Monday, November 24, 2008


Oh man. What to say... Today I'm not focused on the Citi bailout - let's talk about the FDIC "Temporary Liquidity Guarantee" program, and I welcome any insights from readers who trade the corporate bond markets.
Let's go over the quick facts of the program, which was announced Oct 14th, and which caught my attention because I read today that Goldman Sachs will be raising $2Billion under the program on Tuesday.
"Under the plan, certain newly issued senior unsecured debt issued on or before June 30, 2009, would be fully protected in the event the issuing institution subsequently fails, or its holding company files for bankruptcy. This includes promissory notes, commercial paper, inter-bank funding, and any unsecured portion of secured debt. Coverage would be limited to June 30, 2012, even if the maturity exceeds that date. Participants will be charged a 75-basis point fee to protect their new debt issues."
Obviously, if Goldman is issuing debt backed by the FDIC, it should have yields that are very close to corresponding treasury yields, which is a mere fraction of what Goldman would pay in the open market. In essence, the FDIC is attaching CDS protection to every bond issued by qualifying firms, and the firms themselves pay for this protection which is given to the buyer: 75 bps.
Now, this plan brings up a lot of thoughts smashing through my head: 1) This is basically what AIG did - they tried to guarantee everything that everyone brought them, which worked fine until it started to NOT work, then it unraveled quickly. 2) On the other hand, the US Government is clearly not AIG, and what they're really doing here is allowing companies to get cheap funding without (the government) having to pick up the tab for it - all they (the government) do is put their seal of approval on it, and buyers have no dis-incentive that I can think of - the debt is essentially risk free. Brilliant right? 3) But we never found out which banks are the "good banks" and which banks are the "bad banks" because we never marked all the crappy assets to market - so the government can very well end up guaranteeing the debt of companies that chug cock and will not be able to pay it back.
But anyway, let's move on to a specific example - because Eric emailed me and said "As a holder of CIT debt yielding 28%, this program makes me happy!" Eric owns CIT debt maturing in 2011, which yields in excess of 25%. Now, this debt was already outstanding, so it's not guaranteed by the FDIC. But why would CIT ever default on this debt? Even though they have billions of dollars of debt outstanding and maturing in the next few years, why would they default on any of it if they can issue new guaranteed debt? Well duh, they need to be able to sell the new debt to refinance the old debt - but why wouldn't they be able to sell new debt - IT'S GUARANTEED! What would discourage a buyer of the debt from owning it?
All I can think of is one thing, but it's a big thing - and it comes back to the central point of this whole calamitous cycle: deleveraging. There simply isn't enough capital available to be invest to continue to fund all the excess debt we've accumulated over the last ten years or so. If anyone doesn't know what "leverage" means, it's basically the principle where you can take $1 and buy more than $1 worth of stuff for it. For some companies, that means they can buy $5 worth of stuff, for some it means $10. For the Wall Street brokers, it was roughly $30. For Long Term Capital Management, it was $100.
But here's another question, and it's related to the crappy ass CIT debt: at SOME price, buyers will come in and buy short term debt backed from CIT that's backed by the FDIC right? I mean, if it yielded 20 bps over treasuries, maybe it doesn't sell... But if it yields 2% over treasuries, it does, right? Or if the number that it takes it 4%... at some price, buyers come in. Meanwhile, CIT avoids defaulting on their other debt - refinancing it with this new gift from the FDIC. Sure, they may default later, when this new debt comes due, but isn't that better for them than defaulting now? Don't they want to participate in the debt ponzi scheme and take the free roll that something turns around for them, they catch a miracle, and are able to pay off this new debt too? This is something I'd love to hear reader thoughts on. In short, why would CIT(or anyone else) ever default on debt that comes due before the end of the FDIC program's guarantee?
I called my account manager at Solomon Smith Barney (owned by Citigroup, of course) in the beginning of August. I told him, "I want my liquid assets invested such that when Citi goes bankrupt, I don't lose a dime." This meant I had to have them out of a Citi money market, out of the muni-money market they were in, and out of any sort of account that basically had any risk. So I'm in a Treasury money market fund, which yields somewhere around 50 bps probably. Is there any reason at all (apart from liquidity) why I shouldn't buy this new Goldman Sachs debt they'll issue tomorrow, which will probably yield around 3%? Apart from the fact that I can't sell the GS debt in two weeks if I so desire, I think the answer is "no."
The fact of the matter is that we, as a country, are broke. It's not just housing - it's credit cards, auto loans, corporate debt - we're all over levered, and that leverage has to come down. We can't just continue to roll over all of our old debt, because the amount of capital available in the system has shrunk and will continue to shrink as we continue to reduce our borrowing and leverage. We can't solve the problem of house prices being unaffordable by trying to prevent home prices from falling. We can't solve the problem of companies having too much debt by guaranteeing their new debt!
I'm thinking of a few different childhood game cliches as closing lines: don't get caught holding the hot potato, and don't be the one without a chair when the music stops... Someone will be left holding the bag when the ponzi scheme ends - and as usual, it looks like it will be we the taxpayers.
UPDATE: holy crap, speaking of my cliches - check out this quote I just found from July 2007 from former Citi CEO Chuck Prince:
“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.”
Party on.

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