Thursday, September 24, 2009

The Debts of the Spenders: Putting Government Mortgage Purchases into Perspective Part 2

Here is a fine article from the Financial Times that puts my prior post about mortgage backed securities rallying into perspective.

I would like to add that from a yield perspective, these trash buckets can actually offer decent returns based upon the Federal Reserve's continuing support of the housing market.


Moreover, some - if not most - of these offerings are structured in the form of convertible bonds, which are an added bonus. Convertible bonds are hybrid securities that allow the issuer to conserve cash flow by reducing interest payments. In exchange, the holder can convert the debt into equity at a pre-determined strike price.


In the US financial sector, many financials have to decrease their leverage exposure while at the same time maintaining steady cash flow.

Banks MUST re-capitalize equity at the expense of debt. I believe this was Bernanke's/Geither's plan all along. Banks must draw down their leverage (debt) by diluting equity to levels seen before the "Greenspan put." I place this at a conservative 2000-2001 level (before 9/11 made Greenspan lower rates aggressively).

Some readers may disagree and think that it should be lower to pre-LTCM levels or even pre-Gramm-Bleach-Blilely Act (when Glass-Steagall was abolished). This time frame is earlier - late 1990s levels of leverage. Or the time before structured finance even existed.

The actual time frame is irrelevant. All we need to know is that financials need to wind down debt exposure and increase their equity shorings to meet stricter regulatory standards such as Tier 1 capital ratios. Across the board, all regulatory agencies - US, European, Canadian, Chinese, Middle Eastern, etc. - have clamped down on the amount of leverage financials can use.
(For more information on regulatory ratios, I recommend readers do a google search on BASEL II CEBS).

These distressed debt sales packaged as convertible bonds are the key to doing so. While I find it highly unlikely that these bonds will ever trade at original book value again (e.g. close to par), they have experienced substantial gains and offer nice returns for savvy investors. Gain can also be protected by holding offerings in tax protected vehicles such as certain trust instruments or IRAs. Examples of distressed bond offerings that appreciated quite nicely in this year: WSF, BMLRQ, and AZM.

Note - If you are a goldbug or inflation hawk, then bonds are not for you. Inflation can eat away at your real returns. Although I am a long term dollar bear, I do not consider inflation to be a serious issue near term. The US and most Western economies still have to go through a period of debt purging.

*Disclosure - I have long positions in some distressed debt investments including AZM.
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