Hey, I wanted to let you, my loyal readers, know that I guest posted over at Clusterstock. The post, entitled “Investment Bank Scorecard” is my take on this past quarter as a whole. I think it’s worth clicking over and taking a look. I’d sum it up here, but, in all honesty, the value is in the nuances and small insights more than the general thesis.
Also, here is the chart attached to that post, in its orginal form.
There is a lot of chatter about different plans, market anticipations, and pitfalls when it comes to “fixing” the economy and, specifically, nationalization. Despite the fact that I don’t have the same reach as several uneducated members of the media, I figured I’d share what I think the way forward is, regardless.
Step 1: Nationalize Citi and Bank of America. Let’s be honest, with recent talks of expanded stakes, ringfenced assets, and no end of the losses in sight, it’s probably time the U.S. Government came to grips with the fact that they already own the losses and the positive impact of letting shareholders keep the upside is nonsensical. Further, these institutions will need more money for a long time to come. And, if you’re paying attention, you know that the markets seem to twist and turn with the news coming out of financial institutions. Nationalization rumors depress the markets, talks of further government action scare away new capital, and the fundamental health of these firms makes current investors run.
Step 2: Begin lending. With so much chatter and anger about institutions not lending, it almost makes me wonder why there is such a deep lack of understanding. These sick institutions are trying to shrink their balance sheets and have a ton of souring assets on them. They have to raise capital to support their current asset base, so why do we really expect these banks and other firms to lend? Some would claim that lending for the sake of lending got us into this mess, but they are either telling only part of the story or don’t get it–excessive leverage and poor risk management got us to this point. In fact, I suspect that defaults on even the riskiest loans would be much lower if bank capital was free enough to continue making mortgage loans based on normal requirements for returns and risk/reward.
So, how do we begin lending? Simple, start a government bank. Well, not exactly, but the government now owns Fannie, Freddie, AIG, Citi, and BofA (see step 1). Clearly the government now (by step 2) has the infrastructure and technical know-how to manage the logisitical issues of setting up and running a lending platform. Now the government can lend directly and not wait for sick banks to do it. Further, they can underwrite to fairly normal lending standards and get a premium return on their capital. Also, rather than poaching the nationalized entitites’ “talent,” the government cam employ many out of work finance workers throughout the country (after all, lending in Missouri should probably be done by people in Missouri).
Step 3: Begin replenishing bank assets with new, cleaner assets. With all of these souring assets on the books of banks, their capital base being eroded, and leverage decreasing, TARP capital is probably being deployed very inefficiently and, obviously, conservatively. Well, since step 2 involves lending and creating assets, the government should then implement an auction process–all assets the government creates would then be auctioned off, much like treasury bonds are, to banks. Since the government would be lending based on normal underwriting standards (as compared to the previous paradigm of loan underwriting), these assets would have a strong credit profile and will likely perform much better than legacy assets. JP Morgan, for example, should jump at the chance to generate higher levels of retained earnings by buying assets when the rates it needs to pay are at historically low levels, once its capital frees up. This solves the chicken-and-egg problem of curing sick banks, hurting from consumer defaults and depressed economic activity, to free up the credit markets and getting economic activity to increase despite a lack of credit.
One could easily permute this plan in many ways. One possible way is to offer to swap new assets for legacy assets at current market levels to facilitate a much more immediate strengthening of the banks’ balance sheets. Another variation could include some partial government guarentee on assets it originates. I’m sure there are thousands more ways one could add bells and whistles.
Step 4: Broaden the Fannie and Freddie loan modifications and housing stabilization plan to the government’s new properties. I suppose this should be some sort of addendum to step 1, but it’s important enough to require some emphasis on it’s own. With Citi and Bank of America being so large, I’m sure the housing stabilization plan will have a much broader reach once those are wards of the state. We’ve all heard the arguments for stopping foreclosures and refinancing borrowers… When the house next door is foreclosed upon, your house loses tens of thousands of dollar in value, increases housing supply, etc.
Step 5: Break up the institutions that are owned by the government. Markets have been clamoring for Citi to be broken up for years. Bank of America shareholders probably want Merrill to be broken off A.S.A.P. (ditto for Countrywide). Chew up these mammoth institutions and spit out pieces that, in the future, could fail because they aren’t too big. This should be done to AIG, Citi, Bank of America, and both Fannie and Freddie.
Step 6: Immediately implement a new regulatory regime. This is pretty much a “common sense measure.” President Obama has begun to call for this, and it’s pretty clear that with no more major investment banks around, the S.E.C.’s role needs to be re-defined. I’ve already laid out my thoughts on what this new structure should look like.
Between all of these steps, we should have the tainted institutions out of the system, credit will start to free up, banks asset base will become more reliable, and systemic risks will go down as we significantly decrease the number of firms that are “too big to fail.” Seems logical to me…
So, by now you’ve heard of the rant of some guy I’d never heard of before (not to be confused with Barron’s Michael Santoli). Does anyone else find it amusing that Mr. Santelli was ranting on the floor of an “open outcry” trading pit? That’s right, he was ranting about wasteful spending to help homeowners while standing on a monument to the past of finance and inefficient execution.
Mr. Santelli, while I completely accept the fact that you are most likely compensated based on how many viewers you reel in and your entertainment value, and certainly not based on the quality of your journalism (this is CNBC after all, the house of Cramer), analysis, or even grasp of reality, you should still, every now and again, try reading something. From the details of the plan one could learn some simple things:
1. The plan is available only to those people whose mortgages are owned by Fannie or Freddie or those whose mortgages were backed by Fannie and Freddie and put into securities by them. Fannie and Freddie have strict limits on whose mortgages can go into those pools. They have to have high FICO scores, relatively low LTVs, and there is a maximum size allowed. Please note that this restriction, in and of itself, totally disqualifies sub-prime mortgage loans. Let me repeat: sub-prime mortgages and agency-backed mortgages are a totally disjoint set of mortgage loans–there is no overlap.
2. The program does not reduce principal owed. So, in essence, there is no forgiveness of debt, but only a reduction in interest rates and, perhaps, an extending of the term of the loan to reduce monthly payments. People still owe the same amount as before. Sounds like a welfare state to me…
3. The program doesn’t allow refinancing of second homes or investment properties. So all the speculators that own 3 houses on that were supposed to be flipped cannot refinance any mortgages except for the single first mortgage on the house they currently reside in.
4. Second mortgages aren’t covered under the plan. All the people who took out HELOCs to borrow money to buy stocks aren’t going to be bailed out either.
5. There is about $75 billion being used to help stabilize the multi-trillion dollar mortgage market. This number alone implied that there is some selection process to weed out unworthy people from being given government funds.
Look, I want the economy to improve as much as the next guy, but I think swelling the unemployment rolls by one idiotic reporter might be the kind of change I can believe in. Oh, and let’s finally close down the value-destroying open-outcry trading pits. Maybe removing that friction in our economy can help us save a few dollars.
I was going to stop here, but I’ll be honest… the complete and total stupidity of Santelli and those knuckle dragging dinosaurs who still use hand motions to make money, add trnsaction costs, and keep the computers at bay (not all of them, but most of them, I’m sure) on the floor of the C.M.E. are the reason middle America hates everyone in finance. Further, it’s the reason we need a bailout. How often did I hear “not my problem” or “because that’s where the market is” or any number of other, totally tone-deaf incantations from the mouths of people making seven-digit bonuses? Often. And, to be honest, do we have even single piece of tape with Mr. Santelli yelling about taxpayers paying for Citi? Bank of America? How about AIG? No? Well, we gave Merrill Lynch $15 billion and around $4 billion of that was immediately blown through to mint 696 seven-digit bonuses.
At least I can take comfort in knowing that Mr. Santelli will be forgotten in 100 years and that his rant likely has no lasting impact on our society–it showcases the worst, most base and uninformed stupididty. Children, pay attention in school or you’ll wind up working on the CME trading floor for CNBC.
We learned a lot today, although tomorrow we might find that we learned completely different things. Here are the articles that prove the idiom, “When it rains it pours.”
1. Citi, in what can only be described as a series of epic P.R. fails, purchased a $50 million jet. Next in the series was this paragraph from DealBook:
A Citigroup spokesperson told DealBook that he could not confirm the reports that the bank was set to take control of a new jet, citing “security” concerns. “Executives are encouraged to fly commercial whenever possible to reduce expenses,” Citi said in a statement.
Seriously? Security concerns? Now, there are some rumblings that the jet was purchased two years ago. However, if there was ever a time to wage the P.R. war and risk getting sued to keep the big picture impression of your firm together, this was it. I can, without a doubt, say that if I were sitting in Vikram’s seat I would be refusing to pay for the jet or take delivery of it, and would be doing whatever I could to be sued. The headline, “Citi Sued for Failing to Honor Commitment to Purchase Corporate Jet” sounds like music compared to “Citigroup Likely to Face Criticism Over Jet” (the actual DealBook headline).
And in the end, they ceded the ground anyway.
2. Congratulations, you’ve hired some lobbyists! It turns out that a whole bunch of firms, including Citi, American Express, Capital One, Goldman Sachs, KeyCorp, Morgan Stanley, PNC and Bank of New York Mellon, all hired lobbyists. The whole notion of a company hiring a lobbyist, clearly, leads to obvious questions about companies representing their own interests and those of their shareholders instead of those of the people (who, now, are also their shareholders). I can’t possibly imagine what firms are thinking when they hire these lobbyists, except that they will “get away with it.” Absolutely ridiculous.
And, no sooner than I had noted this, newly confirmed Treasury Secretary Geithner cracks down on lobbying.
3. Apparently, Bank of America approved everything they used against John Thain when it came time to push him out. From the Elusive January 23rd version of the WSJ article:
Thain also left for a vacation in Vail, Colo., after the losses came to light, accelerated bonus payments at Merrill so they could be collected before the end of the year and scheduled a trip this week to attend the World Economic Forum in Davos, Switzerland […]
Vitriol between the Bank of America and Merrill camps also stemmed from the fact that Merrill had paid out bonuses much earlier than expected. A person familiar with Merrill’s bonus scheme said executives typically are told what their bonus will be by the second week of January and the payments are made in the second half of the month. Some people inside Bank of America believe Merrill accelerated the payouts to avoid having them cut amid a much-leaner plan at Bank of America.
(Emphasis mine.)
And, from the FT:
Ken Lewis, BofA’s embattled chief executive, ousted Mr Thain on Thursday after news of the bonus payments appeared in the Financial Times. BofA told the FT last week that Mr Thain had made the decision to pay bonuses in December instead of January and it had been “informed” of the move. The bank said Merrill was an independent company until the deal closed on January 1.
[…]
BofA yesterday confirmed there were conversations about the bonus payments prior to the pay-outs: “We never said we didn’t talk with them about it. But, in the end, it was their decision and they informed us of it.”
(Emphasis mine.)
Jeeze. Ken Lewis needs to go… His P.R. war to keep his job despite fleecing taxpayers is pathetic.
Okay, I really wanted to write something insightful about John Thain’s recent dismissal. There’s lots of information swirling around since the story caught fire and, especially with John Thain’s recent memo, I think there’s an underlying story emerging. However, the story keeps changing… Not just as new facts are revealed, but the actual article keeps changing! Let’s look at the timeline.
January 22nd — The narrative turns to John Thain’s excesses and the Ken Lewis flies to New York and dismisses Mr. Thain around 11:30AM.
Later Janaury 22nd — The blogosphere catches fire with the story. Mr. Blodget writes about it here (this link is extremely important later, we’ll come back to it). Deal Journal also dedicates a lot of ink to the events (the last link is great reading, btw). Felix also writes up his thoughts.
January 23rd — The Wall St. Journal sprays their pages with several articles about the situation. Deal Journal provides a nice roundup (note this link too).
January 26th (today) — There is more reporting about BofA’s role in the P.R. nightmare that is Merrill’s early bonus payments.
January 26th (today)– I try to go back and write about the entire incident. Wanting to ensure I catch the emotion and facts as they evolved, I try to go back to the original WSJ article.
The last step is the problem. The article from the 22nd, with all it’s anonymous sourcing and inflammatory language, is totally gone. In it’s place there’s an article dated the 26th, with some of the same information, but a totally different structure. Now, let’s examine the excerpt I was able to find, from Clusterstock (first important link):
Bank of America had lost confidence in Mr. Thain, this person said, after Mr. Lewis learned of mounting fourth-quarter losses at Merrill from the transition team handling the Bank of America-Merrill merger rather than from Mr. Thain himself. And when Mr. Lewis asked Mr. Thain what happened, the Bank of America CEO did not get a “good explanation for what was happening and why,” this person said.
The Bank of America CEO also concluded Mr. Thain has exercised “poor judgment” on a number of fronts. He left for a vacation in Vail, Colo., after the losses came to light, bonus payments at Merrill were accelerated so they could be collected before the end of the year and Mr. Thain had planned to fly this week to Davos, Switzerland, even though Bank of America had signaled that such a trip was not a good idea, this person said.
(Emphasis mine.)
This section appears nowhere in the new article from the WSJ. The entire article has been rewritten. Specifically, the charge about the bonuses being accelerated, emphasized above, is totally gone.
Now, I encourage you to see for yourself. Please don’t take my word for it.. Instead, go click on the links from the 22nd and 23rd, and follow the links to WSJ articles about John Thain being dismissed and see where the link takes you. I’ll even reproduce those here, in context. However, don’t feel shy about verifying!
Well, yes, of course he did. And it’s apparently a common affliction at Bank of America (BAC). WSJ: Bank of America had lost confidence in Mr. Thain, this person said, after … (from Clusterstock)
Bank of America and Merrill Lynch arranged the deal in less than 48 hours, and the hasty work shows. Thain’s departure Thursday is the clincher… (from Deal Journal)
It was always a bit weird that John Thain was going to stay on at Bank of America, but as it turned out, he lasted less than a month before getting fired this morning by the equally-beleaguered Ken Lewis. (from Felix)
Amazing. Maybe someone has the original article so I can write about what’s been going on and in the public sphere of debate, instead of having to rely on revisionist history.
Felix has a post focused on some of the numbers in the CBO report on TARP. Specifically, it looks at subsidy rates (amount lost from various “bailouts” due to mark-to-market as a percentage of the original investment). First, I’ll note my strong objections to using mark-to-market at any given point in time as a true measure of what something has “cost” taxpayers. One issue that permeates this crisis is the government officials managing their response to (and this is borrowed from somewhere, but I simply cannot remember from where or find it) have something released before the asian markets open. Mark to market, however, is definitely the easiest to measure, hence the use of it. Things like economic activity, bank lending, credit rates for banks, etc. should be used as measures of TARP effectiveness.
Now, let’s move on to my other point–this is like calling the winner in the first few minutes of a game. Any analysis of the effectiveness of the bailouts is likely to be a bit skewed since what would have happened without them isn’t truly known. But drawing any conclusion on a five year investment less than three months after it was made is especially premature. The probability of taxpayers’ investments seeing an actual loss is, actually, quite low in my estimation. Why? These institutions were bailed out already, and that is, in some sense, an endorsement of not letting them fail in the near future. Be dismantled? Perhaps. Be sold? Possibly. But die, like Lehman did? Certainly not. In fact, if Bank of America and Citi prove anything, it’s that politicians are more likely to buy back into the game than face the taxpayers and explain how they lost tens of billions of dollars backing the wrong horse. Don’t get me wrong, I think there significant holes in the strategy for TARP.
This situation, of course, defines moral hazard when the current management is allowed to stay. Citi management can go around doing whatever they want to fix Citi, if they fail we pay. If they win, they look good. Same for Bank of America… Ken Lewis decides to acquire Merrill in a shotgun wedding and then plays chicken to get a subsidy. Did they lower the price of the Merrill acquisition? No. As a matter of fact, the government didn’t just have a right to put their boot on the professional throat of Ken Lewis, but they had a responsibility to–Mr. Lewis actually showed an active interest in leveraging the financial crisis and government strategy. But, I digress.
The point is we won’t know how our investments perform for quite some time, and if the strategy the government employs remains constant then taxpayers are unlikely to lose a dime. So, you won’t find me with a real-time accounting of the TARP investments in Bloomberg anytime soon.
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.
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
One thing that came up often as Merrill’s recent C.D.O. sale and capital raise were discussed is how one could really say the following two statements, from the Merrill press release, are not conflicting with my statement. Let’s examine the Merrill statements first…
Seems obvious, then, that a decline in value will mean they take the assets back. Well, then why did I make the following statement (in the comments)?
Simply put, there are a lot of different ways one can structure a trade like this. First, there are the moving parts of the economic terms: the interest rate, the margin amount (think of this exactly the same as buying a stock on margin: essentially a loan) required upfront, the level of margin required to be maintained, etc. The interest rate is easy, I would think the interest rate would be somewhere around L+100bps or so. The terms for margin could be tricky, though. For example, the financing could be structured such that it requires 25% of the market value up front and requires that any time the equity decreases by 5% it is paid back in to ensure the fund always owns 75% of the risk.
Now, regardless of whether these terms are correct or not, we have hit a snag. The second statement, cited above, from the release seems to indicate that this isn’t really possible. Lone Star’s vehicle will only own these mortgage assets, so where does the rest come from? There are a number of ways Merrill can enforce this margin be kept up. First, as is common, they give themselves the power to do so by putting in “cross default” provisions. This allows Merrill to seize assets and other monetizable interests that are in its possession or control through financing arrangements with Lone Star. An example would be if a private equity fund owned a company and also purchased some securities with a repo agreement to finance them. If the private equity fund defaulted and the company had collateral with the firm providing the repo financing, the collateral could be seized. It’s also possible that there is a requirement for Lone Star to fund the margin, although not necessarily keep it in the vehicle.
Let’s see that, immediately, something interesting falls out from these terms. First, Lone Star has to be willing to fund some margin in the short run. If the assets drop in value to drive their equity down by some threshold amount (5% in the above example), they would need to fund that or potentially suffer elsewhere (cross default) or, potentially, face the assets being taken back altogether. This last option is clearly in Merrill’s best interest since it could seize the 25% equity already in the trade and have the upside of the assets as well–assuming Lone Star would never have put in more than the 25% upfront. This seems to defy logic, especially with assets being volatile in the short run and the clear implication that 22% of face value would become the valuation benchmark. One must also admit that Lone Star will be willing to put more money into this trade when the most mundane part of the transaction is considered, namely the interest owed on the 75% being borrowed. Consider this: if there was truly no way for Lone Star to put money into these assets then Merill would own them again ~30 days after the transaction closed. Why? Monthly interest payments on the financing. Lone Star will owe around 1/12th of 1 month L.I.B.O.R. + 100bps every month. That isn’t coming out of the margin, I would bet.
So what have I shown? There are enough degrees of freedom that one can cast scenarios where John Thain is either kicking his feet up and relaxing or where he’s calling down to the C.D.O. trading desk every ten minutes asking for marks on the assets to see if they are coming back to “Mother Merrill.” I will caveat the above by saying that I don’t know what is required to be disclosed in these sorts of arrangements, but it seems like Merrill would have the higher burden to disclose anything adversely affecting their financial status, and the lack of further bad news in the financing should be taken as an indicator.
It is for these reasons that some of the speculation surrounding the C.D.O. portion of the sale were a bit simplistic and probably not accurate in the way they stated what the true economics of the trade were. For example, saying they sold for five and change cents on the dollar is not true. We also cannot say that Merrill has sold it’s upside but retained it’s downside. Nor can we say both at once. All of these gloss over a level of nuance necessary to fully understand the transaction or require a number of assumptions.
Now that you know more than you ever wanted to know about financing, what was the point? Well, let’s examine these two statements from a NYT piece on Thain and the recent Merrill activity:
“We went to a lot of trouble to get this deal done, and we structured it in a way where there is very little chance that we ever get these C.D.O.’s back or take the same risk back,” Mr. Thain said.
Mr. Thain has been accused of misleading investors because as recently as mid-July he said that he felt comfortable with Merrill’s capital levels. He said his statements like the one on the second-quarter earnings call were true when he made them. “We would not have needed to raise more capital unless we completed the C.D.O. sale,” he said.
John Thain pretty much says the structure is well protected in the first statement. We’ve shown above that this transaction only makes sense for Lone Star if they are willing to let it run in the short term (and that makes sense if they truly think these assets are under-valued, otherwise why purchase them en masse). Couple this with all the criticism and negative P.R. John Thain and Merrill are taking for having to do the equity raise, and it’s pretty clear that that magnitude of attention is only worth is if this sale ended this chapter. Since he specifically states the contingency in the above quotation, I’m hard-pressed to think the sale has very little chance of ever being kicked back to Merrill.
In the end, I could be wrong and forced to eat my words. We’ll see, though, and I rather doubt it.
Dear John Thain 
