Structured Products Are Alive And Well, Not Dead, Thanks To "Too Big To Fail"

After the demise of Lehman Brothers I recall reading an article about the end of structured products on Wall Street. The author's premise sounded logical given that the purchasers of Lehman structured products were considered unsecured creditors in Lehman's bankruptcy. Who would line up to "lend" money to a bank without either FDIC insurance or as part of the FDIC's Temporary Liquidity Guarantee Program? Hence, the end of structured finance. The end of a lucrative line of business for banks and, hopefully, less ways to lose money for investors.

Well, wrong. Structured products are alive and well. They may not be quite as daring as a few years back, but they are being sold with abandon and playing to investors quest for a deal too good to be true. Want a 10+ percent return with a relatively short maturity, plus the possibility to earn even more yield if underlying security does well? Would you like it even better if you were given ten percent downside protection? These are the kinds of deals that a proliferating in todays market satisfying investors desire for yield, growth, and safety. But it takes about 170 pages of disclosure to protect the issuer.

The main components of the typical deal aren't terribly complicated. To varying degrees, the bank buys the index or security, sells a call, buys some downside protection, collects their fee and uses the excess, if any, money. An investor could do the same thing for a lot less cost AND WITHOUT ANY CREDIT RISK! Plus, it can be done more tax efficiently than structured as all ordinary income.

What I find offensive is the credit risk. In these structured products you are making an unsecured loan to the issuer! You aren't making an investment in the S&P500 Index or Ford or a commodity. The issuer owns the securities. All the buyer has is the issuer's promise to pay. An investor should substitute Lehman for Bank of America or Citigroup when considering a structured product. Do you want to be an unsecured creditor? If you buy, you are.

Government bailouts have kept these types of investments alive. "Too Big To Fail" takes some of the risk out of making big banks unsecured loans. But government policies can change. There isn't a law that says the government will protect all stakeholders the next time a big bank self destructs. And sales pitches that sound too good to be true, usually are.

More Bank Dilution Looms

Investors in financial shares have fared well this year as almost all are significantly higher than their March lows. Those that bought shares near the lows have obviously fared better than the original owners. But the time has come to be wary. Dilution looms, again, on the horizon.

Banks have had ready access to capital this year as they attempt to work through their myriad mistakes. First, the Government provided needed support, then hungry investors started lining up to buy financial secondary offerings. The result was the same: loans were written off, capital depleted, new capital acquired, and original investors diluted. Painful only for the original owners.

While mortgage and credit card loan delinquencies are still at record levels, commercial real estate lending was poorly underwritten and is now showing serious weakness, another capital consuming issue is raising its head. On January 1, 2010, FAS167 will take effect unless delayed. The effect will be that banks must set aside additional capital to support off balance sheet credit card receivables and other securitizations. Whether or not the assets are brought back on the balance sheet or not, more capital must be found to support the potential risk of implied recourse. The big credit card issurers, JPM,C,WFC,BAC,COF, to varing degrees, will be affected. Since current capital isn't plentiful, they will sell more shares and dilute the current base.

Several days ago, First National Nebraska, a moderate sized regional bank with a large credit card operation, filed to sell $250 million of new common and preferred securities. The major reason given for the decision was the need to support off balance sheet credit card securitizations. The decision to sell new shares was a difficult one for First National as it is owned, almost exclusively, by one family. They felt the need, and pressure, to dilute themselves to comply with FAS167. What do you think the professional, non-owner, managers will do? Yes, sell new shares to whom ever will buy them, Government or public.

Setting aside concerns about the remaining potential loan losses and adequacy of loan loss reserves, capital raising is coming again to the banks courtesy of the accountants and transparency. Bank shares will be worth less in 2010.

Mister Market Is Laughing At Me

I will never be a great investor because I never follow my convictions and place all my marbles on my view of the future. My hedged bets tend to minimize being right and being wrong. That approach suits me as I sleep well and am still solvent. In the current rally, my stock positions have grown nicely and make me feel good. My cash position, on the other hand, makes me want to go sit in the corner.

As I stare into the corner I calculate how much I could have made had I put all my cash to work in equities. That bothers me. Then I remember how horrible it feels when stock prices tick downward and net worth sinks. An especially sick feeling if you are retired and no longer earn any replenishing investable cash. That's why I attempt to stay cautiously invested. Home runs aren't worth the risks involved.

Within the next six months I'll be happy that I'm not fully invested and I hope that I recognize an appropriate time to pull back from my long positions. I probably won't and that is why market timing is difficult.

JP Morgan is instructive. I should have bought it six months ago. Now it sells at almost its ALL TIME HIGH! Even after the dilution that came from issuing lots of new shares to repay TARP loans. You'd think that all the problems are finished. No, they remain. Now JPM is the best of the big banks, but they are still loaded down with non-performing consumer loans and accelerating losses. Loss Reserves have been built, but they will need further provisioning. The market has been celebrating the slowing of JPM's rate of losses. Losses are still growing, just not as fast! Is that worthy of a stock price that is very near its all time high? I don't think so, but I wish I had bought some six months ago. Now sure isn't the time to buy, but traders are.

Goldman Sachs is a similar story, as are the BRIC and commodity stocks. Their recent results have been astounding. They make me green with envy and feel like donning a dunce cap. Until I think about the likelihood of them remaining at current levels, then I regain some comfort in my liquidity.

A review of a DOW chart of the Great Depression depicts a strong bounce back before returning to lower levels. We've had our bounce back, and it may go higher, but I suggest preparing for a return to bleaker times. I will sleep peacefully, even though I will wish I had made some easy money when Mister Market taunts me.

Credit Isn't The Only Thing Hurting Banks

I possess 20 years of commercial banking experience, 10 of those as CEO. Even though the industry has changed dramatically in the nearly 20 years I have been out of banking, I feel that I should be able to spot trends, analyze financial statements, and differentiate a good bank from a poor performer. This past year has shown that I can't.

Short positions on numerous financials made me a decent amount of money, but it could have been a fortune had I not always removed my position after a nice gain since they continued to trend downward. All the money I made on shorts, and then some, was lost on a bank turnaround that I was convinced I had figured out, National City. It's a long story, but suffice to say that I had twenty pounds of analysis that turned out to be faulty. 

Being a slow learner, I still follow the banks and look at opportunities. The sharp run up that the banks have experienced isn't sustainable. The yield curve is very lucrative at present and mortgage refinancing fees are plentiful. But in a de-leveraging economy good lending opportunities will be much scarcer than at peak earnings. Lower future earnings leads to lower P/Es and stock prices. Not to be forgotten are the huge loan losses that loom and the eventual dilution that will follow capital raising.

On top of the credit problems that bankers are dealing with, their buddies at the FDIC are adding to the banks misery. Since regulators have done such a poor job of controlling bank lending quality, on and off balance sheet, the FDIC Insurance Fund is in need of replenishment. Besides raising the deposit insurance fee, FDIC has levied a special assessment of 20 basis points. That is huge! At cocktails the other evening the president of a local 200MM bank told me his assessment was going to be $400,000! That is an immediate hit to earnings, or if the bank doesn't have earnings, book value.

Our banks will be earnings constrained for some time.

After all the stress test publicity abates and banks possibly enjoy an upward run, the trend is likely to be down. Since I have proven to myself that i know nothing about the industry anymore, I intend to short selected regional banks and stay with those positions. But for heavens sake, don't follow any of my advise when it comes to banks.

DON'T BUY THE BRIDGE THEY ARE TRYING TO SELL YOU

The market's 10%ish run up last week was sustained by: the nation's three largest banks saying they were profitable during the first two months of the year, General Motors decision not to use the March allotment of bailout funds, and a smaller than expected decrease in retail sales in February compared to January's results. Stocks were ready for a run and they liked what they heard.

Now lets think about those three developments. Banks should be wildly profitable when funding costs are near zero. The issue that remains with us is was the loan loss provision adequate and will they still need new capital that will dilute common shareholders? The answer to the first part of the question is no, while the last portion's answer is yes. Even with boatloads of help from the Fed and Treasury, banks are going to have a rough decade ahead as they learn how to be conservative lenders again and develop a cost structure that fits their diminished earnings capacity. GM said they didn't need the money in March, they publicly said they were not saying that they no longer wanted it available. Until car sales start growing GM will be under pressure and there are no other lenders, since bankers have developed an appropriate understanding of risk, other than the Federal Government. On retail sales, one months result is not a trend. Spending is weak and will stay that way for a long time.

So why did the market's participants get excited? Because it was time and lots of short positions got covered. The good times may extend another 10%. But remember that a 20% run up only gets you back 10% of your losses. The market's decline has been brutal and I feel she isn't done torturing us. She's offering to sell us the Brooklyn Bridge right now and I suggest you take a pass.

Just say no to committing new money and use the market's euphoria to lighten up on positions. Outside of another 10% upward, the probabilities, in my view, are greater that we continue down as opposed to a sustained up trend.