Inside Goldman’s ABACUS Trade

Today, in the Huffington Post, I posted a document that shows an earlier incarnation of the ABACUS trade (although, not that different from the one that has got the SEC up in arms). I also explained it as well as I could. Head on over and let me know what you think.

Why 2010 will be Challenging for Goldman Sachs

I figured I’d let 2009 go out with a bang and post another of my contrarian views: 2010 will be rough for Goldman Sachs. Why? Well, to know the answer to that, you should head on over to the Huffington Post where the full piece is online.

Happy New Year!

A Recounting of Recent History

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.

Revisiting a Debate We Should be Past

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.

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.

Notes and Predictions: The Stress Test

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.

Citi’s Earnings: Even Cittier Than You Think

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.

To Understand the A.I.G. Problem, Look no Further than the Public Resignation Letter

I’ll admit it, Jake DeSantis’ resignation letter got me extremely annoyed. It’s a bait-and-switch–a one-sided telling of the story that doesn’t even jive with itself. I’ve been a bit torn about whether or not to write about it, but here we are. So, let’s get started (my comments are interlaced, in bold).

Dear Mr. Liddy,It is with deep regret that I submit my notice of resignation from A.I.G. Financial Products. I hope you take the time to read this entire letter. Before describing the details of my decision, I want to offer some context:

First of all, why is this letter public? They even have a screenshot of an email being sent from Mr. DeSantis to Mr. Liddy. To me, this is a huge P.R. ploy. When one writes a letter, knowing it will be made public, it immediately destroys the ability to “take it at face value.”

I am proud of everything I have done for the commodity and equity divisions of A.I.G.-F.P. I was in no way involved in — or responsible for — the credit default swap transactions that have hamstrung A.I.G. Nor were more than a handful of the 400 current employees of A.I.G.-F.P. Most of those responsible have left the company and have conspicuously escaped the public outrage.

Ahhhhhh… Herein lies the most major problem. This is the common thread people are likely to hear over and over again. “It wasn’t my division/trading book/group that lost the money.” Well, unfortunately, this is completely and totally irrelevant. First of all, did anyone complain when that group was “juicing” the returns of your equity compensation? Did anyone hear, “I can’t take this! It wasn’t my group that made all this money!” No. Hypocrite. Second, you work at the same firm. This firm, 400 people large, as the letter states, is around the same size as my high school class. There are two possibilities for any front-office employees claiming to not know what the credit default swap businesses were doing: they are lying (highly, highly likely) or their head was in the sand (less likely). Firms like this have “town hall meetings.” There are transactions that cross areas and force people to work together and meet one another. Senior management (What is Mr. DeSantis’ title? Ahhh, yes, “Executive Vice President” …. Thank you screenshot) sits on executive committees, working groups, and other teams for business development, strategy sessions, and to ensure that everyone knows what is going on. In fact, we know that even accountants asked questions and saw enough inconsistencies to blow the whistle on A.I.G.! So, yes, very few people actually executed the trades. But, no, no one who worked there bears no responsibility for asking the right questions or raising concerns over things they didn’t understand.

This is exactly the same problem that existed in many other firms, so it’s not unique to A.I.G. This is one reason why Goldman is so successful, their co-presidents walk the floor and know traders and senior executives from all the businesses. A wide net is cast for opinions when doing a transaction or making a large decision. The partnership mentality exists there in a huge way, versus this “fiefdom” or “silo” mentality where people talk about “their business.”

After 12 months of hard work dismantling the company — during which A.I.G. reassured us many times we would be rewarded in March 2009 — we in the financial products unit have been betrayed by A.I.G. and are being unfairly persecuted by elected officials. In response to this, I will now leave the company and donate my entire post-tax retention payment to those suffering from the global economic downturn. My intent is to keep none of the money myself.

Honestly, I’ll believe it when I see it. You shouldn’t get the credit for saying you’ll give away your money, you should get credit for giving away your money. Also, please note this: A.I.G. reassured them many times they would be rewarded… Doesn’t sound like a formal contract, does it? As for being “persecuted” … Show me the harm that elected officials have actually done. The T.A.R.P. surtax measure looks dead to me. And, if you’re giving it away anyway, not much harm there. Maybe you should have used another word, like, “lectured” or “scolded.”

I take this action after 11 years of dedicated, honorable service to A.I.G. I can no longer effectively perform my duties in this dysfunctional environment, nor am I being paid to do so. Like you, I was asked to work for an annual salary of $1, and I agreed out of a sense of duty to the company and to the public officials who have come to its aid. Having now been let down by both, I can no longer justify spending 10, 12, 14 hours a day away from my family for the benefit of those who have let me down.

I see. So you worked for eleven years because you’re dedicated and honorable, but now that you’re not getting paid for helping to maximize recovery for taxpayers, you’re leaving. Please note that, in reading this, it’s clear that the dysfunctional environment has been around before now, so that’s not the reason he is leaving. Even more amazing is the fact Mr. DeSantis agreed to work for $1 out of, “a sense of duty to the company and to the public officials who have come to its aid.” Is he <expletive> kidding? So the $1 was out pf a sense of duty, but the $742,006.40 (post taxes, we’ll come to that later!) was out of greed? Well, then I think we know what you’re about.

You and I have never met or spoken to each other, so I’d like to tell you about myself. I was raised by schoolteachers working multiple jobs in a world of closing steel mills. My hard work earned me acceptance to M.I.T., and the institute’s generous financial aid enabled me to attend. I had fulfilled my American dream.

Congratulations on a stellar achievement, getting into M.I.T.! Unfortunately, your hyperbole surrounding the phrase “American dream” is asinine. If your dream was to go into debt to go to M.I.T., and then it was fulfilled, you probably should have thought a few steps beyond that.

I started at this company in 1998 as an equity trader, became the head of equity and commodity trading and, a couple of years before A.I.G.’s meltdown last September, was named the head of business development for commodities. Over this period the equity and commodity units were consistently profitable — in most years generating net profits of well over $100 million. Most recently, during the dismantling of A.I.G.-F.P., I was an integral player in the pending sale of its well-regarded commodity index business to UBS. As you know, business unit sales like this are crucial to A.I.G.’s effort to repay the American taxpayer.

The profitability of the businesses with which I was associated clearly supported my compensation. I never received any pay resulting from the credit default swaps that are now losing so much money. I did, however, like many others here, lose a significant portion of my life savings in the form of deferred compensation invested in the capital of A.I.G.-F.P. because of those losses. In this way I have personally suffered from this controversial activity — directly as well as indirectly with the rest of the taxpayers.

Ahhh, here again Mr. DeSantis changes it up a bit. Unfortunately for him, his choice of words is telling. “The profitability of the businesses with which I was associated clearly supported my compensation.” Oh? So you weren’t associated with A.I.G. the corporation? How about A.I.G. Financial Products?

As for your lost deferred compensation, well, then it worked! You were given deferred compensation, tied to the performance of your firm, to align your incentives with everyone else. This is part of the reason your attempts to disassociate yourself from the problems are meaningless. You likely made money, and cashed out portions of your deferred compensation (11 years of continued employment means a lot of it vested, I would assume). You clearly made money from this compensation scheme … Do you now intend to give back the portion you weren’t directly responsible for? No, of course not! Nor should you, by the way–live by the sword, die by the sword, as the saying goes.

Anyway, let’s make apparent what you aren’t saying. How much of this compensation, over the years, was actually in deferred equity compensation? Standard amount for a bonus of your size is 30-40% of your bonus. This could be 20-30% of your total compensation for a given year. So, for the past few years, most likely 30% of your compensation has been in equity, likely vesting over 3-5 years with equal amounts of any years award vesting over each following year… This means that for the first six years you kept 100%, for the next year you kept approximately 94%, then 88% … The lowest proportion being 65-70%. Now, these are all approximate, but unless something is very amiss, it’s all in the ballpark. It isn’t like Mr. DeSantis didn’t know his risk the entire time and one shouldn’t think, from the vagueness, that it’s much higher than it truly is.

I have the utmost respect for the civic duty that you are now performing at A.I.G. You are as blameless for these credit default swap losses as I am. You answered your country’s call and you are taking a tremendous beating for it.

No, no, for all the reasons I’ve stated before, Mr. DeSantis, Mr. Liddy is much more blameless than you are. He didn’t have 11 years to figure out what this division was doing, ask questions, raise red flags, or exercise the option to quit and sell all his unvested stock. You, however, did.

But you also are aware that most of the employees of your financial products unit had nothing to do with the large losses. And I am disappointed and frustrated over your lack of support for us. I and many others in the unit feel betrayed that you failed to stand up for us in the face of untrue and unfair accusations from certain members of Congress last Wednesday and from the press over our retention payments, and that you didn’t defend us against the baseless and reckless comments made by the attorneys general of New York and Connecticut.

Ibid. (Don’t want to sound like a broken record.)

My guess is that in October, when you learned of these retention contracts, you realized that the employees of the financial products unit needed some incentive to stay and that the contracts, being both ethical and useful, should be left to stand. That’s probably why A.I.G. management assured us on three occasions during that month that the company would “live up to its commitment” to honor the contract guarantees.

Honestly, this is where this <expletive> <insulting non-expletive> really gets under my skin. Let me give Mr. DeSantis a piece of advice: When you agree to an employment contract that has a total compensation (post taxes, more on that in a second!) of over $740,000 (don’t forget, he’s getting his benefits, too!), but the salary component of that is $1, you aren’t getting farily compensated by the non-salary portion and making a huge sacrifice by working for a $1 salary. Both cannot be true! This sort of posturing and propaganda falls very nicely into the “what isn’t he saying?” overtone that colors this entire P.R. stunt. Also, note that this entire paragraph is guessing. The only objective portion of this sentence is that A.I.G. management assured a group of people that they would live up to their commitment on three seperate occasions. Keep in mind no representations were made by A.I.G. as t the tax rate they would pay. They could have! This is a common executive perk called a “Tax Gross-Up” … I wonder how it works when there is over 100% tax rate, though…

That may be why you decided to accelerate by three months more than a quarter of the amounts due under the contracts. That action signified to us your support, and was hardly something that one would do if he truly found the contracts “distasteful.”

More guesses. I agree these actions seem inconsistent, though. I wonder if Mr. Liddy himself knew the specifics and timing.

That may also be why you authorized the balance of the payments on March 13.

At no time during the past six months that you have been leading A.I.G. did you ask us to revise, renegotiate or break these contracts — until several hours before your appearance last week before Congress.

I think your initial decision to honor the contracts was both ethical and financially astute, but it seems to have been politically unwise. It’s now apparent that you either misunderstood the agreements that you had made — tacit or otherwise — with the Federal Reserve, the Treasury, various members of Congress and Attorney General Andrew Cuomo of New York, or were not strong enough to withstand the shifting political winds.

I’m sure Mt. Liddy takes comfort in hearing your thoughts on his actions.

You’ve now asked the current employees of A.I.G.-F.P. to repay these earnings. As you can imagine, there has been a tremendous amount of serious thought and heated discussion about how we should respond to this breach of trust.

And yet most of the bonuses have been paid back.

As most of us have done nothing wrong, guilt is not a motivation to surrender our earnings. We have worked 12 long months under these contracts and now deserve to be paid as promised. None of us should be cheated of our payments any more than a plumber should be cheated after he has fixed the pipes but a careless electrician causes a fire that burns down the house.

Ibid.

Many of the employees have, in the past six months, turned down job offers from more stable employers, based on A.I.G.’s assurances that the contracts would be honored. They are now angry about having been misled by A.I.G.’s promises and are not inclined to return the money as a favor to you.

This is also stupid and, likely, doesn’t stand up. Likely this is built from hearsay But, I’ll give the truthfulness of this statement the validity of the doubt. First, understand the point here: the only reason these A.I.G. employees agreed to stay at A.I.G. and fix the mess they and their colleagues created is because they extracted large, guaranteed payments from A.I.G., now owned by taxpayers. Nice! Second, if they are truly the rationally thinking economic agents they claim to be, why did they turn down a job from a stable employer for a job that has an expiration date (the full unwind of A.I.G. F.P.)?

So, either these people are irrational idiots or they ransoming taxpayers and the American economy. I don’t care which they pick, honestly.

The only real motivation that anyone at A.I.G.-F.P. now has is fear. Mr. Cuomo has threatened to “name and shame,” and his counterpart in Connecticut, Richard Blumenthal, has made similar threats — even though attorneys general are supposed to stand for due process, to conduct trials in courts and not the press.

The only motivation? What about, well, Mr. DeSantis put it so well… “a sense of duty to the company and to the public officials who have come to its aid” … ? Oh, right, that was when there was a guaranteed, $700,000+ payment.

So what am I to do? There’s no easy answer. I know that because of hard work I have benefited more than most during the economic boom and have saved enough that my family is unlikely to suffer devastating losses during the current bust. Some might argue that members of my profession have been overpaid, and I wouldn’t disagree.

Woah, stop the presses. So, you’ve been overpaid, your family isn’t “suffering devastating losses,” and you’ve benefited more than most form the past few years. So why are you resigning? Oh, right … because you didn’t get over $700,000.

Well, to your question about what you should now, I have an easy answer! If you’re truly needed to unwind A.I.G. F.P., and you’re going to be available, volunteer to help! Please note: volunteering doesn’t include a $700,000+ bonus. Your $1 salary, however, is still there if you’d like.

That is why I have decided to donate 100 percent of the effective after-tax proceeds of my retention payment directly to organizations that are helping people who are suffering from the global downturn. This is not a tax-deduction gimmick; I simply believe that I at least deserve to dictate how my earnings are spent, and do not want to see them disappear back into the obscurity of A.I.G.’s or the federal government’s budget. Our earnings have caused such a distraction for so many from the more pressing issues our country faces, and I would like to see my share of it benefit those truly in need.

On March 16 I received a payment from A.I.G. amounting to $742,006.40, after taxes. In light of the uncertainty over the ultimate taxation and legal status of this payment, the actual amount I donate may be less — in fact, it may end up being far less if the recent House bill raising the tax on the retention payments to 90 percent stands. Once all the money is donated, you will immediately receive a list of all recipients.

Subtext: Congress will be stealing from the needy if they pass this surtax! Also, note that it’s $742,006.40 after taxes. If his effective tax rate is 35% then the payment is $1,141,548.31. If his tax rate is higher, it’s more!

This choice is right for me. I wish others at A.I.G.-F.P. luck finding peace with their difficult decision, and only hope their judgment is not clouded by fear.

Mr. Liddy, I wish you success in your commitment to return the money extended by the American government, and luck with the continued unwinding of the company’s diverse businesses — especially those remaining credit default swaps. I’ll continue over the short term to help make sure no balls are dropped, but after what’s happened this past week I can’t remain much longer — there is too much bad blood. I’m not sure how you will greet my resignation, but at least Attorney General Blumenthal should be relieved that I’ll leave under my own power and will not need to be “shoved out the door.”

I see. So there’s too much bad blood in the place that paid you millions and millions over ten years. What’s the word… right… perspective!

Sincerely,
Jake DeSantis

Who else now supports the T.A.R.P. surtax measure?

Why Stress Test Really Means Guesswork

Well, we’ve heard a ton about stress tests recently. Want some details on what a stress test entails? The Journal has some details about the tests here. Now, as much as I think GDP and unemployment are fine things to project forward for economists, let’s walk through the way one would use this to actually price an asset. Let’s start with something simple, like a 10-year treasury note (note that treasury bond specifically refers to bonds with a 30-year maturity). Here are all the components one would need to stress test the value of a treasury note.

1. Characteristics of the note itself: coupon, payment dates, maturity dates, etc.
2. What the yield curve would look like at the date you’re pricing the note.

Why would one need to know the shape of the yield curve (term structure of rates)? This is important, in order to “PV” the bond’s cashflows most accurately, one would discount each cashflow by it’s risk–the simplest proxy is to discount each cash flow by the rate of interest one would need to pay to issue a bond maturing on that date. For the government, this rate of interest is the point on the treasury yield curve (actually, the par zero curve) with the same maturity date. An example would be, if I were going to price a cash payment I will receive in two years, and the government can currently issue two-year debt at 5%, I should discount my cash payment (also from the government, since it’s a treasury note) at 5%. Treasuries are the simplest of all instruments to value.

Here’s an example, form the link above, of what a treasury yield curve might look like:

Now, it is completely and totally guesswork to figure out, given unemployment and GDP figures, what the yield curve will look like at any date in the future. Indeed, one can plug these projections into a model and it can come up with a statistical guess… But the only thing we know for sure about that guess is that it won’t be accurate, although it might be close. However, things like inflation will drive the longer end of the yield curve and monetary policy will drive the shorter end, so these certainly aren’t directly taken from the stress test parameters, but would need to be a guess based on those parameters. This is a large source of uncertainty in pricing even these instruments in the stress test.

Next, let’s examine a corporate bond. What would we need for a corporate bond?

1. Characteristics of the bond: coupon, payment dates, maturity dates, special features (coupon steps, sinking funds, call schedules, etc.), where in the capital structure this bond sits, etc.
2. What the yield curve would look like at the date you’re pricing the bond.
3. The spreads that the corporation’s debt will carry at the date you’re pricing the bond.

Oh no. We already saw the issues with #2, but now we have #3. What will this corporations credit spread (interest/yield required in excess of the risk free rate) at the time of pricing? Will the corporations debt, which could trade at a spread of anywhere from 5 to 1500 basis points, be lower? higher? Will the corporations spread curve be flatter? steeper?

Here is a good illustration of what I’m referring to (from the same source as the figure above):

There, the spread is the difference between the purple line and the black line. As you can see, it’s different for different maturity corporate bonds (which makes sense, because if a company defaults in year two, it’ll also default on it’s three year debt.. but the companies’ two year debt might never default, but the company might default during it’s third year, creating more risk for three year bonds issued by that company than two year bonds). It shouldn’t be a surprise, after our exercise above, to learn that the best way to compute the price of a corporate bond is to discount each cashflow by it’s risk (in my example above, regardless of whether the company defaults in year two or year three, the interest payments from both the three year and two year debt that are paid in one year have the same risk).

Well, how does one predict the structure of credit spreads in the future? Here’s a hint: models. Interest rates, however, are an input to this model, since the cost of a firm’s borrowing is an important input to figuring out a corporation’s cashflow and, by extension, creditworthiness. So now we have not only a flawed interest rate projection, but we have a projection of corporate risk that, in addition to being flawed itself, takes our other flawed projections as an input! Understanding model error yet? Oh, and yes unemployment and the health of the economy will be inputs to the model that spits out our guess for credit spreads in the future as well.

Next stop on the crazy train, mortgage products! What does one need to project prices for mortgage products?

1. Characteristics of the bond: coupon, payment dates, maturity dates, structure of the underlying securitization (how does cash get assigned in the event of a default, prepayment, etc.), etc.
2. What the yield curve would look like at the date you’re pricing the bond.
3. The spreads that the debt will carry at the date you’re pricing the bond.
4. What prepayments will have occurred by the date you’re pricing the bond and what prepayments will occur in the future, including when each will occur.
5. What defaults will have occurred by the date you’re pricing the bond and what defaults will occur in the future, including when each will occur.

Oh crap. We’ve covered #1-3. But, look at #4 and #5 … To price a mortgage bond, one needs to be able to project out, over the life of the bond, prepayments and defaults. Each is driven bydifferent variables and each happens in different timeframes. Guess how each projection is arrived at? Models! What are the inputs to these models? Well, interest rates (ones ability to refinance depends on where rates are at the time) over a long period of time (keep in mind that you need rates over time, having rates at 5% in three years is completely different if rates where 1% or 15% for the three years before). General economic health, including regional (or more local) unemployment rates (if the south has a spike in unemployment, but the rest of the country sees a slight decrease, you’ll likely see defaults increase). And a myrid of other variables can be tossed in for good measure. So now we have two more models, driven by our flawed interest rate projections, flawed credit projections (ones ability to refinance is driven by their mortgage rate, which is some benchmark interest rate [treasuries here] plus some spread, from #3), and the unemployment and GDP projections.

I will, at this point, decline to talk about pricing C.D.O.’s … Just understand, however, that C.D.O.’s are portfolios of corporate and mortgage bonds, so they are a full extra order of magnitude more complex. Is it clear, now, why these stress tests, as they seem to be defined, aren’t all that specific, and potentially not all that useful?

Citi: Breaking Up is Long Overdue (And Hard to Do Right)

Well, the Citi is burning… or breaking apart at least. Honestly, this has all been rehashed so much, I’ll not even bother citing where I have learned these basic facts and figures. First, though, I will say that Deal Journal‘s coverage has been great as has Alphaville‘s coverage. And, as usual, Felix is translating for us. Read all the coverage there (in between catching up on your reading).

The Facts

So, as is my usual M.O., let’s start with what we know.

• Smith Barney is going into some odd and very complicated joint venture. In an epic win for branding, it will be called “Morgan Stanley Smith Barney.”
• Citi’s private bank (focused on people with net worth of $10 million and up) and brokers who are housed within Citibank branches will not be part of the joint venture. Morgan Stanley’s franchise focusing on high net worth individuals, analogous to the Citi Private Bank, will indeed be part of the joint venture.
• Citi is looking to slim down it’s operations, seemingly across all product lines. Businesses rumored to be “on the block” include risky consumer finance businesses (Primerica and CitiFinancial), private label credit card business (credit cards issued by Citi, but branded by another company, like a retailer), and proprietary trading.
• Many structures are contemplated. Seemingly what will happen is another entity will have all those businesses transferred into it until each can be sold.

The Situation

Okay, seems clear. Now, what can we deduce from this?

First, the Morgan Stanley Smith Barney transaction will be an absolute and total nightmare. I predict the level of success will be somewhere between Merrill’s acquisition of Advest (disaster) and Bank of America’s acquisition of U.S. Trust (moderate success). Why do I believe this? Well, let’s look at what the joint venture creates: a massive, co-branded entity with business lines focused on high net worth individuals and, separately, more traditional clients of full-service brokerages. Also, this behemoth is responsible for selling both Citi and Morgan Stanley products! Morgan Stanley controls the entity and is left with no business lines that overlap with the venture. Citi retains brokers housed in their retail branches and it’s private bank, both direct competitors to the joint venture. Well, that hardly seems logical… To sell a business but still keep enough fragments of it to have to maintain the same infrastructure, support staff, and organizational complexity as if it wasn’t sold–things like stock trading, account processing, compliance, client account management, and relationship management software are all required no matter how many brokers you have.

Now, Citi further complicates it’s own dismantling with respect to the Smith Barney transaction because, well, it’s not east to answer the question, “Which advisers are part of Smith Barney?” For years Smith Barney has been hiring away brokers who focus on high net worth individuals but didn’t want to be part of the private bank–these teams had a structure and style all their own. These teams also use the private bank’s platform and infrastructure. Where do these brokers go? With the joint venture or to the private bank? They need access to products and services which will not be part of the joint venture (but which might be duplicated by Morgan Stanley, although I doubt it). I don’t know where these teams go, and I’d be 97% sure Citi doesn’t know (and Morgan Stanley is, most likely, not aware of the issue).

Just to summarize, we see that Citi has created an entity it intends to compete with and which diminishes their distribution capabilities and other value of their remaining businesses, while not diminishing any of their infrastructure needs.

Next up, we have the dismantling of the mothership–everything that isn’t Smith Barney within Citi. Let’s first note that the infrastructure argument from above applies here, it seems like no business line is going to be cut, merely focused. Although, there are probably still some sort of cost savings here because these franchises rumored to be spun off have always been marred with issues due to the lack of integration. For example, it’s been reported that CitiFinancial lives on it’s own systems and isn’t integrated in any way with other consumer businesses.

Mundane details aside, though, who is going to buy these businesses? In this market, when you cherry pick the worst businesses and try to sell them who is buying these businesses for anything but rock-bottom prices? Further, if you don’t sell the businesses A.S.A.P., then you’re still at risk for the losses. I’ll say that I don’t see the value in identifying to the world the businesses you are about to neglect–totally demoralizing the employees and hitting productivity and profitability hard–before you’re ready to actually dispose of those businesses. Further, why would anyone buy the businesses Citi had that were under-performing all these years? It’ll be interesting to watch how they position these “assets” for sale. Will they admit the problems and put those in front of potential buyers as immediate ways to increase value?

Two last points to be made, both about the investment bank.

1. Citi is spinning off the assets guaranteed by the U.S. Government. What will that do to the financial status of the government’s investment?
2. Citi is said to be shutting down all proprietary trading businesses. Anyone who has been watching knows that those businesses are either the few remaining revenue generators or have dismantled themselves long ago. And some, like Metalmark or the hedge fund that hadn’t launched or began operating yet (but was founded by Morgan Stanley alums), were clearly acquired at top dollar.

Further, this means Citi is going to drastically scale down it’s trading operations. When one is merely an order taker, and cannot use the firm’s capital, there is a very limited upside. You have turned a white collar professional into the best paid grunt ever. While some Citi traders clearly deserve this, it’s not clear that a complete strategy change won’t kill Citi’s sales and trading operation totally.

The Elephants in the Room

After all this, Citi still has some big issues that will challenge it’s ability to operate effectively going forward. Some of these are holdovers from my earlier issues with Citi…

How is Citi going to deal with the politics, infighting, legacy technology issues, and fractured culture? These, I would argue, are the real sources of the tens of billions in writedowns. No effective risk management. No sense of responsibility. No trust in management. No ability to even see all the risks on the books.

Why won’t Citi need more capital or have to deal with further catastrophic losses? Especially with these assets being de-emphasized and starved of capital. I have yet to hear a god answer, really, about why the steps beyond the Smith Barney transaction are even newsworthy. Until something is sold or shuttered, it’s all financial engineering and corporate legal maneuvering.

I guess we’ll see…

Another “Holy Shit!” Moment in Compensation: The P.A.F.

Wow. Seriously, wow…

This year, up to 80% of the stock portion will come via what Credit Suisse is formally calling a “Partner Asset Facility,” of the illiquid assets, largely corporate loans.

Bankers won’t receive a return on the PAF program for eight years, although they can start to collect some of the principal in 2013. If the firm finds outside buyers for the assets, it will pay the proceeds to itself first, then provide the rest to employees.

The PAF applies only to senior bankers within the firm’s investment bank, which includes merger advisory, capital markets and leveraged finance. Those in Credit Suisse’s private bank and asset-management division aren’t subject to the PAF.

I’m going to play both sides of this one… But, how do you know it’s a good move? Hiede Moore’s post, in the next line, offers the proof:

The announcement elicited livid reactions from senior bankers, many of whom questioned whether it was legal. Many said they believed they were being unfairly punished for risky assets bought by colleagues in distant parts of the firm.

I’m not crying for these bankers, exactly, but they missed the point. To be honest, it’s a tremendous incentive for everyone to work together for the good of the firm. These same “livid” investment bankers, I’m sure, have been pushing transactions onto their counterparts in capital markets and trading for years. I know this, specifically of C.S.F.B. Their investment bankers would constantly use the “relationship” reason for doing a given transaction that resulted in real estate exposure for their firm (or leveraged finance commitments). So bankers, as a whole, shouldn’t say they are being unfairly punished for their colleagues decisions to make loans that they asked them to make. Now those bankers will not push loans they think might make it into their compensation! (There was a rumor that something like this happened a long time ago at Salomon Brothers.)

Now, why might this be a bad ideas? Honestly, all the reasons are highly technical. First, the investment is much longer dated than normal equity: first principal distributions come in 2013 and the investment will be zero-return for 8 years. This is a bit unfair, as the vesting and return of cash should be similar to normal equity plans if employees are given no notice. It’s only polite as it concerns things like paying college tuition. That being said, this is a program for senior employees and, thus, they should have planned for bad times and not gambled with their entire lifestyle. The two largest issues, though, are where the firm is using this to their advantage instead of being “just” about it. First, Credit Suisse pays itself before employees. That seems tacky.. pro-rata, maybe? Even pro-rata withe the firm counted more… Second, this makes C.S.F.B. employees much less mobile. When a bank is trying to figure out how to make the bankers being recruited from C.S.F.B. whole on what they lose when they depart their current firm (standard practice), it’s likely that their P.A.F. holdings will be valued at, or near, zero.

Now, despite the problems, I think this is a great lesson and a fair mechanism. And, unlike the clawback, if the firm loses money on the investment, so are the people getting paid in P.A.F. units… So you don’t have to worry about going after an employee, they get reduced along with shareholders.