Posted tagged ‘Bear’

Disclosure? I Call B.S.

August 20, 2008

Disclosure and financial filings seem to be topical today with the S.E.C. announcing the Investment Banking Analyst Mercy Initiative. So, I’ll play ball. I have read a bunch of things recently making claims about the ability of a diligent investor to know what they are “getting into” and what the risks are for investing in a public company that has disclosure requirements. Actually, I haven’t been doing this for decades, so let’s quote someone that has… Tom Brown:

No one, inside or outside the company, could accurately predict what … ultimate losses would be. But what they could do—and what financial services investors can do now, regarding the banks in general–is make reasonable estimates of ranges of losses, and estimate companies’ future earnings power, then compare that to their market values.

(emphasis mine).

I emailed Tom to clarify a few thing, but never heard back. So, as I am prone to do, I’ll assume I’m correct in my interpretation and move on. I’m assuming that this was also the case in the past–how else would people be able to buy into a financial institution in the past if Tom didn’t think his words were just as true two to three years ago? (Nothing has really changed in disclosure requirements, right?) Surely, in the past, the issue would have been taking a view on the performance of the various financial institutions’ assets as well.

I looked at three firms’ disclosure, from 2006, related to C.D.O.’s … what I could find. Now, in the interest of full disclosure, I’m not trained to do this. I’m just a person, with some financial experience, looking at some S.E.C. filings. I knew i was looking for C.D.O. exposure, especially in the context of figuring out what banks would need to be responsible for if the market had a severe dislocation. Let me explain what I mean by this. Remember all the liquidity put chatter? While mostly related to S.I.V.’s, this is still a relevant concept for C.D.O.’s. As in any syndicated deal, most common for selling bond or stock offerings related to corporations but also relevant for securitized products, when an investment bank agrees to do a securitization they have most likely (call it 80+% of the time) agreed to “take down” or purchase the securities they are unable to sell to investors. Easy enough, right? Those assets are what has generated a huge amount of writedowns. It’s very easy to see the relationship between market share in the C.D.O. and securitized products space and magnitude of writedowns.

These relationships, however, are very complex. Multiple investment banks could be selling an individual deal and each could be responsible for purchasing different parts or different percentages of leftover securitizations. These are individually negotiated for each transaction. As a firm is building up assets (for example, sub-prime mortgage-backed securities), before they have enough to actually securitize and create a C.D.O., the bank/investment bank could have all the risk of those assets losing value or defaulting–if the C.D.O. doesn’t get done then it becomes a big problem. It’s also a big difference what types of assets or structures make up the C.D.O. securities. One sees the problem growing. There is a lot of information that needs to be processed to come up with a reasonable estimation of losses. I would claim that it is completely insufficient for a bank, as they have been, to disclose exposures once they start to become a problem.

So, what did I find? Terrible disclosure. I was able to find almost no information. Certainly no information that would have helped come up with an estimate for losses from these firms based in any sort of logic or fact. Now, I’m not saying one should be suspect of current disclosure–I don’t know what is next to blow up or cause big problems and none of these firms are run by the same regime that decided the previous level of disclosure. What I am saying is that I wouldn’t have been able, even if I had known exactly what was going to happen, to know the magnitude of the losses.

First, I looked at Citi. Citi had a notion of participating or structuring. Those numbers were combined and reported together. This helps to determine market share, perhaps. This does nothing to disclose the risk on the balance sheet. This number ($110 billion) could be made up entirely of bonds were Citi is at risk. It could also be entirely made up of bonds where Citi has no risk and is taking fees. There is nothing I found in the 10-K’s to say anything more helpful. So we know losses, if these C.D.O.’s (named V.I.E. or Variable Interest Entities in the disclosure) were sold at 22 cents on the dollar, as Merrill reportedly did, the losses would have been between zero and $86 billion. Whew! Nailed it down… Now, knowing that, do you buy or sell Citi’s stock?

Second, I looked at Merrill. They state some numbers and then footnote saying they might, potentially, hold a financial interest in some of the securitizations. Same situation as Citi. No disclosure as to what kinds of bonds these are. How much was retained? How much in financing obligations exist related to these? What percentage would have had to be retained by Merrill if unsold?

Last I looked at Bear’s filing. Bear was a slight improvement. They actually stated some of what they retained and have some exposure numbers which one could back out some other information from. Still, if I was modeling the losses I would be asking for a lot more information–while an improvement, in my opinion, it wasn’t enough.

Below are the tables from the various filings. Also, if one was looking for C.D.O.’s, I put the number of instances the term of interest appeared.

Now, since the S.E.C. is mandating and revamping filings and disclosure, perhaps they can do something about this. Maybe financial firms should be forced to disclose risk numbers and sensitivities. I certainly don’t have all the answers, but I think it’s pretty clear that no one had the answers, nor did they have the specific questions, before this crisis occurred.

From the Citi 10-K (2006):

Mentions of the word C.D.O. : Thirteen (lucky!)

From Merrill’s 10-K (2006):

Mentions of the word C.D.O. : Zero

From Bear’s 10-K (2006):

Mentions of the word C.D.O. : Eight


On Executives and Risk

July 31, 2008

Okay, I read the NYT Dealbook post on Alan Schwartz, and I have to admit, it completely destroys the entire notion of executives at firms, especially like Bear, as having any real personal risk. Let me quote…

Mr. Schwartz, Bear Stearns’s chief executive during the firm’s near-collapse, has been talking with Goldman Sachs, Citigroup, private equity firm Kohlberg Kravis Roberts and boutique advisory firm Centerview Partners, among others, people briefed on the matter told DealBook.

(emphasis theirs).

Okay, now, here’s the issue I have: Alan Schwartz is the reason Bear doesn’t exist today. Remember the three part WSJ article about Bear going under? Remember what I noted about the first part? Alan Schwartz, who is not a trader, vetoed the very trade(s) that would have saved Bear and was proposed by his senior traders. What happened from that decision was that thousands of people lost their jobs, the firm went out of business, and a lot of other, very bad, things. That’s fine that he made the decision. I almost don’t care that he was wrong. However, it’s a huge moral hazard/slippery slope/perverse incentive/etc. Alan Schwartz should be toxic right now.

One can argue about Stan O’Neil, Chuck Prince, or any of the other C.E.O.’s that lost their jobs but got large payouts. (I don’t support that either, by the way–if you were at the helm, you should take what you’ve already been given and neither ask for nor accept any more. You retire/leave rich nevertheless–but boards were incompetent, stupid, or in league on promising these things, so taking them isn’t the fault of the ex-C.E.O.’s.) However, these C.E.O.’s firms didn’t die and go away and they certainly didn’t veto the proposed lifeline with nothing but a body of irrelevant experience to guide them arguing from a place of no authority. These same kinds of hedges worked at other firms.

The common argument says, “C.E.O.’s get paid more because they have more risk.” Well the other people at Bear Stearns got less money, are out of a job, and, in this market, certainly are finding it difficult to get a new job. These people probably don’t have millions of dollars. Alan Schwartz does have millions of dollars, is out of a job as a result of something he could control, and can land on his feet as a senior deal maker making millions of dollars? Unacceptable and unthinkable. If this situation defines the rule then C.E.O.’s should get paid much less than they currently do and realize that even if they roll the dice and lose when betting with an entire company they will still get a job that pays exceptionally well.

More Bear! (Part One)

May 28, 2008

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

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

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

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

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

(emphasis mine).

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

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

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

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

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

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

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

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

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

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

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

I can’t wait for part two!