aka decline.

With current account deficits, there are no foreign reserves (dollars or Euros) to give investors comfort the debt is guaranteed. Many remember the Asian Financial Crisis, where countries debt was loaned in dollars, ran current account deficits, and were forced into dramatic currency revaluations.

Let’s hope the Federal Reserve’s Swaps work.

But the real question is: Given even Euro denominated Ireland’s problems, what would Dani Rodrik do?

What are the current issues with the bailout plan?

1. Banks will not dilute their equity to the government.
2. The US Congress wants bank equity and further, does not trust Hank Paulson to buy the best CDSs, CMOs, CLOs, and other toxic assets to make the bailout profitable for the taxpayer.
3. We are running out of time. If we do not get a deal done soon, imagine, just imagine what the butterfly spreads on LIBOR at the end of 2009 will look like as banks try desperately to shore up their capital at the close of earnings season.

So let’s act quickly and rationally, using a mechanism we currently operate every day.

Every time the Treasury sells debt to finance the US Government, it runs what is known as a Dutch Auction.

1. It announces how many billions of bonds it intends to sell
2. Everyone intending to buy the bonds bids
   a) An amount
   b) A yield on that amount
3. The Treasury fills its order selecting the best yields and amounts. (for full disclosure, once the Treasury has reached its amount, the highest yield becomes the single yield for all auctioned securities.)

This mechanism is a perfect solution for our current bailout. In short, here is how it would work.

1. The government auctions off a $500 Billion of Equity ($700 may be too much).
2. Registered banks and insurance companies submit anonymous bids of
   a) An amount of capital
   b) A percentage stake of equity stake in each company
3. The Treasury would fill its auction by selecting the best bargains for its dollars.

Once the auctions are awarded, the selected companies would be allowed to do the following:

1. Choose if the awarded money will be preferred equity or common equity
2. If it is preferred, the rate should be floating against current 10 year treasury rate. This should reflect the new marginal cost the taxpayer now incurs to finance the government.
3. If corporations choose to redeem the preferred shares they can buy back the shares at cost plus the current 10 year treasury yield times the share value. The funding would be used to immediately retire treasury debt.
4. If the shares are common, the government can choose to sell these equities at any time or participate in any buy-back plan.

The benefits are as follows:

1. The Taxpayer now owns a share of all banking and economic activity and better, is protected against government borrowing costs.
2. Banks, now with more capital, can write down their subprime assets.
3. In addition, with the participating option, banks need their subprime assets to perform only as well as the treasury rate times the equity they receive. Once they receive their required capital, they can write down their assets to perform as well as a marginal treasury rate.
4. Finally, no one needs to buy anything but equity in banks and insurance companies. If physicists, mathematicians can’t value these assets, let’s not even try. We could administer this auction by election day, move on, and stave off a recession.

Let’s end with a story.

Once, as a broke college student, I attended a church supper with a good friend. After supper was cleared, the entertainment turned to a lottery game, which worked the following way:

1. Everyone who wanted to participate bought a raffle ticket
2. Every round would consist of the Minister drawing a ticket from the bowl
3. If your raffle ticket was selected, you were eliminated from the game
4. Before the beginning of the new round, the remaining entrants could choose to end the game, but only unanimously, and then split the money.

Now, in the early rounds when there were roughly 100 people playing, no way would there be consensus to end the game. But sure enough, as the numbers dwindled down to six or seven, a decision to collude was reached. As a champion of that decision, I too walked away with $300, enough to pay my bills for that month of school.

One by one as the Government works toward a solution, banks are failing and being sold off at miniscule values to the equity holders, eliminated from the game. First it was IndyMac, then Bear Stearns, then Lehman, then AIG, then WaMu and finally yesterday, Wachovia (who by the way, only a week ago had its chairman on CNBC saying how great Wachovia was going to be when it emerged from this crisis).

Maybe they’ll now be few enough to collude in this fashion and take the money as equity, letting us all move on.

Since the First Note, The Government’s Credit Committee, with members Barney Frank, Chris Dodd, and Richard Shelby took more time to get comfortable with Hank Paulson’s proposal.

While the debate in Washington raged on, one month LIBOR increased from 3.19% to 3.70%. Three month LIBOR increased from 3.21% to 3.76%. Commercial Paper increased from 2.50% to 2.70%. Letter of Credit facilities are not expanding. Essentially the way balance sheets are funded is grinding to a halt.

So, how could most corporations raise capital faced with this problem? One answer would be to short treasury securities of the same duration. Simply borrowing the securities, selling them into the market for cash, with the promise to deliver those securities later would do the job.

And why not? Treasury securities expiring on Dec 31 are yielding a paltry 1.02%. Treasury securities expiring on Dec 15 are yielding .68%. Would a betting man believe yields would increase or decrease in the next week? Considering inflation increased over the past year and that the US will sell an additional $700 Billion of debt into the market, yields will most certainly rise.

So, given the demand to short and the rational argument that yields will increase, the fact that the spread is so significant is in fact very significant. Money that normally would buy commercial paper and be infused into interbank offerings is now moving to “quality”. That quality is the United States government backed bonds and notes.

We can quickly examine the balance sheet and income statement of the US Government to know the following:

1. Liabilities just increased by close to $1 trillion, including Fannie Mae, Freddie Mac, AIG and the proposed bailout.
2. Projected top line tax revenue is expected to decline as housing values sink and oil relief is still far off.
3. Inflation is still a huge risk.

So how is this quality? The simple answer is that it is not. And if the US Government is not quality, then imagine how much mistrust is in the private market right now. And this is exactly why those shorting trades are not occurring and not helping to re-balance the spread, lowering TED.

For all of 2008 until now, we heard and read the financial sector was amuck, but corporate American remained strong. Yet now, we are conceivably in a macro-economic death-spiral.

1. If companies continue to be faced with high interest rates and refusal of credit, they will stop expanding.
2. Further, for all those companies who did not hedge exposure (and with lack of quality counter-parties, it is conceivable this is a lot), they will be forced to pay higher rates of interest now on all existing loans and notes.
3. To meet higher rates, companies will have to cut expenses, essentially wages. Reductions of wages will depress the economy further.
4. Consumer spending will continue to decline, making more companies unable to meet existing obligations.
5. Credit spreads will increase for fear of company credit and the cycle will continue.

This week will be as wild as the last one….