Just six months ago, at the bottom of the financial crisis during the darkest days of October and November 2008, it was unclear whether the American banking industry would survive.  Fannie Mae, Freddie Mac and AIG had already been effectively nationalized (more than 80% of stock owned by the Feds) and Citigroup, Bank of America, Morgan Stanley and others appeared to be on the doorstep of investor-owned demise. 

Now, in May 2009, the world seems a much better place for bankers and the rest of us that use bank money.   I for one, don’t think banks will lead the market higher, but they need to at least regain their health and participate in the economy for growth to happen.  It seems they are on their way.  BAC, one of the sickest of the surviving banks, successfully sold over 1 billion shares after hours on Tuesday to close the gap on its capital needs according to the government “Stress Test”. 

Dick Bove, who has been a lone voice for the survival of the banking industry, sees a very bright future for BAC, at least as compared to now.  He came public Monday with a statement that he expects BAC earnings to normalize around $4 per share, even after dilution, within the next 2-3 years.  Applying a 10-12 multiple to earnings, this implies a $40-48 future share price as compared to the $12 today. See his comments towards the end of the embedded news clip.

A great way to play the banks over the next few years is UYG, the leveraged ETF of the financial index.  UYG is today comprised mainly of the superior banks such as JP Morgan, Goldman Sachs and Wells Fargo, but BAC also has a place on this index.  Barrons posted an article on options trading strategies for BAC stock that might provide some ideas to capitalize on the return of the banks:

http://online.barrons.com/article/SB124265990717130781.html

Some of you may remember Michael Milken.  He was The Bad Boy from the 1980s leveraged buyout (LBO) craze and the father of modern junk bond debt financing to conduct LBOs.  He ran the Drexel Burnham Lambert high yield bond desk until 1989 at which point, he ran it into the ground and in 1990, DBL out of business.  For this and other mischief and overreaching, he earned himself a one-way ticket to Federal prison for SEC violations in his dealings with client and fellow Bad Boy, Ivan Boesky.  Milken served a two year prison sentence and apparently came back a changed and philanthropic man.

So, if anyone can speak with authority on the national bond market and what it means to business, it should be Michael Milken.  How refreshing he has turned his formidable analytical powers to helping the rest of us understand the bond market. 

Today (Tuesday, August 21)  in the WSJ, Milken published an editorial on the corporate bond market drawing parallels to the mid 1970s.  Those of you that are loyal “Wealth-Ed” readers know that I am of the opinion that history is a prelude to the future, that is history (almost) repeats.  I have also noted the market similarities between now and the mid 1970s as well as the late 1930s.   Milken puts some specific analysis behind that speculation.

In Milken’s opinion, we are working through the worst of times and not far from much better times.  I have been recommending investments in the high yield bond market as the spreads (TED spread) between high yield and Treasuries were until recently at record levels.  The fact those spreads are improving shows healing in the market.  The bond market almost always gets the story right before the stock market.  So an improving high yield market is a good indicator for stocks and the economy.

• OPINION
• APRIL 21, 2009

Why Capital Structure Matters

Companies that repurchased stock

By MICHAEL MILKEN

Thirty-five years ago business publications were writing that major money-center banks would fail, and quoted investors who said, “I’ll never own a stock again!” Meanwhile, some state and local governments as well as utilities seemed on the brink of collapse. Corporate debt often sold for pennies on the dollar while profitable, growing companies were starved for capital.

Chad Crowe

If that all sounds familiar today, it’s worth remembering that 1974 was also a turning point. With financial institutions weakened by the recession, public and private markets began displacing banks as the source of most corporate financing. Bonds rallied strongly in 1975-76, providing underpinning for the stock market, which rose 75%. Some high-yield funds achieved unleveraged, two-year rates of return approaching 100%.

The accessibility of capital markets has grown continuously since 1974. Businesses are not as dependent on banks, which now own less than a third of the loans they originate. In the first quarter of 2009, many corporations took advantage of low absolute levels of interest rates to raise $840 billion in the global bond market. That’s 100% more than in the first quarter of 2008, and is a typical increase at this stage of a market cycle. Just as in the 1974 recession, investment-grade companies have started to reliquify. Once that happens, the market begins to open for lower-rated bonds. Thus BB- and B-rated corporations are now raising capital through new issues of equity, debt and convertibles.

This cyclical process today appears to be where it was in early 1975, when balance sheets began to improve and corporations with strong capital structures started acquiring others. In a single recent week, Roche raised more than $40 billion in the public markets to help finance its merger with Genentech. Other companies such as Altria, HCA, Staples and Dole Foods, have used bond proceeds to pay off short-term bank debt, strengthening their balance sheets and helping restore bank liquidity. These new corporate bond issues have provided investors with positive returns this year even as other asset groups declined.

The late Nobel laureate Merton Miller and I, although good friends, long debated whether this kind of capital-structure management is an essential job of corporate leaders. Miller believed that capital structure was not important in valuing a company’s securities or the risk of investing in them.

My belief — first stated 40 years ago in a graduate thesis and later confirmed by experience — is that capital structure significantly affects both value and risk. The optimal capital structure evolves constantly, and successful corporate leaders must constantly consider six factors — the company and its management, industry dynamics, the state of capital markets, the economy, government regulation and social trends. When these six factors indicate rising business risk, even a dollar of debt may be too much for some companies.

Over the past four decades, many companies have struggled with the wrong capital structures. During cycles of credit expansion, companies have often failed to build enough liquidity to survive the inevitable contractions. Especially vulnerable are enterprises with unpredictable revenue streams that end up with too much debt during business slowdowns. It happened 40 years ago, it happened 20 years ago, and it’s happening again.

Overleveraging in many industries — especially airlines, aerospace and technology — started in the late 1960s. As the perceived risk of investing in such businesses grew in the 1970s, the price at which their debt securities traded fell sharply. But by using the capital markets to deleverage — by paying off these securities at lower, discounted prices through tax-free exchanges of equity for debt, debt for debt, assets for debt and cash for debt — most companies avoided default and saved jobs. (Congress later imposed a tax on the difference between the tax basis of the debt and the discounted price at which it was retired.)

Issuing new equity can of course depress a stock’s value in two ways: It increases the supply, thus lowering the price; and it “signals” that management thinks the stock price is high relative to its true value. Conversely, a company that repurchases some of its own stock signals an undervalued stock. Buying stock back, the theory goes, will reduce the supply and increase the price. Dozens of finance students have earned Ph.D.s by describing such signaling dynamics. But history has shown that both theories about lowering and raising stock prices are wrong with regard to deleveraging by companies that are seen as credit risks.

Two recent examples are Alcoa and Johnson Controls each of which saw its stock price increase sharply after a new equity issue last month. This has happened repeatedly over the past 40 years. When a company uses the proceeds from issuance of stock or an equity-linked security to deleverage by paying off debt, the perception of credit risk declines, and the stock price generally rises.

The decision to increase or decrease leverage depends on market conditions and investors’ receptivity to debt. The period from the late-1970s to the mid-1980s generally favored debt financing. Then, in the late ’80s, equity market values rose above the replacement costs of such balance-sheet assets as plants and equipment for the first time in 15 years. It was a signal to deleverage.

In this decade, many companies, financial institutions and governments again started to overleverage, a concern we noted in several Milken Institute forums. Along with others, including the U.S. Chamber of Commerce, we also pointed out that when companies reduce fixed obligations through asset exchanges, any tax on the discount ultimately costs jobs. Congress responded in the recent stimulus bill by deferring the tax for five years and spreading the liability over an additional five years. As a result, companies have already moved to repurchase or exchange more than $100 billion in debt to strengthen their balance sheets. That has helped save jobs.

The new law is also helpful for companies that made the mistake of buying back their stock with new debt or cash in the years before the market’s recent fall. These purchases peaked at more than $700 billion in 2007 near the market top — and in many cases, the value of the repurchased stock has dropped by more than half and has led to ratings downgrades. Particularly hard hit were some of the world’s largest companies (i.e., General Electric, AIG, Merrill Lynch); financial institutions (Hartford Financial, Lincoln National, Washington Mutual); retailers (Macy’s, Home Depot); media companies (CBS, Gannett); and industrial manufacturers (Eastman Kodak, Motorola, Xerox).

Without stock buybacks, many such companies would have little debt and would have greater flexibility during this period of increased credit constraints. In other words, their current financial problems are self-imposed. Instead of entering the recession with adequate liquidity and less debt with long maturities, they had the wrong capital structure for the time.

The current recession started in real estate, just as in 1974. Back then, many real-estate investment trusts lost as much as 90% of their value in less than a year because they were too highly leveraged and too dependent on commercial paper at a time when interest rates were doubling. This time around it was a combination of excessive leverage in real-estate-related financial instruments, a serious lowering of underwriting standards, and ratings that bore little relationship to reality. The experience of both periods highlights two fallacies that seem to recur in 20-year cycles: that any loan to real estate is a good loan, and that property values always rise. Fact: Over the past 120 years, home prices have declined about 40% of the time.

History isn’t a sine wave of endlessly repeated patterns. It’s more like a helix that brings similar events around in a different orbit. But what we see today does echo the 1970s, as companies use the capital markets to push out debt maturities and pay off loans. That gives them breathing room and provides hope that history will repeat itself in a strong economic recovery.

It doesn’t matter whether a company is big or small. Capital structure matters. It always has and always will.

Mr. Milken is chairman of the Milken Institute.

 

Doug Kass has a terrific track record of predicting the tops and bottoms of recent markets.  He has been known as a short seller the past several years as he thought the market over-valued.  Now, however, he has picked March 5, 2009 as the bottom and has gone long.  He was nearly alone in his convictions on that date, but has recently been joined by more and more investors, including yours truly.  Why does Kass think we have reached the bottom of this Bear?  Read on for more:

http://www.seabreezepartners.net/newsArticle.asp?id=449

March 24, 2009

Why the Bears Are Wrong
By Doug Kass, The Edge

I continue to believe that the early March low represented a yearly and, quite possibly, a generational market bottom.

The mustard seeds for the economy and the U.S. stock market have begun to take root.  The rate of change in 10 of 12 factors in my watch list are improving.

On Feb. 17, I presented a watch list of conditions that, if in an improving trend, would likely indicate that a sustainable up move is possible for equities.

It is time to review this checklist (and add one more factor) to determine the market’s standing. Our new grades and those of two weeks ago are in parentheses and will be updated in the weeks and months ahead.

1. 1. Bank balance sheets must be recapitalized. Yesterday a comprehensive bank rescue package was introduced. It is obviously too early to consider its full impact, but the details of the program suggest to this observer that it will likely be effective in clearing toxic bank assets. (We grade the package a B+, up from a D+ only two weeks ago.)
   2. Bank lending must be restored. While bank lending standards remain tight, my view is that yesterday’s announcement of ring-fencing toxic bank assets will almost unquestionably succeed in unclogging the transmission of credit. (Grade B, up from a c previously.)
   3. Financial stocks’ performance must improve. Financial stocks have finally awakened from the dead, and the recent outsized move to the upside could foreshadow continued market strength. Historically strong relative performance in the shares of asset managers — such as Franklin Resources (BEN), T. Rowe Price (TROW) and AllianceBernstein (AB) — presage a better equity market, and Monday’s strong group action was conspicuous in its outperformance. (Grade B+, up from a D.)
   4. Commodity prices must rise as a confirmation of worldwide economic growth. Beginning two weeks ago, commodities’ prices began to strengthen, and the Fed’s message last week accelerated that trend. Gold, copper (at the highest level since November) and crude oil (over $54 a barrel) continued to rise yesterday, reflecting a combination of continuing inflationary and currency debasement fears coupled with the possibility that worldwide economic growth might stabilize sooner than later. Finally, the TIPS market is forecasting some higher inflation, and a little inflation is better than a lot of deflation. (Grade B, up from a C+.)
   5. Credit spreads and credit availability must improve. Spreads remain worrisome and the transmission of credit remains poor, but the economy should gain traction as public policy is implemented, money is made more available and lending terms are liberalized. (Grade D, flat from two weeks ago).
   6. We need evidence of a bottom in the economy, housing markets and housing prices. As I have written, the retail industry has exhibited evidence of sequential improvement in the January through March period. Other economic signs are somewhat more ambiguous but, nevertheless, are showing some life. Months of inventory of unsold homes are declining and so are mortgage rates, but home prices have yet to stabilize despite an improvement in the affordability indices and a better relationship between home ownership and rental costs. Nevertheless, yesterday’s strong existing homes sales release raises the specter of a better spring selling season than most anticipate. I contend that housing could surprise to the upside and might lead most other economic indicators higher. (Grade C+, up from a C-.)
   7. We need evidence of more favorable reactions to disappointing earnings and weak guidance. I am encouraged by the better price action in the face of poor earnings results and guidance in a wide range of companies, including Freeport-McMoRan Copper & Gold (FCX), FedEx (FDX), Airgas (ARG) and General Electric (GE). (Grade B+, up from a C+.)
   8. Emerging markets must improve. China’s economy (PMI and retail sales) and the performance of its year-to-date stock market have turned decidedly more constructive, but other emerging markets remain moribund. (Grade B up from a C.)
   9. Market volatility must decline. The world’s stock markets remain more volatile than a Mexican jumping bean. (Grade C+, flat with two weeks ago.)
   10. Hedge fund and mutual fund redemptions must ease. I am comfortable writing that the worst of the redemptions are behind the asset management industry. Nevertheless, the disintermediation and disarray in the hedge fund and fund of fund industries still have a ways to go. And while brokerage account liquidations appeared to have decelerated last week (coincident with rising share prices), my high net worth brokerage contacts (such as Baron Von Broker) continue to experience account closures and a panicked constituency. (Grade C, up from a D).
   11. Marginal buyers must emerge. Low invested positions at hedge funds and by individual investors no doubt fueled March’s market rise as the fear of being out has begun to replace the fear of being in. These two classes could continue to be the near-term marginal buyers fueling stocks. Corporate acquirers could also emerge as important marginal buyers, and the recent step up in merger and acquisition activity — for example, Genentech (DNA), Petro-Canada (PCZ), Schering-Plough (SGP) and Daimler (DAI) — is a concrete indicator that another important marginal buyer has surfaced. As the year progresses, a meaningful upside move awaits a broad asset allocation move of pension funds out of fixed income and into equities. (Grade B, up from a C.) To the above factors, I am adding a 12 factor in my watch list:
   12. The market’s internals must improve. I am comforted by a number of improving technical conditions that have emerged since the March low and that have continued in force over the past two weeks since the market has made program off that nadir. Indeed, the conditions of the recent low were different than others — in sentiment, volume, number of new lows and in intensity. The move from the October lows to the March lows indicated growing fear and gave way to rising cash positions and the loss of hope, but the market’s internals were improving. November’s DJIA low of 7,552 was nearly 11% below the October low of 8,451, and the March low of 6,547 was 22.5% under October’s low. While each new low was more frightening than the prior one, however, there were improving technical and sentiment signals. For example, NYSE volume at the October low expanded to 2.85 billion shares; at the November low, volume dropped to 2.23 billion shares; and at the March low, volume was only 1.56 billion shares. As well, new lows traced decreasing levels: At the October low, there were 2,900 new lows; at the November low, there were 1,515 lows; and at the March low, there were only 855 new lows on the NYSE. Moreover, the combination of last Tuesday’s 12:1 ratio of advancing stocks over declining stocks coupled with that day’s 27:1 up-to-down volume ratio has not occurred in almost 65 years. Remarkably, yesterday was the fifth 90% upside day in March, which is evidence of a broadening market.

In summary, 10 out of 12 factors (including our newest, market internals) on my watch list are in an improving mode. Though many variables are currently accorded relatively low grades and the outlook remains debatable, the delta (rate of change) in almost my entire watch list is improving and flashing a green light for the U.S. stock market.

A classical wall of worry is being reinforced by an overwhelming consensus that the recent advance was a bear market rally. Moreover, the negative “chatter,” as Jim “El Capitan” Cramer describes it, appears loosely constructed and fails to credibly argue against the salutary effect that $4 trillion of stimulus will have on the domestic economy.

Based on the 12 considerations comprising my watch list, I respectfully disagree with the prevailing negative consensus, most of whose members failed to properly analyze the cracks in the foundation of credit, in the economy and in equities two years ago. Indeed, it remains my view that the fear of further investment losses and possible investor redemptions are clouding many managers’ objectivity in assessing the markets.

In the fullness of time, public policy aimed at stimulating the economy (in general) and in housing (in particular) should bear fruit, as will the ring-fencing of toxic bank assets serve to unclog the transmission of credit.

While it is unrealistic to expect a straight up move, I am growing increasingly confident in my variant and optimistic view that the early March low was not only a yearly low but, quite possibly, a generational low.

Coming Monday, March 30:  Jeremy Grantham 1st Quarter Commentary

I have had a running debate with other blogsters regarding the current Fed policy of loose money. Being a student of history, especially the Great Depression, I know that one of the biggest factors contributing to the Depression was the fact a conservative (Hoover-led) government, Treasury and Federal Reserve kept money tight after the stock market broke down in October 1929. In fact, the Fed raised its Federal Funds rate in 1930 as it reacted to the perceived inflationary threat showing up in reports from data generated in 1928 and 1929 during the Roaring 20s Bubble.

I have contended that as assets aggressively contract, primarily real estate the past two years, some offset is needed to balance the national books. Otherwise, we have a deflation by definition (to little money chasing too many goods) and deflation is never a good thing as it causes people to save excessively (hoard) and not spend. This stops the economy and also feeds on itself. Some of my blog opponents feel that we should just let Free Markets work; that the market will do a better job of solving our problems than government. But history shows otherwise. A free market is a great thing during normal times, but it is too severe a master during times of stress.

To help me make my point, I am borrowing a column from “Barrons Online” posted yesterday. It says all that I have been trying to say, but more eloquently. Here it is:

TUESDAY, OCTOBER 28, 2008
UP AND DOWN WALL STREET DAILY

Pushing on a String or at the End of Their Rope?
By RANDALL w. FORSYTH

Sado-monetarists decry the doubling of the Fed’s balance sheet, but is it enough?

THE FEDERAL OPEN MARKET COMMITTEE begins a two-day policy meeting Tuesday amid what now is conceded to be the worst financial crisis since 1930s. And, as in the Great Depression, the U.S. central bank is being criticized for being too easy and risking inflation amidst a severe debt deflation.

The Fed has doubled the size of its balance sheet in just seven weeks to attack the crisis. That has elicited squawks from what Barron’s much-missed late friend and colleague, John Liscio, called the “sado-monetarists” who think that the central bank’s efforts to cushion the pain of credit contraction invariably puts us on the road to perdition. As when he coined the phrase back in the early 1990s, the Fed is expanding its credit to offset the contraction in credit in the private sector.

Michael T. Darda, chief economist of MKM Partners, notes the Fed has expanded its balance sheet by $900 billion since early September, a seeming eternity ago when the Mets were cruising to the post-season and temperatures were sizzling. But that seemingly Zimbabwe-like 206% annual rate of increase in the Fed’s assets in the latest 26 weeks hasn’t ignited a monetary inflation. Quite the opposite, in fact.

A record percentage — nearly 25% — of the high-powered money the Fed has provided effectively sit idle as excess reserves, Darda points out. In other words, banks are sitting on a huge precautionary cushion. Banks are hoarding cash and are loath to lend to each other except for overnight periods.

That means banks are unlikely to unleash a new, inflationary wave of lending; quite the opposite. Yet the high levels of excess reserves in 1937 caused the sado-monetarists of the day to sound the inflation alarm back then and spur the Fed to tighten. That aborted the recovery and extended the depression, resulting in a resumption of the bear market. (Note: check out long term stock price charts and you will clearly see how the stock market cratered in 1937 due to this Fed tightening).

This time around, the deflationary symptoms are everywhere. Industrial commodity prices have been halved while the 30-year Treasury bond yield has sunk to its lowest level ever, under 4% last week. Gold has plunged to around $700 an ounce from $1,000 while the dollar has surged. And risky asset classes have melted down, he notes.

While the Fed is pumping more reserves into the banking system, less is being transformed into broad money and credit. And that money is turning over more slowly (velocity is falling, to use the economists’ jargon.) The combination renders Fed policy “far less potent than it would otherwise be,” Darda concludes.

That leaves the question, what’s the FOMC to do at this point? The consensus of Fed watchers and the futures market is that the panel will cut its federal-funds rate target another 50 basis points (half percentage point) to 1% when it announces its decision Wednesday at 2:15 PM EDT. That would leave the Fed’s main policy rate at its previous nadir touched in the past cycle and would, in effect, leave it relatively few basis points left to cut before the funds rate reached zero.

“The question is what the Fed does next,” write ISI’s Washington policy analysts, Tom Gallagher, Andy Laperriere and Melissa Loesberg. “We think it might have one more conventional rate cut before resorting to unconventional measures. But the real answer is that the Fed will wait for fiscal policymakers to take their turn,” they conclude. (Note: this will come in the form of another national “special rebate” of around $1000-1500 that will be passed by Congress during a special session in November and distributed in time to impact Christmas spending, so I predict).

Goldman Sachs’ economists also look for a 50 basis point cut from the FOMC but think a 75-basis-point slash, halving the fed-funds rate to 0.75%, is a 33% possibility. An important factor in the FOMC’s decision will be the results of the Fed’s latest quarterly survey of bank loan officers, which Goldman notes the policy makers will have in hand. This survey, taken in September, will be made public next month. The previous survey released in August showed a sharp tightening in credit standards for consumer, mortgage and business loans.

In other words, the Fed has been pushing on a proverbial string.
More than pure quantitative measures, price indicators show persistent credit tightness. Spreads between market interest rates and risk-free or administered rates have come in from their peaks, but remain elevated.

In particular, the three-month London interbank rate has come down to around 3.50% as of Monday, from the peak of about 4.80% on Oct. 10, but this benchmark remains above the 2.80% that prevailed in September before the Lehman bankruptcy and the Fed’s 50-basis-point cut, to 1.5%, on Oct. 8. (Note: Why is Libor still so high, when the Fed keeps pushing the Funds Rate lower? The answer is that banks don’t want to lend to each other, or are afraid to, after so much bank carnage. This means that what interbank lending does occur, does so at a higher interest rate than in a freer, less risky market. This impacts us because Libor is the index for many consumer loans and mortgages, and is also a barometer of economic health).

Three-month Libor also remains elevated against OIS — the overnight interbank swap rate, which reflects the market’s view on the fed-funds effective rate. The Libor-OIS spread is down to 263 basis points from a peak of 366 basis points on Oct. 10. But before the crisis, when banks were willing to lend to each other, Libor-OIS was a relatively trivial handful of basis points.

Getting Libor down is a more important, though less visible aim of the FOMC. The Fed’s program to purchase commercial paper, which commenced Monday, should take further pressure off the money market. The Fed initially set a rate of 1.88% for top-grade three-month paper Monday, far below Libor, which should help to continue pull the interbank rate lower, according to Banc of America Securities’ head of credit research, Jeffrey Rosenberg.

The Fed’s unprecedented push of liquidity may have nearly doubled its balance sheet but it still has not offset the private sector’s need, according to Bridgewater Associates. The world has accumu
lated so many dollar debts, and the ability to refinance and expand these debts was so ingrained in the financial system that its breakdown requires an unprecedented response from the Fed. But with so much of the global financial system out of the reach of central banks, the risks to policy makers are numerous.

With debt deflation engulfing the credit markets and the economy here and abroad, the sado-monetarists should get over their Whip Inflation Now fetishes.