Archive for the ‘Repetition’ category

Vicious Nothings Whispered into my Ear

November 21, 2008

The rumors are that Citi is going to be taken over. Investment bank goes to State Street. Deposits will be split between Morgan Stanley and Goldman Sachs. Keep in mind this is just a rumor…

What isn’t a rumor, however, is that someone did a trade in their personal account in the morning against Goldman Sachs. By the end of the day they tried to do another trade involving Goldman Sachs and were told that it was on the “restricted list.” Something is going on.

Detailed Causes of the Crisis and Post-Crisis

November 9, 2008

Since this is a political season, and with the economic crisis, I think everyone in finance understands there is a sort of “silly season” that ensues. We certainly noted the sort of irrational behavior that would immediately make an economist question their beliefs. To me, though, the most offensive form of this stupidity comes from those who believe the Community Reinvestment Act and Fannie and Freddie sparked the whole crisis. Mr. Ritholtz rails against this notion over and over again. Oddly, I haven’t seen anyone else tackle this issue… Of course, I’m also way behind on reading my feeds. I even wrote Mr. Ritholtz an email (something I always tell myself is useless afterwards, since I don’t ever get a response, but is usually cathartic) noting that he was being very informative by setting the record straight. Well, maybe I expressed this sentiment with a tirade…

Every time I hear a Republican talking head on a news program saying Fannie and Freddie caused the problem I want to jump through my T.V., explain that the answer “betrays not even a modest understanding of the contributing factors to the current crisis, it’s scope, and magnitude” and begin to rattle off about flawed ratings agencies, excessive leverage (for investment banks and funds), over-reliance on models, a flawed compensation model for Wall St., managements needs to one-up their own earnings and those of competitors, explosive year over year growth of unproven financial technologies, over-reliance on “fast money” to distribute risk, fund’s need to earn outsized returns to attract assets, funds’ need to buy crappy bonds to build a “relationship” that would allow them to get “good” bonds from banks, poor disclosure from companies (specifically investment banks, as I’ve discussed on my blog), and extremely low rates for a very long time. Of course I’m just a normal guy who actually knows what’s going on, I don’t get invited onto these shows.

(Emphasis added, mine.)

Let’s tackle these, shall we?

  1. Excessive Leverage — If the plot of the credit crisis had included a deus ex machina it would have been an instant de-levering of troubled investment firms. This didn’t happen and several collapsed. I don’t want to be repetitive, but the Deal Professor says it plainly when he says, “Sometimes, You Can Only Raise Capital When You Don’t Need It” … If a firm is highly levered, as Bear was, Lehman was, Fannie was, Freddie was, and A.I.G. was, then when the market gets bad, losses pile up, and credit tightens it’s a death spiral. There’s a large distance between well-capitalized and insolvent, but once you move from adequately-capitalized to under-capitalized it’s probably impossible not to hit insolvent or bankrupt. Oh, and let’s not forget how this became a problem in the first place … the rules were relaxed in 2004.
  2. Flawed Rating Agencies — This is pretty obvious. Moodys errors. Rating agencies noting any deal, even one “structured by cows,” would be rated. And lastly, the smoking gun that seems to be the largest caliber, the fact that … well, I’ll let Mr. Raiter speak for himself:… “Mr. Raiter said that the residential mortgage rating group at S.& P. had captured the largest market share among its main competitors — 92 percent or better — ‘and improving the model would not add to S.& P.’s revenues.‘” Wow! Honesty, stupidity, incompetence … all on display. Now, to be honest, I have no idea what difference these problems made. What I do know is that the rating agencies were used as a means of outsourcing risk management and credit analysis. While it shouldn’t be a huge shock that the rating agencies missed the mark, the magnitude by which they missed is a huge problem if everyone took their ratings as fundamentally true. What these “statistical rating agencies” should have been doing is running securities and mortgage loans through abhorrently conservative scenarios and fixing ratings based on those…. they didn’t. They were argued down to “realistic” scenarios based on past experience. The issues above merely compound the problem.
  3. Over-Reliance on Models — Related to the rating agencies’ issues, this one is a great catchall for terrible risk management. Let’s be honest, no one saw the fundamentals in housing getting so bad. That’s not the issue, I didn’t see it so I can’t exactly blame others for not seeing it. What I can do, however, is blame risk management professionals for not preparing for it. When you have, as Citi did, tens of billions of dollars in highly correlated assets, you should know there’s a risk of tens of billions of dollars in writedowns. When you have tens of billions of dollars in commercial mortgages, as Lehman did, you should realize the risks there. Similar lessons for WaMu, Wachovia, and CountryWide. Instead, though, like the rating agencies, there was a push to have “realistic” or “back tested” results. Let’s go to Mr. Viniar, C.F.O. of Goldman, for his take: “Even scenario analysis, which can address some of VAR’s deficiencies, came up short … [This] ’caused us to look at more-extreme scenarios than we used to look at,’ says Viniar. ‘It made us expand out the tails of what we deemed a realistic possibility.'” Logical, concise, and conservative. It seems Goldman didn’t attempt to show lower risk numbers so that they could deploy more capital or be looked upon as safer by the stock market. No, they looked at more extreme scenarios. They reacted quickly. However, in quoting this passage I sandbagged you, dear readers. This quotation is actually much more relevant to this situation than one would think–it comes from 2001! Mr. Viniar, people probably won’t remember (seems like a lifetime ago), but I noted before, was the guy who convened a firm-wide meeting on exposure to the housing markets. The takeaway is that the firm that looked at the most extreme scenarios, not the ones that models said were most likely, weathered the storm the best.
  4. Flawed Compensation Model — This one is pretty obvious. Lots of money flowed into people’s P.A.’s (that’s “personal account”) each year based on fees and mark-to-market gains for complex structured products. In many instances these risks were distributed and off the balance sheets of investment banks. However, these businesses were grown, and none of the risks were well understood–the people in the lead, though, lead the charge to increase their compensation. I was personally aware of a senior trader/banker/whatever that pushed a firm, one that has seen tens of billions in writedowns and may or may not still be alive, who pushed for balance sheet commitment of 2-3x the current size in the C.D.O. business. This would have exposed this institution to writedowns larger than most firms equity base. This proposal was shot down, but still… Clearly making eight digits was going to someone’s head. Now, we all know that I believe one should be accountable for their decisions, so it shouldn’t be a surprise that when one has made tens of millions of dollars in bonus and salary, but their decisions lead an institution to take massive losses, reduces shareholder value significantly (keeping in mind shareholders might be woefully unaware of the risks being taken), and leads to thousands of people losing their jobs, merely being fired isn’t enough. Especially since these issues are only beginning to be understood when these people are fired, usually. Becoming an instant millionaire is a huge, huge problem. It’s the “swing for the fences if you’re down” mentality, and it’s also the “worry about the tail events if they happen” mentality. Put simply, there should be the ability to claw-back compensation based on performance for years. Perhaps a ten year lockup of wealth is extreme, but given these issues and famous blowups in the past, and taking into account the tradition of good times to last several years, maybe ten years is harsh but not extreme. Maybe employees should be allowed to hedge exposure to stock prices after a few years, but still have risk if negligence is discovered or things go wrong that were set in motion by that person. Obviously something drastic needs to be done, perhaps merely paying less is sufficient, but I doubt it.
  5. Management Pressures — Highly correlated to the flawed compensation model, it’s the case that management was pushed hard to get earnings up. Having seen the “budget” process (an odd name, I thought, since a budget, to me, merely means expenditures) up close, I saw people come up with reasonable numbers, submit them to senior management, and be told, “More!” Well, guess what <expletive>s? If someone tells you they can reasonably deliver something and you always add 10-20% to those numbers, there is more risk taking and less rationality to how that profit is achieved. Maybe the long term effects of pushing the envelope are much worse than not taking those risks to begin with. This is one reason Goldman seems to outperform so often, they understand what they are getting themselves into. They truly work together and achieve revenues through teamwork instead of edict. Now, underperformance is punished, but setting reasonable goals is step one when trying to exceed them. The next generation of management should fight their bosses tooth and nail not to set unreasonable baseline expectations and should figure out objective measures that reflect an employee or business’s effectiveness. The tyranny of quarterly earnings shouldn’t make grown ups act stupidly because they can’t “just say no.” Here’s a hint: if you run a company with a nine- or ten-digit balance sheet and you don’t realize your business is complex enough that you shouldn’t manage to the next ninety days, then you should step aside. Seems simple to me. Maybe that’s why Google doesn’t bother with quarterly guidance.
  6. Explosive Growth of Unproven Financial Technologies — Being a bit of a purist I am hesitant to call financial products or methods “technologies,” but I’ll use that word for now. The truth of the matter is, these products had never seen a massive downturn. Sub-prime loans as we know them today hadn’t seen a recession until now. C.D.O.’s backed by structured products hadn’t existed during a protracted period of fundamnetal credit distress before. This was known and talked about often. For as much as this was talked about, it was an observation that was never extrapolated. Hedging and risk management still looked at historical levels of distress and credit problems. The market had grown by orders of magnitude, but that wasn’t part of the equation. Quite simply, the fact that these markets grew so much so fast meant no one had a good handle on the feedback effects of this growth. This is somewhat obvious and very moot, so I won’t dwell on the problems of such massive growth.
  7. Over Reliance on “Fast Money” To Distribute Risk — Anyone who knows structured products understand this point. Basically, the fair-weather buyers are “fast money.” This client based is distinct from “buy and hold” or “real money” accounts. Here is where the shell game of wall street really kicked into high gear. Hedge funds would buy bonds with the intention of selling at a profit later. Investment banks would, to show strength of the market, put out “bids” or interest to purchase securities they had just created at a higher price than they had just sold said securities at. Hedge funds would then immediately sell back to Wall St. firms, at a profit, to take advantage of their desire to show the market their securitizations “trade well” or “at a premium.” When firms are making money on the securitization, they can afford this. Speaking more generally, hedge funds just “trade bonds around” more. In recent years insurance companies and banks, the institutions that buy securities and rarely sell them (for a myriad of reasons), went from 70+% of the buying base for structured products to 20-30% of the buying base. This means that in a bad market 70-80% of the bonds that exist can be sold (dumped?) at a moments notice. Add in the fact that during this period there was explosive growth (as noted above) and you see why when the markets hit trouble the huge wave of selling occurred, liquidity dried up, and prices plummeted.
  8. The Flawed Model for Relationships Funds have with Wall St. (coupled with Funds’ Needs for High Returns to attract Assets) — The way a bank figured out if a hedge fund was a good customer was, basically, how much a fund helped that bank get out of risk (stupidly, as stated above, since banks were likely to be more hurt by a fund owning assets and were more likely to wind up needing to repurchase those assets, but I digress…). However, when assets were in short supply relative to demand, only the top clients were able to purchase securities banks were creating. So, one might wonder, how did a nascent fund, at the bottom of the food chain, get access to the desirable securities? Easy solution: they purchased the undesirable securities to “help out” a Wall St. firm. These were more risky, although they were generally carried a higher rate of return in the event of no credit problems. These new funds, then, showed higher returns, attracted more money, and bought more securities from banks. Net effect? Most funds had a poor mix of products–higher risk bonds or assets that would get hit much harder than generic securities and more generic securities. Keep in mind that, to get high returns, funds were buying C.D.O. products and other structured products that had higher returns in general, but funds also levered these products and thus funds were much more exposed to moves in the market. Funds, as everyone knows, get paid a percentage of assets under management and returns, so to grow their revenue stream many funds just had to buy lots of securities (and, to establish a strong enough relationship to be allocated enough securities, plenty of lower quality securities). This was the prisoner’s dilemma of the syndicate system–funds cooperated every time. (Just to put some numbers on it, when a fund would try to buy residential or commercial mortgage backed securities it was possible for demand to outstrip supply 2- or 3-to-1. Accounts with strong relationships usually got 100% to 80% of the requested amount of bonds being issued. Weak relationships or smaller firms could receive as little as 10-20% of their desired allocation.) This is a complex process and nuanced point, feel free to email me for more explanation.
  9. Poor Disclosure from Companies — This is a point I’ve raised before. I won’t go over it again. The short story is that firms got away with a lot because they didn’t tell anyone what they were doing.
  10. Extremely Low Rates for a Very Long Time — I’ve raised this point before as well (between the numbered lists). Rates were very low and, suddenly, a product that trades at 50-100bps over L.I.B.O.R. traded 50-100% higher than L.I.B.O.R. If your benchmark was treasury rates to outperform your benchmark meaningfully you needed to get much higher spreads, and thus take higher risk. This is why C.D.O.’s experienced such explosive growth (see the problems the growth cased above). Low rates also made it more attractive to get a floating rate mortgage, which a huge majority of sub-prime mortgages were. This was part of the ex-post concern with Alan Greenspan’s encouraging people to take out A.R.M.’s.

In short, Fannie and Freddie were part of the problem, but not in and of themselves. In fact, if Fannie and Freddie had caused these problems by selling banks their bonds, then we wouldn’t have a problem at all. Why? Because Fannie and Freddie would be “on the hook” for the bonds they guarantee. If these bonds went bad no firms would have taken losses on them (since the government stepped in to keep them solvent and backstopped their obligations). Okay, now that I’m done ranting I’m going to rant on something new. The post-crisis narrative of what went wrong… (don’t you love the rise of the word “narrative”?).

  1. The failure of rating agencies, risk managers, and risk management models. This has been getting the most press because it’s easy to explain (not why these things failed, but the fact they failed).
  2. Sheer size. This is pretty silly, if you ask me. Bigger doesn’t have to mean riskier. The practices that get a firm to a massive size could be an issue. Super-concentrating the health of the markets with very few players could be a huge problem. The “Too Big to Fail” issue might fit some situations, but didn’t cause this crisis. No one wants to have to rely on the government to save them.
  3. Executive pay. This is a limited view on the actual problem. In fact, in most firms, C.E.O.’s aren’t the highest earning individuals.
  4. Hedge funds and short selling. Really? Let’s trace the logic here (or lack thereof): a firm runs it’s business poorly and I bet it will decline in value. Clearly I am at fault there. The “free markets at all costs except losses” crowd, like those currently at Treasury, are putting a band aid on an amputated leg here. Especially with the very firms begging to be protected turning around and getting fees from products circumventing the bank on short selling. (What a stupid move, some firms deserve to be in worse trouble.)
  5. Everything else. Why get into the details of the actual causes when you can distill down issues to “good” versus “bad” and simple fights? No one has…. so I’m doing it! But I doubt all the other things will make it into the popular understanding of what went wrong.

There you go. My hands are tired, so I’ll stop here. Feel free to comment and ask questions.

In The Year 2010: Residential Mortgage Edition

October 17, 2008

Okay, in a series I just thought of, called “In The Year 2010″ I will sit here and guess what will be going on by the end of 2010 with respect to various products. (Inspired by the Conan O’Brian skit “In The Year 2000″). This is a thought experiment, nothing more.

Residential mortgages. What can be said about where they’ve been that hasn’t been said already? I can’t even pepper that sentence with links because I wouldn’t know where to start. I mean to cover this product from the capital markets side, but let me starts by saying that this industry will probably be scared of it’s own shadow when it comes to making loans–probably for quite some time. Gone will be the sub-prime loans we all know and, well, we all just know them… 720 FICO, 25% DTI, 72% LTV? Greenlight. 600 FICO, 50% DTI, 90% LTV? Redlight. It’ll nearly be that simple.

Now, given that the loans will likely be much cleaner, what will the capital markets products look like? Easy! Well… hold on. First, there are some powerful subtleties. First, Fannie and Freddie won’t be nearly the same presence as they were in the residential mortgage markets in general, and probably sub-prime and Alt-A mortgage markets specifically (buying AAA’s). That’s one source of liquidity down. Second, CDO buyers are gone (this product will be a different post, but keep in mind CDO’s are not all mortgage related). CDO’s would buy the lower credit pieces, such as BBB’s (including BBB+, BBB, and BBB- … For Moody’s lovers, Baa1, Baa2, Baa3) and lower rated classes. Oh, and not as many investment banks are around. Guess what they bought? The residuals. Residuals were the 1-5% of the securitization that was unrated by the agencies and took the first losses of every pool. Banks “took these down” assuming they would pay off and that was how they would make their money. Most of those banks are also either not around or hurting.

So, we have fewer AAA buyers, fewer buyers of the lowest rated pieces, and fewer buyers of the lowest unrated pieces. Hmmmm…. I’m guessing there will be less securitization volume. However, I do think there will be securitizations going on. The financial technology is sound–slice up risk to those who can best take said risk. However, securitizations will be much simpler beasts. Gone will be the reliance on the rating agencies to evaluate risk. I doubt anyone will see a AA+ and a AA tranche on deals, risk will be cut into much broader swathes.

With these facts in mind, will AAA’s (or, more generally, high quality low-leverage securities) have a home? Well, at 10+% returns with banks paying 5% to the government for billions in new equity capital (just an example), which they can still lever over 10x (from what I can tell banks generally run 11-15x leverage), AAA’s seem like a good buy. Now, granted, those estimates for returns aren’t adjusted for losses, although AAA’s taking a loss hasn’t happened yet to my knowledge. This would seem to indicate that banks (there are no more investment banks) have a compelling value proposition when it come to holding market-rate AAA securities that are higher quality than found in ABX, but still not prime. Even if these AAA’s only returned 7%, and with current prime mortgage rates at around 6.5% that seems ridiculously unlikely, with 5% cost of capital they could be making over 20% ROE (way over, I’m being conservative and fudging downward). A lot of the these numbers aren’t apples to apple, but we’re also guessing at the future, so we use what we have.

If AAA’s have a home, the next question is what becomes of the lower-rated pieces. Well, my belief is that these will go wholesale to hedge funds and specialized funds focused on these products. The returns will be something in the 20-30% realm, near current levels. Credit analysis will drive value in this market, but if loan pools are kept clean enough then there can be sufficient liquidity to ensure a given securitiation can be sold (i.e. there will be enough funds bidding to ensure that, at a price, bonds will be sold). This is probably the easier problem than the AAA’s to be honest. The hedge funds that will do a lot of work to get a good return already exist, AAA buyers will need to convince themselves that they should be doing those transactions before anything starts happening.

Lastly, I think a market that will grow is the whole loan market. There will be a lot more trading volume in raw loan positions–transactions that aren’t driven by securitizations and don’t need to have tranches of risk in order to sell. Without going too much into the details, this market will be driven by dynamics of servicing arrangements, accounting rules, and detailed credit analysis. Currently this market is thriving, but in the form of “scratch and dent” trades of non-performing and re-performing (people that stopped paying and restarted paying later) pools of mortgage loans.

So, to sum up, what I believe the residential mortgage market will see is a return to simpler times. Selling off loans either a pool of actual loans or in two tranche securitizations seems reasonable. Indeed, this theme will most likely hold for other products as well, but the reasons fit here, so I’ll call it now and risk sounding redundant later.

Now, just to mess with everyone, I’ll use a newly added WordPress feature: polls! Tell me your thoughts on this…

Craziest Weekend in Wall St. History: Questions Abound!

September 15, 2008

What a weekend. I’m sure Wall St. feels a bit brutalized by the events. Now, here are my questions…

1. Doesn’t Lehman have to be involved in moving trades that are facing them? I simply do not understand what the “Lehman Risk Reduction Trading Session” is all about. Indeed, if one looks at the I.S.D.A. Novation Protocol Guide, it’s the case that the “Transferor” (the “Stepping out party”) needs to agree on certain terms. For example:

Negotiating a proposed Novation Transaction:

The Transferor will contact the Transferee to agree a price [sic] for the Novation Transaction.

Seems like “negotiating” and “to agree” seem to indicate the transferor has some decisions and veto power. Also, let’s be honest, all the banks sitting at the table for this situation showed that they aren’t willing to lend a helping hand to their competitors and are acting in self-interest while potentially risking the entire system’s stability (more on this in a bit). How do we know they will be candid with each other and the world regarding their exposures? If I were a bank, I would seek to novate all the in-the-money trades with Lehman and not the ones that are out-of-the-money, right?

And, now that Lehman is winding down, the trades that will be novated away could be hedges. So you have Lehman, sitting with assets it now needs to sell, as their hedges are being novated away and without the ability to put new hedges on. What does this mean? Lehman, in trying to recover maximum value for creditors, will now have to sell quicker or will be holding assets that are unhedged and much more exposed to further market deterioration. Something just doesn’t make sense with this whole thing…

To further complicate things, since the holding company is filing for chapter 11, not chapter 7 does that trigger this special session? Does it matter which entity it is? I suppose we’ll see. Oh, and then there’s this that seems to indicate there’s really no reduction of risk occurring at all, from the W.S.J.:

Some traders said it was difficult to find new counterparties for many of their outstanding trades with Lehman. The snags included different terms and maturity dates on derivatives contracts, and market prices changed rapidly Sunday afternoon. “People were screaming at each other over the phone, asking: How can this work?” one trader said.

William Gross, chief investment officer at bond-fund giant Pacific Investment Management Co., said very few Lehman trades were offset. “There’s an immediate risk related to the unwind of these positions,” he said.

(Emphasis mine.)

2. How is a solvent company with a recovery plan, on Wednesday, now insolvent? If you say it’s similiar to Bear or you mutter the words “run on the bank” then you’re either making something up or you have insider information that has been reported nowehere in the media. Proof? From the W.S.J.’s Marketbeat Blog:

“Ongoing pressure and anxiety in the markets resulted in significant cash outflows toward the week’s end, leaving Bear with a significantly deteriorated liquidity position at end of business on Thursday,” the agency wrote.

Lehman’s prime-brokerage business is smaller than Bear’s relative to its more diverse portfolio, Mr. Sprinzen noted. And Lehman doesn’t depend on hedge-fund clients’ free credit balances to the same extent. In Bear’s case, the “run on the bank” by prime-brokerage clients was a major contributor to its fall.

(Emphasis theirs! [Again, wow!])

Lehman’s prime brokerage certainly isn’t anywhere near large enough to bring down the firm, as was Lehman’s. So, did the Fed and Treasury cause this? By trying to set up a suitor did they make other firms unwilling to fund them and thus cause their death?

Remember that there was consensus before that Lehman could survive.

3. The Treausury and the Fed have a lot of decisions to make. What will they do? Why did they choose this path?

First, it was earlier reported that the Merrill-Bank of America tie-up would be unde-rcapitalized and need regulatory approval. That reference, from the New York Times article has since been removed.

Second, A.I.G. is now hunting for government loans to survive. How can they provide those when they refused Lehman? How can they refuse those when they provided them for Bear? A.I.G. is hardly at the center of the financial system. And, by the way, they went from selling units to not selling units and needing loans in a matter of hours!

Also, what of stability? First, Lehman is just as at the center of credit derivative markets as Bear Stearns was, in corporate credit default swaps and interest rate derivatives probably more-so. And what’s to stop people asking questions and begin to pummel Morgan Stanley or Goldman Sachs?

As Barry cites, perhaps the Fed has caused it’s own problems here:

To be eligible for a bailout, firms must also demonstrate a particular genius for screwing up. Before it went bust, Bear Stearns had a monstrous $33 of debt for every dollar of capital, and hedge funds it owned destroyed hundreds of millions of dollars of clients’ cash. It got a bailout. Lehman Brothers, which has taken painful measures to reduce its risk, is perversely less likely to get direct government help. “The worst Lehman can do is destroy the firm,” said Barry Ritholtz, CEO of Wall Street research firm FusionIQ and author of the forthcoming Bailout Nation. “Bear Stearns, on the other hand, set up the firm so that if they screwed up, they could threaten the entire financial system.” That may explain why Treasury Secretary Paulson has thus far resisted providing federal succor to Lehman.

(Italics theirs.)

4. As for Lehman’s assets, who gets them and what are the terms? I would claim that there should be an auction run. And, perhaps, when that auction is run there would be enough capital to save Lehman? Well, Lehman owns those assets at a different leverage ratio so how would that play? Depends on the price. We have to see if investment banks, like Goldman, did the math and withheld capital from a rescue assuming they could buy the assets on the cheap later.

Okay…. more to come, but that’s what is initially sitting uneasily with me.

Bold Statement: Time to Start Partying

September 10, 2008

I’m making a bold statement here: We’ve turned a corner. The Worst is over. Our evidence?

1. The Fannie and Freddie issue was always odd because, for as long as I can remember, there was an implicit guarentee that was unquestioned in all ways. It was a bullet point on every presentation about agency debt. It was a sub–bullet point on every presentation about agency M.B.S. Well, if Fannie and Freddie were always meant to be supported by the government, then why would people doubt that was the case? If the government guarntee was always pre-supoposed, why doubt it? Well, finally, the common sense statement that everyone doubted has been made explicit–which shouldn’t have needed to happen. However, I would claim, when you start doubting the obvious it’s a sign of a bottom. Especially now that the doubt has been quashed and the market is back to “pricing to reality.”

2. Lehman is resolved. As the rumors and estimates piled up Lehman has gotten crushed. Clearly this firm was the last big unknown as it dominated the news constantly. We knew every gyration and hiccup of the Korean Development Bank and their flirting and courtship with Lehman. Amazing. Well, with their announcement today, we know their losses, their plans for selling stakes in their businesses, and the extent of their real estate woes. Coupled with the mortgage market recovering slightly and stabilizing (see #1 above) the losses from mark to market aren’t likely to spiral far from here.

So, with these two very recent events, it seems reasonable to assume we’re out of the woods… I’ll be bold and predict, then, the reasonable assumption matches reality.

Update: Quite a tizzy over at Seeking Alpha about this post. I’m not calling a bottom here. I left a comment there if you would like to see it.

More Bear! (Part Three)

May 30, 2008

Kate Kelly drops the finale on us today. My thoughts:

1. Why, in the name of anything or anyone, didn’t Bear use it’s leverage? No one wanted them to file. They bent Jamie Dimon over (well, $10 per share isn’t bending him over, but paying five times the original price seems to be…) when they saw an opening. Everyone fought to ensure they didn’t have to file for bankruptcy, they must have known that it would be a disaster scenario that no one wanted to see played out… so why didn’t they use that more? “Make the J.C. Flowers bid work, or find a way to match it, otherwise I’ll be filing tomorrow. I’ll fax over the preliminary bankruptcy filing in five minutes.” Why not, right? If Bear’s position could deteriorate further then they can pass some form of legal test that they did what they were also looking out for creditors… Would the Fed and U.S. Treasury Secretary let them file and throw the world into disarray? If it looked like they caused, or stopped something that could have prevented, financial market Armageddon then they would be blamed. Seems like they balked on using this tactic, and I don’t understand why.

2. Oh, yeah… where is 2,000 DJIA points coming from?

At their gloomiest, regulators believed a bankruptcy filing could stoke global fears, threatening to topple other financial institutions and to send the Dow Jones Industrial Average into a 2,000-point nose dive.

Ugh. Please, stop guessing at stupid crap. If I said 500 would that be okay? Dimensioning the problem in terms of stock market movements is stupid. Hopefully this wasn’t their actual thought process. None of the agencies involved should be setting policy or taking action to prop up the stock markets. Jeeze…

3. I’ve been told by a whole bunch of reliable people that Ken Griffin, of Citadel fame, has a brother that heads up a large group at Bear Stearns (errr… did…). If Alan Schwartz can call a Morgan Stanley banker to get some Fed help why couldn’t Bear leverage Ken’s own brother, who would be very sympathetic to Bear, to figure out their “Citadel is shorting us” problem. Maybe they didn’t know? I could be missing something, I suppose…

4. We all know that Jamie Dimon manhandled Vikram Pandit on the call. I won’t re-hash it. Seems a bit… unnecessary, but it’s an interesting statement on each man’s demeanor.

5. Okay, this amazes me…

The next day, March 21, was Good Friday. J.P. Morgan turned up the heat, telling Mr. Cohen that if Bear Stearns didn’t make the desired concessions, the bank didn’t see how it could provide funding for the brokerage to trade the following Monday. In an ugly replay of the weekend before, Bear Stearns was imperiled again.

If J.P. Morgan wouldn’t guarantee Bear Stearns’s trades on Monday, the firm would most likely have to file for bankruptcy protection.

The article isn’t specific, but weren’t they required to provide financing? Or is this not the 28-day loan? the article isn’t specific here, but I can’t imagine that if J.P. Morgan was providing funding that it wasn’t somewhere in the terms they had agreed to at some point. Something is missing, and the missing facts probably makes the above passage “kosher” … however, since it’s not there, it just seems weird that J.P. Morgan was refusing monies to Bear when it had an interest in their survival, or, perhaps, even had an obligation to fund them.

6. I anticipate many people will chime in on this…

But this time around, Bear Stearns’s business was so weak, it wasn’t eligible for a Chapter 11 reorganization filing. Instead it faced a Chapter 7 liquidation, in which a court-appointed trustee would take over the firm, likely throwing out management and launching a sale of its assets to repay debts.

Many people great legal minds have opined on how Bear could only ever file for Chapter 7 … yet there is constantly mention of Chapter 11.

7. The last few sentences are just… hoaky. Why are those in there? I don’t know.

Well.. an interesting chain of events. An interesting take on it from the WSJ. Honestly, these are the kinds of things I think allows the WSJ to add the most value. Anyone can reshash the trading day, but this is where financial sources and real reporting shines. Good job WSJ!

More Bear! (Part Two)

May 29, 2008

The next installment in the WSJ’s look at Bear’s Collapse hit today. To be honest, nothing interesting stood out. Well, except the following..

1. Why was a Moodys downgrade of Bear Stearns–branded RMBS bonds cause the stock to drop? Something there makes no sense. These are insulated from the credit of Bear Stearns itself and the bonds are issued by a SPV. Seems off, or, perhaps, smacks of normal financial journalism that takes a fact and conflates it with the cause of the markets moving on that day.

2. I have to profess not knowing a ton about prime brokerage, but it seems that if, as it normal to do, Bear provided leverage on trades for prime broker clients, they need to borrow that money and as funds fled they would be able to require repayment of those loans. Also, since most funds are loathe to keep a lot of cash, as it hurts their performance, there shouldn’t be much cash fleeing with these funds.

3. Spitzer hosed Alan Schwartz. There is Alan Schwartz, talking about how super awesome Bear Stearns is, and Spitzer’s scandal starts interrupts him from saying things like, “Bear made money this past quarter.”

4. They had their lawyer call the Fed. I guess I’m not sure why the chairman of Sullivan & Cromwell was charged with calling the Fed to talk about Bear Stearns situation. Seems very odd. And why was it that when Alan Schwartz called the Fed, he struck a less alarmist tone?

5. J.P. Morgan representatives arrived and were shocked at Bear’s books. We don’t know what that means (their liquidity position? the marks they had on their positions?) exactly. But here’s an odd thing: The JPM crew asked for the Fed–and they were already there! Setup in a conference room was the Fed, having already been there for several hours. Maybe it’s completely logical that the Fed would be there, even if they hadn’t been asked for help yet… Just seems to not jive with Alan Schwartz being cautiously optimistic earlier.’

Ok, like I warned earlier, no much to really talk about in this one…. Soon, part three! The conclusion awaits.

More Bear! (Part One)

May 28, 2008

Well, today begins the three part story of Bear Stearns, as told by the WSJ. Deal Journal has a great summary post … A few thoughts:

1. It struck me that Bear wasn’t able to see the forst through the trees when it came to it’s strategy, specifically demonstrated with the “Chaos” trade. When one thinks about how these sorts of things can play out, especially in unprecedented times, how the decision to unwind these trades came about makes perfect sense. Someone puts on a unique trade and management asks them to justify it. Well, there’s a slide with four or five bullet points explaining why this trade should work (mostly qualitative/anecdotal). Also, there there’s a chart presented that shows a pretty bad history for the trade if it had been put on in the past. Indeed we can examine Mr. Schwartz’s history with the trade to see this:

For some of the assets, the market was frozen, Mr. Schwartz reasoned, so selling was out of the question. On others, he had mixed feelings. He didn’t want to unload tens of billions of dollars worth of valuable mortgages and related bonds at distressed prices, creating steeper losses.

The [hedge, called "the Chaos trade"] was a deeply pessimistic bet — essentially a method for making money if the mortgage and financial markets cratered. The traders bet that the ABX, a family of indexes made up of securities backed by subprime mortgages, would fall. They made similar moves on indexes tracking securities backed by commercial mortgages. Finally, they placed a series of bets that the stocks of major financial companies with exposure to mortgages … would decrease in value as well.

Faced with the fierce divide among his top executives, Mr. Schwartz, who was generally supportive of the chaos trade, decided to abandon it. He wanted specific pessimistic plays that would offset specific optimistic bets, rather than the broader hedges Mr. Marano had employed. Frustrated, Mr. Marano ordered the trades undone.

(emphasis mine).

Now, everything until the last part follows naturally. The last part (matching your hedges to your positions one-to-one) is fine, until you realize that it’s impossible to do this in a liquidity-challenged market. Also, with a massive re-pricing of risk, due to liquidity constraints, one should take a broader view. The CDO market drove demand in securitized products generally and mortgages specifically. Inventories in loans and bonds were sitting on firm’s balance sheets while credit concerns were coming to fruition. So, firms can’t sell risky products, which are losing value from a fundamental re-pricing, and, also, the lack of buying (overall liquidity) is causing a further, more broad technical re-pricing. That is the subtle point from above–why bet on “financial markets cratering” if you own mortgages and call that a hedge? Well, given the widespread ownership of these products, their credit impairment caused widespread credit concerns. With credit worthiness in doubt, liquidity became scarce. Scarce liquidity means less available money to buy these products, and leads to a technical problem with markets and drives prices lower (lower demand … easy, right?). Clearly this requires a deeper understanding of how interconnected markets are and exactly how they work together–potentially a leap of faith or a layer of complexity a firm wasn’t willing to bet on.

There was, however, evidence markets were behaving this way. Spread product was moving in lock step (directionally). LCDX (index of loans, generally made to high yield companies) was moving wider, corporate bonds had a secular widening, and mortgage product was impossible to trade, commanding a larger and larger liquidity premium… Also, LIBOR was rising and banks were finding it harder and harder to borrow. But, instead of using relatively liquid indices and stocks to bet on these “second order” effects, Mr. Schwartz started asking for specific bets that offset highly illiquid positions. Good luck. To ask for relevant hedges is logical, follows from first principles, seems safer, and wasn’t executable–easy for risk managers and executives to demand and impossible to do, leaving the problems unsolved. Keep in mind, too, that the stock market hedges could easily be unwound in the event they failed to be correlated to the loans they were hedging. Would the “specific” hedges that would, themselves, be highly illiquid? No chance. CMBX and ABX have been known to trade in markets that are 5-10 points, or percentage of notional value, and that’s for small size (5-10 million dollars). To hedge the size here … well, I can’t imagine the costs.

Just to review: They had toxic positions, hedged them, and then removed the hedges, but (from what I can tell) didn’t sell the positions (while trying to one-to-one hedge the). There’s something to be said for taking the hit you know about today instead of trying to call a bottom.

2. Regulators were having calls, as regular as daily, with Bear. From the article:

Bear Stearns’s … risk officers were meeting in the sixth-floor executive offices with staffers from the Securities and Exchange Commission. The regulators had traveled from Washington to make sure Bear Stearns had access to the day-to-day loans it needed to fund its trading operation. After scrutinizing the firm’s $400 billion balance sheet well into the afternoon, the regulators agreed to reconvene with Bear Stearns managers for daily briefings until the market crisis passed.

Now, uness Bear is different from ever other financial institution, when it’s regulators come knocking it’s unusual–everyone walks more straight and takes much more care when dealing with them. The reason is simple: there’s nothing to be gained when a regulator is pleased, the best thing that can come from making regulators happy is avoiding the situation where said regulators are unhappy and consequences arise. I wonder if, ever, in the history of Bear, regulators called in to check on their situation daily. This should have been a major warning sign and left employees involved extremely uncomfortable as it was going on.

3. Many sophisticated investors walked away from a deal with Bear.

  • KKR walked away, and we never learn what their concerns were (Bear was focused on not crossing clients)
  • Allianz SE’s Pacific Investment Management Co. (PIMCO) had discussions with Bear that “fell apart”
  • Fortress discussed a merger with Bear (sounds similar to what I wrote about recently) that never went anywhere

Now, J.C. Flowers walked away because both sides had issues, so I don’t count them. Similarly, I don’t count the hiring of Lazard, and that effort failing to bearing fruit. I’m not sure why each of these potential transactions fizzled, but certainly it seems like a pattern that one can read into.

4. Two institutions with a major financial stake in Bear’s viability expressed concerns. One of these, PIMCO, unless I’m missing something glaring, had been in talks to acquire a stake in Bear and declined (second bullet point above). Maybe they knew something the rest of us didn’t, from their earlier talks and whatever due diligence they had performed? It would make sense, but would probably also be illegal. More likely? PIMCO was focused on Bear and extrapolated to the current market conditions. Perhaps, also, some unease exuded from the senior PIMCO ranks…

On a side note, what’s with the illustrations? Maybe this is going to be a chapter or section of a book? It reads that way almost… Newscorp swooping in to add a fresh (and awkward) feel to the WSJ? It was distracting to say the least. Of course Dealbreaker goes (almost scarily) deeper with this observation (as is their charge), and they have some amusing thoughts.

I can’t wait for part two!

I Could be Wrong, But I Think I See a Pattern

February 18, 2008

Well, let’s take a quick survey of the issues that have been plaguing the capital markets. (Note, these aren’t all completely in order, but the spike in “mind-share” of any given story should correspond with the order.)

First there is sub-prime. This problem can best be described as fundamental. I won’t bore anyone with the issues plaguing this market, they have been well documented and aren’t even the least bit vague. Go to the always complete Calculated Risk to read all the details. Do you know how banks would make money off of sub-prime securitizations? Once a group of whole loans was securitized, the banks would keep the bottom most piece–it would get marked to a high yield at a conservative speed and it would get held on balance sheet. Banks would be monetizing the mismatch between the bonds issued and the interest rates being paid by the sub-prime loans. Essentially these structures allowed a more leveraged return for their equity. To do this, the mismatch between shorter and safer assets was exploited.

Second, there was the C.D.O. issue. This was where enterprising structured product people went out and issued bonds with low interest rates off of underlying bonds with higher interest rates. This was done by creating credit support and safety for AAA bonds, which, due to the (perceived?) lesser risk garner less of a need for returns. The party holding the “equity” tranches take the difference between the underlying and the bonds issued. Essentially these structures allowed a more leveraged return for their equity. To do this, the mismatch between shorter and safer assets was exploited.

Third, there was the S.I.V. issue. This was an issue where some banks were funding longer liabilities with shorter ones and exploiting the difference in rates required for a more senior, safer (again, perceived?) set of bonds issues off of the underlying bonds. Sub-prime mortgage bonds were backing some of these vehicles’ liabilities, thus the problems. Essentially these structures allowed a more leveraged return for their equity. To do this, the mismatch between shorter and safer assets was exploited.

Fourth, there was an issue with overnight liquidity for banks. Here banks would borrow on a shorter time frame to fund liabilities by borrowing overnight. The Fed then lowered the discount window rate to facilitate borrowing because overnight funding had spiked and there was a major shortage of liquidity. Banks borrow overnight to more efficiently fund their balance sheet to match their ever-changing cash needs. To borrow more than they need would be “bad” if they paid interest on too large an amount, this would lower their earnings. By only borrowing overnight banks’ liabilities are minimized, and they maximize the spread between what their assets are paying and what the banks are required to pay to hold all the necessary capital against said assets. This works until liquidity is horded by banks and they can’t fund their liabilities when the current funding comes due. Essentially these structures allowed a more leveraged return for their equity. To do this, the mismatch between shorter liabilities was exploited.

Fifth, the T.O.B. market began to see problems (actually, a post I discovered on a blog I read, Accrued interest–he actually alludes to the same parallels I’m alluding to here)..  This was caused by bond insurers having less capital and the overall (perceived?) credit quality of insured municipal debt securities declining. T.O.B. programs allow an exploitation in rates that arise from municipal debt securities being structured to provide a higher amount of credit support. The enhanced credit support allows bonds to be issued with different rates and different durations from the bonds that back them. Essentially these structures allowed a more leveraged return for their equity. To do this, the mismatch between shorter and safer assets was exploited.

Sixth, the auction-rate securities market began to hit the skids. This audience probably remembers the WSJ article about the not-that-bad situation involving  some rich people. Well, the way those securities work is actually pretty simple. One takes some long term bonds and auctions off bonds, with a shorter maturity, backed by longer bonds. The interest rate required to take on the risk of default or some other risk during the short term of the auction-rate securities is, obviously lower because the risk is (perceived to be?) lower (isn’t it less risk to bet on something defaulting in the next year versus it’s entire life?). Essentially these structures allowed a more leveraged return for their equity. To do this, the mismatch between shorter and safer assets was exploited.

Hmmmmm…  As credit issues begin to build up, I wonder what might be next? Perhaps commercial paper issued by corporations as their credit quality deteriorates? Maybe real-estate holdings funded by shorter term loans mean to “bridge” to full financing?I guess we’ll find out.

My Thoughts on the Cycle (From LBO’s to sub-prime)

February 6, 2008

Wall Street is a funny place. Your friends are almost worse for you than enemies. At the top of the market every deal worked. You would enter into a commitment that might have been aggressive for the market, but the truth of the matter was that in an environment where spreads are tightening (essentially rising prices) the market was subsidizing your poor choices. For those that don’t know how the process works, I’ll go through a sample time-line and try to keep it as generic as possible.

  1. A deal is brought to an investment bank, by a sponsor of some kind or a corporation.
  2. The investment bank bids on some aspect of the deal. For an acquisition or L.B.O. it’s usually a role in the debt.
  3. Banks go out to the market and solicit “color” (information). This is used to figure out what economic terms they should quote for a role in the deal. For example, they might offer to arrange a set of loans at an interest rate of 400 basis points above some benchmark (LIBOR, treasuries, swap rates, etc.) based on the information they received.
  4. A process is run to determine who has offered the most attractive terms.
  5. The firms are offered roles. Some might lead portions of the deal and some might just earn fees. The nuances of the various roles and how they work varies based on the product in question (loans, bonds, equity, etc.).
  6. The terms that banks will be agreeing to if they take a role are given to them–these terms are derived from the terms proposed by the banks themselves (see #3). From what I have seen a role is rarely turned down. Not only that, but any given term offered on the deal might be incrementally worse than the worst proposal drawn up by the banks (an aggressive sponsor, for example, will take conditions or covenants and make them more lax, and then present that set of terms–any bank that doesn’t have access to all proposals will be none the wiser until much later).
  7. Banks accept roles and begin the process to close the deal, due diligence the various points that were represented to them, and documenting everything that has been agreed to already. Banks will also, later in the process, begin their process of distributing whatever risk they have taken on (once again, bonds, loans, etc.) where applicable.

Now take into account the fact that P.E. firms have been paying billions in fees, that the leaders of these P.E. firms have very senior relationships, and investment banks have league table pressures. The fact that investment banks trip over each other to bid for a place in deals, sometimes through the market (and, if you read the prescient piece by Steven Rattner you would know banks even rushed to reprice loans as the market moved in their favor, giving P.E. firms back some of the upside despite the fact that the P.E. firms took no risk). Now you see P.E. firms sticking it back to the banks again. While banks were rushing to give back money and while the secular direction of the market was bailing banks out of bad decisions everyone was making money but P.E. firms were making more than their fair share. Now that the market has stalled and banks are stuck holding lots of inventory and sitting on the losing side of underwater commitments there is nearly no movement o the part of P.E. firms.

Now you see investment banks putting some protection for themselves where they should have had them before (the same way P.E. firms have protected themsevles), but there are still these pressures. You still have banks swallowing their pills for P.E. firms–all while these P.E. firms are doing deals that only work because of the banks. This isn’t a relationship or a partnership. And the question is, how will this affect business going forward? I would imagine there would be more outs built into the legal agreements between banks and sponsors (P.E. firms are often called financial sponsors) now. One would also hope that there would be a very senior understanding that economic flexibility works two ways.

Now, one thing I see all over is how, much like a fractal the same tricks are employed by Wall Street over and over again.  The situation described above is essentially EXACTLY the same way the sub-prime situation occurred. Banks bid on loans that they could profit from during a tightening spread environment because the market would bail them out. I remember when sub-prime loan packages were being bought from originators at 103% of their face value (100 million on loans would sell for 103 million dollars).  And now, just like with L.B.O. debt, the day of reckoning has come. Except here, banks can’t really rely on relationship or even a central entity to bargain with to try to get themselves out of their predicament–their own short-term profit motivation has created the same long-term pain.


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