Saturday, March 7, 2009

The Biggest Source for Risk: Government

The perpetual bailouts are wrong on many levels. Today I'll focus on just one. The government has become the single biggest risk in financial markets.

What will the next bailout do? Is it going to wipe out common equity? Preferreds? If so, will it be the C-series? S-series? Or will they screw the junior debt? Senior? Or are they going to let it fail? Or maybe they'll just keep on pumping money in?

With the perpetual, arbitrary, ever-shifting bailouts and interference in the market, the government has paralyzed the already-disfunctional financial market machinery. Regulatory and policy risks are scaring a lot of players to the sidelines, and at the same time creating huge arbitrage opportunities that could turn out to be equally lethal traps.

Take Citi for example. One possible explanation for C's precipitous fall last week is the perceived arbitrage between preferred and common shares, which called for longing preferreds and shorting common. But is it an arbitrage or a trap? The answer depends on how each series of the preferreds will be converted, which was very unclear when the bailout was first announced. It's an arbitrage if you assume all preferreds get the same treatment; otherwise it depends on the conversion formula, which preferred you bought and at what price (you can only buy the publically traded preferreds, not those held by Uncle Sam, Prince Talal, or Sanford Weill), and at what price you shorted the common stock. The latest report, last updated on 3/3, was that the discrimination against publically traded preferreds would not be "so bad". But still, the language is vague and non-commital.

Such confusion is much more common, and deeper, in fixed income and other areas of capital market. Which JPM bond is backed by the government? How strongly? But really? I mean, are you sure? Will Uncle Sam really tear through the veil of secrecy of Swiss banking or is it just a show? Who gets paid through the conduit called Assured Income from Government? What will happen when AIG loses another $100B next quarter? Will GS still get it or will the conduit be shut down finally? Will somebody high in Washington say/do something that pushes the Chinese over the edge and pricks the treasuries bubble? Who will take how much loss in forced mortgage mod? Or could it be a windfall in disguise in the fantacy land of modern accounting? Will they help European banks when the Eastern Europe Crisis of 2009 hits, or will there be another round of global meltdown?

It's uncertain enough without the government messing around. But if they have to mess around, can't they at least make up their mind and show some consistency?

No comments: