The Weekly Tearsheet: Can a liability be an asset?

As expected, the Fed hiked the Fed Funds rate to 5% last week. It removed language from the FOMC statement saying that further hikes might be appropriate, which the market took as a signal that it is ready to pause. During the press conference, Jerome Powell emphasized that the Fed is not looking to cut rates any time soon. Bonds didn’t do much in reaction to the decision, but the flight-to-safety trade was already on with the problems in the regional bank space. The Fed Funds futures are not buying the Fed’s story, with the December futures predicting 75 basis points in rate cuts by the end of the year.

The First Republic seizure did nothing to allay the fears in the regional banks. PacWest Bank was decimated, and Western Alliance was sold off after an article in the Financial Times suggested the bank was evaluating strategic alternatives. Western Alliance denied the report and the stock rebounded, however sentiment in the regional banks is still fragile.

The SEC is looking into whether there is manipulation behind the scenes in these stocks. SEC Chairman Gary Gensler said: “As I’ve said, in times of increased volatility and uncertainty, the SEC is particularly focused on identifying and prosecuting any form of misconduct that might threaten investors, capital formation, or the markets more broadly.”

This means the government is going to look to see if short sellers are pushing the stock down. Governments like to blame short sellers when stocks are falling, and they often put in rules in order to prevent them from falling. It never works. I remember during the Asian Crisis in the late 90s pretty much ever government from Japan to Thailand banned short selling. It caused a lot of hedge funds types to exit these markets, but it certainly didn’t prevent any sort of crash. They are a convenient scapegoat and not much else. Short sellers generally don’t have the firepower to push stocks down like that.

Not only that, but short sellers need to be able to borrow the stock to sell it short, and the easiest way for shareholders to protect the stock if they think short sellers are manipulating it is to tell their prime broker to not lend out their stock. Not only that, but short sellers have to pay a fee to the prime broker, and that fee can be sizeable. In these regional banks, there is a borrow, but it is expensive. Some of these fees are running from the mid-teens to 75% per year. This means that short sellers have a pretty high hurdle rate, and very few short sellers are going to initiate a position with that sort of handicap.

As a general rule, short selling is a much, much harder strategy to execute than going long. This is because when you are long and wrong, your position gets smaller, so it is easier to double down. When a short is wrong, the position gets bigger. Conversely, when you are right, a long’s position gets bigger, and a short’s position gets smaller. Short sellers have to press their bets when they are correct in order to maintain the same dollar exposure. Shorting stocks is a tough business and I am highly skeptical when government declare short sellers the problem.

Larry Summers talked about the problem with looking at marking to market Treasury and MBS portfolios to market without taking into account the liability side of the ledger. His point was that when rates rise, deposits paying below-market rates become valuable and the increase in value of these below-market deposits should offset some of the losses on the bond portfolio.

Is it possible that a liability could be considered an asset? Does that make sense? Actually, it does.

In the late 1990s, discount retailer Bradlees went bankrupt, and a lot of distressed hedge funds were buying up bank debt and trade claims. Distressed debt hedge funds operate in an unusual space - bankruptcies. They will buy up debt (usually at 50 cents on the dollar or below) ahead of a bankruptcy and then play the bankruptcy process. If the company is a chapter 7 candidate (liquidation), they will take possession of whatever assets are available and then sell them to get back their investment. If the company is a Chapter 11 candidate (reorganization), the distressed bonds generally get exchanged for equity in the company and then the hedge fund sells that. You can see some strange assets in a bankruptcy. When TWA went bankrupt in the 1990s, they gave the bondholders frequent flier miles.

The Bradlees story was interesting because the retailer was basically not going to make it. In the 1990s, WalMart was eating everyone’s lunch and the dollar stores were really beginning to take share as well. Discounters like Bradlees were old and tired brands. So when carving up Bradlees there wasn’t much to spread around, except one thing: one of its liabilities.

Bradlees had a below-market long term lease on one of its stores in Manhattan. It sat at the southern end of Union Square, which is prime retail property. The company had a long-term below-market lease on that property and that sub-market lease was worth something. The landlord couldn’t cancel the lease, so this was an instance where a liability was an asset. The distressed investors ended up selling that below-market lease to a new tenant and monetized Bradlees that way.