Have We Seen the Last of the Bear Raids?

So is that it? Is the downturn over? After bouncing off of 6500, or more than half its peak value, and with Citigroup briefly breaking $1, the Dow Jones Industrial Average has rallied back more than 1200 points. So, is it safe to go back in the water? Best to figure out what went wrong first -- what I like to call a bear-raid extraordinaire.

The Dow clearly got a boost from Treasury Secretary Tim Geithner's new and improved plan, announced on Monday, to rid our banks of those nasty toxic assets. The idea is to form a "Public-Private Investment Fund" to buy up $500 billion to $1 trillion worth of bad assets -- mostly mortgage backed securities (MBSs) and collateralized debt obligations (CDOs).

While it's true that private interests can conceptually help establish the right market price for these assets, the reality is Mr. Geithner's public-private scheme won't work. Why? Because the pricing paradox remains -- private parties won't overpay, yet banks believe these assets are extremely undervalued by the market. As Edward Yingling, president of the American Bankers Association, said recently on CNBC, "You have to go into the securities, examine the securities, examine the cash flow. I've seen it done, and the market is so far below what they're really worth."

The Treasury can't just keep throwing money at the problem, but needs instead to figure out what's really been going on -- the aforementioned bear-raid extraordinaire that's crushed Citigroup and Bank of America and General Electric, among others. Only then can Mr. Geithner craft a real plan to fight back.

In a typical bear raid, traders short a target stock -- i.e., borrow shares and then sell them, hoping to cover or replace them at a cheaper price. Once short, traders then spread bad news, amplify it, even make it up if they have to, to get a stock to drop so they can cover their short.

This bear raid was different. Wall Street is short-term financed, mostly through overnight and repurchasing agreements, which was fine when banks were just doing IPOs and trading stocks. But as they began to own things for their own account (MBSs, CDOs) there emerged a huge mismatch between the duration of their holdings (10- and 30-year mortgages and the derivatives based on them) and their overnight funding. When this happens a bear can ride in, undercut a bank's short-term funding, and force it to sell a long-term holding.

Since these derivatives were so weird, if you wanted to count them as part of your reserves, regulators demanded that you buy insurance against the derivatives defaulting. And everyone did. The "default insurance" was in the form of credit default swaps (CDSs), often from AIG's now infamous Financial Products unit. Never mind that AIG never bothered reserving for potential payouts or ever had to put up collateral because of its own AAA rating. The whole exercise was stupid, akin to buying insurance from the captain of the Titanic, who put the premiums in the ship's safe and collected a tidy bonus for his efforts.

Because these derivatives were part of the banks' reserve calculations, if you could knock down their value, mark-to-market accounting would force the banks to take more write-offs and scramble for capital to replace it. Remember that Citigroup went so far as to set up off-balance-sheet vehicles to own this stuff. So Wall Street got stuck holding the hot potato making them vulnerable to a bear raid.

You can't just manipulate a $62 trillion market for derivatives. So what did the bears do? They looked and found an asymmetry to exploit in those same credit default swaps. If you bid up the price of swaps, because markets are all linked, the higher likelihood (or at least the perception based on swap prices) of derivative defaults would cause the value of these CDO derivatives to drop, thus triggering banks and financial companies to write off losses and their stocks to plummet.

General Electric CEO Jeff Immelt famously complained that "by spending 25 million bucks in a handful of transactions in an unregulated market" traders in credit default swaps could tank major companies. "I just don't think we should treat credit default swaps as like the Delphic Oracle of any kind," he continued. "It's the most easily manipulated and broadly manipulated market that there is."

Complain all you want, it worked. In early March, Citigroup hit $1 and Bank of America dropped to $3 and GE bottomed at $6.66 from $36 not much more than a year ago. Same for Lloyds Banking Group in the U.K. dropping from 400 to 40. Citi CEO Vikram Pandit recently announced that the bank was profitable in January and February. (How couldn't they be? With short-term rates close to zero, any loan could be profitable). Never mind they still had squished CDOs, it was enough to get some of the pressure off, for now.

Oddly, with the new Treasury plan, these same bear raiders are still incentivized to manipulate the price of swaps to depress toxic derivative prices, especially so with the government's help to get hedge funds to turn around and buy them. Perversely, they may get rewarded for their own shenanigans.

This week's Treasury announcement of private buyers isn't going to magically change the depressed prices of these toxic derivatives. The Treasury needs to fight fire with fire. If I were Mr. Geithner, I'd pull off a bull run -- i.e., pile into the CDS market and sell as many swaps as I could, the opposite of a bear raid. If the bears are buying, I'd be selling, using the same asymmetry against them. Sensing the deep pockets of Uncle Sam, the bears will back off. Worst case, the Fed is on the hook for defaults, which they are anyway!

With the pressure of default assumptions easing, prices of CDOs should rise, which not only gives breathing room to banks, but may actually get these derivatives to a price where banks would be willing to sell them, replacing toxic assets in their reserves with cash or short term Treasurys, which ought to stimulate lending.

So are hedge funds villains? Not especially. The bear raid probably saved us five to 10 years' of bank earning disappointments as they worked off these bad loans. Those that mismatched duration set themselves up to be clawed. Under cover of a Treasury bull run, banks should raise whatever capital they can and dump as many bad loans before the bear raiders come back. Let the bears find others to feast on, like autos, cellular, cable and California.

Andy describes very well a short term liquidity crunch that is ever so present in financial institutions, and makes them vulnerable to "bear raids" and/or "run on the bank' that have ravaged banks during 1930s.

Andy Kessler (born 1958) was co-founder and President of Velocity Capital Management, an investment firm based in Palo Alto, California. He is an author of several books on business, technology, and the health field and has also contributed to The Wall Street Journal.

Books by Andy Kessler:

The End of Medicine: How Silicon Valley (and Naked Mice) Will Reboot Your Doctor‎ - 2006 - 354 pages

Running money: hedge fund honchos, monster markets and my hunt for the big score‎ - 2004 - 312 pages

How We Got Here: A Slightly Irreverent History of Technology and Markets‎ - 2005 - 272 pages

Wall Street Meat: My Narrow Escape from the Stock Market Grinder‎ - 2004 - 272 pages

Private public funding of hedge funds to leverage money to buy toxic assets. If economy recovers, hedge fund keeps all the profits, and if economy falters and the funds lose money, taxpayer eats the losses. Wall Street via politicians have hijacked Wash DC and made arrangements where only the taxpayers will be screwed when everything goes wrong again.

"banks believe these assets are extremely undervalued"

That's because they are.

The details of the asset plan make sense. Basically they are going to put the FDIC on the hook for debt written against these assets, up to 6 to 1 leverage or so. That means the "carry" on them will be huge, because debt can be issued against them at insured CD rates.

Do some vulture investors want 30 cents on the dollar when the things are really worth 60? Sure, they'd like to freely double their money. But if you can borrow most of the price, you can double your *equity* paying 50, if they are really worth 60. It is a perfectly sensible plan, and all the "it won't work" nonsense is based on the same old puritanical market-perfection belief that the lowest quotes to date are the "true value". Which is nonsense, and the banks know it is nonsense. So will the new players who take these deals. PIMCO isn't going to hold out for 30 when they can do the math and see they can double their money paying 50.

Pols are enamored with pseudo public-private “partnerships” (aka Third Way) because it’s a no-lose game for them.

Heads - they win, tails - you lose. Handy scapegoats are usually on hand, and hardly any accountability as most recent experience with GSEs (Fannie, Freddie and others) has shown.

No, the treasury invests in the equity right beside them, dollar for dollar, so it will receive as much upside as any of the partners. And all the incentive is, is that the FDIC will insure debt raised on this stuff as collateral. Guess what? If it stays in the banking system instead, the FDIC already does insure the debt that is carrying this stuff, because it is being carried by insured bank deposits and CDs, this instant.

Opening up that ability to the bond funds is a new incentive that can indeed get this stuff out of the banking system and into long term buy-and-hold hands. And the only risk the government is running in that, is one it is already running through its existing guarantees.

They simply know what they are doing, and everyone else is pretending the government can somehow get off the hook by blaming somebody else or letting somebody or other fail. They can't. Grok already, the treasury *already* owns all the downside. F. D. I. C.

But if you can borrow most of the price, you can double your *equity* paying 50, if they are really worth 60.

Which is exactly what Citi and BoA are doing now. It's an easy way to get really profitable really fast, using leverage, and pay off TARP loans (which is in everybody's interest) if / when financial system is stabilized and bear raids or run on the bank are no longer in the picture. That would unclog the credit facilities of the banks, which have been already thawing due to lower spreads and LIBOR rates.

They are reducing leverage. They care more about their stock prices. What is true though is narrowing spreads and recovering bond prices mean all the financial institutions will see mark down pressure evaporate. This was already in the cards in November - it was clear in the late November to mid December period that corporate bond prices had already bottomed. The stocks went down for another quarter because it takes that long for the price recovery to show up in earnings. But nobody should be surprised when B of A et al announce they are profitable again, shortly.

The spread between corporates and treasuries simply was and is the crisis. If the Fed wanted to address it directly they'd just arb that spread directly. Instead they continue to do it indirectly, wanting private actors to take the lead. That is delaying things, but sooner or later it turns.

The original losses have all been written off long since. All the big banks have been cash flow positive throughout - the "losses" are all marks and additions to loss reserves, not cash going out the door.

I will wait for the treasury market to reflect your confidence in this scheme. If the Chinese start to buy 10+ year treasuries, then they must have analyzed the toxic asset plan and came to the same conclusion that you have, it will work, thus the US will be able to back their treasuries and eventually pay their debts. On the other hand if they do not, we got problems.

They are reducing leverage overall, as they should, but they are increasing their profit using as much leverage on these short term (sort of) "arbitrage" trades as they can. It's [almost] a sure thing, and very cheaply financed currently

Also true is that credit thaw started right after TARP liquidity injection (despite all the political theatre) and had nothing to do with latter developments or lack thereof. Market prices also had reacted to clear anti-business bias and huge deficit spending of incoming Obama administration.

All the big banks have been cash flow positive throughout - the "losses" are all marks and additions to loss reserves, not cash going out the door.

Also correct. Most people don't distinguish between cash flow, free cash flow, operating losses and non-cash goodwill / write-offs losses, especially of the "kitchen sink" variety. All they see are more scary headlines with the largest losses ever. Media (including financial media) is only too happy to amplify it without understanding or explaining any of it to the public, which erodes confidence and creates or amplifies panic. It's a negative feedback loop, which only plays into the hands of politicians who crave the crisis - to exploit for their own purposes.

But if you can borrow most of the price, you can double your *equity* paying 50, if they are really worth 60.

Your scenario is true if the banks are willing to sell at 50 with a true value of 60.

But what about all of the banks that have most of their toxic assets still marked around 92-95 and won't budge downwards unless it's them buying their own debt?

There are still a lot of banks carrying their commercial loans at 100.

This is why the PPIP won't work. The 84 that the FDIC uses as an "example" auction is a dream. Very few banks will touch that.

Citi and BAC are buying all of the Alt-A and ARM that they can get their hands on. They're about to game the system - at the taxpayers expense.

I think anyone thinking of jumping in ought to study and take to heart the treacherous and devastating slide of the Dow from October of 1929 into the mid thirties. There were a lot of what only later were seen as bear market rallies.

It's not really clear here , but if you look carefully you'll see some rallies on the long slow decline. Then imagine all the wise saying that we've hit bottom. That only has to happen a few times for a lot of people to lose every dime they've got.

Good post as usual, but I’ve got a couple of questions.

Is there any equitable way to price these assets? As the overall economy still continues to tank, won’t these sub prime based assets continue to lose value as foreclosures and real estate deflation continue?

Is this program large enough in scope to make a difference? Most estimates I have seen put the toxic assets in the 4-5 trillion range...this program is in the 1 trillion range.

I guess my real question is this....is this a fix or just kicking the can down the road?

I’m confused.

This was a classic short squeeze and nothing else. The insiders bought up bunches and bunches of stocks to drive the prices up, and make shorts cover. This HS designed to get you to put your money in to buy the shares these guys just marked up 12% and take them off their hands.

None of this has anything to do with reducing the horrendous debt loads that the American public is holding.

PS. Stocks are not undervalued. They have been overvalued for about 20 years.

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