#bailouts

Why insolvency is the best option for Virgin

Virgin Australia | Climate Active

Narrow Road Capital’s Jonathan Rochford believes that insolvency is the best option for Virgin Australia. The common misconception with insolvency is that most people think that means termination. Not so. Insolvency allows companies to take a long hard look at the business and restructure in ways to ensure the rebirth makes for a healthier business on the other side. The most important point to make is that the sooner the pain is taken, the better the ultimate outcomes.

We recall the last time American Airlines went into Chapter 11 bankruptcy, it ordered 900 brand new Airbus & Boeing aircraft the VERY NEXT DAY. Why? Because the leasing companies knew that helping the ailing airline by restructuring its fleet with more efficient aircraft would facilitate a quicker revival. Insolvency is all about forcing hard questions to be asked and executed upon, not waiting for endless lifebuoys to be tossed when all options haven’t been properly assessed.

Over to Jonathan:

“Virgin Australia has been poorly managed and poorly capitalised for years. Whilst the Coronavirus lock-down is the most recent cause of its woes it is merely the latest in a long list of excuses. Qantas had its turn with the begging bowl in early 2014, I wrote then that the Australian Government should deny it a bailout as it wasn’t necessary. A bailout would have gotten in the way of Qantas fixing its problems, which it ultimately did without government help. The situation is somewhat different for Virgin, it is most likely to go into administration without a bailout. However, insolvency is the best pathway for Virgin as it is the best opportunity to fix the longstanding problems.

The Problems with Virgin

Virgin’s structural problems are the result of years of mismanagement. It is trapped between being much more expensive than Jetstar and with a lesser offering than Qantas, although routinely being almost as expensive as Qantas. As a result, Virgin has consistently struggled to attract the high paying customers and load factors that would take it from being a loss maker to a strong competitor.

Virgin’s ongoing financial problems are no secret. After an IPO at $2.25 in 2003, its shares have rarely traded above $0.50 in the last decade. The company has pursued growth over profits adding marginal routes that weighed down the good business it had servicing the capital city routes. This failed strategy has left the airline overloaded with aircraft. The sale and subsequent repurchase of part of the frequent flyer business has left it loaded with debt, with most of the fleet and the frequent flyer business locked up by secured creditors.

The Alternatives to Insolvency

Virgin is now pursuing a dual pathway to attempt to remain solvent, searching for fresh equity whilst at the same time negotiating with lenders for a debt restructuring. Whilst either of these, or both in combination would give the business more time, both are likely to be fruitless endeavours. Virgin needs to go through a deep restructuring of its entire business including;

-Handing back/selling off aircraft it will not need in the medium term

-Making redundant staff it cannot put to work in the medium term

-Negotiating with suppliers for cheaper goods and services

-Reducing office space and corporate overheads

All of this needs to be done at the same time as the business is burning through cash, estimated to be at a rate of $5-7 million per day. Without most of the fleet being back in the air and carry near capacity loads, a situation extremely unlikely in 2020, Virgin will simply run out of cash. Even if all the unsecured debt was converted to equity it would make little difference to the cost base. The only feasible option to right size the business is voluntary administration.

The Earlier the Better for Insolvency

Given Virgin has limited cash left and is rapidly burning through it, an insolvency in a matter of weeks offers the best prospects of preserving a broad business. The less cash that is left when insolvency begins, the more likely it is that Virgin will follow in the footsteps of Ansett and be sold off for scrap. With a decent starting cash balance and in the current economic environment administrators would have a strong hand to:

-Cut a new deal on the greatly reduced number of aircraft that will be needed; aircraft lenders and lessors will be reluctant to take back aircraft given the current glut and economic outlook. [note FNF Media mentioned the history of actions by leasing companies here]

-Reduce staff numbers and cut staff costs back to levels in line with a low-cost carrier; remaining staff will be glad to still have a job.

-Negotiate with airports for reduced charges; the alternative for airports is being left with a dominant customer that is already throwing its weight around.

-Slash debt levels and reduce the balance of unsecured creditors

-Hand back office space and eliminate unnecessary corporate overheads

A leaner Virgin, with a lower cost base and greatly reduced liability position, has good prospects of attracting new owners and winning back customers. Only an insolvency can deliver this outcome. The alternatives of fresh equity, a debt for equity swap or a government bailout, if put in place without insolvency, would all delay and obstruct the necessary restructuring and increase the risk that Virgin ultimately ends up like Ansett.”

Who the hell is Leeroy Jenkins?

One of the more uniques ways of describing the behaviour of the US Fed. Zerohedge noted that the Fed has gone full Leeroy Jenkins. Who the hell is Leeroy Jenkins?

As you will see in the video clip, the team gamers are discussing a coordinated strategy to defeat the monsters waiting in the next stage of the game. Unfortunately one of the gamers, Leeroy Johnson takes matters into his own hands.

Since 2001, we have continuously said that easy credit would become so addictive. The resulting complacency would turn destructive.

We said that the then-Fed Chairman Alan Greenspan would go down as the most hated central banker in history. Despite being heckled, laughed at and mocked, we never waivered from the key tenet that his actions and those of the subsequent Fed chairs would ultimately end up in tears.

We should have had that cathartic moment to reset back in 2008/09 (and 2000 for that matter). Instead, we merely doubled down on the very same mistakes that got us into trouble in the first place.

If the Fed moves to support the junk bond market, undeserving companies run by irresponsible boards will be kept on life support instead of the free market being able to set clearing prices and potentially terminate them. Why not let market forces determine whether anything of value remains inside their entrails?

The Fed doesn’t have the power to buy equities yet but surely that is a coming attraction. We have seen how dismally it has worked in Japan.

The Head of Japan’s stock exchange admitted that  Japan’s central bank now owns around 60% of all Japanese Exchange Traded Funds (ETF) which is almost a quarter of the broader market. By stealth, the Bank of Japan has become a top 10 shareholder in almost 50% of listed stocks. In a sense, we have a trend which threatens to turn Japan’s largest businesses into quasi-state-owned enterprises (SoE) by the back door. At what point does it stop? When is enough?

We must accept a new reality where bankruptcy is openly accepted as a cure to weeding out excesses in the economy. Should there be demand, more efficient players can pick up the spoils.

We need this to make people realise that moral hazard isn’t going to be tolerated and personal responsibility is the order of the day. Anyone who is more than happy to have a winner-take-all mentality on the upside must be prepared to accept that the loser has to take all as well. Why should Main St bailout people who poorly assessed personal risk because our authorities provided a platform that encouraged the behaviour?

Let us not kid ourselves. There are no excuses in the game of greed. Lessons need to be taught to avoid such calamities in the future.

Sadly, our authorities will reject that advice and continue to fool around using the same reckless tools tried making us pay an ultimately higher price.

Buy Gold.

Surely lightning can’t strike twice, RBA?

The video posted here is of then Treasury Secretary Hank Paulson who steered the US financial system through the GFC. He is speaking to the Financial Services Committee in 2009. Perhaps the most important quote was the one that world central banks failed to heed –

Our next task is to address the problems in the financial system through a reform program that fixes our outdated financial regulatory structure and that provides strong measures to address other flaws and excesses.

Central banks across the globe honestly believe in fairytales to think they have learnt the lessons of 2008 or 2000 for that matter. Sadly they continue to use the only tool they possess – a hammer – which would be great if every problem they encountered was actually a nail.

When will people realise that had central banks practised prudent monetary policy over the past 20 years, they would possess the ammunition to be able to effectively steer the economy through Coronavirus? Everything the RBA and government are deploying is too little and too late. They never ran proper crisis scenarios and are now scrambling to cobble together an ill-contrived strategy wasting $10s of billions in the process all at our expense.

Central banks only have one role – to support markets with consistently sound monetary policy that creates confidence in the marketplace. Not run around like headless chooks and make knee-jerk responses and follow other central banks off a cliff like lemmings to disguise their own incompetency. The willful negligence displayed by our monetary authorities needs to be recognised. The RBA has got the economy trapped in a housing bubble of their own creation.

So when the RBA talks about, “Australia’s financial system is resilient and it is well placed to deal with the effects of the coronavirus” it couldn’t be further from the truth.

While it is true to say that Australia is relatively more healthy than other economies in terms of the percentage of GDP in national debt, the problem is we rely on the health of our foreign neighbours. 37.5% of our exports go to China. What is the first thing that will happen when our trading partners suffer economic weakness at home? Nations that exercise common sense will look to push domestic production and supply so as to boost their local economies. It is a natural process.

Sadly the RBA, APRA and ASIC have been too busy convincing us that climate change was a priority rather than getting businesses to focus on sensible commercially viable shareholder-friendly strategies. Some groups like the AMA have been encouraged to parade their climate alarmist virtues on breakfast TV.

Unfortunately, instead of focusing on fireproofing our establishments from ruthless cutthroat overseas competitors, our businesses and commerce chambers waste time on chasing equality and diversity targets instead of striving to just be the “best in class”.

Sure, we may have certain raw materials (that the lunatic Greens and Extinction Rebellion protestors will do their best to shut down) that China or other nations will rely on, our service sector weighted economy will be crushed. Almost $250bn, a fifth of our GDP, derives from exports.

Just look at Australian business investment as a % of GDP dwindle at 1994 lows. Mining, engineering, machinery and even building investment are nowhere.

That means our ridiculously high level of personal debt will become a problem. It stands at 180% of GDP as recorded by the RBA on p.7 of its Chart Pack. Most of this debt is linked to housing. Housing prices should crater should coronavirus not be solved in short order. Delinquencies will surge. Families that are funding a mortgage with two incomes may end up being forced to do in with one. Then we cut our gym memberships, Foxtel and stop buying coffee from our local cafe. It is the chain reaction we need to be wary of.

That will work wonders for banks with 60-70% mortgage exposure and precious little equity to offset any ructions in housing prices. If you thought Japan was bad after its bubble collapsed – you ain’t seen nothing yet. By the time this is over we could well see Australian banks begging for bailouts. Note that cutting interest rates further kills interest rate spreads and smacks the dollar which hikes the cost of wholesale funding which these banks heavily rely on.

Yet our RBA knows that it must choose the lesser of two evils. It needs to keep the bubble inflated at all costs because the blood that would come from bank failure is just not worth contemplating. Maybe if they had listened to Hank Paulson they might have been able to hold their heads high rather than showing off, the fool’s version of glory.

Milton Friedman once said,

The power to determine the quantity of money… is too important, too pervasive, to be exercised by a few people, however public-spirited, if there is any feasible alternative. There is no need for such arbitrary power… Any system which gives so much power and so much discretion to a few men, [so] that mistakes – excusable or not – can have such far-reaching effects, is a bad system. It is a bad system to believers in freedom just because it gives a few men such power without any effective check by the body politic – this is the key political argument against an independent central bank.

How right he was. When the economy tanks, await the RBA and government pointing fingers at each other when both failed to avert the coming crisis which had been so bleeding obvious for so long.

Batten down your hatches.

Another Chinese bank bailed out

Harbin Bank, a 622 billion yuan (US$90bn in assets) juggernaut in the country’s north became the fifth bank – after Baoshang Bank, Bank of Jinzhou, Heng Feng Bank, and Henan Yichuan Rural Commercial Bank – to be bailed out by the Chinese state.  As can be seen above, the trend of confidence shown by the markets over recent years is waning – fast.

According to Zerohedge, “as was the case with at least one previous bank “rescue”, Harbin Bank was connected to a former oligarch who disappeared not that long ago amid allegations of massive fraud..”

ZH goes on, “Another curious fact: a little over a year ago, Harbin Bank, which in March 2018 had abandoned plans to list its shares in China, announced it would raise over $2 billion in perpetual bonds to replenish its capital after regulators in early 2018 allowed lenders to sell such instruments to bolster their balance sheets. Incidentally, a perpetual bonds is effectively the same thing as equity, but for some bizarre reason sells much better in China where the investing population is apparently stupid enough to be fooled by the clever change in designation. As such, Harbin Bank was the first Chinese lender to announce its intention to sell perpetual bonds to increase its Additional Tier 1 (AT1) capital. We now know what prompted the bank’s rush.”

According to Bloomberg,

Chinese banks reported 2.2 trillion yuan (US$315bn) of non-performing loans at the end of June, which, according to the China Banking and Insurance Regulatory Commission (CBIRC) is the highest level in over 15 years…Troubles facing Guangdong Nanyue’s biggest shareholders may also add to its woes. Neoglory Holding Group Co., which is going through a court-led bankruptcy restructuring after defaulting on its bonds, is the largest shareholder of Guangdong Nanyue with a 16.52% stake, followed by Gionee Communication Equipment Co., which is in liquidation, according to a report published by China Lianhe Credit Rating in June. The two hold a combined 25.4% stake in the lender.

Note in recent times, Baoshang Bank was taken over by the government in May and the Bank of Jinzhou was rescued in July.

We shouldn’t forget “special mention” loans which are not classified as NPLs but potentially at risk of becoming so (equivalent to being 90+ days in arrears), rose to 3.63 trillion yuan (US$521bn), accounting for 3.3% of the total loan volume for commercial banks according to the CBIRC.

Nothing to see here? This doesn’t even include the issues of the shadow bank lending market. The one thing to be sure of is that is likely far worse than the official figures. Peer-to-peer lending ran at around $1 trillion but shonky practices has meant more than 80% of China’s 6,200 P2P platforms ended up shutting or faced serious difficulties. Only 50 were expected to pass scrutiny to continue to operate but the government, keen to revive the slowing economy, has looked to ease restrictions again.

An ominous speech from the Philly Fed in 2013

A Limited Central Bank

Perhaps one of the most prophetic speeches made by the Fed. Unfortunately, central bankers continue to completely and totally ignore what he warned today.

Charles I. Plosser, President and Chief Executive Officer of the Federal Reserve Bank of Philadelphia who served from August 1, 2006, to March 1, 2015, said in the 100th anniversary of the Fed.

When establishing the longer-term goals and objectives for any organization, and particularly one that serves the public, it is important that the goals be achievable. Assigning unachievable goals to organizations is a recipe for failure. For the Fed, it could mean a loss of public confidence. I fear that the public has come to expect too much from its central bank and too much from monetary policy, in particular. We need to heed the words of another Nobel Prize winner, Milton Friedman. In his 1967 presidential address to the American Economic Association, he said, “… we are in danger of assigning to monetary policy a larger role than it can perform, in danger of asking it to accomplish tasks that it cannot achieve, and as a result, in danger of preventing it from making the contribution that it is capable of making.6 In the 1970s, we saw the truth in Friedman’s earlier admonitions. I think that over the past 40 years, with the exception of the Paul Volcker era, we failed to heed this warning. We have assigned an ever-expanding role for monetary policy, and we expect our central bank to solve all manner of economic woes for which it is ill-suited to address. We need to better align the expectations of monetary policy with what it is actually capable of achieving.”

Plosser’s conclusions were:

The financial crisis and its aftermath have been challenging times for global economies and their institutions. The extraordinary actions taken by the Fed to combat the crisis and the ensuing recession and to support recovery have expanded the roles assigned to monetary policy. The public has come to expect too much from its central bank. To remedy this situation, I believe it would be appropriate to set four limits on the central bank:

  • First, limit the Fed’s monetary policy goals to a narrow mandate in which price stability is the sole, or at least the primary, objective.
  • Second, limit the types of assets that the Fed can hold on its balance sheet to Treasury securities.
  • Third, limit the Fed’s discretion in monetary policymaking by requiring a systematic, rule-like approach.
  • And fourth, limit the boundaries of its lender-of-last-resort credit extension and ensure that it is conducted in a systematic fashion.

These steps would yield a more limited central bank. In doing so, they would help preserve the central bank’s independence, thereby improving the effectiveness of monetary policy, and, at the same time, they would make it easier for the public to hold the Fed accountable for its policy decisions. These changes to the institution would strengthen the Fed for its next 100 years.”

Sadly we’re experiencing the opposite.

When President Trump bullies Jerome Powell to hurry up with rate cuts to “keep up with China“, he is only coercing the US Fed chairman to move even further away from these four guidelines. One has to wonder did any of the central bankers ever play with matches as a child?

Perhaps Friedman had it right when he said,

Government has three primary functions. It should provide for military defence of the nation. It should enforce contracts between individuals. It should protect citizens from crimes against themselves or their property. When government– in pursuit of good intentions tries to rearrange the economy, legislate morality, or help special interests, the cost comes in inefficiency, lack of motivation, and loss of freedom. Government should be a referee, not an active player.

 

Truly sickening US Public Pensions data

1 MKT PER HH DEBT 2016

Following on from the earlier post and our 2016 report on the black hole in US state public pension unfunded liabilities, we have updated the figures to 2016. It is hard to know where to start without chills. The current state of US public pension funds represents the love child of Kathy Bates in Misery and Freddie Krueger. Actuarial accounting allows for pension funds to appear far prettier than they are in reality. For instance the actuarial deficit in public pension funds is a ‘mere’ $1.47 trillion. However using realistic returns data (marking-to-market(M-2-M)) that explodes to $6.74 trillion, 4.6-fold higher.  This is a traffic accident waiting to happen. US Pension Tracker illustrates the changes in the charts presented.

Before we get stuck in, we note that the gross pension deficits do not arrive at once. Naturally it is a balance of contributions from existing employees and achieving long term growth rates that can fund retirees while sustaining future obligations. CM notes that the problems could well get worse with such huge unfunded liabilities coinciding with bubbles in most asset classes. Unlike private sector pension funds, the states have an unwritten obligation to step up and fill the gap. However as we will soon see, M-2-M unfunded liabilities outstrip state government expenditures by huge amounts.

From a layman’s perspective, either taxes go up, public services get culled or pensioners are asked politely to take a substantial haircut to their retirement. Apart from the drastic changes that would be required in lifestyles, the economic slowdown that would ensue would have knock on effects with state revenue collection further exacerbating a terrible situation.

CM will use California as the benchmark. Our studies compare 2016 with 2008.

The chart above shows the M-2-M 2016 unfunded liability per household. In California’s case, the 2016 figure is $122,121. In 2008 this figure was only $36,159. In 8 years the gap has ballooned 3.38x. Every single state in America with the exception of Arizona has seen a deterioration.

The following chart shows the growth rate in M-2-M pension liabilities to total state expenditure. In California’s case that equates to 3.2x in those 8 years.

1 MKT PER HH DEBT EXP GROWTH

Sadly it gets worse when we look at the impact on current total state expenditures these deficits comprise. For California the gap is c.6x what the state spends on constituents.

1 MKT PER HH DEBT TAX EXP 2016

Then taking it further,  in the last 8 years California has seen a 2.62-fold jump in the gap between liabilities and state total expenditures.

1 MKT PER HH DEBT TAX EXP 2016 VS 2008

This is a ticking time bomb. Moreover it is only the pensions for the public sector. We have already seen raids on particular state pension funds with some looking to retire early merely to cash out before there is nothing left. Take this example in Illinois.

Sadly the Illinois Police Pension is rapidly approaching the point of being unable to service its pension members and a taxpayer bailout looks unlikely given the State of Illinois’ mulling bankruptcy. Local Government Information Services (LGIS) writes, At the end of 2020, LGIS estimates that the Policemen’s Annuity and Benefit Fund of Chicago will have less than $150 million in assets to pay $928 million promised to 14,133 retirees the following yearFund assets will fall from $3.2 billion at the end of 2015 to $1.4 billion at the end of 2018, $751 million at the end of 2019, and $143 million at the end of 2020, according to LGIS…LGIS analyzed 12 years of the fund’s mandated financial filings with the Illinois Department of Insurance (DOI), which regulates public pension funds. It found that– without taxpayer subsidies and the ability to use active employee contributions to pay current retirees, a practice that is illegal in the private sector– the fund would have already run completely dry, in 2015…The Chicago police pension fund held $3.2 billion in assets in 2003. It shelled out $3.8 billion more in benefits to retired police officers than it generated in investment returns between 2003 and 2015…Over that span, the fund paid out $6.9 billion and earned $3.0 billion, paying an additional $134 million in fees to investment managers.”

1 MKT PER HH DEBT TAX EXP 2016 FUND REV.png

To highlight the pressure such states/cities could face, this is a frightening example of how the tax base can evaporate before one’s eyes putting even more pressure on bail outs.

This problem is going to get catastrophically worse with the state of bloated asset markets with puny returns. Looking at how it has been handled in the past Detroit, Michigan gives some flavor. It declared bankruptcy around this time three years ago. Its pension and healthcare obligations total north of US$10bn or 4x its annual budget. Accumulated deficits are 7x larger than collections. Dr. Wayne Winegarden of George Mason University wrote that in 2011 half of those occupying the city’s 305,000 properties didn’t pay tax. Almost 80,000 were unoccupied meaning no revenue in the door. Over the three years post the GFC Detroit’s population plunged from 1.8mn to 700,000 putting even more pressure on the shrinking tax base.

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