Managing debt is like dieting...

My colleague, Melissa Hart, talks about debt management and bankruptcy. 

Leverage...

Jon Stewart on MF Global, regulation and the effects of leverage.  (via Greg Mankiw's blog).

If there is one repeated lesson from virtually all financial disasters it is that it is not bad bets that are the problem, but the amount of leverage used to make those bets.

Reducing leverage would be the simplest way to prevent future financial disasters.  But, as the case of MF Global shows, even when there were limits to leverage, a well connected ex-regulator could circumvent them.

Homeowner forecloses on Bank of America

This one is pretty much going viral.

Bank capital structure

The Economist has a nice article applying Modigliani and Miller's capital structure theory to the capital structure of banks. M&M said that in the absence of taxes and bankruptcy costs capital structure should not matter.

But banks are different - because large banks are too big to fail, the presence of bankruptcy costs don't matter. Furthermore, as banks benefit from very low debt costs (due to deposit insurance), their optimal capital structure is frequently very high.

In reality, large banks are more risky because of the risk they transfer to outsiders (tax payers) and therefore they should hold more capital than equivalent banks of a smaller size. But of course the banks don't want to hold more equity capital as equity is expensive relative to deposits.

The article is well worth a read.

Triple A Punt - Credit Rating Agencies

The Wall Street Journal's opinion page argues that the Obama administration has left the ratings agencies pretty much unscathed in the round of new regulations for the finance industry.

I'm inclined to agree that a lot of the problems that we have faced in the past year or so have been due to a reliance on the three ratings agencies, who occupy a position of government mandated supremacy. Pension funds, endowments and other regulated investment entities like being able to delegate credit screening to these credit agencies - they don't have to do the credit screening themselves.

Now it turns out that S&P is planning to use the CDS market to help set their ratings. In effect they are going to take a clean market signal and repackage it as a noisy, infrequently updated credit rating.

As the CDS market providesan instantaneous market assessment of risk, the role for credit rating companies should be limited - except for the fact that they have a government mandate.

Jon Stewart on GM

This one is a little old (june 3) but well worth watching if you haven't seen it.

Saab - a negative NPV project.

I'm wrapping up teaching financial management of corporations to MBAs - the last class is tonight (my Monday and Thursday nights will be so empty!).

In class we have talked a lot about NPV as a decision rule for evaluating projects and the recent news of GM's sale of Saab made me wonder what GM's original 2000 NPV analysis of Saab looked like (assuming that there was one). I'm guessing that there wasn't one. But I bet that if there was, they used GM's cost of capital and not a far higher one that a risky division like Saab would merit. Rick Wagoner stated in 2000 that ''The brand attracts a very different consumer than we normally see in General Motors showrooms ..... We want to keep that brand very distinctive and very unique.'' Sounds risky to me.

But by 2002 things looked pretty grim. Indeed, GM admitted that Saab never made money and Rick Wagoner said of Saab "you have to play the cards you're dealt". Wow, what a lame excuse when considering that GM picked the cards it was dealt.

Unfortunately, the US tax payer is now playing those cards.

How accurate is the Dow?

The Dow Jones Industrial average has been reworked again to reflect the bankruptcy of GM. Both the Dow and the S&P 500 are periodically changed when something happens to one of their constituents. The selection process for the new stocks that are added to the indices is a bit of a black box, but one thing appears to be true - both indices may inadvertently engage in a buy high sell low strategy. In effect the stocks that are deleted are ones that have been beaten down, while the stocks that are added are often stars in their sector. Evidence for this is explained here in a nice article on seeking alpha

I blogged about this before, and more I think about it, I think there must be a market for a pure buy and hold mutual fund.

GM and Ch 11. What a surprise.

Is anyone really surprised that GM is about to file Ch.11. I'm not, back in December I thought it was inevitable. The time has come to pull the life support.

Violating APR part 2

As I said a couple of days back, the Government was wrong to violate the priority rules of bankruptcy and favor Chrysler's union over its creditors. In doing so, the administration created the credible threat that they would do this again, and thus also created a disincentive for lenders to lend to unionized firms that are in financial difficulty.

My prediction has come true. George Schultze, manager of Schultze Asset Management LLC says:

Don’t lend to a company with big legacy liabilities or demand a much higher rate of interest because you may be leapfrogged in a bankruptcy.

Violating APR

The Government is stepping in to rig the Chrysler bankruptcy in a manner that, in effect, violates the absolute priority rule (APR). Article here. This rule dictates who gets paid, and in what order, when a company files Ch11.

Deviations from APR are in fact common when a lower ranked claimant is able to extract a concession from a higher claimant, but usually these are matters that occur between two private groups. By dictating the deviation in favor of the auto workers union, the Government is, in effective authorizing a wealth transfer from the bond holders to the union. Had the bond holders known that this was likely, they would have probably not lent money on the terms they did.

Going forward, this is bad policy, because any rational bond holder will be reluctant to lend to a large unionized company because of the risk that their claim will get trashed by the Government in the event of bankruptcy. For example, who is going to lend to GM in the future?

HT: My friend Jeff.

GM bankruptcy debate

Portfolio.com blogger Felix Salmon takes issue with some of GM's arguments against bankruptcy. As Salmon correctly states, chapter 11 is really just a court arranged change of ownership.

Of course it should be no surprise that the management of GM is fighting Ch11. Chapter 11 would result in shareholder's being wiped out and probably a fair amount of the management being replaced. In most cases a firm's management would try to avoid Ch 11 until it becomes impossible because of pressure from debt holders. But GM is in a unique position in that it can keep trying to hit up the Federal Government for more cash.

A reorganized GM would emerge leaner and better able to compete in the future. In the long run, Ch 11 is the best option, regardless of what GM says.

A new motivation for an IPO

Companies go public for a range of reasons. The good - to raise capital to fund projects, the not so good (perhaps) - to let existing equity holders cash out. But portfolio.com has an example I haven't seen before - to bail out the debtholders who are current being defaulted on. Friendfinder Network has been loosing money, has negative equity and is teetering on the brink of bankruptcy, yet is trying to pursue an IPO. As Felix Salmon of Portfolio.com succinctly states:

If anybody really wanted to own Friendfinder Networks, all they would need to do is buy up its bonds, refuse to modify the covenants, accelerate the debt, and force the company into bankruptcy, where it would be handed over to its creditors, with shareholders being wiped out.

Ch 11 and the auto industry

A really nice piece by Joe Stiglitz on why Ch11 is the way to go for the auto industry.

I particularly liked the final paragraph which basically sums it up...

Even if Congress does now give carmakers $15bn as a “stay of execution,” postponing the hard decisions, before the next multi-billon dollar dose of medicine we need to think more carefully about who we are really bailing out and why. This should not end up as just another rescue package for bondholders and shareholders.

I think its pretty obvious that any loan from the Government is just going to delay the inevitable. Furthermore a Car-Czar will have no real power except to pull the financing. Using a medical analogy, this is like a doctor saying that he'll pull the life support plug if the patient doesn't take all the bad tasting medicine. It ain't gonna happen. 6 months from now the big 3 (or 2) will be back, cap in hand, driving their hybrids and begging for more.

On a related note, the Wall Street Journal reviews the Cadillac Escalade Hybrid. To quote the reviewer...

Not in my lifetime has a car company come up with anything as absurd as the 2009 Cadillac Escalade Hybrid, the latest example of hybrid greenwashing

Which reminds me of this "ad" recently posted by Craig Newmark.




Ok, remind me again why we are wanting to bail out these idiots?

HT: Mankiw's Blog

UAL share price drop

Thanks to Craig Newmark for this interesting story.

On Monday (sept 8), UAL (United Airlines) stock dropped 75% amid a story that it had filed for bankruptcy. Turns out the story was from 2002. The original story was on the Florida Sun Sentinel's website. It was on the front page because people had clicked on the old story and made it the most popular news story. (This happens on the BBC news site a lot also).

A google search bot found the story, but as it had no date, assigned the date from the masthead of the paper. Then an analyst (who didn't read the story) uploaded it to Bloomberg. Program trading took over and the "news" triggered a massive sell off of the stock.

The SEC is investigating. The question is: Was this an innocent mistake or was their evidence of a deliberate manipulation of the stock?

Option ARMS

Yet more good stuff from the economist. Option ARMs - adjustable rate mortgages that allow (give the option) of paying less than the interest rate. The difference is then added to the loan balance. In a down market, you end up owing more than you originally borrowed on a house that is worth less than you paid. Oh yes, and these are mainly in CA.

The name option arm is ironic really because these loans are very much like options, where the buyer of the house is betting on house price volatility and hoping that the value of the house ends up in the money. Consider this fact also - in most cases, if the homeowner has been paying below the market interest rate for the loan for 5 years, he/she will have also been paying far below the rental cost of the property. So even in the case of default, where they loose the house, the occupant has still lived in a house at a lower cost than if they rented.

The trouble isn't going to be centered in CA either, my local bank Wachovia is in on the action...

An option-ARM product called Pick-a-Pay (a name that gave fair warning it could lead to trouble) accounts for 45% of consumer lending at Wachovia, a large bank.

Bankruptcy Scores

FinanceProfessor talks about bankruptcy prediction and Altman's Z score.

link here

What is interesting is that it is Altman himself making the prediction. Great stuff.

FinanceProfessor also lists a couple of nice sites that show you how to implement Altman's method in excel.