In the time since I’ve posted last, there have been two major “deals” in the works. One sort of died on the vine and the other has started as of today. I penned the first of what I hope will be many well-received articles over at the Huffington Post. The topic is one that I’ve touched on before, and written pieces that are related to this in the past. This article, though, meshed well with their Obama coverage coordinated to be one year after the election. Now that I’m done “holding off” on writing something until I know what people will want from me, I can start to write here and there regularly again… Sorry for the delay.

Please go check out my inaugural Huffington Post article here.

Yes, that’s right… The guy whose only role, as far as I can tell, is to parrot back gossip, rumors, and “trial balloons” from P.R. people and executives has gone and proved that he is as irrelevant as he seems to be uncomplex. Did you read his attack on Matt Taibbi’s “piece” on Goldman Sachs? Well, I did… and I bled IQ points from doing so. Here’s where Mr. Gasparino shows his inability to reason:

It’s one thing to watch half-literate bloggers in desperate need of attention jump on the Goldman is the root of all evil story; it’s quite another to see respected news organizations with experienced reporters and presumably more experienced editors do it and in the process obscure the fact that Goldman, for all of its sins during the bubble years, was probably the least culpable for the system’s eventual collapse.

(Emphasis mine.)

Oh, and Mr. Gasparino is (highly, highly ironically!) writing this in a section entitled “Blogs and Stories”–since Gasparino’s post/article/whatever falls far short of the reasoned, cogent, logical, and expertise-based sorts of things one gets from the the blogosphere, I’ll let you decide which of these two headings applies to his writing.

Writing a particular piece of drivel and attacking the blogosphere isn’t all that bad in the grand scheme of things–it is, however, a good reason people should stop reading what he says and watching his appearances on air (and people are doing just that). More damning is Mr. Gasparino’s inability to see that he is a major part of the problem. If he went even the slightest bit beyond the drivel he usually passes off as reporting (aforementioned gossip, rumors, and “trial balloons”) he might have been able to educate people to the point where they wouldn’t buy into hyperbole-laden articles. Mr. Taibbi’s job isn’t to be a journalist and provide a fair and dispassionate accounting of the facts–he even says as much:

I’m aware that some people feel that it’s a journalist’s responsibility to “give both sides of the story” and be “even-handed” and “objective.” A person who believes that will naturally find serious flaws with any article like the one I wrote about Goldman. I personally don’t subscribe to that point of view. My feeling is that companies like Goldman Sachs have a virtual monopoly on mainstream-news public relations; for every one reporter  like me, or like far more knowledgeable critics like Tyler Durden, there are a thousand hacks out there willing to pimp Goldman’s viewpoint on things in the front pages and ledes of the major news organizations.

(Emphasis mine.)

(By the way, Mr. Gasparino says what amounts to the same thing: “I have to admit I love to beat up on Goldman; I do it for The Daily Beast and on CNBC every chance I get.”)

Mr. Taibbi’s job is to get page views and tell a story. He even admits that members of the blogosphere (Tyler Durden being a reference to the blog whose traffic has experienced a meteoric rise–Zero Hedge) have a better grasp of whats actually going on than he does. I would hope, for example, that most bloggers wouldn’t make the mistake (I’m being about as charitable as one can be by not calling it “lying” or “misleading” or “taking advantage”) of confusing leverage with VaR as Mr. Taibbi does. Mr. Taibbi, in that same piece, also glosses over technical details of primary dealers of treasury securities (I wonder if he understands bid-to-cover and direct versus indirect) and nuances of equity underwriting (What sort of limits are in place for fees? How does a greenshoe work? What does an investment banker do versus an equity capital markets person? What about a syndicate person?). In his original piece, there is a ton of faulty reasoning and thin (well, mostly non-existent, actually … mostly the reasons for things or support are “because I say so”) evidence for his theories. But, who’s to know? The public knows almost nothing about how the financial system works.

Which brings me back to my original point–Charlie Gasparino is to blame for Matt Taibbi’s drivel. Not solely, obviously, but he is a very public face of a very dumbed-down financial media that is the personification of the phrase, “Couldn’t find his ass with both hands.” If Mr. Gasparino and the financial media can’t report on the markets and financial system reasonably–and instead dumb down their reports, thus helping feed the financial illiteracy of the mainstream public–then he has allowed Matt Taibbi’s piece to gain traction in the minds of the public, not the bloggers. He and his colleagues have completely failed in their charge: to keep the public well-informed when it comes to matters of finance and markets.

If Charlie Gasparino had even the slightest bit of a clue, or if even the most modest degree of intelligence was peeking through his rants and gossip column style of reporting, he might understand that blogosphere should be his friend and best resource. Where else can anyone get a peek into the extremely technical, often changing worlds of trading, banking, finance, etc.? You literally have dozens of people who are giving away their domain expertise for free (anonymous authors–the brave, intrepid, good-looking genius champions of truth and justice that they are [hyperbole included at no extra cost]–don’t even take credit for their work, they are doing it for themsevles and their readers solely!). Mr. Gasparino (and other CNBC personalities whose brains seem to be disconnected during the day to conserve energy–go to the link, but don’t watch the clip, you’ll start spilling IQ points all over the floor) should be looking to these bloggers to help him understand complex issues that it would take years of experience to understand, give him ideas for how to report on an issue and explain the nuances, and even as sources that he can cite to increase the authority of his conclusions.

But, of course, this “get information from where information lives” approach to journalism completely escapes the financial media (I’ve explained how problems like this can be fixed before). Mr. Gasparino prefers, instead, to refer to bloggers as “half-literate” and thinks New York Magazine, because it’s a “respected news organization” (Of course! When I think of the news I think of New York Magazine!), will do a better job than the people in the trenches every day. This is why finance is the reverse of every other major news category I can think of–usually the primary value of the mainstream media is to dig up facts and write complex stories (that show cause and effect or intricate interconnections) while the blogosphere adds a layer of gossip, conjecture, spin, and/or analysis. In finance, the complex picture gets painted by the blogs and the mainstream media reports singular, one-dimensional little tidbits (think, “Chuck Prince gets fired!” or “Goldman Reports profits for this quarter!”). The notable exceptions are some of the detailed timelines published by the WSJ (like Kate Kelly’s three part Bear Stearns article) and a large swathe of the content from Dealbook (Is it a coincidence that Dealbook has bloggers writing for it and contains both the single fact/headline-driven articles as well as detailed analysis and complex reporting? Nope. Although, the reporting done for much of the longer articles isn’t blogger driven.).

In fact, keeping with the clueless theme, Gasparino directly addresses some of Taibbi’s conjecture, attempting to disprove some of the moreimflamatory claims:

Okay, sure, maybe there’s some evidence somewhere proving that the entire regulatory apparatus of the Fed run by an appointee of a Republican president, Ben Bernanke, to the Treasury Department run by a lifelong Republican (Paulson once worked for Richard Nixon) … would drop everything to save Goldman Sachs[.] … But if there is good evidence to that effect, I haven’t seen it. A more plausible explanation for the Goldman bailout via AIG’s bailout (borne out by my reporting for my upcoming book The Sellout) goes something like this: There was panic in Paulson’s office … not because they saw their retirement money tied up in Goldman stock ready to disappear, but because after Lehman fell, the other dominoes would be teetering.

(Emphasis mine.)

Whew! With an expert reporter like Mr. Gasparino on the case (including the reporting he has done for his book), then if he hasn’t seen any evidence, who has? Oh, right, the New York Times:

During the week of the A.I.G. bailout alone, Mr. Paulson and Mr. Blankfein spoke two dozen times, the calendars show, far more frequently than Mr. Paulson did with other Wall Street executives.

On Sept. 17, the day Mr. Paulson secured his waivers, he and Mr. Blankfein spoke five times. Two of the calls occurred before Mr. Paulson’s waivers were granted. [...]

But Mr. Paulson was closely involved in decisions to rescue A.I.G., according to two senior government officials who requested anonymity because the negotiations were supposed to be confidential.

And government ethics specialists say that the timing of Mr. Paulson’s waivers, and the circumstances surrounding it, are troubling. [...]

While that agreement barred him from dealing on specific matters involving Goldman, he spoke with Mr. Blankfein at other pivotal moments in the crisis before receiving [conflict of interest] waivers.

Mr. Paulson’s schedules from 2007 and 2008 show that he spoke with Mr. Blankfein, who was his successor as Goldman’s chief, 26 times before receiving a waiver. [...]

At the height of the financial crisis, Mr. Paulson spoke far more often with Mr. Blankfein than any other executive, according to entries in his calendars. [...]

According to the schedules, Mr. Paulson’s contacts with Mr. Blankfein began even before the height of the crisis last fall. During August 2007, for example, when the market for asset-backed commercial paper was seizing up, Mr. Paulson spoke with Mr. Blankfein 13 times. Mr. Paulson placed 12 of those calls.

By contrast, Mr. Paulson spoke six times that August with Richard S. Fuld Jr. of Lehman, four times with Jamie Dimon of JPMorgan Chase and only twice with John Thain of Merrill Lynch.

Seems like a pretty clear pattern that strikes right at the heart of the matter. I’m sure it was just bad luck for Mr. Gasparino that the one place he tried to move the conversation into a more rational zone, and also the one point he used to show why his upcoming book has any value at all, was the place more professional news outlets actually did some serious reporting and proved him naive. The Times’ piece doesn’t prove beyond a reasonable doubt, conclusively, or to any other standard one would like to use that what Taibbi alleges occurred, but its pretty good evidence that Hank Paulson conducted himself in a way that is questionable ethically. Well, don’t forget that Mr. Gasparino has a better theory in his book–which you can pre-order for $27.99! What’s this magical book about? From the Amazon description:

[Gasparino] shows how and why several of these storied institutions have suffered staggering losses in assets and influence since [2002], triggering the vast financial crisis that is now devastating individual and institutional wallets through the United States and across the globe. Gasparino is known as a dogged reporter who regularly breaks news about Wall Street’s inner workings and who has a direct line into Wall Street’s most prominent dealmakers. His book promises to be one of the first books out of the gate in what will prove to be a crowded market of ‘financial crisis’ books, but his talent for delivering a dramatic narrative and colorful anecdotes and explaining complex financial maneuvers in accessible terms.

(Emphasis mine.)

Actually, instead of spending $27.99 on this book, by the guy who didn’t see any evidence of something the New York Times found significant evidence of (now that its published, maybe he’ll see it … when he reads the Times), you can just read blogs to understand “how and why several of these storied institutions have suffered staggering losses in assets and influence.” You’ll understand it better when you’re done and the information you read has a much, much higher probability of being both correct and complete. Oh, and reading a blog is free…

P.S. Maybe I’ll write a point by point refutation of Taibbi and Gasparino’s remaining arguments at some point… But please don’t think that because the Times found some evidence consistent with what Taibbi alleged that he is correct. Stopped watch and all that.

Yes, I’m alive! I’m terribly sorry for the extended silence, but I’ve had some big changes going on in my personal life and have been out of the loop for a while (honestly, my feed reader needs to start reading itself–I have over 1,000 unread posts when looking at just 4 financial feeds). So, here’s what I haven’t had a chance to post…

1. I totally missed the most recent trainwreck of a P.R. move at Citi. There is so much crap going on around Citi… I really intend to write a post that is essentially a linkfest of Citi material that stitches together the narrative of how Citi got into this mess and how Citi continues to do itself no favors. There was also a completely vapid opinion piece from Charlie Gasperino that said absolutely nothing new, save for one sentence, and then ended with a ridiculous comparison that was clearly meant to generate links. I’m not even going to link to it… It was on the Daily Beast, if you must find it.

2. I haven’t really had the opportunity to comment on the Obama administration’s overhaul of the financial regulatory apparatus. Honestly, it sucks. It doesn’t do much and gives too much power to the Fed. You’d think that after that recent scandal within the ranks of the Fed there would be a political issue with giving it more power. Even more interestingly, all other major initiatives from the Obama administration have been drafted by congress. Here, the white paper came from the Whitehouse itself. That won’t do too much to quiet the critics who are claiming that the Whitehouse is too close to Wall St. Honestly, if one is to use actions instead of words to measure one’s intentions, then it’s hard to point to any evidence that the Obama administration isn’t in the bag for the financial services industry.

3. The Obama administration did an admirable job with G.M. and Chrysler. They were both pulled through bankruptcy, courts affirmed the actions, and there was a minimal disruption in their businesses. Stakeholders were brought to the table, people standing to lose from the bankruptcy, the same people (I use that word loosely–most are institutions) who provided capital to risky enterprises, were forced to take losses, and the U.S.A. now has something it has never had: an auto industry where the U.A.W. has a stake and active interest in the companies that employ its members. Perhaps the lesson, specifically that poorly run firms that need to be saved should cause consequences for the people who caused the problems (both by providing capital and providing inadequate management), will take hold in the financial services sector too–I’m not holding my breath, though.

4. Remember this problem I wrote about? Of course not, that is one of my least popular posts! However, some of the questions are being answered. Specifically, the questions about how and when the government will get rid of its ownership stakes, and at what price, are starting to be filled in. It was rather minor news when firms started paying T.A.R.P. funds back. However, the issue of dealing with warrants the government owns was a thornier issue. Two banks have dealt with this issue–Goldman purchased the securities at a price that gives the taxpayers a 23% return on their investment and JP Morgan decided that it would forgo a negotiated purchase and forced the U.S. Treasury to auction the warrants.

On a side note: From this WSJ article linked to above, its a bit maddening to read this:

The Treasury has rejected the vast majority of valuation proposals from banks, saying the firms are undervaluing what the warrants are worth, these people said. That has prompted complaints from some top executives. [...] James Dimon raised the issue directly with Treasury Secretary Timothy Geithner, disagreeing with some of the valuation methods that the government was using to value the warrants.

(Emphasis mine.)

If I were on the other end of the line, my response would be simple: “Well, Jamie, I agree. The assumptions we use to value securities here at the U.S. government can be, well … off. So, we’ll offer you what you think is fair for the warrants if you’ll pay back the $4.4 billion subsidy we paid when we initially infused your bank with T.A.R.P. funds.” Actually, I probably would have had a meeting with all recipients about it and quoted a very high price for these warrants and declared the terms and prices non-negotiable–does anyone really think that, in the face of executive pay restrictions, these firms wouldn’t have paid whatever it would take to get out from under the governments thumb? As long as one investment banker could come up with assumptions that got the number, they would have paid it. Okay, that’s all for my aside.

5. I’m dreadfully behind on my reading… Seriously. Here’s a list of articles I haven’t yet read, but intend to…

• The Science of Economic Bubbles and Busts — A scientific look at bubbles, specifically the psychology.
• Sheila Bair, FDIC, and the financial crisis — A profile of Sheila Bair. I find the New Yorker profiles very good and nearly impossibly long.
• Rich Harvard, Poor Harvard: Vanity Fair — An interesting look at Harvard and how its fortunes interplay with its endowment and its in-house money manager.
• Prophet Motive — A profile of Nouriel Roubini. My gut tells me he’s a case study in being more lucky than right, but I haven’t read it, so who knows.
• The Way We Live Now – Diminished Returns — A NY Times article whose title makes too much sense to pass up!
• Confessions of a Bailout CEO Wife — As close as I’ll ever get to US Weekly.
• What Does Your Credit-Card Company Know About You? — Ugh. My gut tells me too much. As a Consumerist reader, I think I know what this is, but we’ll see.
• At Geithner’s Treasury, Key Decisions on Hold — An article that got a lot of play as a good case study.
• Paulson’s Complaint — Paulson claiming Lehman didn’t cause the huge problems in the markets and economy that followed its bankruptcy. I don’t buy it.
• The Crisis and How to Deal with It — A weird multi-person article in the New York Review of Books.
• The New York Fed is the most powerful financial institution you’ve never heard of. Look who’s running it — A Slate article by Eliot Spitzer. I admit to not really get the Fed system.
• Tracking Loans Through a Firm That Holds Millions — A look at a servicer, I believe.
• Flawed Credit Ratings Reap Profits as Regulators Fail — Wow. Based on the title, I must have dangerously low blood pressure that needs boosting!
• The formula that felled Wall St — Another look at Gaussian Copula, I think. Felix, also looked at this.
• Peter Orszag and the Obama budget — Another New Yorker profile.
• Geithner, Member and Overseer of Finance Club — A NY Times profile of Tim.
• HMC Tax Concerns Aided Federal Inquiries — Interestingly, an article that got national press, is an investigative piece, and deals with finance from a college newspaper!
• Treasury Chief Tim Geithner Profile –Portfolio profile of Tim. I’ll know everything about him by the end of this list.
• Lewis Testifies U.S. Urged Silence on Deal – I really don’t know about this situation. I want to read up and understand all the details.
• The Wail of the 1% — Honestly, not sure. Talking about the plight of the rich?
• Economic View – Why Creditors Should Suffer, Too — The title makes me want to read this. Confirmation bias, perhaps?
• How Bernanke Staged a Revolution — A profile of Ben Bernanke by the WaPo.
• 5 Ways Companies Breed Incompetence — Just five?
• Ten principles for a Black Swan-proof world — An opinion piece from the FT by Nassim Nicholas Taleb.
• A New Era for Financial Regulation — Megan McArdle looks at the proposed regulatory structure. Honestly, I don’t read her, so I’m skeptical about this piece.
• U.S. Plan to Stem Foreclosures Is Mired in Paper Avalanche — Not sure. One of the longer NY Times pieces.
• Bill Gross of Pimco Is on Treasury’s Speed Dial — A profile of Pimco’s role in fixing the financial problems, conflicts, etc.
• Congress Helped Banks Defang Key Rule — Another fix for low blood pressure.
• Timothy Geithner and Lawrence Summers – The Case for Financial Regulatory Reform — OpEd by Geithner and Summers.
• SEC Chief Strives To Rebuild Regulator — An article on the problems at the S.E.C.
• A Daring Trade Has Wall Street Seething — A writeup of how a small firm worked the system to make money. Should be interesting.
• President’s Economic Circle Keeps Tensions at a Simmer — An interesting case study on how Obama’s economic team works.
• Back to Business – Banks Dig In to Resist New Limits on Derivatives — Hey! We’re paying banks to spend money to lobby ourselves to not regulate them so they can profit off of our money! Sweet!

I hope to get more time to post in the coming days. Also, I am toying with the idea of writing more frequent, much shorter posts. On the order of a paragraph where I just toss out a thought. Not really my style, but maybe it would be good. Feedback appreciated.

Starting with the little spat between John Stewart and CNBC I started to think seriously about how the financial news stations are extremely broken. Now, I’ve mused on specific parts of this equation before. However, I’ve been writing this post, a more complete look, for a while. So, imagine my surprise when Barry Ritholtz beat me to the punch! Barry’s look, though, seems to focus more on the “low-hanging fruit” when it comes to improving CNBC. Personally, I think there is a massive overhaul needed. So, instead of taking the same approach as Barry (telling a network how to improve itself) I’ll focus on describing what my ideal financial news network would look like.

1. Make no buy/sell recommendations. Honestly, the shameless self-promoters that  go on CNBC are quite often wrong. There is no accountability for recommendations–obviously, the logistical issues are both important and daunting. However, there is a much larger problem that is most observable with Jim Cramer. I have no doubt Mr. Cramer is intelligent, just as I have no doubt that his show is useless drivel–he needs to make so many recommendations just to fill his airtime that no one ever sees his performance, CNBC doesn’t track it, and all the studies that look at his recommendations need to make huge assumptions. But, the easiest explanation of why recommendations are bad comes from a post entitled Lawyers vs. Detectives. Clearly, also, there doesn’t exist the air time or continuity to track and update recommendations correctly–the logisitical issues I mentioned earlier. And, to be frank, any idiot can just dump ticker symbols onto the screen and say a few sentences about why those ticker symbols are good or bad… and be completely wrong or stupid. The point of a good finance network should be to bring reporting and analysis to light. (Further evidence: look at Barron’s experts who, as a whole, underperform passive indices. And they are tracked and asked for analysis of their picks regularly.)

2. Emphasize investiagtive journalism. Financially literate, intelligent people can add a whole lot of value when it comes to explaining and digging into economic and financial stories. Think Kate Kelly and her three part tick tock of the Bear Stearns situation as a good example. Think of the deep look into the mortgage industry that NPR did. Think of the detailed profiles of various individuals at the center of the finance world. Clearly, there is a lot of value to be added merely by going beyond the puff piece. Right now what people get 90% of the time when it comes to finance reporting pertains to what the Dow Jones did or is doing for the day. Guess what? When stocks go up, it’s because there are more buyers than sellers. When they go down, vica versa. Trying to divine more than that from the market move on a given day is as useless and surface as it often is wrong.

3. Hire experts and not personalities. I’ll tell you a secret… Maria Bartiromo adds no value if you know anything about markets and finance to start with. I’ve seen her provide an outlet for executives to provide narrative versions of their press releases several times. There is never a question I’ve heard her ask that was probing or had an answer I didn’t already know from reading the NY Times or the WSJ. She doesn’t even understand journalism very well! The entire lineup of attractive and vacuous seat-warmers add no value. Remember this little episode with Fox Business news? Now, that’s a little different because it was live, breaking news. However, a thinking person probably would have stopped before talking about how great a move it was for Apple to buy AMD, despite the fact that such a purchase would have been “WTF?!” move for Apple–the current anchors just talk to talk. I even remember a CNBC anchor pulling up a guest’s chart on a segment (the network had been hyping this segment for a few hours–theoretically the anchor had prepared for it) and asked why, if things were so dire, the chart showed such a strong rally/uptrend. Well, the chart was showing spreads for a certain class of bonds–and, as we all know, when yield goes up, price goes down! She was anchoring a segment on fixed income (and had already been chatting about the topic for a few minutes!) and still couldn’t figure out what was going on in a very simple chart… Surely there’s room for improvement!

The model, though, for financial news anchors should really be an engaged, credentialed moderator. Thomas Keene, honestly, is a great example of this. I don’t catch his show (or podcast) as often as I would like, but whenever I do it’s clear he’s intelligent, familiar with the underlying issues, and that he views his job as getting his guests to make their case as well as expose the “other side” of the argument. A network should be able to create a lineup of intellectual experts (with relationships and enough personality to be interesting) in equity markets, corporate credit/finance, economics, macroeconomics, currencies, commodities, personal finance, etc. Networks haven’t seemed to figure out that, unlike human interest stories and traditional news, having some domain expertise is vital to being able to ask the right questions and get the underlying reasoning out into the open.

4. Go beyond soundbites and short on-air segments. I think finance is much more complicated than normal news, in the same way that political news usually is more complicated: there are lots of underlying dynamics, complex rules, and large parts of the process are hidden from view and established through precedent. Unlike a plane crash, terrorist attack, or story about some zany celebrity antic, financial news that focuses on the “what” instead of the “why” is dull, uninteresting, and useless. This is why financial news, in the first place, tries to explain what’s going on. So, it should only be natural that financial news, if it needs the “why” to be useful and is more complicated than garden-variety news, needs to allocate more than a few minutes to a given issue. No one is going to understand what’s going on with commercial real estate in five minutes. CDOs can’t even be explained in ten minutes, let alone covered in the context of the credit crisis in that time.

How can a financial news network, then, ensure that there is enough depth to a story or segment? Well, time is obviously a big piece of the equation. To revisit a prior example, Thomas Keene usually has guests on for 30+ minutes. However, media and a command of visual aides and interactive media online is also important. Some of the most compelling explanations of how CDOs work and different aspects of the credit crisis are graphics. Further, finance is based on data–models, data highlighted in charts and stories, and other material should all be made available online.

5. Embrace new media. As far as I can tell, no financial news station has a strong online presence. If a strong group of credentialed experts is the backbone of the network’s on-air talent (see #3 above) then they should have deeper, more valuable insights than what they can cover on the air. These thoughts should be blogged about, tweeted, and whatever else to make them as accessible as possible–more and more the “conversation” is online and to join it one must have their thoughts online. The NY Times does a good job at this–their columnists and reporters write all sorts of blog entries ranging from deep, researched pieces to random musings and clever one-line arguments.

Further, with my idealized network, all the content from on-air segments would be put on YouTube and made available to whomever wants to link or embed it. Openness and access would be key strategies for the network. A part of this is also making the on-air personalities and others who contribute regularly interact with the public as much as possible (currently, Twitter is a great medium for this).

6. Emphasize standards–make objectivity, fairness, and accountability the network’s core values. Barry talked about this in his list:

7.  Fact Check: An awful lot of things on air get stated with authority and confidence. Much of them are little more than junk or pop myths. Why is it that the more dubious a proposition is, the greater the confidence the speaker seems to muster? Consider fact checking as much of the statements that are made on air as possible, and making frequent corrections.

Now, this ties in with some of what I’ve said above. However, my point goes beyond this. Executives should not want to go one my idealized network when they need to “get out a statement”–the “narrative press release” as an interview is useless and doesn’t hold the subject of the interview accountable for their words. Similarly, when a guest comes on and makes an assertion that is incorrect it needs to be challenged at the time and corrected later–I clearly take a harder stance on this issue than Barry does. If people will be making their investment decisions based on information presented on the network and then they need to trust the network–viewers need to know the network strives to prove correct information and puts every effort into doing just that. Also, the rules of “journalistic engagement” for the network (things like policies on anonymous sourcing) should be public.

7. Make education a pillar of the network. Finance and markets, as I describe in multiples places above, are complicated and often counter-intuitive–a fair amount is “inside baseball.” Having a section of the website and some on-air time dedicated to explaining both terms and important but obscure facts and market dynamics is an important service. Simple things, like bond math, are important and static–these concepts (that subtly undergird all other topics–remember the anecdote about the misread chart above) should be revisited whenever absolutely necessary while being available at all times.

If these simple pieces were all followed, I believe there would exist a simple to follow, engaging financial network that would add a ton of value where there currently is a void. Then, maybe, the other networks would need to follow suit. I won’t hold my breath.

Recently, Felix Salmon, Clusterstock, and others have been mentioning an essay from the Hoover Institute about the financial crisis. Now, I haven’t yet linked to the essay in question… I will, but only after I’ve said some thing about it.

I was on the front lines of the securitization boom. I saw everything that happened and am intimately familiar with how one particular bank, and more generally familiar with many banks’, approach to these businesses. I think that there are no words that adequately describes how utterly stupid it is that there is still a “debate” going on surrounding banks and their roles in the financial crisis. There are no unknowns. People have been blogging, writing, and talking about what happened ad naseum. It’s part of the public record. Whomever the author of this essay is (I’m sure I’ll be berated for not knowing him like I was for not knowing Santelli — a complete idiot who has no place in a public conversation whose requisites are either truth or the least amount of intellectual heft), unless it’s writing was an excesses in theoretical reasoning about a parallel universe, it’s a sure sign they don’t what they are talking about that they make some of the points in the essay. Let’s start taking it apart so we can all get on with our day.

For instance, it isn’t true that Wall Street made these mortgage securities just to dump them on them the proverbial greater fool, or that the disaster was wrought by Wall Street firms irresponsibly selling investment products they knew or should have known were destined to blow up. On the contrary, Merrill Lynch retained a great portion of the subprime mortgage securities for its own portfolio (it ended up selling some to a hedge fund for 22 cents on the dollar). Citigroup retained vast holdings in its so-called structured investment vehicles. Holdings of these securities, in funds in which their own employees personally participated, brought down Bear Stearns and Lehman Brothers. AIG, once one of the world’s most admired corporations, made perhaps the biggest bet of all, writing insurance contracts against the potential default of these products.

So Wall Street can hardly be accused of failing to eat its own dog food. It did not peddle to others an investment product that it was unwilling to consume in vast quantities itself.

(Emphasis mine.)

Initial premise fail. I had a hard time finding the part to emphasize since it’s all so utterly and completely wrong. Since I saw everything firsthand, let me be unequivocal about my remarks: the entire point of the securitization business was to sell risk. I challenge anyone to find an employee of a bank who says otherwise. This claim, that “it isn’t true that Wall Street made these mortgage securities just to dump them on them the proverbial greater fool” is proven totally false. There’s a reason the biggest losers in this past downturn were the biggest winners in the “league tables” for years running. As a matter of fact, there’s a reason that league tables, and not some other measure, were a yardstick for success in the first place! League tables track transaction volume–do I really need to point out that one doesn’t  judge themselves by transaction volume when their goal isn’t to merely sell/transact?

In fact, the magnitude of writedowns by the very firms mentioned (Merrill and Citi) relative to the original value of these investments imply that a vast, vast majority of the holdings were or were derived from the more shoddily underwritten mortgages underwritten in late 2006, 2007, and early 2008. In fact, looking at ABX trading levels, as of yesterday’s closing, shows the relative quality of these mortgages and makes my point. AAA’s from 2007 (series 1 and 2) trading for 25-26 cents on the dollar and AAA’s from early 2006 trading at roughly 67 cents on the dollar. The relative levels are what’s important. Why would Merrill be selling it’s product for 22 cents on the dollar if the market level is so much higher (obviously the sale occurred a few months ago, but the “zip code” is still the same)? This is a great piece of evidence that banks are merely left holding the crap they couldn’t sell when the music stopped.

Now, onto the next stop on the “How wrong can you get it?” tour.

It isn’t true, either, that Wall Street manufactured these securities as a purblind bet that home prices only go up. The securitizations had been explicitly designed with the prospect of large numbers of defaults in mind — hence the engineering of subordinate tranches designed to protect the senior tranches from those defaults that occurred.

Completely incorrect. Several people who were very senior in these businesses told me that the worst case scenario we would ever see was, perhaps, home prices being flat for a few years. I never, not once, saw anyone run any scenarios with home price depreciation. Now, this being subprime, it was always assumed that individuals refinancing during the lowest interest rate period would start to default when both (a) rates were higher and (b) their interest rates reset. [Aside: Take note that this implicitly shows that people running these businesses knew that people were taking out loans they couldn't afford.] Note that the creation of subordinate tranches, which were cut to exactly match certain ratings categories, was to (1) fuel the CDO market with product (obviously CDO’s were driven by the underlying’s ratings and were model based), (2) allow AAA buyers, including Fannie and Freddie, an excuse to buy bonds (safety!), and (3) maximize the economics of the execution/sale/securitization. If there were any reasons for tranches to be created, it had absolutely nothing to do with home prices or defaults.

Further, I would claim that there wasn’t even this level of detail applied to any analysis. We’ve seen the levels of model error that are introduced when one tries to be scientific about predictions. As I was told  many times, “If we did business based on what the models tell us we’d do no business.” Being a quant, this always made me nervous. In retrospect, I’m glad my instincts were so attuned to reality.

As a matter of fact, most of the effort wasn’t on figuring out how to make money if things go bad or protect against downside risks, but rather most time and energy was spent reverse engineering other firm’s assumptions. Senior people would always say to me, “Look, we have to do trades to make money. We buy product and sell it off–there’s a market for securities and we buy loans based on those levels–at market levels.” These statements alone show how singularly minded these executives (I hate that term for senior people) and businesses were. The litmus test for doing risky deals wasn’t ever “Would we own these?” it was “Can we sell all the risk?”

But wait, there’s more…

Nor is it plausible that all concerned were simply mesmerized by, or cynically exploitive of, the willingness of rating agencies to stamp Triple-A on these securities. Wall Street firms knew what the underlying dog food consisted of, regardless of what rating was stamped on it. As noted, they willingly bet their firm’s money on it, and their own personal money on it, in addition to selling it to outsiders.

One needs the “willingly bet [their own] money on it” part to be true to make this argument. I know exactly what people would say, “We provide a service. We aggregate loans, create bonds, get those bonds rated, and sell them at the levels the market dictates. It isn’t our place to decide if our customers are making a good or bad investment decision.” I know it’s redundant with a lot of the points above, but that’s life–the underlying principles show up everywhere. And, honestly, it’s the perfect defense for, “How did you ever think this made sense?”

And, the last annoying bit I read and take issue with…

Nor is it true that Wall Street executives and CEOs had insufficient “skin in the game,” so that “perverse” compensation incentives created the mess. That story also does not pan out. Individuals, it’s true, were paid sizeable bonuses in the years in which the securities were created and sold.

[...]

Richard Fuld, of failed Lehman Brothers, saw his net worth reduced by at least a hundred million dollars. James Cayne of Bear Stearns was reported to have lost nearly a billion dollars in a matter of a few months. AIG’s Hank Greenberg, who remained a giant shareholder despite being removed from the firm he built by New York Attorney General Eliot Spitzer in 2005, lost perhaps $2 billion. Thousands of lower-downs at these firms, those who worked in the mortgage securities departments and those who didn’t, also saw much wealth devastated by the subprime debacle and its aftermath.

Wow. Dick Fuld, who got $500 million, had his net worth reduced by $100 million? That’s your defense? And, to be honest, if you can’t gin up this discussion, then what can you gin up? The very nature of this debate is that all of these figures are unverifiable. James Cayne was reported to have lost nearly a billion dollars? Thanks, but what’s your evidence? The nature of rich people is that they hide their wealth, they diversify, and they skirt rules. So, sales of stock get fancy names like prepaid variable forwards. Show me their bank statements–even silly arguments need a tad of evidence, right?

Honestly, at this point I stopped reading. No point in going any further. So, now that you know how little regard for that which is already known and on the record this piece of fiction is, I’ll link to it…

Here ya go.

Although, Felix does a great job of taking this piece down too (links above)… Although, he’s a bit less combative in his tone.

Well, we can all rest assured that H.R. 627, the Credit Cardholders’ Bill of Rights Act of 2009, will indeed pass. I’ve been a huge advocate of strengthening consumer protection in the past, so this is a welcomed change.  However, I’m worried that legislators have managed to put restrictions and requirements on credit card companies without taking the last step: making them ineligible to be waived in boiler-plate language. Or, more importantly, the difference between “opt out” and “opt in” … From the text of the bill:

‘(k) Opt-in Required for Over-the-Limit Transactions if Fees Are Imposed-

‘(1) IN GENERAL- In the case of any credit card account under an open end consumer credit plan under which an over-the-limit fee may be imposed by the creditor for any extension of credit in excess of the amount of credit authorized to be extended under such account, no such fee shall be charged, unless the consumer has expressly elected to permit the creditor, with respect to such account, to complete transactions involving the extension of credit under such account in excess of the amount of credit authorized.

‘(2) DISCLOSURE BY CREDITOR- No election by a consumer under paragraph (1) shall take effect unless the consumer, before making such election, received a notice from the creditor of any over-the-limit fee in the form and manner, and at the time, determined by the Board. If the consumer makes the election referred to in paragraph (1), the creditor shall provide notice to the consumer of the right to revoke the election, in the form prescribed by the Board, in any periodic statement that includes notice of the imposition of an over-the-limit fee during the period covered by the statement.

‘(3) FORM OF ELECTION- A consumer may make or revoke the election referred to in paragraph (1) orally, electronically, or in writing, pursuant to regulations prescribed by the Board. The Board shall prescribe regulations to ensure that the same options are available for both making and revoking such election.

‘(4) TIME OF ELECTION- A consumer may make the election referred to in paragraph (1) at any time, and such election shall be effective until the election is revoked in the manner prescribed under paragraph (3).

(Emphasis mine.)

Now, you’ll notice that any election remains in force until one revokes it. Also, you’ll notice that there are periodic disclosure requirements. For educated consumers (for example, readers of The Consumerist or the Wall St. Journal’s personal finance blog “The Wallet”) this should sound familiar.  It’s well established that credit cards already contain language describing how they treat information they collect on you–most sell or share this information. As this FDIC page says, though, you can usually opt out. Raise your hand if you’ve ever, in all your time on this round ball of dirt, seen how to opt out or been told of this ability by anyone (other than me, just now). If more than 0.5% of you are raising your hand, there are liars galore reading. Now, opting out on those particular issue is a different animal–there are lots of forms of information sharing you cannot opt out of. In fact, credit bureaus can sell your information too. (Wouldn’t it be nice if this legislation fixed these practices as well?) Despite these differences, the point remains that opt in protections can be abused and aren’t really protections at all. As a matter of fact, it would be nice if we saw protections that were non–waive-able.

Just goes to show that, even when considering laws strengthening consumers’ protection against abusive practices, it pays to read the fine print.

As the results of the stress test start leaking out slowly, it’s a fun exercise to make some educated guesses/predictions about what the future holds and take note of pertinent facts. As we’ve discussed before, there is a lot to take issue with when considering the results of the stress test at all, especially given the added layers of uncertainty stemming form the limited information provided in the scenarios. So, without further delay, let’s get started.

1. The baseline scenario will prove wholly inadequate as a “stress test.” Please, follow along with me as I read from the methodology (pdf).  I’ll start with the most egregious and reckless component of the mis-named baseline scenario (I would rename it the, “if payer works” scenario) : what I will refer to as “the dreaded footnote six.” From the document:

As noted above, BHCs [(Bank Holding Companies, or the firms being stress tested)] with trading account assets exceeding $100 billion as of December 31, 2008 were asked to provide projections of trading related losses for the more adverse scenario, including losses from counterparty credit risk exposures, including potential counterparty defaults, and credit valuation adjustments taken against exposures to counterparties whose probability of default would be expected to increase in the adverse scenario.(6)

[...]

(6) Under the baseline scenario, BHCs were instructed to assume no further losses beyond current marks.

(Emphasis mine.)

Holy <expletive>! In what alternate/parallel/baby/branching universe is this indicative of anything at all? Assume no further losses beyond current marks? Why not assume everything returns to par? Oh, well, that actually was a pretty valid assumption for the baseline scenario. From the document:

New FASB guidance on fair value measurements and impairments was issued on April 9, 2009, after the commencement of the [stress test].  For the baseline scenario supervisors considered firms’ resubmissions that incorporated the new guidance.

(Emphasis mine.)

Thank goodness! I was worried that the “if prayer works” scenario might have some parts that were worth looking at. Thankfully, for troubled banks, I can skip this entire section. (Confidence: 99.9999%)

2. Trading losses will be significantly understated across all five institutions that will need to report them. First, only institutions with over $100 billion in trading assets were asked to stress their trading positions. Second, from the section on “Trading Portfolio Losses” from the document:

Losses in the trading portfolio were evaluated by applying market stress factors … based on the actual market movements that occurred over the stress horizon (June 30 to December 31, 2008).

(Emphasis mine.)

Okay, well, that seems reasonable, right? Hmmmm… Let’s take a look. Here is what some indicative spread movements for fixed income products looked like January 9th of 2009, according to Markit (who has made it nearly impossible to find historical data for their indices, so I’m resorting to cutting and pasting images directly–all images are from their site):

(Click on the picture for a larger version.)

Well, looks like a big move is taken into account by using this time horizon. Clearly this should provide a reasonable benchmark for the stress test results, right? Well, maybe not.

(Click on the picture for a larger version.)

Yes, that’s right, we’ve undergone, for sub-prime securities a massive widening during 2009 already. Also, as far as I can tell, the tests are being run starting from the December 2008 balance sheet for each company. So, if I’m correct, for the harsher scenario, trading losses will be taken on December 2008 trading positions using December 2008 prices and applying June 2008 to December 2008 market movements. For sub-prime, it seems pretty clear that most securities would be written up (June 2008 Spread: ~200, December 2008 Spread: ~1000, Delta: ~800, Current Spread: ~2600, December 2008 to Today Delta: ~1600, Result: firms would take, from December 2008 levels, half the markdown they have already taken).

Also, it should be a shock to absolutely no one that most trading assets will undergo a lagged version of this same decline. Commercial mortgages and corporate securities rely on how firms actually perform. Consumer-facing firms, as unemployment rises, the economy worsens and consumption declines, and consumers default, will see a lagged deterioration that will appear in corporate defaults and small businesses shuttering–both of these will lead to commercial mortgages souring.  Indeed we’ve seen Moody’s benchmark report on commercial real estate register a massive deterioration in fundamentals. That doesn’t even take into account large, exogenous events in the sector. Likewise, we see consistently dire predictions in corporate credit research reports that only point to rising defaults 2009 and 2010.

In short, for all securities, it seems clear that using data from 2H2008 and applying those movements to December 2008 balance sheets should produce conservative, if not ridiculously understated loss assumptions. (Confidence: 90%)

3. Bank of America will have to go back to the government. This, likely, will be the end of Ken Lewis. It’s not at all clear that Bank of America even understands what’s going on. First, if I’m correctly reading Bank of America’s first quarter earnings information, the firm has around $69 billion in tangible common equity. Also, it should be noted that the FT is reporting that Bank of America has to raise nearly $34 billion.  Now, with all this in mind, let’s trace some totally nonsensical statements that, unlike any other examples in recent memory, were not attributed to anonymous sources (from the NYT article cited above):

The government has told Bank of America it needs $33.9 billion in capital to withstand any worsening of the economic downturn, according to an executive at the bank. [...]

But J. Steele Alphin, the bank’s chief administrative officer, said Bank of America would have plenty of options to raise the capital on its own before it would have to convert any of the taxpayer money into common stock. [...]

“We’re not happy about it because it’s still a big number,” Mr. Alphin said. “We think it should be a bit less at the end of the day.” [...]

Regulators have told the banks that the common shares would bolster their “tangible common equity,” a measure of capital that places greater emphasis on the resources that a bank has at its disposal than the more traditional measure of “Tier 1” capital. [...]

Mr. Alphin noted that the $34 billion figure is well below the $45 billion in capital that the government has already allocated to the bank, although he said the bank has plenty of options to raise the capital on its own.

“There are several ways to deal with this,” Mr. Alphin said. “The company is very healthy.”

Bank executives estimate that the company will generate $30 billion a year in income, once a normal environment returns. [...]

Mr. Alphin said since the government figure is less than the $45 billion provided to Bank of America, the bank will now start looking at ways of repaying the $11 billion difference over time to the government.

(Emphasis mine.)

Right around the time you read the first bolded statement, you should have started to become dizzy and pass out. When you came to, you saw that the chief administrative officer, who I doubt was supposed to speak on this matter (especially in advance of the actual results), saying that a bank with $69 billion in capital would be refunding $11 billion of the $45 billion  in capital it has already received because they only need $34 billion in capital total. Huh? Nevermind that the Times should have caught this odd discrepancy, but if this is the P.R. face the bank wants to put on, they are screwed.

Now, trying to deal with what little substance there is in the article, along with the FT piece, it seems pretty clear that, if Bank of America needs $34 billion in additional capital, there is no way to get it without converting preferred shares to common shares. There is mention of raising $8 billion from a sale of a stake in the China Construction Bank (why are they selling things if they are net positive $11 billion, I don’t know). That leaves $26 billion. Well, I’m glad that “once a normal environment returns” Bank of America can generate $30 billion in income (Does all of that fall to T.C.E.? I doubt it, but I have no idea). However, over the past four quarters, Bank of America has added just $17 billion in capital… I will remind everyone that this timeframe spans both T.A.R.P. and an additional $45 billion in capital being injected into the flailing bank. Also, who is going to buy into a Bank of America equity offering now? Especially $26 billion of equity! If a troubled bank can raise this amount of equity in the current environment, then the credit crisis is over! Rejoice!

I just don’t see how Bank of America can fill this hole and not get the government to “bail it out” with a conversion. The fact that Bank of America argued the results of the test, frankly, bolsters this point of view. Further, this has been talked about as an event that requires a management change, hence my comment on Lewis.  (Confidence: 80% that the government has to convert to get Bank of America to “well capitalized” status)

Notes/Odds and Ends:

1. I have no idea what happened with the NY Times story about the results of the “Stress Test.” The WSJ and FT are on the same page, but there could be something subtle that I’m misunderstanding or not picking up correctly. Absent this, my comments stand. (Also, if might have been mean.unfair of me to pick on the content of that article.)

2. The next phases of the credit crisis are likely to stress bank balance sheets a lot more. The average bank doesn’t have huge trading books. However, they do have consumer-facing loan and credit products in addition to corporate loans and real estate exposure. In the coming months, we’ll see an increase in credit card delinquencies. Following that, we’ll see more consumer defaults and corporations’ bottom line being hurt from the declining fundamentals of the consumer balance sheet. This will cause corporate defaults. Corporate defaults and consumer defaults will cause commercial real estate to decline as well. The chain of events is just beginning. Which leads me to…

3. Banks will be stuck, unable to lend, for a long time. I owe John Hempton for this insight. In short, originations require capital. Capital, as we see, is in short supply and needed to cover losses for the foreseeable future. Hence, with a huge pipeline of losses developing and banks already in need of capital, there is likely not going to be any other lending going on for a while. This means banks’ ability to generate more revenue/earnings is going to be severely handicapped as sour loans make up a larger and larger percentage of their portfolios.

4. From what I’ve read, it seems that the actual Citi number, for capital to be raised, is between $6 billion and $10 billion. This puts their capital needs at $15 billion to $19 billion, since they are selling assets to raise around $9 billion, which is counted when considering the amount of capital that needs to be raised (according to various news stories). Interestingly, this is 44% to 55% of Bank of America’s needed capital. This paints a very different picture of the relative health of these two firms than the “common wisdom” does. Granted, this includes a partial conversion of Citi’s preferred equity to common equity.

5. I see a huge correlation between under-performing portfolios and a bank trying to negotiate it’s required capital lower by “appealing” the stress test’s assessment of likely losses in both the baseline and adverse scenarios. As I’ve talked about before, not all portfolio performance is created equal. Citi has seen an increasing (and accelerating) trend in delinquencies while JP Morgan has seen it’s portfolio stabilize. So, for the less-healthy banks to argue their losses are overstated by regulators, they are doubly wrong. It’ll be interesting to see how this plays out–for example, if JP Morgan’s credit card portfolio assumes better or worse performance than Citi and Bank of America.

Hey, I wanted to let you, my loyal readers, know that I guest posted over at Clusterstock. The post, entitled “Investment Bank Scorecard” is my take on this past quarter as a whole. I think it’s worth clicking over and taking a look. I’d sum it up here, but, in all honesty, the value is in the nuances and small insights more than the general thesis.

Also, here is the chart attached to that post, in its orginal form.

There is a meme (did you know that word was invented by Richard Dawkins?) going around the blogosphere that, in essence, says Geithner doesn’t have the right to prevent T.A.R.P. repayment, even if no fresh capital is raised. This is incorrect. From the Goldman Sachs T.A.R.P. agreements [pdf!] governing the capital infusion (it’s hidden on the site, but there!):

(Emphasis [yes, that's the green underlining] mine.)

Seems, then, that it’s pretty clear. Whole or partial payments, once allowed by a regulator, require fresh equity raised from a “Qualified Equity Offering.” This is a defined term, and the document defines it as follows:

So, it seems pretty cleat that there are conditions. Now, maybe these aren’t the systemic considerations, but that’s likely why the regulatory approval is required, especially in conjunction with the “stress test,” which we’ve discussed here at length.

Well, Citi reported earnings this past week. And, as many of you know, there are a few reasons you’ve heard to be skeptical that this was any sort of good news. However, there are a few reasons you probably haven’t heard… (oh, and my past issues on poor disclosure are just as annoying here)

On Revenue Generation: First, here are some numbers from Citi’s earnings report and presentation, Goldman’s earnings report, and JP Morgan’s earnings report:

These numbers should bother Citi shareholders. Ignoring the 1Q08 numbers, Citi–whose global business is much larger and much more diverse than it’s rivals–generates no more, if not slightly less, revenue than the domestically focused JP Morgan and much, much less than Goldman. But it gets worse. Goldman’s balance sheet was $925 billion vs. Citi’s $1.06 trillion in assets within it’s investment banking businesses, roughly 10% larger.  I’d compare JP Morgan, but they provide a shamefully small amount of information. As an entire franchise, however, Citi was able to generate their headline number: $24.8 billion in revenue, on assets of $1.822 trillion. JP Morgan, as a whole, was able to generate $26.9 billion, on assets of $2.079 trillion. JP Morgan, then is 14% larger, by assets, and generstes 8% higher revenue.

These numbers should be disconcerting to Citi, it’s no better at revenue generation than it’s rivals, despite having a larger business in higher growth, higher margin markets. Further, in an environment rife with opportunity (Goldman’s results support this view, and anecdotal support is strong), Citi was totally unable to leverage any aspect of it’s business to get standout results… and we’re only talking about revenue! Forget it’s cost issues, impairments and other charges as it disposes assets, etc.

On The Magical Disappearing Writedowns: Even more amazing is the lack of writedowns. However, this isn’t because there aren’t any. JP Morgan had writedowns of, approximately, $900 million (hard to tell, because they disclose little in the way of details). Goldman had approximately $2 billion in writedowns (half from mortgages). Citi topped these with $3.5 billion in writedowns on sub-prime alone (although they claim only $2.2 billion in writedowns, which seems inconsistent). But, that isn’t close to the whole story. Last quarter, in what I could find almost no commentary on during the last conference call and almost nothing written about in filings or press releases, Citi moved $64 billion in assets from the “Available-for-sale and non-marketable equity securities” line item to the “Held-to-maturity” line item. In fact, $10.6 billion of the $12.5 billion in Alt-A mortgage exposure is in these, non–mark-to-market accounts. There was only $500 million in writedowns on this entire portfolio, surprise! Oh, and the non–mark-to-market accounts carry prices that are 11 points higher (58% of face versus 47% of face). What other crap is hiding from the light? $16.1 billion out of $16.2 billion total in S.I.V. exposure, $5.6 billion out of $8.5 billion total in Auction Rate Securities exposure, $8.4 billion out of $9.5 billion total in “Highly Leveraged Finance Commitments,” and, seemingly, $25.8 billion out of $36.1 billion in commercial real estate (hard to tell because their numbers aren’t clear), are all sitting in accounts that are no longer subject to writedowns based on fluctuations in market value, unlike their competitors. These are mostly assets managed off the trading desk, but marked according to different rules than traded assets. If one doesn’t have to mark their assets, then having no writedowns makes sense.

On The Not-so-friendly Trend: This is a situation where, I believe, the graphs speak for themselves.

Do any of these graphs look like things have turned the corner? Honestly, these numbers don’t even look like they are decelerating! Compare this with the (relatively few) graphs provided by JP Morgan.

These aren’t directly comparable, as the categories don’t correspond to one another, and JP Morgan uses the more conservative 30-day delinquent instead of Citi’s 90+-day delinquent numbers. However, JP Morgan’s portfolio’s performance seems to be leveling out and even improving (with the possible exception of “Prime Mortgages”). Clearly, the pictures being painted of the future are very different for these institutions.

On the Stuff You Know About: I’ll be honest, this business about Citi benefiting from it’s own credit deterioration was confusing. Specifically, there is more going on when Citi refers to “credit value adjustments” than just profiting from it’s own Cittieness. However, Heidi Moore, of Deal Journal fame helped set me straight on this–the other things going on are dwarfed by the benefit I just mentioned. Here’s the relevant graphic from the earnings presentation:

And, via Seeking Alpha’s Transcript, the comments from Ned Kelly that accompanied this slide:

Slide five is a chart similar to one that we showed last quarter which shows the movement in corporate credit spreads since the end of 2007. During the quarter our bond spreads widened and we recorded $180 million net gain on the value of our own debt for which we’ve elected the fair value option. On our non-monoline derivative positions counterparty CDS spreads actually narrowed slightly which created a small gain on a derivative asset positions.

Our own CDS spreads widened significantly which created substantial gain on our derivative liability positions. This resulted in a $2.7 billion net mark to market gain. We’ve shown on the slide the five-year bond spreads for illustrative purposes. CVA on our own fair value debt is calculated by weighting the spread movements of the various bond tenors corresponding to the average tenors of debt maturities in our debt portfolio. The debt portfolio for which we’ve elected the fair value options is more heavily weighted towards shorter tenures.

Notice that Citi’s debt showed a small gain, but it’s derivatives saw a large gain (the additional $166 million in gains related to derivatives was due to the credit of it’s counterparties improving). Why is this? Well, notice the huge jump in Citi’s CDS spread over this time period versus cash bonds, which were relatively unchanged. Now, from Citi’s 2008 10-K:

CVA Methodology

SFAS 157 requires that Citi’s own credit risk be considered in determining the market value of any Citi liability carried at fair value. These liabilities include derivative instruments as well as debt and other liabilities for which the fair-value option was elected. The credit valuation adjustment (CVA) is recognized on the balance sheet as a reduction in the associated liability to arrive at the fair value (carrying value) of the liability.

Citi has historically used its credit spreads observed in the credit default swap (CDS) market to estimate the market value of these liabilities. Beginning in September 2008, Citi’s CDS spread and credit spreads observed in the bond market (cash spreads) diverged from each other and from their historical relationship. For example, the three-year CDS spread narrowed from 315 basis points (bps) on September 30, 2008, to 202 bps on December 31, 2008, while the three-year cash spread widened from 430 bps to 490 bps over the same time period. Due to the persistence and significance of this divergence during the fourth quarter, management determined that such a pattern may not be temporary and that using cash spreads would be more relevant to the valuation of debt instruments (whether issued as liabilities or purchased as assets). Therefore, Citi changed its method of estimating the market value of liabilities for which the fair-value option was elected to incorporate Citi’s cash spreads. (CDS spreads continue to be used to calculate the CVA for derivative positions, as described on page 92.) This change in estimation methodology resulted in a $2.5 billion pretax gain recognized in earnings in the fourth quarter of 2008.

The CVA recognized on fair-value option debt instruments was $5,446 million and $888 million as of December 31, 2008 and 2007, respectively. The pretax gain recognized due to changes in the CVA balance was $4,558 million and $888 million for 2008 and 2007, respectively.

The table below summarizes the CVA for fair-value option debt instruments, determined under each methodology as of December 31, 2008 and 2007, and the pretax gain that would have been recognized in the year then ended had each methodology been used consistently during 2008 and 2007 (in millions of dollars).

Got all that? So, Citi, in it’s infinite wisdom, decided to change methodologies and monetize, immediately, an additional 290 bps in widening on it’s own debt. This change saw an increase in earnings of $2.5 billion prior to this quarter.  In fact, Citi saw a total of $4.5 billion in earnings from this trick in 2008. However, this widening in debt spreads was a calendar year 2008 phenomenon, and CDS lagged, hence the out-sized gain this quarter in derivatives due to FAS 157 versus debt. Amazing.

And, while we’re here, I want to dispel a myth. This accounting trick has nothing to do with reality. The claim has always been that a firm could purchase it’s debt securities at a discount and profit from that under the accounting rules, so this was a form of mark-to-market. Well, unfortunately, rating agencies view that as a technical default–S&P even has a credit rating (“SD” for selective default) for this situation. This raises your cost of borrowing (what’s to say I’ll get paid in full on future debt?) and has large credit implications. I’m very, very sure that lots of legal documents refer to collateral posting, and other negative effects if Citi is deemed in “default” by a rating agency, and this would be a form of default. This is a trick, plain and simple–in reality, distressed tender offers would cost a firm money.

The Bottom Line: Citi isn’t out of the woods. In this recent earnings report I see a lot of reasons to both worry and remain pessimistic about Citi in the near- and medium-term. If you disagree, drop me a line… I’m curious to hear from Citi defenders.