Maybe Charlie Gasparino is Too Simple to Grasp The Obvious

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

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

(Emphasis mine.)

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

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

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

(Emphasis mine.)

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

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

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

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

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

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

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

(Emphasis mine.)

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

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

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

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

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

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

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

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

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

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

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

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

(Emphasis mine.)

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

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

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.

Craziest Weekend in Wall St. History: Questions Abound!

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

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

Negotiating a proposed Novation Transaction:

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

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

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

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

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

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

(Emphasis mine.)

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

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

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

(Emphasis theirs! [Again, wow!])

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

Remember that there was consensus before that Lehman could survive.

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

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

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

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

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

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

(Italics theirs.)

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

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

On Recent Stories: Something for Everyone

I haven’t had the opportunity, in a long time, to cobble together some real thoughts. However, here are a few quick takes on what is going on recently…

1. Citi continues to shuffle deck chairs. Now, I don’t know what they could be doing right now to fix their situation. The problem they are facing is that they need to control costs in an environment rife with morale problems. As one commenter on Dealbook pointed out, I don’t know who believes that Jamie Forese is asking a subordinate to become his equal–indeed that’s probably not even within his power to do. I also don’t know why there is such a massive use of management consultants–in a large bank with an everything-needs-signoff-from-the-C.E.O. culture it’s hard to imagine someone who runs a department of 200 people can go out and hire McKinsey … Those managers can’t even upgrade their own travel arrangements to first or business class! Anyway, the real issue with these measures is that the worst abusers are powerful and find their way around these policies and senior management’s time is better spent doing other things than approving new computers and offsite meetings.

IRONY ALERT: As I was writing this post, I saw this item from Research Recap:

McKinsey sees considerable scope for investment banks to cut their noncompensation costs – possibly up to $2 billion in recurring savings.

…

McKinsey said its experience indicates that data, printing, supplies, delivery and professional services usually yield the fastest results; restructuring real estate and IT spending may take longer but generate much larger savings.

McKinsey said its analysis suggests that “executives can embark on this additional belt tightening without harming a bank’s culture and morale.”

Of course, morale at most investment banks is already so low that a further whack at expenses is unlikely to make it any worse.

(emphasis mine.)

Honestly, you can’t make this stuff up…

2. Lehman is approaching a deal to sell a stake in it’s asset management unit,  Neuberger Berman, to a private equity firm. This is a good start for a relationship, of the kind I have already opined on, between Lehman and a business that should be looking for disintermediation. I would, if I were Mr. Fuld, look to sell a stake in the asset management unit, get an equity investment in Lehman itself, and form a permanent J.V. with whatever top-shelf private equity firm will be winning the auction. Maybe Lehman can try cross-selling … “Mr. Kravis, I see you own a part of our asset management division, can I interest you in some cheap real estate debt? With gas prices so high who couldn’t use some hard assets?” Feel free to fo read my prior post–I go into a lot more detail there about the nuances of what the structure, in an ideal world, should look like.

3. Fannie and Freddie are falling … in slow motion! I have no idea, none at all, why the failing and bailout of Fannie and Freddie are both taking so long. Guess what? If Fannie and Freddie are woefully undercapitalized now then what’s the catalyst for things to get better? There is none. This whole situation doesn’t make sense. Are they waiting for the G.S.E.’s to be insolvent? We already know they are leveraged instutions completely concentrated in markets that are dead, dying, or woefully sick. I guess I don’t understand the rationale for waiting to take action… From the WSJ:

The Treasury probably doesn’t need to make a decision imminently unless the companies lose their ability to tap debt markets at reasonable costs, said Joshua Rosner, a managing director at research firm Graham Fisher & Co.

If the Treasury is forced to inject capital into Fannie and Freddie, though, that is likely to be part of a restructuring that would likely wipe out the value of previously issued common and preferred shares and lower the value of subordinated debt.

[Obligatory paragraph about what the stock did today.] …

Fannie increased its holdings of “liquid” investments, cash and short-term securities that can easily be sold, to $103.6 billion, up 43% from June. The move gives the company more flexibility to reduce its future borrowings if market conditions worsen, company officials said.

(emphasis mine.)

In what world is $100+ billion of anything easily sold? Simply stupid. Especially with the Fed pressuring the Treasury Department to ease up on wiping out certain equity holder because of the destruction wiping out parts of the G.S.E.’s capital structure would cause. Have any of these people ever seen markets function in the face of uncertainty? Oh, right … the last year or so. Well, at least that’s going well…

4. The next big problem is here: distressed companies. People expect that this will be the next set of losses and economic distress. Corporates have been fairly resilient, as a sector, to this economic downturn. Part of this is the lag that corporates have from the time consumers start tightening the purse strings to the time that effect is seen on the bottom line. Nothing else to say, really, the numbers are all moving in the same direction.

5. Random Assortment of other things…

A. Remember the rating agencies? Well, now one is going to sell you something that will tell you how much you’re going to lose on the C.D.O. paper you bought because they said was safer than it actually was after using their flawed ratings methodology… Apparently the part of their suite that worked was the part that picked out the downgrade candidates.

B. In a slight nod to my political views, there is finally hard data that we, as a society, have a vested interest in investing in those amongst us that have the least.

More Bear! (Part Three)

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

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

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

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

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

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

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

5. Okay, this amazes me…

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

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

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

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

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

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

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

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

Banking Risk

It’s funny to me that all of these problems are coming to light and, while there are clearly themes as to how these various products all became so prevelent, as well as why, there are some things that still need explaining. What do leveraged loans have to do with all this? Indeed Goldman could be asking itself why it got involved in that market–one in which it had become a major player, unlike some other businesses it was lucky enough to have been unsuccessful in entering. How did C.D.O.’s, a product generally managed off of trading floors where many market-sensitive businesses didn’t lose money, seem to be a categorical loser for banks? The answer seems pretty plain to me: These were products driven by “bankers.”

A “banker” is a person, as I think of them, whose job is to pitch a transaction to an entity/person/institution/group and get the fees involved in said transaction. They don’t manage risk, that is generally outsourced–but they do worry about it insofar as one can dimension the risk. Bankers make assumptions. Bankers LOVE assumptions. “Assume that trend continues.” “Assume defaults come in at 80% of the model for this collateral.” “Assume that debt gets taken out.” “Assume rates rally.” “Assume a static L.I.B.O.R.” “Assume this rate scenario and no losses.” It’s simply amazing. Why would one stress losses and not interest rates? Wouldn’t it be a better assumption that if 10% losses are occurring when 2.5% are projected that it’s because interest rates are higher than expected and people can’t get new loans? Well, the bonds don’t perform under those scenarios and showing that would make them harder to sell. Merely an example, I digress.

Bankers run the process on C.D.O.’s and  on leveraged loan deals. Their job is to put together scads and scads of powerpoint presentations detailing all kinds of details. Bankers show nice graphs like supply (amount of bonds issued) versus spreads (yield premium required for a bond’s incremental) to show some trend. Bankers trot out the all-knowing league tables for their product. (As we now know, the most accurate thing predicted by the C.D.O. league tables turned out to be writedowns–but bankers were judged on their standing in these league tables!) So, what if a banker was so successful at pitching these transactions that they were able to sign up dozens, creating a pipeline, and lock up the fees? They were a superstar! Imagine the fees on billions of dollars of C.D.O.’s? If their bank provided the financing for the C.D.O. issuer to acquire the assets? Higher fees! If the bank agreed in advance to buy the bonds and take them onto is own balance sheet if the market wouldn’t buy them? Higher fees! If these arrangement were made, 10-15 C.D.O.’s could earn $100 million in fees. Was there more risk? Of course, how do you think bankers would justify higher fees for these incremental commitments?! But, when your job is to spend months courting C.D.O. issuers, and you spend countless hours on conference calls telling them what a good deal issuing a C.D.O. is, and when you repeat, over and over, how strong the market is, citing many datapoints, then you’ll probably convince yourself too. Indeed, when told a deal you got a client to agree to commit to is too risky, by a risk manager or other independant person, then you will probably fight back… hard! (And, feel free to substitute C.D.O. with leveraged loan transaction in every instance.)

The point is the mentality. Bankers weren’t paid to manage risk day-to-day, watch the market, and hedge. Bankers became salespeople with some analytical and technical expertise. They weren’t thinking about hedging–they might not even have assets to hedge, they hadn’t created bonds yet. Market fluctuations didn’t affect the revenues from fee income. Although, a commitment to buy unsold bonds if the market has lost liquidity and values are plummeting is a risk, it’s not one bankers would have assumed, and definitely not hedged. Indeed these bankers, at some firms, even had separate reporting lines than the traders and risk management professionals. Their division was generating lots of revenue, so their senior layers of management gained a lot of power. A perfect storm? Seems like it was.

In fairness, the perfect storm that occurred was due to a fundamental problem–the disappearance of liquidity. In the heyday it wouldn’t have seemed rational to consider scenarios that correspond to what the market has actually experienced. But the methods of accounting for and cataloging the risk of, for example, derivative contracts exposed to tail events or highly illiquid investments clearly wasn’t used (When a P.E. firm makes a highly illiquid equity investment, I would bet bankruptcy risk is discussed!). Indeed most of the C.D.O. bankers were ex-lawyers, ex-structurers, or converted salespeople who didn’t have the background in these views on risk either. As for leveraged loans, the leveraged finance professionals were also mainly investment bankers and refugees from other relationship-driven fee-based businesses. I even know of people that jumped between the two (C.D.O.’s and leveraged loans)!

Another point, that seems obvious, is the scheme of compensation. Roger Ehrenberg had a recent post that discusses some of these issues. My personal belief is that the mentality was much more of an issue than the structure of the compensation scheme–but the perils of compensation, as it currently stands in the financial world, are well discussed and documented.

Maybe I just have the benefit of 20/20 hindsight, but maybe the traders and other people who poke fun at bankers (see Monkey Business  and, of course, DealBreaker) for not seeing the forest through the trees were on to something.

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

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

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

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

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

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

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

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

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

T-Minus 12 Months to the Rally

One trend recently is that many funds or money managers that can raise opportunistic money have started to call asking for distressed opportunities to invest in. These funds are all looking for high return (18-20%) opportunities and usually take a few months to get up and running in addition to a few more months to start sourcing actual buying opportunities. (These funds usually employ leverage, so high return hurdles don’t refer to nominal spreads.) With so many platforms springing up, from both established players and nascent funds, how long can it be before these players fall prey to competition? If you are the same bid for bonds and loans that the larger, relationship firms are, how do you invest your newly raised funds? How long before they relax their return hurdles and the lower parts of the various debt capital structures finds buyers at tighter levels? I guess we’ll see…