BUT….

….you can't exactly argue that we're not heading in this direction.

Something else to think about: it's fairly easy to argue that we got into this situation because our economic policy was designed to remove negative consequences from the economic cycle instead of just letting things run their course. SO, if we do the same via certain bailout strategies that are more aimed at maintaining the status quo, the easiest/most appealing answer, etc, what happens to us in the future?

(From the WSJ):   "As home prices slide and loan defaults pile up, some mortgage companies are slashing the amount that borrowers owe, deciding that a permanent cut in the loan balance may pay off if that helps teetering borrowers avoid foreclosure.

The small but growing push sharply contrasts with most loan-modification programs. Borrowers often get a lower interest rate or years longer to pay off their mortgage. But such changes may not be enough to make the loan payment affordable and don't fix the problem of borrowers owing more than their home is worth.

Reducing the principal on mortgages is "a last resort," says Paul Koches, executive vice president at Ocwen Financial Corp., a West Palm Beach, Fla., loan servicer that has shrunk the amount owed on 10,884 delinquent mortgages as of Sept. 30. That is 23% of all the loans modified by Ocwen so far this year.

On average, such borrowers saw their loan payments drop by 20% to 40%, typically by lowering the loan balance and interest rate. Ocwen estimates that the savings for investors who own the mortgages vary from a nominal amount to more than $325,000 per loan compared with the likely return if the loans wound up in foreclosure.

Many mortgage lenders and servicers have been reluctant to drastically change loan terms, in part because of worries that would antagonize investors who own securities tied to the loans. Mortgage servicers are responsible for collecting mortgage payments and working with troubled borrowers.

Not everyone agrees reducing the loan balance is the right move. J.P. Morgan Chase & Co.'s new effort to restructure as much as $70 billion in mortgage loans doesn't include principal write-downs. Instead, J.P. Morgan will sometimes base new loan payments on a smaller loan balance, while requiring that the full loan amount be repaid when the borrower refinances or sells the home. This approach lets the bank benefit from any subsequent increase in home values, a spokesman says.

But as foreclosures mount and the economy worsens, there is "a begrudging acceptance...that this is the way things have to move," says Sharon Greenberg, a mortgage strategist with Barclays Capital, a unit of Barclays PLC."

Graphic courtesy of the WSJ

In other words we're heading towards a situation where it's likely that a large number of borrowers are going to have their debt forgiven en masse, and it's probably only a matter of time before previously rejected proposals to begin forgiving credit card debt catch hold.

All of this begs the question: if we have a crisis that was caused by irresponsibility on the part of both borrowers, regulators and lenders, what happens when you start effectively rewarding many of these same people for their misdeeds and punishing those who behaved responsibly?

I understand that in extreme times extreme measures are needed, but I just can't support anything that rewards the irresponsible and doesn't punish those who need to be bailed out.

In any case, if idea of debt forgiveness continues to take hold don't be surprised if America's debt addiction subsides for only a short time period before it comes back stronger than ever.

Mind you I understand that debt forgiveness may very well turn into a necessary evil, but there should be some sort of penalty imposed on those who receive it, and/or the banks should only do it on the condition that they get a piece of the action if the value of the home recovers.

You can read more here.

Sources:

The WSJ: "New Tact in Default Battle: Cutting Mortgage Principle" -- Ruth Simon, November 20, 2008.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.

Mitt Romney wrote a  Op Ed in Today's NYT on the Auto Industry that is a must read; I won't say much about the specifics other than to say that I agree with him 100%.

I will say that he brings up a point or rather a "way of thinking" that should be applied to all other bailout efforts, rescues, etc, etc, namely that the architects of such solutions must ask themselves: "are we investing in change or are we simply maintaining the status quo?

Whether it's homeowners or corporations it doesn't make much sense for the Government to inject funds into the maintenance of situations that are either broken and/or unsustainable, as all you're doing is throwing good money after bad and delaying the inevitable. Instead the Government should be in the business of making investments as opposed to providing hand-outs, investments that enable the party(s) receiving assistance to turn things around, repay the taxpayer and emerge stronger than ever.

There is no point in using taxpayer money to fund delay tactics.

Better yet look at it from the "Main Street" level: would you lend money to a fiscally irresponsible friend/relative/individual who was having trouble making ends meet, if they were just going to use the money to meet short-term needs, weren't going to change their habits, look for a higher paying job and you knew they had no real means of paying you back?

Then why are some folks calling for the Government to do the same for various companies and individuals who are in analogous situations?

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.

I've been thinking about homeowner rescue plans and it occurs to me that the banks are ignoring a fairly obvious solution, consider this:

Outside of loss of income/sudden financial hardship situations, many of the people facing foreclosure are in those situations because they purchased a home they couldn't afford with an exotic mortgage, correct?

In other words any relief that comes from "loan modification" or "foreclosure rescue"  is either the result of forgiving principle (unlikely),  creating a new exotic loan situation that only temporarily makes the payment affordable, and/or just delaying foreclosure proceedings. The latter is especially pointless because waiting a few months isn't going to magically increase the income of the homeowner, thus making their mortgage affordable.

So what to do?

How about some sort of arbitrage transaction?

Think about the following scenario:

You're a bank that recently foreclosed on a home with a $250k mortgage balance, a home that you're probably going to wind up selling for less than that amount at auction because the current market price has dropped to say $200k.

  At the same time you have a customer that is currently struggling with a $350k mortgage who could reasonable only afford something in the $250k-$280k range,  a mortgage you're desperately trying to modify despite the fact that all you're really doing is buying time.

In other words you're a bank with two losing situations on its hands.

How about making it ONE losing situation via having the bank assume possession of the more expensive house, while the homeowner takes over the cheaper one under the condition(s) that he/she remain in the house for 5-7 years and agree to take on a mortgage of 10-15% higher than the mortgage balance on that home.

This sort of transaction would instantly put the homeowner into a situation they could afford, mitigate the bank's losses and leave the bank with ONE losing situation instead of TWO.

If you think about this isn't an especially innovative idea, nearly everyone who has managed rental properties has dealt with situations where they move cash strapped tenant to a unit they could more easily afford in order to avoid having to evict them.

I.e. it's better to have one of your existing customers paying you 20% less on a go-forward basis, than to have them paying you nothing at all.

Now yes, I'm fully aware that something like this would be easier said then done after all we're talking homes not an everyday widget like a Cellphone, you'd have supply issues, legal issues, real life issues around people's willingness to move to another part of town (or another one nearby), location preferences,  etc. In all likelihood the banks would have to coordinate and possibly trade/exchange foreclosed properties between one another in order to address the supply issues, thus opening  several cans of legal and financial worms.

BUT

Just because something may be difficult doesn't mean its impossible.

Furthermore the end result is likely to be significantly more positive for everyone involved than the results derived from the current arsenal of tactics, which at best only are delaying the inevitable and at worse are just grossly ineffective.

Truth be told it all comes down to whether or not people are willing to accept the reality of a situation, instead of attempting to preserve the unsustainable because it's more appetizing to do so. Politicians and bankers shouldn't be promising to keep people in their current house because that's the answer everyone likes, they should promising to TRY and put them into an affordable housing situation while being honest about the fact that it could mean trading down to a cheaper home or renting.

The goal shouldn't be to "keep people in their current homes"  per se,  it should be to put them into an sustainable housing situation, and while this may lead to unpleasant choices/consequences it's a necessary part of stabilizing the overall housing market. While the current architects of the current arsenal of "rescue" tactics have their hearts in the right place, it doesn't change the fact that by delaying the inevitable they're only  prolonging the housing crisis.

The foreclosures, prices declines, etc, are all a necessary part of a market correction that is a requirement for stable markets in the future. It's time for policy makers, politicians, executives, home owners, et al, to accept this fact, and focus on mitigating the impact instead of trying to prevent negative consequences altogether.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.

The usual mixture of news stories and other tidbits I think you may find interesting:

First a story on the auto industry in Britain, which discusses how a car dealer used a two for one deal to get rid of excess stock; lest we get too smug whilst reading about Britain's automotive retail woes let's not forget that many dealers in the U.S. are doing the same thing , they're just not advertising it in the same way.

Staying on the subject of the automotive sector here is a story from the WSJ that illustrates the stark differences between the foreign auto manufacturers and the domestic ones. The basic story is that while companies like Honda, Toyota and BMW are using the LA car show to unveil new green technologies, new models, etc, GM and Chrysler aren't even attending; this is on top of the fact that foreign manufacturers are opening up new plants whilst Detroit is closing them.

Looking towards the future I think the best solution is for Detroit to declare bankruptcy so that they're able to get out from under their various liabilities, Dealer agreements, etc, and then for the Government to step in and provide the necessary financial assistance for the companies to get back on their feet. As I've said numerous times on this blog Detroit's primary problem is that it's too inefficient to sell cars profitably, how else do you explain the positive financial performance of rivals who have a fraction of the market share yet enjoy a multiple of the profits?

Better yet: GM would be wildly profitable if it were just say 25-33% as efficient as Honda, so a true "bail-out plan" has to involve activities that move the company towards that level of efficiency. Merely lending the company money won't necessarily help them achieve those goals, but freeing them of the billions worth of financial obligations that are currently crushing them will. 

Without first some form of bankruptcy or a cancellation of many of the company's financial liabilities, all the proposed bailout package can do is merely prolong the inevitable.

Granted bankruptcy isn't an ideal solution and does offer some challenges in the realm of buyer confidence, damage to the brand, etc, however when you consider that the alternative merely delays the inevitable I don't see how Detroit has any other options.

Speaking of which here is a WSJ Op-Ed that outlines many of GM's financial liabilities in more detail and comes to a similar conclusion as my own.

It looks like Steve & Barry's isn't going to survive and is headed towards liquidation; normally I'm loathe to blame the current environment for a business' problems, but in this case it's hard to argue against the fact that turning around a retailer in this economy is an exceedingly difficult task. After all you have to not only fix the problems created by past mismanagement, but you also have to try and generate sales in an environment where consumers are cutting back on spending.

Long-term there may need to be a significant number of changes, adjustments and resetting of expectations within the retail space, because the current crisis is likely to influence some long-term changes in the way that people approach spending, saving and the usage of credit. At the very least retailers are going to adjust to consumers who from having credit bubble era access to credit to access that's more in line with the levels seen in the mid '90s.

Here is a story from the WSJ discussing how some banks are rejecting TARP capital, and how others whose requests for capital are rejected are probably only a week or two from failing. It's going to be interesting to see how things work out for the banks in the former category, as their rejection of TARP capital could conceivably put them at a competitive advantage. Still the fact that these companies were intelligent enough to manage their loans in a way that didn't make them so vulnerable to the credit crisis, suggests that they many of them will emerge from the crisis stronger than ever.

I mean which group of executives do you want to place your faith in: the group that ran over-leveraged and undercapitalized institutions that would lend to anyone with a heartbeat, or the group that managed their balance sheets properly?

Let's not forget that while we're all suffering from the crisis, it's something that was created by the actions of people who let greed override their common sense/sense of financial self-preservation. At the end of the day it's ridiculous that we're in this mess because our largest banks unilaterally decided to lend money to those who couldn't pay it back, over-leverage themselves and allow themselves to be undercapitalized.

I.e. we're in a crisis that was created by a legion of clowns who decided to throw the rules for smart banking out of the window.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.

Here is an interesting article from the WSJ that helps to convey the complexities of the credit crisis :

(From the WSJ): "All around Washington, policy makers are scrambling to figure out how to get banks lending again. Lawmakers have criticized banks for not using new federal money to make loans and have threatened to place conditions on additional money. Regulators last week sent out a directive, encouraging banks not to hold back on lending.

But there's a flaw in that logic. Banks actually are lending at record levels. Their commercial and industrial loans, at $1.6 trillion in early November, were up 15% from a year earlier and grew at a 25% annual rate during the past three months, according to weekly Federal Reserve data . Home-equity loans, at $578 billion, were up 21% from a year ago and grew at a 48% annual rate in three months.

Graphic Courtesy of the WSJ

The numbers point to one of the great challenges of the crisis. The credit crunch is surely real, but it is complex and not easily managed. Banks are lending, but they're also under serious strain as they act as backstops to a larger problem -- the breakdown of securities markets.

The worst of the credit crisis is being felt not in banks but in financial markets. Loans from a bank might stay on its books. Increasingly in the past decade, loans were packaged into securities and sold to investors around the world -- pension funds, endowments, mutual funds, hedge funds and others. Institutional investors gobbled up this and other kinds of credit that didn't come via traditional commercial banks, such as junk bonds or commercial paper.

To get credit flowing, policy makers need to repair financial markets as well as banks. But investor confidence in credit markets has been shattered, in part because many debt securities performed so much worse than their credit ratings suggested they would.

Issuance of asset-backed securities -- instruments used to package credit-card and auto-loan debt during the boom -- was down 79% in the year through October from last year, to $142 billion, according to Dealogic data. In 2005 and 2006, investors snapped up more than a trillion dollars of these instruments. Junk-bond issuance was down 66% in the first 10 months of the year from the same period in 2007.

A new paper by Harvard Business School economists David Scharfstein and Victoria Ivashina sheds light on how the recent rise in bank lending plays into this. Bank loans are rising, the economists say, because companies -- from General Motors to Tribune -- have turned to banks for precautionary cash. With markets shut down, they're drawing on existing credit lines to meet financing needs or simply to have money in reserve in case they need it later."

While the data presented in this article does fly in the face of conventional wisdom, something to keep in mind is that the data points provided are measuring increased usage of credit lines granted during the boom, more than they are an increased willingness by the banks to lend overall. The best way to look at it is to consider a scenario where an individual (or business) has significant amounts of credit on existing credit lines available (even if they've been cut), despite the fact that they would have difficulty getting new credit . This would enable them to draw down existing credit lines and show up on the banks books as an increase in lending, even though this same individual (or business) wouldn't be able to get new credit.

I.e. this is more of a function of people using credit issued prior to the boom then it is a function of banks being more willing to issue new credit.  

Still on a go-forward basis this situation does present a variety of issues and risks for the banks to deal with, for instance:

Increased HELOC lending in an environment where home values are decreasing, thus reducing the likelihood that people can refinance their way out of trouble if they get overextended. This is especially true for homeowners who are currently in homes they wouldn't been able to buy without the lowered lending standards of the boom.

In all likelihood some of these consumers are drawing on HELOCs to pay their primary mortgage, and/or taking money from a HELOC and then turning right back around and using it make the HELOC payment.

The increase in HELOC lending suggests that many banks were vigilant enough with respect to cutting lines of credit, and/or monitoring the debt loads of their customers. It also means that there is a growing risk of an increased rate of future defaults in '09, which is especially troublesome when you consider the financial state of the banks at the moment.

Corporate Lending : in a similar situation to the above the companies that are leaning on their credit lines the most, are more likely to be struggling companies then they are companies that are simply using lines of credit in an environment where it's difficult to raise money via other means. This is not to say that financially healthy companies aren't using their lines of credit, just that struggling companies are much more likely to have to use what are usually emergency credit facilities.

Needless to say this also represents a major risk for the banks. 

Credit Markets: the fact that the banks are holding more loans on their books means that they're not only more exposed to the risk from these loans, but they've also lost a means by which they could raise cash. Holding on to risky assets and not be able to raise cash, is a double whammy that is going to (has already really) hit various institutions rather hard.

Overall the discussion of bank lending needs to be more holistic and connected to reality, as it has to consider the financial state of the banks, the difference between old and new credit lines and future risks. Furthermore we need to reset expectations around lending standards and ease of credit access, as I believe we're still comparing the present day to the credit boom (a time when standards were too lax) as opposed to thinking about today vs. the late 90s, 00-01.

Let's not forget that in the home mortgage market the overwhelming majority of the defaults are concentrated amongst the exotic loans (be they subprime or prime), while the default rate for fixed rate traditional mortgages (you know those old school mortgages that required down payments?) has barely budged.

Meaning that we should be more concerned about who the banks lend to and under what terms, than we should about lending volume in general.

You can read more here.

Sources:

The WSJ: "Banks Keep Lending, but That isn't Easing the Crisis" -- Jon Hilsenrath, November 17, 2008.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.

Back in the old days of Mortgage Lending (when loans were originated to solvent homebuyers with down payments, and at levels they could comfortable service) , the common rule was that homeowners would be limited to a mortgage that was within 25-28% of their monthly gross household income, with 31-33% being allowed for high income buyers/people with a lot of disposable income.

I think that the architects of "homeowner rescue programs" should keep this rule in mind, because you can't modify, rescue, legislate, etc, someone out of a situation that is simply unaffordable.

I.e. the question offered should be: "would the monthly payment for a fixed APR, market rate mortgage for this particular individual be in the 28-33% (dependant on income level) range?"

If the answer is yes then this is an individual that can possibly be helped, if not then you're just delaying the inevitable for that homeowner as they've just gone from a financially unmanageable situation to one that's slightly less so. Individuals who fit in the latter category would be better served if they were provided assistance that would help them to move on to a more sustainable housing situation, as opposed to trying to enable them to stay in their homes at all costs.

Trying to enable people to stay in financially unsustainable housing situations will not only magnify the eventual negative impact on the finances of these individuals, but it will also extend the housing downturn as you're just creating a glut of future foreclosures.

While I'm sure this all sounds rather harsh, the fact remains that until we accept the mathematical reality of the current crisis (at all levels) we're not going to be able to engineer the solutions that will enable the economy to recover. The thinking needs to move towards the mathematical reality of things, as opposed to the reality we'd like.

In other words:

You can't rescue people from a financially unsustainable housing situation.

AND

Nothing should be done to halt the decline in housing prices, as they were hyper-inflated in the first place and a price correction is a necessary part of having a stable housing market in the future. 

Again while these are unpleasant harsh realities that people would rather not think about/believe, confronting these realities is a critical part of devising the solutions that will help us emerge successfully from this crisis. Furthermore thinking/solutions that are disconnected from reality will only prolong the crisis, and/or in many cases serve to make things worse.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.

Here is an graphic from the Economist depicting the forecasts from the OECD for the U.S., the Eurozone, Japan and OECD overall:

Graphic courtesy of The Economist

(From the Economist): "AS THE leaders of the G20 countries gather in Washington, DC, to discuss the financial crisis on Saturday November 15th, the economic outlook is grim. Gloomy forecasts just released by the OECD predict that America, Japan, the euro area and the OECD as a whole will slide into recession in 2009—if they are not already there. Barack Obama faces a tough challenge: America's output is set to shrink by 0.9%, although it should bounce back more strongly the following year. Inflation will continue to fall, although Japan will again suffer from deflation. And the unemployment rate will climb to 7.5% in America and 9% in the euro area."

Of course this is just a forecast and it more or less comes from the types of policy makers who were telling us not to worry last year, which makes one wonder if the worse is over now that the policy wonks have allegedly caught up to the eight ball.

Still my prediction is that even if the economy recovers the typical consumer/household will be dealing with the after effects of the current crisis for some time into the future, whether that means continuing to dig out of debt, dealing with the after effects of being unemployed, foreclosure, etc, etc. One thing policy makers have to keep in mind as they devise solutions to the economy at the Macro level, is how to deal with the impact to individuals at the household level.

Sources:

The Economist: "How bad will it get?" -- November 14, 2008.

Here is a change, instead of blaming their problems on the credit crunch (you know the crisis they caused themselves), HSBC executives are hitting hard at the bailouts, irresponsible behavior and the banking executives behind the whole mess.

(From the Financial Times): "The state-sponsored bail-outs of western banks risk rewarding management teams for failure, the chief executive of HSBC warned.

Michael Geoghegan’s comments on Monday reflect a deep frustration the recent bail-outs has caused among executives at HSBC, which, despite suffering heavy losses in the US mortgage market, has weathered the credit crisis in better shape than many of its rivals.

He said: “There is no question that guarantees have been given to failed managements.

“I hope these guarantees don’t last too long because they may create the wrong type of behaviour by managements in those banks.”

He added that they risked distorting the market.

However, HSBC executives acknowledged the rescues in the US and Europe were necessary to stabilise the banking system and restore the flow of credit to the economy.

Mr. Geoghegan was speaking as HSBC signaled that the recovery in its US consumer finance division might take longer than the three years the bank initially forecast."

Of course there is a touch of hypocrisy here because HSBC has plenty of their own irresponsible lending problems, however it's nice to see someone in the industry being at least somewhat honest.

While I've been critical of HSBC in the past (and I still think they should dump their U.S. based subprime lending operations), I have to give them props for being able to show a YoY earnings increase (albeit helped by one time items) in an era where practically of their rivals are either losing money or showing drastic earnings declines. Couple this with the fact that the bank has been able to shore up its capitalization position without government help, and I think that HSBC could emerge as one of the world's strongest banks after the world's economies recover.

Of course in this day and age it's always best to be a little wary of all banks, as too many of them have used all sorts of "legal chicanery" to appear significantly stronger than they are.

E.g. heavily scrutinize balance sheets and proceed with extreme caution.

Sources:

The Financial Times: "HSBC chief hits at state bank bail-outs" -- Peter Thal Larsen, November 10, 2008.

You can read more here.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.

I spent this past weekend relaxing and catching up on some episodes of CNBC's "American Greed" that I DVR'd several months ago. One of the episodes was about Barton Watson a con man who cooked the books at his Tech Company (A PC VAR), in order to procure lines of credit from banks that he used to both run the company and finance a high-flying lifestyle for him and the company's executives.

I.e. he overleveraged his company on the back of faux assets.

Doesn't this scenario sound rather similar to companies using regulatory arbitrage to escape capitalization requirements, valuing debt securities (and other derivatives) via "mark to model" and then borrowing money against same?

Mind you the frauds committed by Barton's company were a bit more involved than just inflating the value of an asset and taking out a loan against it (inventing customers, false invoices, setting up fronts for banks to call, creating fake computer equipment, etc), and Barton and company weren't even using much of the funds received for legitimate business purposes.

I.e. I'm not arguing that what Barton did wasn't a crime (because it certainly was), I'm just arguing that what many of what the banks, hedge funds, AIG, et al, did was definitely in the same neighborhood as far as corporate malfeasance. Because at a certain level if you replace borrowing against a fake P/L, with borrowing against "mark to myth" derivatives there isn't a real fundamental difference.

Funny how one act is a crime and the other is just bad judgment, especially when you can argue that many of the banks, hedge funds, etc, had faux balance sheets too. 

(From the WSJ): "Troubled electronics retailer Circuit City Stores Inc. filed for Chapter 11 bankruptcy Monday in an effort to stay ahead of lenders owed $898 million.

With going-out-of-business sales already in full swing at about 20% of its outlets, the nation's second-largest consumer electronics chain by revenue says it has an immediate need for financing.

The company cited erosion of vendor confidence and consumer retreat in the face of the global economic crisis for the bankruptcy filing.

Bruce Besanko, chief financial officer of the chain, said in court papers that the Chapter 11 filing is an effort to salvage a restructuring effort that has already cost thousands of jobs. An expected $75 million tax refund has yet to arrive, leaving the cash-strapped retailer struggling to make sure it has goods for the holiday season, Mr. Besanko said in a court filing.

Circuit City will ask the U.S. Bankruptcy Court in Richmond, Va. for permission to roll its existing bank debt into a Chapter 11 loan, in order to free up cash to stock the shelves, court papers say.

In what is becoming a familiar pattern in retail bankruptcies, the company's existing lenders, led by Bank of America Corp., will finance the bankruptcy, as long as the new loan they make is used to pay off their existing loans.

The lenders have agreed to loan Circuit City $1.1 billion to keep the retailer's doors open through the holiday season. The amount available under the bankruptcy loan will be cut to $900 million on Dec. 29.

With money tight, banks find themselves stuck bailing out distressed companies, instead of simply handing off the troubled credits to new lenders, as they were able to do before the credit crunch.

Circuit City cited "the widespread liquidity crisis among all major banks and other lending institutions throughout the country," in arguing for court approval of the Chapter 11 loan. The company has two years of losses under its belt, including a $404 million loss for the six months ended in August.

Circuit City's Canadian operations are being placed under the protection of insolvency courts as well, court papers say."

The problem here is that Circuit City is virtually guaranteed to lose money this holiday season, and has proven themselves incapable of making money in a market that is still profitable (even now) for all of its competitors and has arguably been one of retail's bright spots this year. The problem has never been debt related it's been the way the company operates, as I've said dozens of times before the company hasn't been able to make money selling virtually the same products, at the same prices as its competitors.

Furthermore CC isn't filing bankruptcy in order to free up cash to invest into improvements into the business, they're filing bankruptcy so they can afford to stock the shelves for the coming holiday season. A company that needs to file bankruptcy just to raise the cash to buy products, isn't likely to have enough resources left over to make key investments into the company. This filing is more about buying time and hoping something works out, than it is about finding a way to survive while a turnaround plan is implemented.

Extending Circuit City new financing so they can continue to operate, ease pressure from creditors, vendors, etc, is basically prolonging the inevitable, unless fundamental changes are made to the way the company operates.

I.e. the company's creditors have agreed to finance hope and another round of losses, as it doesn't look like Circuit City is going to be doing anything different this coming holiday season that will allow it to turn a profit.  

In the end the new loans granted to Circuit City are probably more about buying time for its lenders with respect to the credit crunch, then they are about believing the company has a legitimate shot at survival.

If the company continues to lose money on a go-forward basis (and all signs point to this happening), then it stands to reason that the company won't be able to successfully emerge from bankruptcy.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.

I figured the above was apropos of the news around AIG's huge loss and the Government's "revised" rescue package; mind you I'm not characterizing the AIG situation in exactly the same manner as the comic panel, but it certainly feels that way now doesn't it?

There is no point in revisiting what led AIG to this point as I did that last week here; however I will say that the situation begs for a new approach to corporate government and regulation. Namely that companies need to be monitored not only in terms of how well they're adhering to the "rules", but in terms of the amount of risk they pose to the economy if they were to go belly up, need a rescue, etc. The reason I'm advocating for "risk monitoring" is because while  business is often multiple steps ahead of the politicians and regulators, it's much easier (especially if the people doing the monitoring come from the business world) to asses the  amount of risk a particular company poses for the economy.

While placing caps on how large certain companies can get it's something that will make many people (myself included) cringe, the fact remains that without the caps we're allowing the creation of singular entities that have the capability of taking down large swatches of the economy with them if they run into severe difficulties.

After all we already have limits on the % of the nation's deposits a bank can obtain via acquisition (granted those rules have been ignored lately), and the FDIC can seize banks if their capitalization levels fall below a certain point so they don't fail and cause a panic. Why can't we take similar steps with other types of companies and place a cap on their growth, so that the health of the economy isn't depending on a small number of executives always making smart, rational decisions?

I guess on a go-forward basis we have to ask our selves the policy question: "is our belief in free market ideologies so strong that we're willing to suffer the consequences of allowing future companies to become the next Mortgage GSE(s), AIG, etc, instead of reigning them in to protect the stability of the overall economy?"

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the op

In order to give you a better idea of the degree to which the credit markets are frozen, take a look at the passage below: 

(From the WSJ): "Banks and other finance companies making loans for autos, credit cards and college tuition are having virtually no success in selling those loans to other investors, a potent sign of just how tight credit markets remain.

The market for selling such loans -- by packaging, or securitizing, them into bonds -- had just one $500 million deal for all of October, according to Barclays Capital. That compares with $50.7 billion worth of deals made one year earlier, according to market-research firm Dealogic. The overall market for so-called asset-backed securitization is estimated at $2.5 trillion.

This creates repercussions for lenders and consumers alike.

Banks and other finance companies are stuck holding more loans on their balance sheets, which crimps their ability to offer new loans. That, in turn, shrinks available credit for consumers, who need it to finance an education, buy a new car, or pay for household expenses using a credit card. Banks were already reining in lending to customers as they try to reduce exposure to loans that may ultimately go unpaid.

For years, the asset-backed securitization markets fueled the explosion in consumer borrowing, as it allowed lenders to spread their risk to other investors such as pension funds, hedge funds and insurers. But the securitization pools have dried up after losses in the mortgage markets, where risk was also widely dispersed via securitized bonds.

The October dry spell has caused year-to-date securitization volumes to drop. Credit-card volumes are down 31%, auto loans are off 45% and student loans have fallen about 41%, according to Barclays. October's sole transaction came from AmeriCredit Corp., which provides auto loans to less creditworthy borrowers.

"We are at a standstill," said Craig Leonard, a structured-debt syndicate banker at Barclays Capital said.

The deals that are getting done are also more expensive for the banks. At the end of October, the risk premium charged on a triple-A rated credit-card deal reached 4.67 percentage points over comparable two-year Treasury yields, up almost 3.2 percentage points from June, according to J.P. Morgan data.

Even through June of this year, securities backed by student loans and credit-card debt remained popular with investors. But investors already burned by sinking bond valuations are likely to stay clear of these markets, because of the downturn in the economy and expected increase in job losses."

So the first thing that jumps out is that the securitization market that had (on aggregate) $51 billion worth of transactions last October had only a single $500 million transaction this past one, in other words: the securitization market declined by 99% last month. 

The other issue is that many of the hedge funds that the banks would normally sell securitized loans to no longer exist, the pension funds are trying to preserve capital and the insurers may very well need outside capital infusions just to keep functioning. But the real problem is that the banks used securitization to both spread risk around and raise capital, and now the investors know that these debt securities aren't as safe and dependable as advertised. Especially now that a slowing economy increases the risk inherent in any lending or debt security transaction.

It's hard to get investors to believe in what you're selling when you sold them garbage in the past, and all signs are pointing towards the banks having a weaker pool of customers to deal with on a go-forward basis.

Fixing the situation will require the banks to raise their lending standards so that they're selling higher quality debt securities in the first place, on top of strengthening the economy so that the banks have a stronger pool of customers to work with. Unfortunately while the former is fairly clear cut, the latter is more of an abstraction at the moment.

Moving forward consumers are going to need reset their expectations around credit, because the combination of higher standards (that were too low anyway) and fewer investors in debt securities (fewer hedge funds, other investors being more cautious) is going to make credit harder to come by.

What's unknown at this point is how things will look after the credit crunch: will consumer credit be generally harder to get (compared to the credit boom), or if we'll see more of a "scale back approach where people with $40k/yr salaries will no longer be able to easily finance $45k cars and will have to instead finance $20-$25k ones instead. Hopefully we'll see more of the latter than the former.

On a go-forward basis the ideal situation is one where consumers can easily obtain credit, just not in amounts that are out of touch with one's income level and ability to pay it back. Think: aggregate credit card limits capped at 75% of income, car loans limited to 40-60% of income, mortgages originated at 22-28% of gross monthly, etc.

You can read more here.

Sources:

The WSJ: "Bond Woes Choke Off Some Credit to Consumers" -- Robin Sidel, Prabha Natarajan, November 6, 2008.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.

Interesting chart from Paul Kedrosky's "Infectious Greed" Blog, depicting the "net notional" and "gross notional" CDS exposure for various countries and companies.

Courtesy of Infectious Greed

So you're aware the "net notional" reflects the net amount of debt being covered by various CDS, after adjusting for hedges, longs, shorts, etc. The reason for this is that people often hedge their CDS positions, and/or you have situations where party A owes party B $10M, and is also owed $15M by party C, thereby nullifying the amount of net risk involved. Of course that scenario assumes that party C has the money to pay party A, and/or isn't depending on a soon to be insolvent party D as the source of the funds with which to service its debts.

E.g. the net notional exposure may very well be significantly higher than what is indicated here, when you consider that many of the counterparties may be in financial trouble and there is good reason to be suspcious of the models and underlying assumptions that have gone into any derivatives contract written over the past 10 or so years.

Needless to say the situation around CDS definitely needs to be looked at in more detail.

Either way, very interesting data and you can find more of it here.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.

The usual round-up of interesting news stories and other tidbits I think you may find interesting:

Let's start off with something lighthearted: 15 reasons why Mr. Rogers was the best neighbor ever; while I'm not exactly a shiny happy optimist but in times like this it's nice to read something like this considering everything that's going on right now.

Here is a listing of the banks that are participating in the TARP program, it includes the date the capital infusion was announced and the amount received by the bank through 11/3/08. The list is sortable by bank, state and amount.

Generally speaking the best way to look at this list is to think about the amount received Vs. their market cap, P/L for '07 and '08, and loan losses & write downs; the reason for this is that it can help you to differentiate between the banks that are using TARP as a cheap way to raise capital/not to lose a competitive advantage and those that are taking TARP money to remain solvent.

Looking at the car industry for a second, here is a listing of the top 20 vehicles sold last month as well as the YoY change in sales from '07. Ironically despite Detroit's troubles the Chevy Malibu and the Ford Focus are the only cars to show double digit increases from last year (no doubt driven by a combination of a new model (Malibu), extra deep discounts and the Focus being a popular small car); still any cause to celebrate is undoubtedly negated by the fact that the vehicles it's competitors sell in similar volumes are sold for an actual profit.

Still it's a faint ray of hope.

Putting the results above into better perspective let's look at a graphic depicting auto sales from GM, Toyota, Ford and Chrysler over the past three months:

Graphic courtesy of the WSJ

While these short-term trends are definitely interesting, it's probably better to look at trends the span the course of 6-18 months, because the economy is so volatile right now that it's hard to tell if we're seeing the beginning of at least a medium term trend or a short-term anomaly.

However looking at the data puts GM sales of the Chevy Malibu into better perspective: they may be selling a lot more Malibus but they're selling far fewer of their other models, it's even quite possible that their Malibu sales are just cannibalizing sales from their other brands. Overall GM can't survive many more months of sales dropping as precipitously as they have over the August to October time period.

Additionally it's rather interesting to note that Chrysler's sales have suffered the least over the past three months, whether or not this is a strength that Chrysler can leverage long-term remains to be seen.

Here is a piece from the WSJ around Retailer expectations of a gloomy holiday shopping season; I think this has to be one of the more obvious "calls" this year, especially when you consider that last year was pretty abysmal despite the best efforts of some to spin things to appear otherwise. In my view the changing world of consumer credit (from the perspective of banks and consumers) is going to cause some long-term changes in the retail arena, as consumers are forced to cut back on the hyper-consumption of the last 25+ years and manage their finances more conservatively.

I think that over the medium to long-term there needs to be a resetting of expectations around retail results, consumer spending, etc, because the world is changing and we can't use the metrics of old anymore. So much of our economy is built on credit that it's going to take some time for all of the effects of our changing economy to be noticed/discovered, and coming  period of expectation setting may last for quite a few years.

In a somber economic indicator, Utility Companies across the nation are reporting a surge in the number of disconnects and past due bills, indicating that many people are struggling to make ends meet and are probably choosing food and gas over paying their utilities. I suspect that if you were to talk to the collection departments of cell phone companies, cable companies, etc, you would see a similar trend.

In my view this trend is a function of rising unemployment, general economic struggles and lack of access to credit (nearly every electric company takes credit cards these days), and is something that will probably get quite a bit worse before it improves.

Like I've said in the past whether or not we're in an "official recession" matters little to many folks on Main Street.

Disclosure: at the time of publishing the author didn't own a position in any of the companies mentioned in this article; the ideas expressed are solely the opinions of the author and shouldn't be viewed as financial or investment advice.