The Big Picture | Derivatives

Video: David Einhorn, Greenlight Capital, William Ackman, Pershing Square Capital

Friday, May 09, 2008 | 10:11 PM

in Credit | Derivatives | Financial Press | Video

Every now and again, CNBC puts on a superlative show. Friday morning's Squawk Box was one of those times when they hit the ball out of the park.

As I was heading out the door to work, I heard David Einhorn of Greenlight Capital begin chatting about shorting stock, soft SEC enforcement, and Allied Capital (ALD). CNBC also announced that William Ackman of Pershing Square Capital was coming on in a while.

So before leaving the house, I TiVo'd Squawk, and then headed off to work. I watched the show Friday evening, and it was fantastic. Watch the videos below and see if you agree.

• The Short & Short of It
Short selling can be good for the markets, with Owen Lamont, DKR Fusion, David Einhorn, Greenlight Capital and CNBC's Steve Liesman

click for video

• Whistle-Blowing pt. 1

Activist investors face challenges convinsing regulators to face the facts, with William Ackman, Pershing Square Capital Management and David Einhorn, Greenlight Capital Management

click for video

• Whistle-Blowing, 2
click for video

• Hedging Your Bets

Discussing fraud on Wall St., with David Einhorn, Greenlight Capital Management president

click for video

Fannie Mae is Fantastic !

Wednesday, May 07, 2008 | 06:42 AM

in Credit | Derivatives | Financial Press | Real Estate

At lunch with a journo friend, the question arose as to whether or not yesterday's front page NYT article on Fannie Mae (FNM) was inflammatory or not.

I am not sure if inflammatory was the correct word, but the Times certainly got the gestalt right of how bad things are at the mortgage GSE these days.

Consider these Fannie Mae facts:

• Their loss of $2.2B was 4X greater than expected ($-2.57B v.s. $-.640m expected)
• FNM accounted for 81% of the home-loan market in Q1 2008
• Shareholder equity dropped to less than zero for the first time in 15 years (from $20.5 billion in Q4)
• Subprime exposure: $51.2B
• Alt-A exposure: $344.6B
• Fair market value of assets dropped to $12.2 billion last quarter from $35.8 billion in December. This includes $56.1 billion in Level 3 assets;
• Moody’s downgrades FNM’s financial strength one level to ‘B’
• Credit and derivative losses rose fivefold to $8.9 billion; expects bigger credit losses in 2009;
• Estimates for credit losses in 2008 were boosted to 13 basis points to 17 basis points (up from 11 to 15 basis points). Each basis point, 0.01%, = 15 cents of earnings/sh (Morgan Stanley)
• Company issued $6B in securities to shore up balance sheet
• FNM cut their dividend to preserve capital
• Fannie Mae warns the housing slump will persist into next year.
• CEO sees 7-9% decrease in home prices in 2008 (previous estimate: 5 - 7%)
• FNM’s regulator, Office of Federal Housing Enterprise Oversight (OFHEO), said it will lower surplus capital requirements to 15 percent from 20 percent. Hence, this should allow more (not less) lending into the troubled mortgage market.
• Ofheo also lifted its consent order -- imposed in 2006 after $6.3 billion in accounting errors;
• Barney Frank’s (approved by BB) proposed mortgage bailout boosted FNM -- it rallied 15% from opening lows.

Hence, the cure for too much leverage and a lack of mortgage lending standards is more leverage and increased lending.

Note: We no longer have any short positions in FNM . . .

As the old cliche goes: "It's not the news; it's how the markets react to the news that matters." We agree.

click for larger graphic

courtesy of NYT

Sources:
Doubts Raised on Big Backers of Mortgages
CHARLES DUHIGG
NYT, May 6, 2008
http://www.nytimes.com/2008/05/06/business/06fannie.html

Fannie to Boost Capital After Posting Big Loss
JAMES R. HAGERTY
WSJ, May 7, 2008; Page C2
http://online.wsj.com/article/SB121007526280870313.html

Video: Bear Stearns Bailout "Worst Fed Mistake in a Generation"

Wednesday, April 30, 2008 | 03:30 AM

in Derivatives | Federal Reserve | Financial Press | Video

On Monday, I pointed to a WSJ article, regarding the Fed's past head of monetary affairs comments on moves to prop up Bear Stearns. (Bear Stearns Bailout "Worst Fed Mistake in a Generation")

Here is the video that was the basis of that article:
click for video, then select Reinhart from list

Previously:
Bear Stearns Bailout "Worst Fed Mistake in a Generation"
http://bigpicture.typepad.com/comments/2008/04/bear-stearns-ba.html

Sources:
What Lies Beyond the Credit Crunch? Part II
AEI, April 28, 2008 2:00 PM
http://www.aei.org/events/eventID.1712,filter.all/event_detail.asp#

Our Overextended Fed
Vincent R. Reinhart
Wall Street Journal, Wednesday, March 26, 2008
http://www.aei.org/docLib/20080428_ReinhartOurOverextendedFed.pdf

Creating Fake Alpha

Monday, April 28, 2008 | 08:00 PM

in Corporate Management | Derivatives | Wages & Income

Saturday's discussion about the UBS report, including the post on banker's compensation, led to some intriguing email from people who must remain nameless because of their professional affiliations.

Included amongst the feedback was the phrase "Creating Fake Alpha," which I had first read in John Cassidy's Portfolio column earlier this month, titled The Banker's Bailout:

"Then there is the central and controversial issue of how to pay people who work for financial firms. In blowup after blowup, compensation schemes based on short-term performance have encouraged traders, division heads, and C.E.O.’s to act recklessly.

In the typical case, a trader or executive places a bet that pays off immediately—or soon enough to increase the individual’s bonus or stock-options value—but exposes the firm to long-term dangers.

Examples include Merrill’s decision to step up its production of mortgage securities just as the outlook for the real estate market darkened and Bear’s refusal to keep an adequate reserve of cash on hand. Earlier this year, Raghuram Rajan, a former chief economist at the International Monetary Fund, referred to such behavior as “creating fake alpha—appearing to create excess returns but in fact taking on hidden risks.”

One possible solution to this is to "force traders and senior executives to take a more long-term view." And the way you accomplish that is simple: Pay the traders and risk managers in stock or options that don’t vest for five or 10 years.

Perhaps when we look back at this era from a future vantage point, we will see that this was the last great era of finance (see today's WSJ: Is Finance's Economic Role Ebbing?).

I wonder if the bankers and financial engineers responsible for creating the subprime meltdown and the credit crunch may have finally killed the goose that laid the golden eggs . . .

~~~

What say ye?

Previously:
UBS $37B Write Down, Part II: Compensation
http://bigpicture.typepad.com/comments/2008/04/ubs-37b-write-d.html

Sources:
Analyzing Bear Stearns' Bailout
John Cassidy
Portfolio, Apr 14 2008
http://www.portfolio.com/views/columns/economics/2008/04/14/Analyzing-Bear-Stearns-Bailout

Is Finance's Economic Role Ebbing?
Sector May Make Up Smaller Part of GDP as Jobs Are Being Cut
JUSTIN LAHART
WSJ, April 28, 2008
http://online.wsj.com/article/SB120933096635747945.html

Related:
Switching boats in midstream to ride out credit storm
John Dizard
FT, August 14 2007 03:00
http://www.ft.com/cms/s/0/0739ecac-49fe-11dc-9ffe-0000779fd2ac.html

Bankers’ pay is deeply flawed
Raghuram Rajan
FT, January 8 2008 18:04
http://www.ft.com/cms/s/0/18895dea-be06-11dc-8bc9-0000779fd2ac.html

Rhodes of Citigroup Says Credit Crisis `Half Way' Over

Monday, April 28, 2008 | 04:30 AM

in Credit | Derivatives | Video

click for video

William Rhodes, vice chairman of Citigroup about the outlook for the U.S. economy and financial markets, trade policy and his expectations for China's growth.

Source:
Rhodes of Citigroup Says Credit Crisis `Half Way' Over
Kathleen Hays
Bloomberg April 25 2008
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=avGIXeWKBadQ

UBS $37B Write Down, Part II: Compensation

Saturday, April 26, 2008 | 11:26 AM

in Corporate Management | Derivatives | Wages & Income

Buried at the end of the report discussed earlier is the specific criticism of the financial compensation system in place at UBS for traders and the engineers of structured products.

The bigger question is how little their quaint little system differs from any other large bank or brokerage firm on Wall Street. Remind me to ask Johns Thain & Mack about that.

Excerpt:

6.3.8 Compensation

UBS has identified the following contributory factors related to compensation and incentives:

• Structural incentives to implement carry trades: The UBS compensation and incentivisation structure did not effectively differentiate between the creation of alpha (i.e., return in excess of a defined expectation) versus the creation of return based on a low cost of funding.

• Asymmetric risk / reward compensation: The compensation structure generally made little recognition of risk issues or adjustment for risk / other qualitative indicators (e.g. for Group Internal Audit ratings, operational risk indicators, compliance issues, etc.). For example, there were incentives for the CDO structuring desk to pursue concentrations in Mezzanine CDOs, which had a significantly higher fee structure (approximately 125-150 bp) than High-Grade CDOs (approximately 30-50 bp).

• Insufficient incentives to protect the UBS franchise long-term: Under UBS’ principles for compensation, deferred equity forms a component of compensation that generally increases with seniority. Essentially, bonuses were measured against gross revenue after personnel costs, with no formal account taken of the quality or sustainability of those earnings.

Gee, with that compensation structure in place, how could anything possibly go awry . . . ?

Previously:
Report on UBS' $37 Billion Writedown
http://bigpicture.typepad.com/comments/2008/04/report-on-ubs-3.html

Related:
Bankers’ pay is deeply flawed
Raghuram Rajan
FT, January 8 2008 18:04
http://www.ft.com/cms/s/0/18895dea-be06-11dc-8bc9-0000779fd2ac.html

Report on UBS' $37 Billion Writedown

Saturday, April 26, 2008 | 07:06 AM

Kids, we have some fascinating reading in store for you this weekend.

The "conservative" Swiss banking giant UBS -- and I put that in quotes for obvious reasons -- wrote down a previously unimaginable $37 Billion dollars. Their shareholders were (ahem/cough) quite perturbed. So the nice folks at UBS, with an assist from KPMG, put together a 50 page report detailing the hows and whys UBS took such a humungo hit.

For what you would expect to be a dry report, it is absolutely compelling reading. It explains much more than the subprime fiasco. The report implies that management didn't really understand what the hell they were getting into with their purchases of Warburg/Dillon Read Capital Management. This unit eventually became UBS' internal hedge fund (it has since been shut down).

I wonder if management ever truly understands the nuts and bolts of these large acquisitions. We will find out if JPM knew what they were ~~getting into~~ getting the Fed into with the Bear Stearns (BSC) acquisition.

The report includes an indictment of the firm's compensation packages. The current structure -- big salaries and bigger bonuses -- encourages the riskiest and most short term of strategies. Prudence, risk management, and long term thinking were not money makers for employees. When the time came for the company to take its writedowns, many of these bad actors were long since gone. Go on, take the money and run.

You may not be surprised to learn that external consultants were involved and recommended "streamlining of risk processes." I don't know if these unnamed consultants were McKinsey & Co., but the whole description has a faint Enron-like smell to it.

A few other questions arise from the report:

Why do very risky strategies seem to end up in Fixed Income ?

How did Risk Control fail so badly?

Why was there an "Absence of risk management" and "Incomplete risk control methodologies" ?

Who created these compensation system ?

Again, this is just the tip of the iceberg in terms of asking what went wrong.

I wonder if this the inevitable banking equivalent of the Minsky moment. Perhaps these megabanks are simply too big, too unwieldy to be appropriately managed as hedge funds, rather than sleepy conservative banking institutions. The perverse incentives encourage reckless behavior.

Fascinating stuff . . .

Sources:

Shareholder Report on UBS's Write-Downs
18 April 2008
http://www.ubs.com/1/e/investors/agm.html

UBS ShareholderReport.pdf (download)

Related:

A good name sliced, diced and traded
John Gapper
FT, April 24 2008 03:00 | Last updated: April 24 2008 03:00
http://www.ft.com/cms/s/0/51099762-1198-11dd-a93b-0000779fd2ac.html

How UBS came undone
Roderick Boyd
Fortune, APRIL 23, 2008: 4:38 PM
http://money.cnn.com/2008/04/23/news/companies/ubs_deflates.fortune/

Too many risks, too few controls, says UBS report on write-downs
David Gow in Brussels
The Guardian, Tuesday April 22 2008
http://www.guardian.co.uk/business/2008/apr/22/ubs.europeanbanks

Unrealized Level 3 Gains

Thursday, April 24, 2008 | 08:13 PM

in Corporate Management | Credit | Derivatives | Earnings

If it weren't for the large non- cash profits on "hard-to-value" holdings, Goldman Sachs (GS) wouldn't have had much profit last quarter. Lehman Brothers (LEH) would have had significantly less. And Morgan Stanley (MS) wouldn't have had any.

That's according to Bloomberg's Jonathan Weil:

"Here's Rule No. 1 from Wall Street's public-relations playbook: If the company you run has big losses on hard-to-value assets, scream your head off about the accounting rules.

And what if the squishy values result in huge gains instead, as they have in the not-so-distant past? Rule No. 2: Stay mum about it for as long as the rules allow.

For months, we've seen a growing parade of executives and politicians complain that fair-value accounting rules are to blame for financial institutions' imploding balance sheets. Even the International Monetary Fund got in on the act in an April 8 report, suggesting the need for "some latitude in the strict application of fair value accounting during stressful events.''

There has been no commensurate outrage about fuzzy mark-to-market accounting that lets companies post unrealized gains on illiquid balance-sheet items."

Go read the full article . . .

Source:
Goldman, Morgan Stanley Hit `Level 3' Jackpot
Jonathan Weil
Bloomberg, April 23 2008
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a0ZGtAQHLpiA

Is The Worst of the Credit Crunch Behind Us?

Monday, April 21, 2008 | 06:47 AM

in Credit | Derivatives | Federal Reserve | Psychology/Sentiment

One of the more common refrains we keep hearing is that the worst of the credit crisis is behind us. Not only that, but banks have written down so much bad debt, that there is an upside surprise ahead of us!

I'm not so sure about that. As to the first part, credit spreads, mortgage rates, and the actions of the Bank of England strongly imply we are still in the thick of it. As to the latter, I simply doubt management has been that forthcoming.

I am not the nly one with such doubts. The WSJ looks at the specific accounting quirks that allow banks to write down much less bad debt -- about 20% less -- than they actually have:

"Outsize losses reported last week by Citigroup Inc. and Merrill Lynch & Co. could have been a lot worse except for a quirk in the way companies account for different types of securities.

Citigroup took $15 billion in write-downs and credit charges, leading the big bank to report a first-quarter loss of $5.1 billion. But $2.3 billion in other write-downs didn't hit the company's income statement.

The same was true at Merrill. The broker had $6.6 billion in write-downs, leading to a loss of $1.9 billion. But Merrill took at least $3.1 billion in other write-downs that didn't count toward its loss."

Best of all, its all legal according to the accounting rules:

"So, where did those other charges go? Into a special bucket in shareholders' equity called "other comprehensive income." The beauty of this bucket is the charges land on the balance sheet, but don't dent the companies' bottom line.

It all gets down to how a company classifies a security. A company can say it plans to hold a security until it matures, that it is available for sale or that it is being actively traded. Securities being held to maturity are held at their original cost and their value is written down only if they are deemed to be impaired. Securities that are traded are always marked to market, and gains or losses immediately hit profit.

The available-for-sale category is a middle ground in which the value of the securities is written down or up depending on market prices, but the loss or gain ends up in the "other comprehensive income" bucket. It stays there until the change in value is considered more permanent. At that point, a company finally takes the losses out of the bucket, and they hit the bottom line.

How much worse the balance sheets of the major banks and brokerages will get before the credit crunch is fully behind us is still anyone's guess. Those of you who have been trading the beaten up banks best be nimble enough to reverse course if another leg down starts.

As to BoE, their announcement today of a plan to swap about "50 billion pounds ($100 billion) of government bonds for mortgage-backed securities to lower credit costs" shows the global impact of the credit crunch remains unabated:

The plan will "unfreeze the situation we've got at the moment,'' Chancellor of the Exchequer Alistair Darling said yesterday in an interview with the BBC, without specifying how much would be made available. "What the Bank of England will do is, in effect, lend the banks that money. In the meantime, the Bank of England will take a security.''

Prime Minister Gordon Brown's government is trying to encourage lending after a surge in borrowing costs prompted banks to withdraw their best mortgage offers, threatening to exacerbate the worst housing downturn since 1992. The plan is a change of approach by the Bank of England after three interest-rate cuts since December failed to ease the logjam."

Some people have been calling the banks an opportunity of a lifetime. I am far less sanguine about the sector over the intermediate and longer term. This remains a troubled sector, with its losses not fully realized yet.

Related:
Credit crisis a "global calamity"--Kaufman
John Parry
Reuters, Fri Apr 18, 2008 11:40am EDT http://www.reuters.com/article/ousiv/idUSN1845613820080418

Sources:
A Way Charges Stay Off Bottom Line
DAVID REILLY
WSJ, April 21, 2008; Page C1
http://online.wsj.com/article/SB120873768772029985.html

Bank of England Will Unveil Swap to Ease Home Lending
John Fraher and Gonzalo Vina
Bloomberg, April 21 2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=a1Xcc.MQyy.g&

Kryptonite Caused GE's Miss

Thursday, April 17, 2008 | 07:26 AM

in Corporate Management | Credit | Derivatives | Earnings

The sub-prime problem is Kryptonite to GE.

I'll get to that in a minute, but before I do, a brief review. Last week, I questioned CNBC's embarrassingly softball interview of GE CEO Jeff Immelt. As noted, it would have behooved Immelt to demand his reporters ask him tough questions in order to protect the NBC/CNBC brand.

I suggested ordering the anchors not to go soft on him: "I expect you to maintain our reputation as the pre-eminent business news channel, and if you are too soft on me, it costs the company its reputation. Ask me tough questions. Raise difficult issues. Challenge me as if this were 60 Minutes. Anyone who pulls their punches or throws me a softball question is fired."

That did not happen.

Now, less than a week later, both the WSJ and the NYT are questioning GE's strategies. And even more intriguingly, analysts are rethinking their decade of unswerving support about this whole industrial conglomerate thingie.

As is so often the case, many of the fundie guys completely miss the point. They seem to barely get just why GE missed so badly this quarter. Even worse, they misunderstand how GE was such a wonderfully consistent and predictable beat-by-a-penny machine for so long.

The answer to both of these issues can be summed up in two words: GE Capital.

Over the years, GE Capital was this wonderful black box straight from planet Krypton. It had super powers under the Earth's yellow sun that other merely mortal companies did not. Jack Welch played the role of Superman, with an ability to make this enormous global conglomerate meet or beat every quarter, regardless of economic conditions. His unearthly powers were unmatched by other companies.

Transparency? Ha! No analyst ever really knew what was going on in there. It was a highly leveraged hedge fund, but that never really mattered, just so long as GE kept up the illusion that these profits were the result of ordinary industrial -- rather than leveraged financial -- operations.

Unfortunately for Immelt, he is facing not just a run of the mill domestic slowdown, but a much more important problem for GE: The credit crunch and subprime debacle. This has hamstrung GE Capital's ability to pull a penny or two out as necessary.

In other words, sub-prime is Kryptonite to GE. Not only has it lost its ability to fly and repel bullets -- i.e., beat every quarter, regardless -- but it actually weighed the company's earnings down with its losses.

Jack Welch went on CNBC yesterday, and again today, to defend the GE conglomerate model; it was a futile effort to those who know how GE managed their earnings for so many years during the Welch regime. His appearance only served to remind viewers of how wonderful life was when Jack's magic black box had all its superpowers. Even worse, Immelt is stuck with a superhero -- but no superpowers.

GE Capital has been exposed to Kryptonite, and as everyone knows, when exposed to particles of its home planet, Superman becomes powerless.

As has GE Capital. . .

Previously:
Surprise: Gee! No, G.E.
http://bigpicture.typepad.com/comments/2008/04/gee-no-ge.html

Sources:
G.E.’s Shortfall Calls Credibility Into Question
NELSON D. SCHWARTZ and CLAUDIA H. DEUTSCH
NYT, April 17, 2008
http://www.nytimes.com/2008/04/17/business/17electric.html

Embattled GE CEO Defends Strategy
Immelt Scolded By Welch on TV; Appliance Sale?
KATHRYN KRANHOLD and CAROL HYMOWITZ
WSJ, April 17, 2008; Page A1
http://online.wsj.com/article/SB120839179207621423.html

How Greenspan & Bernanke Invalidated Friedman

Monday, April 14, 2008 | 03:01 PM

in Credit | Derivatives | Economy | Politics

Hedge fund manager Scott Frew is a friend and occasional fishing partner. He had a few words to say about this morning's discussion re: Volcker and Bernanke:

I wanted to flesh out some of what Barry wrote earlier about former and current Fed Chairs Volcker and Bernanke. We must begin with Bernake’s now infamous Deflation speech. It is certainly “The Speech.” And I think in many ways it’s a terrifying document.

I am, by the way, in total agreement that Greenspan’s the guy who’s responsible for all of this; the particularly insidious quality of bubbles is that once you’re in one, the future is more or less pre-ordained.

An ironic corollary of that thought is that it pretty much invalidates the entire, mainstream (most certainly including Bernanke and Greeenspan), Milton Friedman-inspired critique/view of the Great Depression as having resulted from bad monetary policy on the part of the Fed as the bubble burst. They needed, according to that critique, to be much looser than they were, and all the problems would have been avoided.

So, in a sense, Bernanke’s an acolyte of that same church (recall him saying to Friedman, at some dinner or something honoring him, Never again; i.e., as a result of the lessons learned, taught by Friedman, the central bank would never repeat those Depression errors,), can’t fall back himself on a “It’s Greenspan’s fault” defense, because that’s antithetical to their whole view of history.

I see The Speech itself as a terrifying document, although it’s also an absolute blueprint for what’s going on today -- you’ve got to give Ben credit for foresight; he’s running down the checklist he provided there, item by item, line by line. Too bad none of it’s working, at least to date, but instead is exacerbating the problems.

Continue reading "How Greenspan & Bernanke Invalidated Friedman"

Chart of the Day: Spreads Relative to Historical Highs

Monday, April 14, 2008 | 11:45 AM

in Credit | Derivatives | Economy

Interesting chart via a recent IMF report:

The chart above comes from Gary E., who also sends along this commentary:

Angel Gurria, Mexico's external debt negotiator in the 1980's and -90's and later Finance and Foreign Minister, (now Secretary-General of the OECD) used to take a beating from the arrogant bankers he was forced to sit across the table with. Wow, the tide turned! Now the banks are begging the governments they once called "deadbeats" for capital. Beware, my emerging market friends, once (or maybe if) the G7 christens their 'inflation fighting aircraft carrier', the tide will turn.

Not unlike the 1970's, EM is almost purely an inflation trade. And have you seen Eastern Europe's current account deficits? Bulgaria's 21 percent of GDP CA deficit financed by foreign real estate speculators? Nevertheless, look at how the trade of buying historical highs and selling historical lows has paid.

Angel Gurria must be laughing now - about "20-year old traders in tennis shoes."

Source:
Spreads relative to historical highs
January 2008
http://www.imf.org/external/pubs/ft/gfsr/2008/01/pdf/chap1.pdf

Must See TV: Volcker's Speech on Financial Crises

Monday, April 14, 2008 | 04:47 AM

in Credit | Derivatives | Federal Reserve

Paul A. Volcker on the credit crisis, Greenspan, Bernanke, etc.

The rest of the speech touches on Bear Stearns, the Fed's Mandate, past and present Fed chairs, etc.

Volcker: Economic Club of NY Speech Part 2

Volcker: Economic Club of NY Speech Part 3

Volcker: Economic Club of NY Speech Part 4

Volcker: Economic Club of NY Speech Part 5

Thanks to RemiG2006 for uploading these clips.

Taking Moody's to Task

Friday, April 11, 2008 | 06:45 AM

in Credit | Derivatives | Real Estate

Moody's (MCO) is one of the key enablers in the housing crisis and the sub-prime debacle. Considering the massive damage they are at least partially responsible for, they have escpaed been relatively unscathed -- so far. Their reputation is in tatters, and their stock price is down, but given the culpability, payola, and gross incompetence, one might have thought an Arthur Anderson-like demise was a possibility.

I had forgotten that Warren Buffett was Moody's biggest shareholder; he should consider himself lucky that Moody's situation hasn't tarnished his reputation, either.

The WSJ calls Moody's out on their role as objective arbiter of ratings:

"Bond-rating agency Moody's Investors Service used to be an ivory tower of finance. Analysts were discouraged from having a drink with a client. Phone calls from bankers went unanswered if they rang during intense, almost academic debates about credit ratings.

A decade ago, as the housing market was just beginning to take off, Moody's was a small player in analyzing complex securities based on home mortgages. Then, Moody's joined Wall Street and many investors in partaking of the punch bowl.

A firm once known for a bookish culture began to focus on the market share that affected its own revenue and profit. The rating firm became willing, on occasion, to switch analysts if clients complained. An executive overseeing mortgage ratings went skydiving with a client. By the height of the mortgage-securities frenzy in 2006, Moody's had pulled even with its largest competitor, rating nine out of every 10 dollars raised in these instruments. It gave many of the bonds its coveted triple-A rating.

Profits at the 99-year-old firm, which John Moody started to rate railroad bonds, rose 375% in six years. The share price quintupled.

Now, Moody's and the other two major rating firms, the Standard & Poor's unit of McGraw-Hill Cos. and the Fitch Ratings unit of Fimalac SA, are under fire for putting top ratings on securities that ultimately collapsed in value. Investors, many of whom relied on ratings to signal which securities were safe to buy, have lost more than $100 billion in market value. The credibility of the ratings system is in tatters as new downgrades of mortgage securities come almost weekly. Investigators from Congress, the Securities and Exchange Commission and several state attorneys general are examining the rating firms' practices."

Instead of competition forcing the firm to be cautious in the face of other's recklessness, it actually levered them up further in order for them to stay competitive.

The genius of financial engineering and unfettered capitalism in its fullest flower . . .

Source:
RATING GAME: As Housing Boomed, Moody's Opened Up
AARON LUCCHETTI
WSJ April 11, 2008; Page A1
http://online.wsj.com/article/SB120787287341306591.html

The UnTradeables

Wednesday, April 09, 2008 | 07:00 PM

in Credit | Derivatives | Markets | Trading

There is an elephant in the room that I haven't yet seen discussed: The UnTradeables.

In our discussion last week on SFAS 157, there was a subtext not articulated: The broad category of items that are actually too illiquid to trade. These include "one offs" such as Dry Cleaning stores, non-chain restaurants, Mom & Pop shops.

They are untradeable because the amount of research into each item, relative to their market cap/size, makes it too inefficient. No one will spend $100k for the due diligence on a $200k store.

For a while, Pez candy dispensers were an UnTradeable -- until eBay created a market where these can be effectively bought and sold. However, the total value of all the Pez dispensers in the world wasn't measured in the trillions, or even 100s of billions. Even tho they are relatively illiquid, their small capitalization makes it viable. And don't forget, there is no leverage involved in any of the eBay items. Hence, no margin calls.

Now consider the size of the derivative marketplace based upon mortgages: Everything from RMBS to CDOs to CDC. It runs into the trillions.

If they cannot be effectively priced, are these products essentially untradeable?

Consider these factors:

• The price relative to the requisite cost of research/due diligence;

• The size of the market relative to the overall regular and ongoing demand for that investment product;

• The buyers and sellers with an expertise and knowledge of this paper.

This may be the crux of the issue with subprime/derivative problem: The paper is, or at least should be, Untradeable . . .

~~~

What say ye?

Former U.S. Federal Reserve Chairman Paul Volcker on the current financial crisis

Tuesday, April 08, 2008 | 09:55 PM

in Credit | Derivatives | Economy | Federal Reserve

Former U.S. Federal Reserve Chairman Paul Volcker speaks in New York about practices leading to the current financial market crisis, the role of the Federal Reserve in preventing and dealing with such crises and the need for changes in market regulation.
>

click for video

Excerpt:

Former Federal Reserve Chairman Paul Volcker questioned the central bank's decision to rescue Bear Stearns Cos. with a $29 billion loan, saying it was at "the very edge'' of its legal authority.

"The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices,'' Volcker said in a speech to the Economic Club of New York.

Fed Chairman Ben S. Bernanke last month agreed to lend against Bear Stearns securities, paving the way for JPMorgan Chase & Co. to buy its Wall Street rival. Bernanke, who worked with Treasury Secretary Henry Paulson to broker the bailout, last week defended the move as necessary to prevent "severe'' damage to financial markets.

Volcker, the Fed chairman from 1979 to 1987, had implicit criticism for U.S. regulators and market participants who allowed "excesses of subprime mortgages'' to spread into ``the mother of all crises.'' The Fed's Bear Stearns loan was unusual, he said.

"What appears to be in substance a direct transfer of mortgage and mortgage-backed securities of questionable pedigree from an investment bank to the Federal Reserve seems to test the time-honored central bank mantra in time of crisis: lend freely at high rates against good collateral; test it to the point of no return,'' he said.

Sources:
Volcker Says Fed's Bear Loan Stretches Legal Power
John Brinsley and Anthony Massucci
Bloomberg, April 8 2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=aPDZWKWhz21c

Volcker Video
http://www.bloomberg.com/avp/avp.htm?clipSRC=mms://media2.bloomberg.com/cache/vl8TvJRLodUg.asf

Greenspan 'Reputation Tarnishment' Tour Continues

Tuesday, April 08, 2008 | 06:49 AM

Alan Greenspan seems to be hellbent on destroying what little reputation he has left.

Over the past few years, the man formerly known as The Maestro has been slowly revealed as the grand architect of a Fed era which will forever be known for easy money and non regulation.

Thus, the inflationary spiral we are presently enjoying, with $100+ Oil and $5 milk, is only the first half of his legacy. The second part is the enormous credit crisis/housing debacle directily attributable to his malfeasance. Greenspan's ideological refusal to allow the Fed to fulfill its role of Banking System Regulator is what is directly the root cause of many of the conflagrations we are dealing with today -- from housing to credit to derivatives to the demise of Bear Stearns.

Here comes the fun part: The man that helped bring about the Housing crisis is now saying its almost over. Never mind the historic inventory overhang, accelerating foreclosures, and all of the price metrics that reveal Houses remain way too expensive. According to Easy Al, the end of the problem will soon be here:

"Former Federal Reserve Chairman Alan Greenspan said the drop in U.S. home prices will probably end "well before'' early next year as the number of houses on the market diminishes, aiding an economic rebound.

"It will not be until early 2009 that we will get close to having eliminated most of this'' home inventory, Greenspan told a conference in Tokyo today sponsored by Deutsche Bank AG and co-hosted by Bloomberg LP. "But it is very likely that home prices will stabilize well before that.''

Greenspan added that the extent of damage stemming from the collapse of the subprime-mortgage market won't be known for months. He described the credit crisis as the worst in 50 years, echoing the assessment of International Monetary Fund economists."

That's kinda like Mrs. O'Leary's cow telling you that the fire is almost over. If he is proven to be wrong about this also -- and I think he will be -- that should be the final nail in the coffin of his reputation.

UPDATE: April 8, 2008 9:14am

When I wrote this up early this morning, I had not yet seen the front page of the WSJ:

His Legacy Tarnished, Greenspan Goes on Defensive http://online.wsj.com/article/SB120760341392296107.html

Video after the jump.

Previously:
Free Lunch: Myths of the Greenspan Era (January 2006) http://bigpicture.typepad.com/comments/2006/01/free_lunch_myth.html

Source:
Greenspan Says U.S. Home Prices May Stabilize in 2008
Scott Lanman and Lily Nonomiya
Bloomberg, April 8 2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=aK6fhJY95tPg&

Continue reading "Greenspan 'Reputation Tarnishment' Tour Continues"

Bailout Poem

Saturday, April 05, 2008 | 05:15 PM

in Credit | Derivatives | Finance | Real Estate

If it wasn't so sad, it would be terribly amusing:

Tom Toles

Thanks, Kitty.

Forbes Video (3/28/08)

Friday, April 04, 2008 | 03:00 PM

in Credit | Derivatives | Video

Here is last week's video via Forbes on more bank write-downs for the Financials and iBanks, and on a long-lasting U.S. recession. Avoid Home Builders.

click for video (2008-03-28)

Hank Paulson's Cognitive Dissonance

Tuesday, April 01, 2008 | 06:28 AM

in Credit | Derivatives | Psychology/Sentiment | Taxes and Policy

>
"The Paulson plan belongs in a fictional world where financial institutions do a good job in regulating and monitoring themselves. Unfortunately, that’s not the world we live in."

-Why the Paulson Plan is DOA

So says Michael Mandel of Businessweek. In addition to the quote above, he goes further, calling the Treasury Secretary to task:

"In the middle of perhaps the greatest financial upheaval since the Great Depression, Treasury Secretary Hank Paulson is proposing a change in financial regulations which basically amounts to a big wink to Wall Street. His plan will go nowhere, both for political and practical reasons. In fact, it does not even meet the minimum standard of improving transparency, which would reduce the possibility of a similar crisis in the future...

The most striking thing about the current problems is just how much money the banks and the investment banks have lost. They apparently had no idea of how risky their own exposure was. The supposedly smart guys were simply stupid."

I concur with Mandel: In order to avoid these issues in the future, depository banks and investment banks need full and transparent reporting of their holdings. No more side pockets, off-the-book SIVs, or buried derivatives exposures. In fact, they should also clearly report the potential losses they have on their books via exposure to leveraged and risky counter-parties as well.

How did this all come about? Over the past 25 years or so, we have migrated from a world that was excessively regulated to a new world that was excessively deregulated. The initial problems were too much complexity, high costs, and time consuming bureaucracy. That's been replaced with an equally problematic situation: No adult supervision in places where the children require adult supervision.

Less financial supervision? More self-regulation? What hallucinogenics were taken prior to making those recommendations?

Bankers are not the folks who should be garnering less transparency, and less onerous regulatory requirements. Only a clueless ideologue would even dare suggest as much. Unfortunately, we have a clueless idealogue running the Treasury department. When confronted with what can only be described as insurmountable evidence that self-regulation has failed miserably, our man at Treasury proposes more self-regulation.

Riddle me this, Batman: If these finance wizards were any good at the job of self-regulation, would we even be having discussions as to how to resolve a global credit crisis?

If you are wondering how certain people can fail to understand this, the simple answer is cognitive dissonance. If Paulson were to confront reality -- lack of supervision is how banks got themselves in this mess in the first place -- his entire world view would crumble. Thus, the problem is not one of lack of supervision, its an issue of efficiency! Hence, we get these absurd attempts to make the lack of regulatory supervision "more efficient."

The Paulson plan isn't about avoiding future meltdowns in the financial system -- its about allowing Hank Paulson (and others) to cling to their now disproven deregulatory fantasies . . .

Source:
Why the Paulson Plan is DOA
Michael Mandel
Economics Unbound, March 30 2008

SFAS 157: Market Prices Too Low? Just Ignore Them!

Monday, March 31, 2008 | 06:47 AM