This post first appeared on Minyanville.
Americans should be wary of letting the government invest $700 billion of taxpayer money on highly illiquid, difficult-to-price assets. To say that we're virtually guaranteed to turn a profit is offensive and insulting to anyone with a sense of how convoluted, risky and opaque these securities really are.
Indeed, it appears even politicians are no longer sure this is a such good idea.
For evidence of just how well government-run bureaucracies manage vast pools of money, one need look no further than the nation’s largest pension fund, the California Public Employees’ Retirement System, or Calpers.
This June, a joint venture between the fund and a California developer filed for bankruptcy. Calpers had dumped almost $1 billion into raw land outside Los Angeles at the height of the real estate boom, which turned out to be kind of a bad idea: Calpers could lose its entire investment.
In late 2006, the fund made another equally ill-timed bet on highly speculative real estate.
Together with developer Tishman Spears, Calpers plunked down $500 million to buy the 80-acre swath of housing developments that make up Peter Cooper Village and Stuyvesant Town on Manhattan’s east side. After much debate in New York about the fate of the developments -- whose thousands of units were formerly reserved for low-income renters -- MetLife sold the 56-building complex for $5.4 billion.
With the New York economy beginning to slow and property values showing cracks up and down Manhattan, Calpers may have yet again bought at the top.
According to the Wall Street Journal, the deal was financed with $4.4 billion in debt from Wachovia (WB) and Merrill Lynch (MER). Now, Standard and Poor’s (MHP) has downgraded a portion of that debt connected with a $3 billion mortgage used to fund the project.
S&P is concerned not only about the 10% drop in the property’s value, but also about whether rental cash flow and money generated from selling off individual units will be able to cover the debt service. Tishman, for its part, says cash flow is improving, and that credit markets have prematurely written an unhappy ending for the investment.
The continued inability of government-run investment funds to make good decisions is deeply unnerving, given the fact that bureaucrats could soon have their grubby little paws on a slush fund of unparalleled size.
Tuesday, September 30, 2008
Monday, September 29, 2008
Wachovia Runs Out of Ground
This post first appeared on Minyanville.
Saddled with mounting losses in its huge mortgage portfolio, Wachovia (WB) has become the latest bank to lose its independence.
Rumors swirled over the weekend: The company was said to be in advanced talks with both Wells Fargo (WFC) and Citigroup (C) about a potential merger. Formerly the nation's sixth-largest bank, Charlotte-based Wachovia would have provided either suitor a retail stronghold in its native southeast. For Wells Fargo in particular, this would have nicely complemented their strong presence on the West Coast.
In the end, Citigroup managed to close the deal, with a little help from its friends at the FDIC.
Citi will pick up the majority of Wachovia’s operations, as well as the bulk of its assets and liabilities. With respect to its $312 billion mortgage portfolio, the Wall Street Journal reports, Citi will assume the first $42 billion in losses and the FDIC will be on the hook for the rest. In return, the FDIC will receive $12 billion in preferred stock and warrants.
Notably, Wachovia didn’t fail, as Washington Mutual did just last week. Citigroup will be assuming the company’s senior and subordinated debt, which is good news for the credit default swap market. After the collapses of Lehman Brothers and WaMu triggered billions in insurance obligations, the giant unregulated market is struggling to sort out the chaos of tangled contracts.
The transaction’s sticking point was Wachovia’s massive portfolio of Option Adjustable Rate Mortgages, or Option ARMs. After its ill-fated purchase of California thrift Golden West at the peak of the housing market in 2006, Wachovia has seen falling home prices and rising delinquencies chew through its balance sheet.
Golden West was one of the biggest issuers of Option ARMs in California during the housing boom. These loans were used to jam homeowners into houses well beyond their means. Borrowers could choose to pay interest rates as low as 1% per month - but would see the balance of their loan grow over time. Known as a negative amortization mortgage, the difference between the low teaser rate and a market rate would be tacked on to the loan balance each month.
The scheme worked well when home prices were on the rise, as homeowners could simply sell their way out of trouble. When property values began to fall however, borrowers become stuck inside a ticking time bomb.
Option ARMs were popular with many now-extinct mortgage lenders; Countrywide, IndyMac, Bear Stearns and Washington Mutual were all leaders in the space. These major players literally competed with each other to see who could buy the loans faster, with less due diligence and at the highest price.
As the credit crisis evolved, so too did the extent of Wachovia’s woes. When the company reported earnings in July, I noted a myriad of unsavory business practices under investigation in addition to loan loss provisions 3100% higher than the previous year.
A month before that report, former Undersecretary of the Treasury Robert Steel replaced Kenneth Thompson as chief executive. In all likelihood, Steel traveled from Washington to Charlotte with the intention of finding a buyer for the troubled bank.
The merger marks the latest in rapidly developing consolidation in American’s banking landscape. Two of the most wounded players, WaMu and Wachovia are now off the field.
With many more, smaller casualties waiting on line to be carted off -- like National City (NCC), Downey Savings (DSL) and Zions Bancorp (ZION) -- this process has only just begun.
Saddled with mounting losses in its huge mortgage portfolio, Wachovia (WB) has become the latest bank to lose its independence.
Rumors swirled over the weekend: The company was said to be in advanced talks with both Wells Fargo (WFC) and Citigroup (C) about a potential merger. Formerly the nation's sixth-largest bank, Charlotte-based Wachovia would have provided either suitor a retail stronghold in its native southeast. For Wells Fargo in particular, this would have nicely complemented their strong presence on the West Coast.
In the end, Citigroup managed to close the deal, with a little help from its friends at the FDIC.
Citi will pick up the majority of Wachovia’s operations, as well as the bulk of its assets and liabilities. With respect to its $312 billion mortgage portfolio, the Wall Street Journal reports, Citi will assume the first $42 billion in losses and the FDIC will be on the hook for the rest. In return, the FDIC will receive $12 billion in preferred stock and warrants.
Notably, Wachovia didn’t fail, as Washington Mutual did just last week. Citigroup will be assuming the company’s senior and subordinated debt, which is good news for the credit default swap market. After the collapses of Lehman Brothers and WaMu triggered billions in insurance obligations, the giant unregulated market is struggling to sort out the chaos of tangled contracts.
The transaction’s sticking point was Wachovia’s massive portfolio of Option Adjustable Rate Mortgages, or Option ARMs. After its ill-fated purchase of California thrift Golden West at the peak of the housing market in 2006, Wachovia has seen falling home prices and rising delinquencies chew through its balance sheet.
Golden West was one of the biggest issuers of Option ARMs in California during the housing boom. These loans were used to jam homeowners into houses well beyond their means. Borrowers could choose to pay interest rates as low as 1% per month - but would see the balance of their loan grow over time. Known as a negative amortization mortgage, the difference between the low teaser rate and a market rate would be tacked on to the loan balance each month.
The scheme worked well when home prices were on the rise, as homeowners could simply sell their way out of trouble. When property values began to fall however, borrowers become stuck inside a ticking time bomb.
Option ARMs were popular with many now-extinct mortgage lenders; Countrywide, IndyMac, Bear Stearns and Washington Mutual were all leaders in the space. These major players literally competed with each other to see who could buy the loans faster, with less due diligence and at the highest price.
As the credit crisis evolved, so too did the extent of Wachovia’s woes. When the company reported earnings in July, I noted a myriad of unsavory business practices under investigation in addition to loan loss provisions 3100% higher than the previous year.
A month before that report, former Undersecretary of the Treasury Robert Steel replaced Kenneth Thompson as chief executive. In all likelihood, Steel traveled from Washington to Charlotte with the intention of finding a buyer for the troubled bank.
The merger marks the latest in rapidly developing consolidation in American’s banking landscape. Two of the most wounded players, WaMu and Wachovia are now off the field.
With many more, smaller casualties waiting on line to be carted off -- like National City (NCC), Downey Savings (DSL) and Zions Bancorp (ZION) -- this process has only just begun.
Bailout Treats Symptoms, Not Disease
This post first appeared on Minyanville and on our sister site Cirios Real Estate.
The bailout is done! Time to breathe a sigh of relief.
Or is it?
As details emerge about the financial bailout package that was jammed through Congress over 10 days of political theater at its most nauseating, there’s still a striking omission from the plan to right American’s economic ship.
The failure of bureaucrats and regulators to propose a realistic solution for the foreclosure problem is emblematic of their inability to treat the root cause of an issue, focusing instead on simply applying band-aids to the visible symptoms.
The bailouts of Bear Stearns, Fannie Mae (FNM) and Freddie Mac (FRE), and AIG (AIG) all claimed to remove the cancer - but all they did was hasten the patient's demise.
Treasury's plan will deliver money into the banking system to sop up toxic assets sitting on the balance sheets of our financial institutions. This is a necessary -- albeit unfortunate -- step, but it still doesn't address the root of the rot: Milions of homes are worth less than the outstanding balance of the owner's mortgage.
Billions of dollars in negative equity are destroying Main Street’s balance sheet even as it devours Wall Street, eroding the value of the very securities Taxpayers are about to start buying.
As long as Washington tries to fight foreclosures with ineffective loan modification programs that simply prolong the problems, foreclosures will continue to set records. Modifying a mortgage for someone who is barely scraping by is sort of like rescuing him from the side of a cliff, only to leave him on the edge, dangling by one arm.
Foreclosures are often blamed for spiraling home prices and the resulting collapse in value of securities tied to the mortgages used to buy those houses. According to Bloomberg, the government’s aid package is designed to support “financial companies reeling from the record number of home foreclosures.”
Foreclosures don't cause houses to lose their value. Foreclosures happen when a home loses value such that it’s worth less than the mortgage used to buy it, and the homeowner can’t sell or refinance if his interest payments become overwhelming.
Defaults become delinquencies, which become foreclosures, which become evictions, which become repossessions, which flood the market, depressing prices as supply outstrips demand.
Back in what seems like ancient history, when home prices only went up, banks weren’t too concerned with defaults, since homeowners could almost always sell themselves out of a problem. Foreclosures stayed low because the liquid, appreciating housing market bailed out troubled homeowners on its own. That's part of the reason the industry is so ill-equipped to handle the scope of the current problem: it never had to before.
But now, with so many borrowers underwater -- owing more on their house than it's worth -- defaults result in not only eventual liquidation of the property, but profound distress in the homeowner’s life and real losses for investors. Furthermore, delinquent borrowers are less inclined to pay for upkeep or security, and many foreclosed homes are seriously damaged by the time a bank is able to take possession of it.
Being underwater is debilitating. To sell, not only does a homeowner have to pay a Realtor 6% whether he gets a raw deal or not, but he has to pay the bank the difference between where his home sells and the outstanding balance of his loan.
For many who have seen the value of their homes fall hundreds of thousands of dollars, this is an impossibility. Most homeowners, once they’re upside down, just want to stay in their homes.
A more effective plan to curb foreclosures would require an independent reviewer to evaluate each delinquent mortgage, determine the borrower’s ability to pay going forward and the amount, if any, of negative equity that needs to be destroyed to bring the loan amount back under the home’s value.
Since the notion that buying Wall Street’s toxic assets will result in windfall profits is a willfully distributed fallacy aimed at getting the public on board for the bailout, Taxpayers would be well-served dumping money into a blender that’s at least in their own backyard.
British Prime Minister Gordon Brown recently proposed a similar plan, where the government will buy delinquent mortgages from banks for the outstanding balance of the loan. The home is then rented to the existing tenant or a new one and managed by a local housing association.
The government would absorb the difference between the loan amount and the resale value, which would hasten increase sales activity, clearing out the glut of homes listed too high for the simple reason that the owner can't afford to sell at a lower price.
This type of personalized bailout, unfortunately, reeks of moral hazard. Many individuals who made bad financial decisions will get to keep their homes, albeit without actual ownership. But the current socialization of our free markets is simply moral hazard be design, so if Congress is so hell-bent on bailing out Wall Street, why not share the spoils with Main Street.
If Congress wants this bailout to help the American people and keep the financial system in tact, a sizable portion of the funds should be directed at fixing the asset that’s at the center of this turmoil: the residential property.
Home prices need to come down further. They will come down further. It’s only a matter of time. We can either let home prices bleed down, slowly eroding the value of the securities they support and violently uprooting families, or the government can plug the hole.
Washington Mutual (WM) is already off the field, as JP Morgan (JPM) continues to play widowmaker for the financial system. Wachovia (WB) isn't likely to remain independent for long. The sooner the rebuilding process begins, the better.
This crisis, and the resulting ebb and flow of what remains of the free market has already tipped the scales, started us sliding down a path of deflation in everything from stock prices, to cereal boxes, soda bottles, not to mention homes.
This is a good development. The hardest lesson Americans will learn from this crisis, should learn from this crisis, is that sometimes it’s necessary to live within our means. There is virtue in simplicity. More is not always better. Bigger is not always better. Sometimes, amazingly enough, less is often better.
This progress is the only true way we'll make it out of this mess.
The bailout is done! Time to breathe a sigh of relief.
Or is it?
As details emerge about the financial bailout package that was jammed through Congress over 10 days of political theater at its most nauseating, there’s still a striking omission from the plan to right American’s economic ship.
The failure of bureaucrats and regulators to propose a realistic solution for the foreclosure problem is emblematic of their inability to treat the root cause of an issue, focusing instead on simply applying band-aids to the visible symptoms.
The bailouts of Bear Stearns, Fannie Mae (FNM) and Freddie Mac (FRE), and AIG (AIG) all claimed to remove the cancer - but all they did was hasten the patient's demise.
Treasury's plan will deliver money into the banking system to sop up toxic assets sitting on the balance sheets of our financial institutions. This is a necessary -- albeit unfortunate -- step, but it still doesn't address the root of the rot: Milions of homes are worth less than the outstanding balance of the owner's mortgage.
Billions of dollars in negative equity are destroying Main Street’s balance sheet even as it devours Wall Street, eroding the value of the very securities Taxpayers are about to start buying.
As long as Washington tries to fight foreclosures with ineffective loan modification programs that simply prolong the problems, foreclosures will continue to set records. Modifying a mortgage for someone who is barely scraping by is sort of like rescuing him from the side of a cliff, only to leave him on the edge, dangling by one arm.
Foreclosures are often blamed for spiraling home prices and the resulting collapse in value of securities tied to the mortgages used to buy those houses. According to Bloomberg, the government’s aid package is designed to support “financial companies reeling from the record number of home foreclosures.”
Foreclosures don't cause houses to lose their value. Foreclosures happen when a home loses value such that it’s worth less than the mortgage used to buy it, and the homeowner can’t sell or refinance if his interest payments become overwhelming.
Defaults become delinquencies, which become foreclosures, which become evictions, which become repossessions, which flood the market, depressing prices as supply outstrips demand.
Back in what seems like ancient history, when home prices only went up, banks weren’t too concerned with defaults, since homeowners could almost always sell themselves out of a problem. Foreclosures stayed low because the liquid, appreciating housing market bailed out troubled homeowners on its own. That's part of the reason the industry is so ill-equipped to handle the scope of the current problem: it never had to before.
But now, with so many borrowers underwater -- owing more on their house than it's worth -- defaults result in not only eventual liquidation of the property, but profound distress in the homeowner’s life and real losses for investors. Furthermore, delinquent borrowers are less inclined to pay for upkeep or security, and many foreclosed homes are seriously damaged by the time a bank is able to take possession of it.
Being underwater is debilitating. To sell, not only does a homeowner have to pay a Realtor 6% whether he gets a raw deal or not, but he has to pay the bank the difference between where his home sells and the outstanding balance of his loan.
For many who have seen the value of their homes fall hundreds of thousands of dollars, this is an impossibility. Most homeowners, once they’re upside down, just want to stay in their homes.
A more effective plan to curb foreclosures would require an independent reviewer to evaluate each delinquent mortgage, determine the borrower’s ability to pay going forward and the amount, if any, of negative equity that needs to be destroyed to bring the loan amount back under the home’s value.
Since the notion that buying Wall Street’s toxic assets will result in windfall profits is a willfully distributed fallacy aimed at getting the public on board for the bailout, Taxpayers would be well-served dumping money into a blender that’s at least in their own backyard.
British Prime Minister Gordon Brown recently proposed a similar plan, where the government will buy delinquent mortgages from banks for the outstanding balance of the loan. The home is then rented to the existing tenant or a new one and managed by a local housing association.
The government would absorb the difference between the loan amount and the resale value, which would hasten increase sales activity, clearing out the glut of homes listed too high for the simple reason that the owner can't afford to sell at a lower price.
This type of personalized bailout, unfortunately, reeks of moral hazard. Many individuals who made bad financial decisions will get to keep their homes, albeit without actual ownership. But the current socialization of our free markets is simply moral hazard be design, so if Congress is so hell-bent on bailing out Wall Street, why not share the spoils with Main Street.
If Congress wants this bailout to help the American people and keep the financial system in tact, a sizable portion of the funds should be directed at fixing the asset that’s at the center of this turmoil: the residential property.
Home prices need to come down further. They will come down further. It’s only a matter of time. We can either let home prices bleed down, slowly eroding the value of the securities they support and violently uprooting families, or the government can plug the hole.
Washington Mutual (WM) is already off the field, as JP Morgan (JPM) continues to play widowmaker for the financial system. Wachovia (WB) isn't likely to remain independent for long. The sooner the rebuilding process begins, the better.
This crisis, and the resulting ebb and flow of what remains of the free market has already tipped the scales, started us sliding down a path of deflation in everything from stock prices, to cereal boxes, soda bottles, not to mention homes.
This is a good development. The hardest lesson Americans will learn from this crisis, should learn from this crisis, is that sometimes it’s necessary to live within our means. There is virtue in simplicity. More is not always better. Bigger is not always better. Sometimes, amazingly enough, less is often better.
This progress is the only true way we'll make it out of this mess.
Investors Flee Commercial Paper Markets
This post first appeared on Minyanville.
The bailout of the financial system has officially become a typical Washington dog-and-pony show. Partisan politics, it turns out, do in fact trump economic expediency and our elected officials' desire to act in the best interests of their constituency.
Meanwhile, back in reality, the short-term money market -- the oil that greases the gears of the financial system -- is coagulating.
According to the Wall Street Journal, cash is flowing out of the commercial paper market at an alarming rate. In the past two weeks, the market contracted by $113 billion, the largest amount since last summer when the Federal Reserve was forced to take unprecedented steps to unfreeze credit markets.
Companies use commercial paper investments to squeeze a little extra return out of cash they have lying around on their balance sheets. These securities, which typically last a few days or weeks, yield more than traditional money market accounts and were once considered nearly as safe as cash.
Proceeds are then lent out to companies that don’t keep much cash on hand and need to take out short term loans to fund their day-to-day operations.
The seizing up of these markets is affecting businesses large and small.
The Journal notes that payroll processor Paychex (PAYX), which relies on vast pools of liquidity to distribute paychecks for 500,000 American companies, is moving working capital into more secure instruments, some backed by the now nationalized Fannie Mae (FNM) and Freddie Mac (FRE).
Small businesses, on the other hand, that rely on short term loans to bridge the gap between cash outlays and payment for services are having to tap more expensive long term debt.
The cost of many of these loans is tied to the London interbank offer rate, or LIBOR, which remains at record highs. LIBOR represents the amount banks pay to borrow from other banks, and when uncertainty and fear reach the levels we’re currently experiencing, trust all but evaporates. Institutions brave enough to lend charge heftily for their trouble, and the ripple effects can be felt throughout the economy as the lion’s share of interest rates on adjustable rate mortgages and other consumer debt are tied to LIBOR.
As most traders sat down for dinner last night, be it at their desk or in their dining room, news broke that Washington Mutual (WM) had finally succumbed to losses in its massive loan portfolio. JP Morgan (JPM), again the beneficiary of a government orchestrated bailout, snapped up the ailing thrift’s deposit base.
While the removal of one of the most injured players from the financial field is an inevitable step towards repairing our broken system, the fallout isn’t likely to make banks any more willing to part with their precious cash.
Investors hate the unknown, and Washington is currently doling out uncertainty in vast quantities. Markets remain on edge and clogged, with all hopes of becoming unstuck hinging on a bailout plan that’s looking less and less likely to play out as Wall Street had hoped.
The bailout of the financial system has officially become a typical Washington dog-and-pony show. Partisan politics, it turns out, do in fact trump economic expediency and our elected officials' desire to act in the best interests of their constituency.
Meanwhile, back in reality, the short-term money market -- the oil that greases the gears of the financial system -- is coagulating.
According to the Wall Street Journal, cash is flowing out of the commercial paper market at an alarming rate. In the past two weeks, the market contracted by $113 billion, the largest amount since last summer when the Federal Reserve was forced to take unprecedented steps to unfreeze credit markets.
Companies use commercial paper investments to squeeze a little extra return out of cash they have lying around on their balance sheets. These securities, which typically last a few days or weeks, yield more than traditional money market accounts and were once considered nearly as safe as cash.
Proceeds are then lent out to companies that don’t keep much cash on hand and need to take out short term loans to fund their day-to-day operations.
The seizing up of these markets is affecting businesses large and small.
The Journal notes that payroll processor Paychex (PAYX), which relies on vast pools of liquidity to distribute paychecks for 500,000 American companies, is moving working capital into more secure instruments, some backed by the now nationalized Fannie Mae (FNM) and Freddie Mac (FRE).
Small businesses, on the other hand, that rely on short term loans to bridge the gap between cash outlays and payment for services are having to tap more expensive long term debt.
The cost of many of these loans is tied to the London interbank offer rate, or LIBOR, which remains at record highs. LIBOR represents the amount banks pay to borrow from other banks, and when uncertainty and fear reach the levels we’re currently experiencing, trust all but evaporates. Institutions brave enough to lend charge heftily for their trouble, and the ripple effects can be felt throughout the economy as the lion’s share of interest rates on adjustable rate mortgages and other consumer debt are tied to LIBOR.
As most traders sat down for dinner last night, be it at their desk or in their dining room, news broke that Washington Mutual (WM) had finally succumbed to losses in its massive loan portfolio. JP Morgan (JPM), again the beneficiary of a government orchestrated bailout, snapped up the ailing thrift’s deposit base.
While the removal of one of the most injured players from the financial field is an inevitable step towards repairing our broken system, the fallout isn’t likely to make banks any more willing to part with their precious cash.
Investors hate the unknown, and Washington is currently doling out uncertainty in vast quantities. Markets remain on edge and clogged, with all hopes of becoming unstuck hinging on a bailout plan that’s looking less and less likely to play out as Wall Street had hoped.
Unlucky Number 13: Washington Mutual Fails
This post first appeared on Minyanville.
It’s official: The biggest bank failure in US history is now, well, history.
Last night, troubled thrift Washington Mutual (WM) collapsed into the open arms of JPMorgan (JPM), who again picked up a former competitor courtesy of a government-orchestrated bailout. The failure marks the 13th bank failure this year.
In the past 10 days, since the financial crisis began to escalate after the failure of Lehman Brothers and the government’s seizure of AIG (AIG), WaMu lost almost $17 billion in deposits, according to the Wall Street Journal. This exodus of cash left it in a precarious position, one regulators felt was too weak to allow the bank to continue as an independent entity.
Details are hazy, but JPMorgan will acquire the Seattle-based bank’s deposits, retail branches and certain other operations. Initial reports indicate the FDIC’s war chest to protect against bank failures won’t need to be tapped (some feared WaMu’s collapse would cost more than $20 billion to clean up). It remains unclear what will happen to WaMu’s battered loan portfolio.
WaMu has been trying to sell itself for weeks, after its share price fell so low that raising capital through traditional means became all but impossible, but potential suitors like Wells Fargo (WFC) and Citibank (C) balked when they got a good look at the bank’s books. Saddled with future losses on its deteriorating mortgage portfolio, even WaMu’s alluring footprint on the West Coast couldn’t coax an offer out of its suitors.
JPMorgan CEO Jamie Dimon, however, seems to have a penchant for making deals endorsed by the federal government.
Shareholders, who have already undergone considerable pain, will likely get nothing as a result of the takeover, and the Journal reports senior debt holders could be wiped out as well. This could set off a chain reaction in the market for credit default swaps, or financial insurance policies that allow traders and investors to bet on the likelihood of defaults on various debt instruments.
If in fact WaMu defaults on its senior debt, financial institutions that sold these swap agreements could face liabilities that dwarf the nominal value of the debt itself. The credit default swap market is huge and unregulated, and obligations to pay out in the event of default typically exceed the outstanding amount of the underlying security by orders of magnitude. This market is already busily trying to deal with the fallout from Lehman Brothers’ bankruptcy: Another round of defaults won’t simplify matters.
Almost 10 months ago, WaMu announced plans to lay off workers, close branches and scale back its lending operations in an attempt to cut costs. We noted on the Buzz at the time that WaMu has been ahead of the curve in nearly every aspect of the credit crunch, dating back to a decision in 2006 to stop buying loans from some of the small mortgage banking institutions that originated the worst quality loans during the mortgage bubble.
Since that time, banks of all shapes and sizes have cut costs, laid off workers and scaled back lending. It should come as no surprise if WaMu’s collapse is the first of many bank failures that make the FDIC’s first 12 "problem children" seem like toddlers in comparison.
It’s official: The biggest bank failure in US history is now, well, history.
Last night, troubled thrift Washington Mutual (WM) collapsed into the open arms of JPMorgan (JPM), who again picked up a former competitor courtesy of a government-orchestrated bailout. The failure marks the 13th bank failure this year.
In the past 10 days, since the financial crisis began to escalate after the failure of Lehman Brothers and the government’s seizure of AIG (AIG), WaMu lost almost $17 billion in deposits, according to the Wall Street Journal. This exodus of cash left it in a precarious position, one regulators felt was too weak to allow the bank to continue as an independent entity.
Details are hazy, but JPMorgan will acquire the Seattle-based bank’s deposits, retail branches and certain other operations. Initial reports indicate the FDIC’s war chest to protect against bank failures won’t need to be tapped (some feared WaMu’s collapse would cost more than $20 billion to clean up). It remains unclear what will happen to WaMu’s battered loan portfolio.
WaMu has been trying to sell itself for weeks, after its share price fell so low that raising capital through traditional means became all but impossible, but potential suitors like Wells Fargo (WFC) and Citibank (C) balked when they got a good look at the bank’s books. Saddled with future losses on its deteriorating mortgage portfolio, even WaMu’s alluring footprint on the West Coast couldn’t coax an offer out of its suitors.
JPMorgan CEO Jamie Dimon, however, seems to have a penchant for making deals endorsed by the federal government.
Shareholders, who have already undergone considerable pain, will likely get nothing as a result of the takeover, and the Journal reports senior debt holders could be wiped out as well. This could set off a chain reaction in the market for credit default swaps, or financial insurance policies that allow traders and investors to bet on the likelihood of defaults on various debt instruments.
If in fact WaMu defaults on its senior debt, financial institutions that sold these swap agreements could face liabilities that dwarf the nominal value of the debt itself. The credit default swap market is huge and unregulated, and obligations to pay out in the event of default typically exceed the outstanding amount of the underlying security by orders of magnitude. This market is already busily trying to deal with the fallout from Lehman Brothers’ bankruptcy: Another round of defaults won’t simplify matters.
Almost 10 months ago, WaMu announced plans to lay off workers, close branches and scale back its lending operations in an attempt to cut costs. We noted on the Buzz at the time that WaMu has been ahead of the curve in nearly every aspect of the credit crunch, dating back to a decision in 2006 to stop buying loans from some of the small mortgage banking institutions that originated the worst quality loans during the mortgage bubble.
Since that time, banks of all shapes and sizes have cut costs, laid off workers and scaled back lending. It should come as no surprise if WaMu’s collapse is the first of many bank failures that make the FDIC’s first 12 "problem children" seem like toddlers in comparison.
Thursday, September 25, 2008
Hedge Funds Hoard $600 Billion in Cash
This post first appeared on Minyanville.
While they’re not deviously plotting the demise of the worlds’ most powerful financial institutions, hedge funds are loading up on another popular trade: Cash.
According to the Financial Times, Citigroup estimates hedge funds have recently squirreled away as much as $600 billion in cash, of which $100 billion is held in money market funds - those same money market funds Washington so graciously propped up last week.
With good risk-reward investment opportunities in short supply, hedge funds -- paid handsomely to manage risk -- are relying heavily on the safety of cash to ride out recent market turmoil. It’s telling that for those whose livelihoods depend on beating the market, the investment du jour is no investment at all.
Money market funds, which offer a superior return to most traditional bank accounts, hold more than $3 trillion dollars for retail and institutional investors alike. The funds are offered by private wealth managers, as well as big financial institutions like JPMorgan (JPM), Charles Schwabb (SCHW) and even General Electric (GE).
Managers are supposed to invest in safe financial instruments that yield their clients a moderate but secure return. Since there's no chance for principal appreciation, funds compete on this return alone. During the credit boom, certain funds stretched for yield on the back of cheap leverage, investing in riskier and riskier assets, including the now-infamous mortgage-backed securities and other structured debt.
Last week, as if markets needed any more problems, the Reserve Primary Fund announced it had become only the second fund in history to “break the buck.” It turns out that in order to earn investors a higher yield, the fund had purchased debt backed by Lehman Brothers. When Lehman folded, the fund was forced to write off more than $785 million and halt redemptions as clients clamored for cash.
As uncertainty spread about which fund could be next, investors raced to withdraw money from what were feared to be the “next shoe.” That is, until the Treasury Department stepped in to prevent what could have been the bank run to end all bank runs.
Money markets don’t just act as a savings account on steroids; large financial institutions use them to maximize the cash they use to run day-to-day operations. Their willingness to sock away precious dollars at competing banks represents a healthy level of trust, that when they wake up in the morning the money will be right where they left it.
The past week has witnessed an evaporation of that trust, as banks are literally hoarding cash, forgoing returns in the interest of keeping their money close to home. Despite hopes the $700 billion bailout plan will defeat partisan politics in time to rescue the financial system, banks still won’t part with their cash. The recent spike in the London interbank offered rate, or Libor, is evidence of just how pervasive fear is.
Risk, as Mr. Practical is apt to say, is high.
While they’re not deviously plotting the demise of the worlds’ most powerful financial institutions, hedge funds are loading up on another popular trade: Cash.
According to the Financial Times, Citigroup estimates hedge funds have recently squirreled away as much as $600 billion in cash, of which $100 billion is held in money market funds - those same money market funds Washington so graciously propped up last week.
With good risk-reward investment opportunities in short supply, hedge funds -- paid handsomely to manage risk -- are relying heavily on the safety of cash to ride out recent market turmoil. It’s telling that for those whose livelihoods depend on beating the market, the investment du jour is no investment at all.
Money market funds, which offer a superior return to most traditional bank accounts, hold more than $3 trillion dollars for retail and institutional investors alike. The funds are offered by private wealth managers, as well as big financial institutions like JPMorgan (JPM), Charles Schwabb (SCHW) and even General Electric (GE).
Managers are supposed to invest in safe financial instruments that yield their clients a moderate but secure return. Since there's no chance for principal appreciation, funds compete on this return alone. During the credit boom, certain funds stretched for yield on the back of cheap leverage, investing in riskier and riskier assets, including the now-infamous mortgage-backed securities and other structured debt.
Last week, as if markets needed any more problems, the Reserve Primary Fund announced it had become only the second fund in history to “break the buck.” It turns out that in order to earn investors a higher yield, the fund had purchased debt backed by Lehman Brothers. When Lehman folded, the fund was forced to write off more than $785 million and halt redemptions as clients clamored for cash.
As uncertainty spread about which fund could be next, investors raced to withdraw money from what were feared to be the “next shoe.” That is, until the Treasury Department stepped in to prevent what could have been the bank run to end all bank runs.
Money markets don’t just act as a savings account on steroids; large financial institutions use them to maximize the cash they use to run day-to-day operations. Their willingness to sock away precious dollars at competing banks represents a healthy level of trust, that when they wake up in the morning the money will be right where they left it.
The past week has witnessed an evaporation of that trust, as banks are literally hoarding cash, forgoing returns in the interest of keeping their money close to home. Despite hopes the $700 billion bailout plan will defeat partisan politics in time to rescue the financial system, banks still won’t part with their cash. The recent spike in the London interbank offered rate, or Libor, is evidence of just how pervasive fear is.
Risk, as Mr. Practical is apt to say, is high.
Wednesday, September 24, 2008
Buffett Pans for Goldman
This post first appeared on Minyanville and was noted in the Wall Street Journal.
You can almost hear the sound of sheep falling into line, clamoring to follow the lead of the world’s greatest investor.
After the market closed yesterday, Warren Buffett -- bottom fisher extraordinaire -- announced he would be making a $5 billion investment in Goldman Sachs (GS). Financial commentators are now eager to take the Oracle of Omaha’s entry into the financial fray as a sign of the long-awaited bottom.
However, as the Wall Street Journal notes, Buffett’s last foray into Wall Street -- his 1987 investment of $700 million into Solomon Brothers -- immediately preceded October’s market crash. Ultimately, Buffett profited handsomely from the trade after Citigroup (C) folded the once-proud investment bank into its massive operations - but only after serving a 9-month stint as Solomon’s interim chairman, which he described as “far from fun, [but] interesting and worthwhile.”
This time around, Buffett took down preferred shares that pay out 10% and warrants giving him the right to buy $5 billion of Goldman stock at $115 per share, or around 10% of the company’s outstanding equity. Goldman popped on the news in after-hours trading; if the $135 last trade holds when markets open this morning, Buffett will have already booked around $900 million in profits. Not bad for an evening’s work.
Coming on the heels of Morgan Stanley's (MS) capital infusion of $8 billion from Mitsubishi Finance, the largest bank in Japan, the inevitable question is now: Does Buffett’s validation of the Goldman brand -- coupled with the massive bailout rambling its way through Washington -- mark an end to the credit crisis that has intensified to seemingly apocalyptic proportions in recent weeks?
Treasury Secretary Hank Paulson, the architect of the $700 billion financial aid package, weighed in with his answer today during his testimony before the Senate Banking Committee. When asked if he believed the bailout would calm the roiled financial markets, Paulson responded that financial markets would stabilize only when American home prices stop going down.
Indeed.
The credit crisis is bigger than one man, irrespective of how adept his investment decisions may be. It’s bigger than one firm, no matter how deftly its traders navigate choppy markets. The deleveraging that’s under way, which the Federal Reserve will try to prevent with hyperinflation and false price discovery, isn’t something that can be corralled over a weekend or during a hectic week in Washington.
While Buffett's move may provide extra fuel for already historically volatile markets, it's unlikely to do much to stabilize home prices, or to loosen up the massive oversupply of residential real estate that continues to force them downward.
If Paulson’s own assessment of the situation is accurate then, fundamentally -- still -- nothing's changed.
You can almost hear the sound of sheep falling into line, clamoring to follow the lead of the world’s greatest investor.
After the market closed yesterday, Warren Buffett -- bottom fisher extraordinaire -- announced he would be making a $5 billion investment in Goldman Sachs (GS). Financial commentators are now eager to take the Oracle of Omaha’s entry into the financial fray as a sign of the long-awaited bottom.
However, as the Wall Street Journal notes, Buffett’s last foray into Wall Street -- his 1987 investment of $700 million into Solomon Brothers -- immediately preceded October’s market crash. Ultimately, Buffett profited handsomely from the trade after Citigroup (C) folded the once-proud investment bank into its massive operations - but only after serving a 9-month stint as Solomon’s interim chairman, which he described as “far from fun, [but] interesting and worthwhile.”
This time around, Buffett took down preferred shares that pay out 10% and warrants giving him the right to buy $5 billion of Goldman stock at $115 per share, or around 10% of the company’s outstanding equity. Goldman popped on the news in after-hours trading; if the $135 last trade holds when markets open this morning, Buffett will have already booked around $900 million in profits. Not bad for an evening’s work.
Coming on the heels of Morgan Stanley's (MS) capital infusion of $8 billion from Mitsubishi Finance, the largest bank in Japan, the inevitable question is now: Does Buffett’s validation of the Goldman brand -- coupled with the massive bailout rambling its way through Washington -- mark an end to the credit crisis that has intensified to seemingly apocalyptic proportions in recent weeks?
Treasury Secretary Hank Paulson, the architect of the $700 billion financial aid package, weighed in with his answer today during his testimony before the Senate Banking Committee. When asked if he believed the bailout would calm the roiled financial markets, Paulson responded that financial markets would stabilize only when American home prices stop going down.
Indeed.
The credit crisis is bigger than one man, irrespective of how adept his investment decisions may be. It’s bigger than one firm, no matter how deftly its traders navigate choppy markets. The deleveraging that’s under way, which the Federal Reserve will try to prevent with hyperinflation and false price discovery, isn’t something that can be corralled over a weekend or during a hectic week in Washington.
While Buffett's move may provide extra fuel for already historically volatile markets, it's unlikely to do much to stabilize home prices, or to loosen up the massive oversupply of residential real estate that continues to force them downward.
If Paulson’s own assessment of the situation is accurate then, fundamentally -- still -- nothing's changed.
Tuesday, September 23, 2008
Goldman, Morgan Want Your Money
This post first appeared on Minyanville.
Armed with stronger backing from federal banking regulators, Goldman Sachs (GS) and Morgan Stanley (MS) are going shopping for cash.
Yesterday, the last bastions of Wall Street independence announced plans to transform into more traditional banks, subjecting themselves to deeper regulatory scrutiny and tighter limits on leverage. The move also allowed them to pursue customer deposits, a more stable funding source than the recently chaotic money markets.
This morning, Bloomberg reported the 2 firms are already on the prowl, combing the banking landscape for deposits they can snatch up on the cheap. This may seem odd, since Goldman and Morgan were fighting for their lives just a few short days ago - and Morgan was desperately searching for an infusion of capital.
The new designation could help the 2 firms raise money, even in this tough environment. Indeed, shortly after the announcement yesterday, news broke that Mitsubishi UFJ Financial, the largest Japanese bank, will pour over $8 billion into Mother Morgan.
Potential investors may be comforted by new borrowing limits for the formerly leverage-dependent institutions. In addition, financing operations with customer deposits rather than through money markets will decrease the risk of a liquidity squeeze.
Rather than targeting entire banking institutions, Goldman is more interested in buying deposits on the wholesale market or from collapsed institutions like IndyMac, which is currently being liquidated by the FDIC. Morgan plans to expand offerings like certificates of deposit to its more than 3 million retail brokerage clients.
Goldman and Morgan, however, have a more daunting challenge ahead than simply finding cheap deposits to shore up liquidity: Trust.
The events of the past 15 months, specifically the dramatic government intervention into the free markets, has created a systemic shift in the way the public views Wall Street.
Main Street instinctively knows it shouldn’t trust the alchemists of lower Manhattan; we should have learned our lesson after the dot-com crash. But Wall Street simply dreamed up a better disguise, hiding their structured mortgage bets behind the government-constructed façade of affordable housing for all.
Now, the very firms largely responsible for the crisis must go to the public, hat in hand, and ask that they turn their checking and savings accounts over to them.
That may be a tough sell.
Armed with stronger backing from federal banking regulators, Goldman Sachs (GS) and Morgan Stanley (MS) are going shopping for cash.
Yesterday, the last bastions of Wall Street independence announced plans to transform into more traditional banks, subjecting themselves to deeper regulatory scrutiny and tighter limits on leverage. The move also allowed them to pursue customer deposits, a more stable funding source than the recently chaotic money markets.
This morning, Bloomberg reported the 2 firms are already on the prowl, combing the banking landscape for deposits they can snatch up on the cheap. This may seem odd, since Goldman and Morgan were fighting for their lives just a few short days ago - and Morgan was desperately searching for an infusion of capital.
The new designation could help the 2 firms raise money, even in this tough environment. Indeed, shortly after the announcement yesterday, news broke that Mitsubishi UFJ Financial, the largest Japanese bank, will pour over $8 billion into Mother Morgan.
Potential investors may be comforted by new borrowing limits for the formerly leverage-dependent institutions. In addition, financing operations with customer deposits rather than through money markets will decrease the risk of a liquidity squeeze.
Rather than targeting entire banking institutions, Goldman is more interested in buying deposits on the wholesale market or from collapsed institutions like IndyMac, which is currently being liquidated by the FDIC. Morgan plans to expand offerings like certificates of deposit to its more than 3 million retail brokerage clients.
Goldman and Morgan, however, have a more daunting challenge ahead than simply finding cheap deposits to shore up liquidity: Trust.
The events of the past 15 months, specifically the dramatic government intervention into the free markets, has created a systemic shift in the way the public views Wall Street.
Main Street instinctively knows it shouldn’t trust the alchemists of lower Manhattan; we should have learned our lesson after the dot-com crash. But Wall Street simply dreamed up a better disguise, hiding their structured mortgage bets behind the government-constructed façade of affordable housing for all.
Now, the very firms largely responsible for the crisis must go to the public, hat in hand, and ask that they turn their checking and savings accounts over to them.
That may be a tough sell.
Monday, September 22, 2008
And Then There Were None: Goldman, Morgan Become Bank Holding Companies
This post first appeared on Minyanville.
Regulators were at it again over the weekend, rewriting the rulebook of America’s financial landscape.
Late Sunday, Goldman Sachs (GS) and Morgan Stanley (MS) announced plans to become banks, seeking the sounder funding base of traditional deposit-taking institutions. The last remaining independent Wall Street brokerages will be transformed, now supervised by the Federal Reserve and other national regulators.
According to the Wall Street Journal, the Fed allowed Goldman and Morgan to reorganize themselves as bank holding companies, thereby subjecting them to more restrictive rules and regulations. The new designation offers greater access to federal lending facilities and gives the 2 firms the chance to open retail branches and accept customer deposits -- widely considered a more reliable method of funding.
The money markets, until recently the brokerages’ primary source of liquidity, were in a historic state of disorder following the collapse of Lehman Brothers and the governments’ seizure of Fannie Mae (FNM), Freddie Mac (FRE) and AIG (AIG). The uncertainty surrounding once-strong firms made access to cash highly unreliable.
Rather than merging with commercial banks, Goldman and Morgan decided to retreat, delever and rebuild under a more conservative business model.
Deposit-taking institutions face tighter capital requirements and can’t use leverage as freely as investment banks, which reduces their ability to make outsized profits when times are good. It does, however, create more insulation to protect against losses when bets go sour.
Bad bets by the truckload saddled both Goldman and Morgan with assets of such questionable value that investors feared the once-proud institutions would sheepishly follow Merrill Lynch (MER) into the arms of a big commercial bank.
Morgan had been holding talks with Wachovia (WB) about a potential merger, while Goldman adamantly refused to even consider the idea of a buyout.
When traders went to bed 10 short days ago, 4 big investment banks -- storied firms deeply entrenched in the American ideology of entreprenuership and risk-taking -- still existed, however tenuously.
Now, there are none.
William Isaac, a former chairman of the Federal Deposit and Insurance Corporation, told Bloomberg: "The decision marks the end of Wall Street as we know it. It's really too bad, as our country has benefited greatly from the entrepreneurial risk-takers on Wall Street."
Many, fearful of free markets, wary of trusting men and women to make their own decisions, will welcome Wall Street’s demise, calling it a victory for the little guy, a much-needed punishment for the greediest of the greedy. And while some of the bankers who poured into lower Manhattan each morning certainly exemplified self-interest at its worst, the positive impact Wall Street’s risk-taking has had in building this country cannot be downplayed.
Bridges, skyscrapers, our highway system and countless other industrial cornerstones of our economy would not have been possible if crafty financiers hadn’t figured out how to use credit and risk to enhance economic growth. Risk-taking is a natural, healthy part of capitalism. In fact, without it, the free markets cannot function.
We got out over our skis, to be sure, but that doesn't mean the entire concept of lending, borrowing and taking on projects that may or may not turn out well should be condemned in its entirety.
The destruction of debt required to bring our economy back into balance and enable healthy growth to sprout anew must be led by those willing to take risk, to wade bravely into markets before they're fully healed. Now that the foremost private risk-takers in this country are out of the way, public speculators are poised to step in and sop up $700 billion in toxic assets sitting on the financial industry’s collective balance sheet.
Don’t forget to pay your taxes this spring.
Regulators were at it again over the weekend, rewriting the rulebook of America’s financial landscape.
Late Sunday, Goldman Sachs (GS) and Morgan Stanley (MS) announced plans to become banks, seeking the sounder funding base of traditional deposit-taking institutions. The last remaining independent Wall Street brokerages will be transformed, now supervised by the Federal Reserve and other national regulators.
According to the Wall Street Journal, the Fed allowed Goldman and Morgan to reorganize themselves as bank holding companies, thereby subjecting them to more restrictive rules and regulations. The new designation offers greater access to federal lending facilities and gives the 2 firms the chance to open retail branches and accept customer deposits -- widely considered a more reliable method of funding.
The money markets, until recently the brokerages’ primary source of liquidity, were in a historic state of disorder following the collapse of Lehman Brothers and the governments’ seizure of Fannie Mae (FNM), Freddie Mac (FRE) and AIG (AIG). The uncertainty surrounding once-strong firms made access to cash highly unreliable.
Rather than merging with commercial banks, Goldman and Morgan decided to retreat, delever and rebuild under a more conservative business model.
Deposit-taking institutions face tighter capital requirements and can’t use leverage as freely as investment banks, which reduces their ability to make outsized profits when times are good. It does, however, create more insulation to protect against losses when bets go sour.
Bad bets by the truckload saddled both Goldman and Morgan with assets of such questionable value that investors feared the once-proud institutions would sheepishly follow Merrill Lynch (MER) into the arms of a big commercial bank.
Morgan had been holding talks with Wachovia (WB) about a potential merger, while Goldman adamantly refused to even consider the idea of a buyout.
When traders went to bed 10 short days ago, 4 big investment banks -- storied firms deeply entrenched in the American ideology of entreprenuership and risk-taking -- still existed, however tenuously.
Now, there are none.
William Isaac, a former chairman of the Federal Deposit and Insurance Corporation, told Bloomberg: "The decision marks the end of Wall Street as we know it. It's really too bad, as our country has benefited greatly from the entrepreneurial risk-takers on Wall Street."
Many, fearful of free markets, wary of trusting men and women to make their own decisions, will welcome Wall Street’s demise, calling it a victory for the little guy, a much-needed punishment for the greediest of the greedy. And while some of the bankers who poured into lower Manhattan each morning certainly exemplified self-interest at its worst, the positive impact Wall Street’s risk-taking has had in building this country cannot be downplayed.
Bridges, skyscrapers, our highway system and countless other industrial cornerstones of our economy would not have been possible if crafty financiers hadn’t figured out how to use credit and risk to enhance economic growth. Risk-taking is a natural, healthy part of capitalism. In fact, without it, the free markets cannot function.
We got out over our skis, to be sure, but that doesn't mean the entire concept of lending, borrowing and taking on projects that may or may not turn out well should be condemned in its entirety.
The destruction of debt required to bring our economy back into balance and enable healthy growth to sprout anew must be led by those willing to take risk, to wade bravely into markets before they're fully healed. Now that the foremost private risk-takers in this country are out of the way, public speculators are poised to step in and sop up $700 billion in toxic assets sitting on the financial industry’s collective balance sheet.
Don’t forget to pay your taxes this spring.
Friday, September 19, 2008
Fed Amputates Invisible Hand
This post first appeared on Minyanville.
A week ago, the United States had the most efficient capital allocation system in the world.
Our free-market economy enabled money, credit and resources to be sent to the economic players who needed it. Entrepreneurs could raise money to start new, innovative businesses; researchers could seek out cures for diseases that touch millions of lives, as well as those that afflict just thousands; firms that made enough bad decisions went bankrupt.
The job of regulators was to ensure the system functioned and to set up rules by which honest business could be conducted. It wasn't a perfect system, but it was better than the alternative.
This is the alternative.
When government invades free markets to the extent it has -- specifically in the last 24 hours -- the system ensuring capital gets where it needs to be breaks down. Money is instead doled out to the firms well connected enough in Washington to lobby for handouts.
Beltway bureaucrats have been trying to rewrite this country's economic rules and protect Wall Street from its own mistakes for over a year. Still, the free market prevailed, punishing the firms that made the most egregious bets during the housing boom: Countrywide, Bear Stearns, IndyMac, Merrill Lynch (MER), AIG (AIG), Lehman Brothers, National City (NCC), Washington Mutual (WM) and Wachovia (WB).
According to our once-free market, these firms needed to be wiped out, gobbled up and liquidated, so real economic growth could take hold from a stronger foundation.
This morning, we heard many claim the government's actions -- temporarily banning short selling, the creation of a Treasury Department distressed-asset hedge fund, the establishment of a federal backstop for money markets, to name but a few -- were necessary to prevent a wider financial and economic crisis. The shortsightedness of this argument is astounding.
A couple hundred years ago, Charles Darwin opined that nature has long been engaged in weeding out the weak, protecting the strong. This natural ebb and flow of dominance according to a given species' inherent characteristics has governed the world's socioeconomic landscape for more than 4 billion years.
The actions taken overnight seem to refute Darwin's claim that Mother Nature can manage her own backyard. Adam Smith's invisible hand is capitalist Darwinism, moving the weak aside so the strong can survive.
To take that power away from the market is tantamount to shoving God aside and rewriting the evolutionary playbook.
The effects of these actions, this fundamental ideological shift from capitalism towards socialism, represents a seismic shift in the history of this country. The events of the past week -- and what it says about our collective ability to take our lumps, drink our medicine and recognize that the path to the ultimate goal is one littered with hairpin turns and drop away cliffs -- will not be lost on future generations.
The events of the upcoming months and years, whether we're content to continue to hand over more and more power to the few, elected and non-elected alike, will show the true mettle of the American spirit.
A week ago, the United States had the most efficient capital allocation system in the world.
Our free-market economy enabled money, credit and resources to be sent to the economic players who needed it. Entrepreneurs could raise money to start new, innovative businesses; researchers could seek out cures for diseases that touch millions of lives, as well as those that afflict just thousands; firms that made enough bad decisions went bankrupt.
The job of regulators was to ensure the system functioned and to set up rules by which honest business could be conducted. It wasn't a perfect system, but it was better than the alternative.
This is the alternative.
When government invades free markets to the extent it has -- specifically in the last 24 hours -- the system ensuring capital gets where it needs to be breaks down. Money is instead doled out to the firms well connected enough in Washington to lobby for handouts.
Beltway bureaucrats have been trying to rewrite this country's economic rules and protect Wall Street from its own mistakes for over a year. Still, the free market prevailed, punishing the firms that made the most egregious bets during the housing boom: Countrywide, Bear Stearns, IndyMac, Merrill Lynch (MER), AIG (AIG), Lehman Brothers, National City (NCC), Washington Mutual (WM) and Wachovia (WB).
According to our once-free market, these firms needed to be wiped out, gobbled up and liquidated, so real economic growth could take hold from a stronger foundation.
This morning, we heard many claim the government's actions -- temporarily banning short selling, the creation of a Treasury Department distressed-asset hedge fund, the establishment of a federal backstop for money markets, to name but a few -- were necessary to prevent a wider financial and economic crisis. The shortsightedness of this argument is astounding.
A couple hundred years ago, Charles Darwin opined that nature has long been engaged in weeding out the weak, protecting the strong. This natural ebb and flow of dominance according to a given species' inherent characteristics has governed the world's socioeconomic landscape for more than 4 billion years.
The actions taken overnight seem to refute Darwin's claim that Mother Nature can manage her own backyard. Adam Smith's invisible hand is capitalist Darwinism, moving the weak aside so the strong can survive.
To take that power away from the market is tantamount to shoving God aside and rewriting the evolutionary playbook.
The effects of these actions, this fundamental ideological shift from capitalism towards socialism, represents a seismic shift in the history of this country. The events of the past week -- and what it says about our collective ability to take our lumps, drink our medicine and recognize that the path to the ultimate goal is one littered with hairpin turns and drop away cliffs -- will not be lost on future generations.
The events of the upcoming months and years, whether we're content to continue to hand over more and more power to the few, elected and non-elected alike, will show the true mettle of the American spirit.
Thursday, September 18, 2008
AIG: Also Too Big To Fail
This post first appeared on Minyanville.
The largest insurer in the US was indeed too big to fail.
In an unprecedented move intended to calm frenzied financial markets, the US government assumed control of American International Group (AIG) late last night.
According to the Wall Street Journal, in return for an $85 billion loan to keep AIG solvent, the US government will pick up a 79.9% equity stake in the troubled financial services company. The loan is backed by the assets on AIG’s balance sheet along with its profitable insurance and aircraft leasing businesses. The government seizure is expected to stem fears the insurer would be forced into liquidation.
Such an event would have unleashed chaos in financial markets.
AIG’s massive exposure to the $64 trillion credit default swap market and the implications of its impending collapse proved too much for government officials to stomach.
During the past week, AIG scoured Wall Street for cash - to no avail. An emergency lending facility led by JPMorgan (JPM) and Goldman Sachs (GS) fell apart. Numerous attempts to shed assets failed. Even a short-lived plan to lend itself $20 billion self-destructed.
As recently as yesterday afternoon, reports swirled that a federal bailout was off the table. The company’s stock was punished, falling as low as $1.25 before recovering to close Tuesday at $3.75.
At $1.25 per share, AIG's market capitalization was a touch over $3 billion. The price tag of the emergency loan therefore highlights the extent to which this company was levered beyond all rationality.
Late yesterday, Treasury Secretary Paulson, Federal Reserve Chairman Bernanke and New York Fed President Timothy Geithner convened and determined the potentially catastrophic effect of an AIG bankruptcy could not be risked. The bailout is aimed at averting the unraveling of AIG’s massive trading positions - an exercise in financial triage no one wanted try.
In the days since Lehman Brothers’ (LEH) collapse over the weekend, Wall Street has scrambled to determine the true extent of the resulting losses. Countless firms -- many seemingly detached from roiling financial markets -- came forward to acknowledge damage inflicted by the investment bank’s demise.
Constellation Energy (CEG), a Baltimore-based supplier of energy, tumbled nearly 40% yesterday as its ties with Lehman sparked concerns over its liquidity prospects. The company, for its part, denied Lehman’s failure would materially impact its business.
The general consensus was that fallout from the collapse of AIG would make Lehman look like a walk in the park. As Toddo wrote yesterday, “The counter-party risk at AIG makes Lehman Brothers look like a pimple on an elephant’s ass. Something needs to be done and soon.”
The extent to which the landscape of the world’s financial markets has been changed in the past 72 hours is mind-boggling. In the course of a few days, one major investment bank collapsed (Lehman), another hastily sold itself to avoid a similar fate (Merrill Lynch (MER)), and the largest insurance company in the United States was seized by the government (AIG).
And it’s only Wednesday.
The largest insurer in the US was indeed too big to fail.
In an unprecedented move intended to calm frenzied financial markets, the US government assumed control of American International Group (AIG) late last night.
According to the Wall Street Journal, in return for an $85 billion loan to keep AIG solvent, the US government will pick up a 79.9% equity stake in the troubled financial services company. The loan is backed by the assets on AIG’s balance sheet along with its profitable insurance and aircraft leasing businesses. The government seizure is expected to stem fears the insurer would be forced into liquidation.
Such an event would have unleashed chaos in financial markets.
AIG’s massive exposure to the $64 trillion credit default swap market and the implications of its impending collapse proved too much for government officials to stomach.
During the past week, AIG scoured Wall Street for cash - to no avail. An emergency lending facility led by JPMorgan (JPM) and Goldman Sachs (GS) fell apart. Numerous attempts to shed assets failed. Even a short-lived plan to lend itself $20 billion self-destructed.
As recently as yesterday afternoon, reports swirled that a federal bailout was off the table. The company’s stock was punished, falling as low as $1.25 before recovering to close Tuesday at $3.75.
At $1.25 per share, AIG's market capitalization was a touch over $3 billion. The price tag of the emergency loan therefore highlights the extent to which this company was levered beyond all rationality.
Late yesterday, Treasury Secretary Paulson, Federal Reserve Chairman Bernanke and New York Fed President Timothy Geithner convened and determined the potentially catastrophic effect of an AIG bankruptcy could not be risked. The bailout is aimed at averting the unraveling of AIG’s massive trading positions - an exercise in financial triage no one wanted try.
In the days since Lehman Brothers’ (LEH) collapse over the weekend, Wall Street has scrambled to determine the true extent of the resulting losses. Countless firms -- many seemingly detached from roiling financial markets -- came forward to acknowledge damage inflicted by the investment bank’s demise.
Constellation Energy (CEG), a Baltimore-based supplier of energy, tumbled nearly 40% yesterday as its ties with Lehman sparked concerns over its liquidity prospects. The company, for its part, denied Lehman’s failure would materially impact its business.
The general consensus was that fallout from the collapse of AIG would make Lehman look like a walk in the park. As Toddo wrote yesterday, “The counter-party risk at AIG makes Lehman Brothers look like a pimple on an elephant’s ass. Something needs to be done and soon.”
The extent to which the landscape of the world’s financial markets has been changed in the past 72 hours is mind-boggling. In the course of a few days, one major investment bank collapsed (Lehman), another hastily sold itself to avoid a similar fate (Merrill Lynch (MER)), and the largest insurance company in the United States was seized by the government (AIG).
And it’s only Wednesday.
Tuesday, September 16, 2008
Why Should I Care?: Lehman Brothers
This post first appeared on Minyanville.
Of all the days for your air conditioner to break.
Late, as usual, you weave past slower commuters, driven by the promise of a cool subway car - an icebox in an otherwise sweltering city.
As the train makes its way down the dirty tracks, fellow straphangers sway, bumping into you with alarming frequency. Craning your neck, you can barely make out the lucky few who managed to claim a seat: A construction worker with dusty boots and stained jeans, mouth agape and snoring soundly; a nurse in scrubs and sneakers.
How many bedpans would he change by the time you finished your second cup of coffee?
Then an odd combination: A janitor, nametag and all, chatting casually with a banker, his profession worn proudly on his pinstriped sleeve. What could these guys possibly have in common?
“Have you heard when they’ll make the announcement?”
“No. Nothing. Radio silence from the CEO.”
“Hell of a day to work at Lehman Brothers (LEH).”
“You said it.”
It’s easy to file the collapse of a major investment bank under “good riddance” - fitting comeuppance for some greedy traders who tore the moral fabric of this country in the name of their year-end bonus.
Why should anyone care if a few rich guys at Merrill Lynch (MER) lose their jobs because their firm made so many bad bets it had to sell itself to Bank of America (BAC) in a hastily thrown together weekend deal?
Even if you aren’t interested in doling out empathy for any of the 25,000 Lehman employees -- a precious number of whom were party to the reckless risk-taking that led to the firm’s demise -- viewing the turmoil on Wall Street as confined to the narrow streets of lower Manhattan is to misunderstand the vital role these financial institutions play in our economy.
Consider the employees at Blowtorch, a startup movie studio that takes flyers on independent filmmakers. The company raised $50 million dollars late last year, a good chunk of which came from an unnamed hedge fund. It hired editors, graphic designers and countless other artistic types who couldn’t dissect a balance sheet or model a mortgage prepayment if their lives depended on it - and liked it that way.
Then, just this April, the hedge fund decided to pull out, leaving Blowtorch on the ropes. It laid off most of its new employees and scaled back considerably. The credit crunch, 3000 miles away from sunny California, claimed a group of victims who played no role whatsoever in its creation.
Fortress Investments (FIG), one of the first hedge funds to go public, is a major source of capital for Hollywood movie studios, which borrow tens of millions of dollars to churn out the summer blockbusters hoards of regular Americans watch each summer. So far Fortress has weathered the crisis better than most, but, were it to fall on hard times, there’s a good chance we’d have fewer big-ticket event films in the coming years.
Investment banks like Goldman Sachs (GS) and Morgan Stanley (MS) finance projects not just around the country, but around the world - everything from apartment buildings in China to cement factories in India. The company also employs tens of thousands of Americans, many of whom sweep floors, file files and have no idea about the firm’s strategic direction.
Leverage -- cheap leverage especially -- played a significant role in allowing these firms to get as big as they did, make as much money as they did. Imagine what you could accomplish if you were able to borrow $24 for every dollar in your bank account - much the way Lehman did. A correction is underway, and it’s far from over.
Many would argue this is a welcome development -- and it probably is -- but the road to healthy, economic expansion will be traversed in painful steps.
These firms will contract and rein in their massive economic exploits, the effects of which will ripple around the world and contribute to the ongoing economic slowdown. Jobs will be lost, expansion plans will be postponed and retirement accounts will suffer.
The banker and the janitor have more in common than you think.
Of all the days for your air conditioner to break.
Late, as usual, you weave past slower commuters, driven by the promise of a cool subway car - an icebox in an otherwise sweltering city.
As the train makes its way down the dirty tracks, fellow straphangers sway, bumping into you with alarming frequency. Craning your neck, you can barely make out the lucky few who managed to claim a seat: A construction worker with dusty boots and stained jeans, mouth agape and snoring soundly; a nurse in scrubs and sneakers.
How many bedpans would he change by the time you finished your second cup of coffee?
Then an odd combination: A janitor, nametag and all, chatting casually with a banker, his profession worn proudly on his pinstriped sleeve. What could these guys possibly have in common?
“Have you heard when they’ll make the announcement?”
“No. Nothing. Radio silence from the CEO.”
“Hell of a day to work at Lehman Brothers (LEH).”
“You said it.”
It’s easy to file the collapse of a major investment bank under “good riddance” - fitting comeuppance for some greedy traders who tore the moral fabric of this country in the name of their year-end bonus.
Why should anyone care if a few rich guys at Merrill Lynch (MER) lose their jobs because their firm made so many bad bets it had to sell itself to Bank of America (BAC) in a hastily thrown together weekend deal?
Even if you aren’t interested in doling out empathy for any of the 25,000 Lehman employees -- a precious number of whom were party to the reckless risk-taking that led to the firm’s demise -- viewing the turmoil on Wall Street as confined to the narrow streets of lower Manhattan is to misunderstand the vital role these financial institutions play in our economy.
Consider the employees at Blowtorch, a startup movie studio that takes flyers on independent filmmakers. The company raised $50 million dollars late last year, a good chunk of which came from an unnamed hedge fund. It hired editors, graphic designers and countless other artistic types who couldn’t dissect a balance sheet or model a mortgage prepayment if their lives depended on it - and liked it that way.
Then, just this April, the hedge fund decided to pull out, leaving Blowtorch on the ropes. It laid off most of its new employees and scaled back considerably. The credit crunch, 3000 miles away from sunny California, claimed a group of victims who played no role whatsoever in its creation.
Fortress Investments (FIG), one of the first hedge funds to go public, is a major source of capital for Hollywood movie studios, which borrow tens of millions of dollars to churn out the summer blockbusters hoards of regular Americans watch each summer. So far Fortress has weathered the crisis better than most, but, were it to fall on hard times, there’s a good chance we’d have fewer big-ticket event films in the coming years.
Investment banks like Goldman Sachs (GS) and Morgan Stanley (MS) finance projects not just around the country, but around the world - everything from apartment buildings in China to cement factories in India. The company also employs tens of thousands of Americans, many of whom sweep floors, file files and have no idea about the firm’s strategic direction.
Leverage -- cheap leverage especially -- played a significant role in allowing these firms to get as big as they did, make as much money as they did. Imagine what you could accomplish if you were able to borrow $24 for every dollar in your bank account - much the way Lehman did. A correction is underway, and it’s far from over.
Many would argue this is a welcome development -- and it probably is -- but the road to healthy, economic expansion will be traversed in painful steps.
These firms will contract and rein in their massive economic exploits, the effects of which will ripple around the world and contribute to the ongoing economic slowdown. Jobs will be lost, expansion plans will be postponed and retirement accounts will suffer.
The banker and the janitor have more in common than you think.
AIG May Capture Biggest Red Flag
This post first appeared on Minyanville.
If there was ever a Monday to skip that morning coffee and run on pure adrenaline, this is it.
As Lehman Brothers (LEH) and Merrill Lynch (MER) jockey for top placement in this morning’s headlines, American International Group (AIG) is dramatically staking a claim for the financial market’s biggest red flag.
Lehman and Merrill, already collapsed into the hands of bankruptcy courts and Bank of America (BAC), respectively, have well-publicized and largely understood troubles. Loaded up with securities tied to US mortgage debt, their capital bases have been eroded by losses and writedowns on bad assets.
Although losses have been hard to quantify -- due to obfuscation by management and underhanded accounting aimed at hiding the true extent of the damage -- most investors can at least wrap their heads around the issues.
The US’s largest insurer, on the other hand, is besieged by losses in its opaque credit products division and is rushing to sell assets and raise capital to stay alive. Professor Sedacca has been eyeing the firm as a potential cancer for weeks, in fear that its mammoth exposure to the credit markets may put the entire system at risk.
AIG has seen its balance sheet destroyed by losses on complex derivative instruments known as credit default swaps. The company sold these insurance contracts to other financial institutions that owned mortgage-backed securities, putting AIG on the hook for any losses that may occur. And they have indeed occurred.
Although many such obligations are yet to be paid out, the value of these assets have opened a gaping hole in AIG’s balance sheet.
The company, which has raised over $20 billion this year, is seeking another $40 billion. To that end, it's asked the Federal Reserve for a bridge loan to give it time to find the cash, according to the Wall Street Journal. AIG’s -- and indeed Wall Street’s -- concern is that ratings agencies Moody’s (MCO) and Standard and Poor’s may not wait around to downgrade the company's debt.
The New York Times reports the company may not last more than a couple days if such a downgrade were to occur.
AIG, and indeed all financial institutions, covet high credit ratings to keep their borrowing costs and capital requirements low.
If there was ever a Monday to skip that morning coffee and run on pure adrenaline, this is it.
As Lehman Brothers (LEH) and Merrill Lynch (MER) jockey for top placement in this morning’s headlines, American International Group (AIG) is dramatically staking a claim for the financial market’s biggest red flag.
Lehman and Merrill, already collapsed into the hands of bankruptcy courts and Bank of America (BAC), respectively, have well-publicized and largely understood troubles. Loaded up with securities tied to US mortgage debt, their capital bases have been eroded by losses and writedowns on bad assets.
Although losses have been hard to quantify -- due to obfuscation by management and underhanded accounting aimed at hiding the true extent of the damage -- most investors can at least wrap their heads around the issues.
The US’s largest insurer, on the other hand, is besieged by losses in its opaque credit products division and is rushing to sell assets and raise capital to stay alive. Professor Sedacca has been eyeing the firm as a potential cancer for weeks, in fear that its mammoth exposure to the credit markets may put the entire system at risk.
AIG has seen its balance sheet destroyed by losses on complex derivative instruments known as credit default swaps. The company sold these insurance contracts to other financial institutions that owned mortgage-backed securities, putting AIG on the hook for any losses that may occur. And they have indeed occurred.
Although many such obligations are yet to be paid out, the value of these assets have opened a gaping hole in AIG’s balance sheet.
The company, which has raised over $20 billion this year, is seeking another $40 billion. To that end, it's asked the Federal Reserve for a bridge loan to give it time to find the cash, according to the Wall Street Journal. AIG’s -- and indeed Wall Street’s -- concern is that ratings agencies Moody’s (MCO) and Standard and Poor’s may not wait around to downgrade the company's debt.
The New York Times reports the company may not last more than a couple days if such a downgrade were to occur.
AIG, and indeed all financial institutions, covet high credit ratings to keep their borrowing costs and capital requirements low.
Where Were You When Lehman Brothers Failed?
This post first appeared on Minyanville.
There’s a thing about living through historic events, those moments when we shudder with the recognition that the world just hopped the tracks and is barreling along in an altogether different direction.
For my parents’ generation -- and I’m sure for many Minyans -- that feeling is sparked by the question, “Where were you when JFK was shot?” More recently, “Where were you on 9/11?” sends similar chills down our collective spines.
I don’t wish to compare the collapse of an investment bank -- Lehman Brothers (LEH) -- or the purchase of one financial institution by another -- Merrill Lynch (MER) by Bank of America (BAC) -- to such profoundly significant points in history. To do so is as much a muddling of human and economic tragedies as it is a really challenging experiment in comparing apples to oranges.
Nevertheless, it’s these singularly unique events that shape our future histories, both human and financial.
Swept up by the moment, we typically spend its short duration reporting, discussing, analyzing and criticizing; glued to the television for the latest breaking news. Immediately afterwards, we trip over ourselves to pontificate about the way in which our lives will change forever. And indeed, they may.
But forever is an awfully long time.
As the hours pass today, events will unfold and details will emerge. Individuals with direct knowledge of various situations will be cited anonymously by news sources clamoring to be the first to break the story.
As the hours pass today, fortunes will be made and lost. Vast sums will be erased from balance sheets, even as equally impressive totals are added to others.
As the hours pass today, people will lose their jobs. Others will receive the promotion they never saw coming.
As the hours pass today, more hours will take their place.
Those too, shall pass.
Often the hardest thing to find on days like this is simply a bit of perspective. No doubt, we’ll read about how this crisis compares to those past and those sure to come. Conclusions will be drawn, extrapolations made, predictions brought forward by talking heads and so-called experts.
That sort of perspective will be plentiful today.
But it’s the other sort of perspective, the kind that can’t be found under the florescent lights of an office or hidden inside the flickering ticks, that’s in short supply on days like this.
Look for it on your walk to work, out the window of the train, or in a leaf, quietly disengaging from its branch and fluttering to the ground, listlessly playing in the wind, settling silently on the earth, never to fly again. When you find it, smile, acknowledge it, accept it. Appreciate the fact that today is a historic day, one that you’re not likely to soon forget.
Step outside the office, look past the charts.
In the bustle of waiting for the next crisis to scream across headlines, you're about as likely to be missed as you will regret a few moments spent in quite reflection of the day, and what you'll say when your grandkids ask where you were when it happened.
There’s a thing about living through historic events, those moments when we shudder with the recognition that the world just hopped the tracks and is barreling along in an altogether different direction.
For my parents’ generation -- and I’m sure for many Minyans -- that feeling is sparked by the question, “Where were you when JFK was shot?” More recently, “Where were you on 9/11?” sends similar chills down our collective spines.
I don’t wish to compare the collapse of an investment bank -- Lehman Brothers (LEH) -- or the purchase of one financial institution by another -- Merrill Lynch (MER) by Bank of America (BAC) -- to such profoundly significant points in history. To do so is as much a muddling of human and economic tragedies as it is a really challenging experiment in comparing apples to oranges.
Nevertheless, it’s these singularly unique events that shape our future histories, both human and financial.
Swept up by the moment, we typically spend its short duration reporting, discussing, analyzing and criticizing; glued to the television for the latest breaking news. Immediately afterwards, we trip over ourselves to pontificate about the way in which our lives will change forever. And indeed, they may.
But forever is an awfully long time.
As the hours pass today, events will unfold and details will emerge. Individuals with direct knowledge of various situations will be cited anonymously by news sources clamoring to be the first to break the story.
As the hours pass today, fortunes will be made and lost. Vast sums will be erased from balance sheets, even as equally impressive totals are added to others.
As the hours pass today, people will lose their jobs. Others will receive the promotion they never saw coming.
As the hours pass today, more hours will take their place.
Those too, shall pass.
Often the hardest thing to find on days like this is simply a bit of perspective. No doubt, we’ll read about how this crisis compares to those past and those sure to come. Conclusions will be drawn, extrapolations made, predictions brought forward by talking heads and so-called experts.
That sort of perspective will be plentiful today.
But it’s the other sort of perspective, the kind that can’t be found under the florescent lights of an office or hidden inside the flickering ticks, that’s in short supply on days like this.
Look for it on your walk to work, out the window of the train, or in a leaf, quietly disengaging from its branch and fluttering to the ground, listlessly playing in the wind, settling silently on the earth, never to fly again. When you find it, smile, acknowledge it, accept it. Appreciate the fact that today is a historic day, one that you’re not likely to soon forget.
Step outside the office, look past the charts.
In the bustle of waiting for the next crisis to scream across headlines, you're about as likely to be missed as you will regret a few moments spent in quite reflection of the day, and what you'll say when your grandkids ask where you were when it happened.
A Minyanville Primer: Credit Default Swaps
This post first appeared on Minyanville.
Fear, today, is not in short supply.
Of the myriad fears racing around Wall Street, one of the greatest is what will happen to the tangled web of credit default swaps, or CDS, that tie the global financial system together like a team of spiders hopped up on amphetamines.
It was to protect this market that the Treasury Department backed JP Morgan's (JPM) purchase of Bear Stearns this March. With news of Lehman Brothers' (LEH) bankruptcy filing late last night, traders will now be forced to unwind bets they hoped they'd never have to sort out.
The durability of this massive, unregulated market is about to be tested: trillions of dollars in contracts have been triggered in the past week, first with the siezure of Fannie Mae (FNM) and Freddie Mac (FRE), and most recently by Lehman's collapse.
Credit Default Swaps, or CDS, offer financial firms a quick way to offload part or all their exposure to debt backed by state and municipal governments, corporations, or structured debt tied to consumer loans. A CDS is an agreement in which two parties agree to trade, or ‘swap’ risk for a default event that may happen in the future.
Lets say for example, The Bank of Boo owns corporate debt issued by Daisy’s Department Store.
If Daisy has a strong balance sheet, good cash flows and a long track record of making her debt payments, credit ratings agencies such as Moody’s (MCO) and Standard and Poor’s are likely to rate her debt well, making her bonds available for purchase by a wide range of financial institutions, including the Bank of Boo.
Boo’s primary risk is that Daisy falls on hard times and stops making her interest payments. Credit ratings help Boo determine the chances of this. A higher rating indicates lower risk, and therefore a lower potential return. Conversely, Boo can make a higher return for buying lower rated pieces of Daisy’s debt that are the first to go sour if she has financial troubles.
Enter the CDS.
If Boo lends Daisy $1,000,000 at 5%, he earns $50,000 per year in interest plus a repayment of principal over the life of the loan. To protect this investment, Boo may buy a Credit Default Swap from Sammy’s Structured Products, a financial insurer setting up shop in Minyanland. The CDS contract stipulates that Boo pays Sammy a fee, while Sammy is obligated to step in and make Boo whole if Daisy is unable to make her payments.
CDS contracts are priced in basis points, or hundredths of percentage points. So, Boo may pay 100 basis points, or 1% of the notional value of the loan for his credit protection. Although this insurance reduces Boo’s potential income by $10,000 per year, in the event Daisy defaults, Sammy is obligated to pay up and make sure Boo doesn’t lose his investment.
CDS contracts can be written for any type of debt product, and during the golden years of cheap leverage -- now long since gon -- were actively used as speculative tools rather than simply as credit protection
Suppose a news story breaks that Daisy is being investigated for unsavory business practices and her future profitability becomes questionable.
If Hoofy’s Hedge Fund owns the same bonds the Bank of Boo does and goes to Sammy to buy a CDS contract for protection, the now higher risk of default means Sammy will charge a higher fee, say, 200 basis points for the same CDS he sold Boo for 100 basis points. More risk, more chance Sammy will have to pay up, so he charges more to back Daisy's now sketchier debt.
But Boo already bought the same CDS for 100 basis points, and if he believed Daisy were still a good credit, he could turn around and sell his contract for twice what he paid for it -- the new market price.
In the market for securities backed by subprime mortgages, CDS protection for owners of the riskiest tranches of debt has skyrocketed in value. Since the height of the subprime lending boom in the middle of the 2006, the cost of CDS protection on BBB rated (low quality) subprime mortgage backed securities has risen by over 2000%.
It's easy to see how investors such as John Paulson won big with short-side bets in this market. And since CDS prices move in the opposite direction as the value of the bonds they protect, it is also easy to see how financial firms like Merrill Lynch (MER) saw the value of mortgage backed securities portfolios plummet.
Regulators claim to have drawn a line in the sand, backing up tough talk that firms must fail in order for the free market to punish bad decision makers. We're about to find out if the multi-trillion dollar market for credit default swaps is, in fact, too big to fail.
Fear, today, is not in short supply.
Of the myriad fears racing around Wall Street, one of the greatest is what will happen to the tangled web of credit default swaps, or CDS, that tie the global financial system together like a team of spiders hopped up on amphetamines.
It was to protect this market that the Treasury Department backed JP Morgan's (JPM) purchase of Bear Stearns this March. With news of Lehman Brothers' (LEH) bankruptcy filing late last night, traders will now be forced to unwind bets they hoped they'd never have to sort out.
The durability of this massive, unregulated market is about to be tested: trillions of dollars in contracts have been triggered in the past week, first with the siezure of Fannie Mae (FNM) and Freddie Mac (FRE), and most recently by Lehman's collapse.
Credit Default Swaps, or CDS, offer financial firms a quick way to offload part or all their exposure to debt backed by state and municipal governments, corporations, or structured debt tied to consumer loans. A CDS is an agreement in which two parties agree to trade, or ‘swap’ risk for a default event that may happen in the future.
Lets say for example, The Bank of Boo owns corporate debt issued by Daisy’s Department Store.
If Daisy has a strong balance sheet, good cash flows and a long track record of making her debt payments, credit ratings agencies such as Moody’s (MCO) and Standard and Poor’s are likely to rate her debt well, making her bonds available for purchase by a wide range of financial institutions, including the Bank of Boo.
Boo’s primary risk is that Daisy falls on hard times and stops making her interest payments. Credit ratings help Boo determine the chances of this. A higher rating indicates lower risk, and therefore a lower potential return. Conversely, Boo can make a higher return for buying lower rated pieces of Daisy’s debt that are the first to go sour if she has financial troubles.
Enter the CDS.
If Boo lends Daisy $1,000,000 at 5%, he earns $50,000 per year in interest plus a repayment of principal over the life of the loan. To protect this investment, Boo may buy a Credit Default Swap from Sammy’s Structured Products, a financial insurer setting up shop in Minyanland. The CDS contract stipulates that Boo pays Sammy a fee, while Sammy is obligated to step in and make Boo whole if Daisy is unable to make her payments.
CDS contracts are priced in basis points, or hundredths of percentage points. So, Boo may pay 100 basis points, or 1% of the notional value of the loan for his credit protection. Although this insurance reduces Boo’s potential income by $10,000 per year, in the event Daisy defaults, Sammy is obligated to pay up and make sure Boo doesn’t lose his investment.
CDS contracts can be written for any type of debt product, and during the golden years of cheap leverage -- now long since gon -- were actively used as speculative tools rather than simply as credit protection
Suppose a news story breaks that Daisy is being investigated for unsavory business practices and her future profitability becomes questionable.
If Hoofy’s Hedge Fund owns the same bonds the Bank of Boo does and goes to Sammy to buy a CDS contract for protection, the now higher risk of default means Sammy will charge a higher fee, say, 200 basis points for the same CDS he sold Boo for 100 basis points. More risk, more chance Sammy will have to pay up, so he charges more to back Daisy's now sketchier debt.
But Boo already bought the same CDS for 100 basis points, and if he believed Daisy were still a good credit, he could turn around and sell his contract for twice what he paid for it -- the new market price.
In the market for securities backed by subprime mortgages, CDS protection for owners of the riskiest tranches of debt has skyrocketed in value. Since the height of the subprime lending boom in the middle of the 2006, the cost of CDS protection on BBB rated (low quality) subprime mortgage backed securities has risen by over 2000%.
It's easy to see how investors such as John Paulson won big with short-side bets in this market. And since CDS prices move in the opposite direction as the value of the bonds they protect, it is also easy to see how financial firms like Merrill Lynch (MER) saw the value of mortgage backed securities portfolios plummet.
Regulators claim to have drawn a line in the sand, backing up tough talk that firms must fail in order for the free market to punish bad decision makers. We're about to find out if the multi-trillion dollar market for credit default swaps is, in fact, too big to fail.
Friday, September 12, 2008
Oil Companies, Bureaucrats Caught With Pants Down
This post first appeared on Minyanville.
Our nation’s energy policy -- or lack thereof -- will be central to this year’s presidential slugfest. While Obama cautions against tapping into our natural gas resources (citing potentially dire environmental consequences), McCain and Palin advocate aggressive drilling to break our dependence on foreign oil.
Meanwhile, we lowly citizens must painfully empty our wallets to fill our gas tanks and heat our homes, and hope that government representatives are looking out for our best interests.
And as long as those best interests include public officials doing blow and sleeping with energy company employees, we’re in good hands.
The Interior Department, the agency responsible for keeping tabs on the Minerals Management Service, or MMS, released a report alleging that energy industry representatives and the government workers charged with regulating their behavior have cultivated a “culture of substance abuse and promiscuity.”
The MMS, according to the Wall Street Journal, “oversees the nation's natural-gas, oil and other mineral resources on the outer continental shelf, and [draws] up leases for drilling in offshore waters,” and in some years is Washington’s biggest revenue generator, second only to the Internal Revenue Service. Its royalty-in-kind, or RIK, program allows oil companies to pay for drilling rights with oil instead of cash.
Crude’s fantastic run over the past few years means the RIK program has generated tens of millions more in revenue than they would have had the royalties been paid in cash. Needless to say, “cozy” relationships between oil companies and government officials could unduly influence the allocation of these valuable contracts.
In addition to the sex and drugs, employees from Chevron (CVX), Hess (HES), Gary-Williams Energy and a US unit of Royal Dutch Shell admitted to giving gifts and picking up restaurant and bar tabs for government employees. They denied, however, that such actions were rewarded with preferential treatment.
Needless to say, such denials are suspect. If there's a planet where free booze, sex and drug don't come with strings attached, I’d like a one-way ticket, please.
Both parties have seized on the report to point the finger at the other. As the election nears and the mudslinging heats up, we’ll no doubt hear more than a few cheap shots hurled at these promiscuous petroleum players.
Our nation’s energy policy -- or lack thereof -- will be central to this year’s presidential slugfest. While Obama cautions against tapping into our natural gas resources (citing potentially dire environmental consequences), McCain and Palin advocate aggressive drilling to break our dependence on foreign oil.
Meanwhile, we lowly citizens must painfully empty our wallets to fill our gas tanks and heat our homes, and hope that government representatives are looking out for our best interests.
And as long as those best interests include public officials doing blow and sleeping with energy company employees, we’re in good hands.
The Interior Department, the agency responsible for keeping tabs on the Minerals Management Service, or MMS, released a report alleging that energy industry representatives and the government workers charged with regulating their behavior have cultivated a “culture of substance abuse and promiscuity.”
The MMS, according to the Wall Street Journal, “oversees the nation's natural-gas, oil and other mineral resources on the outer continental shelf, and [draws] up leases for drilling in offshore waters,” and in some years is Washington’s biggest revenue generator, second only to the Internal Revenue Service. Its royalty-in-kind, or RIK, program allows oil companies to pay for drilling rights with oil instead of cash.
Crude’s fantastic run over the past few years means the RIK program has generated tens of millions more in revenue than they would have had the royalties been paid in cash. Needless to say, “cozy” relationships between oil companies and government officials could unduly influence the allocation of these valuable contracts.
In addition to the sex and drugs, employees from Chevron (CVX), Hess (HES), Gary-Williams Energy and a US unit of Royal Dutch Shell admitted to giving gifts and picking up restaurant and bar tabs for government employees. They denied, however, that such actions were rewarded with preferential treatment.
Needless to say, such denials are suspect. If there's a planet where free booze, sex and drug don't come with strings attached, I’d like a one-way ticket, please.
Both parties have seized on the report to point the finger at the other. As the election nears and the mudslinging heats up, we’ll no doubt hear more than a few cheap shots hurled at these promiscuous petroleum players.
Lehman Averts Disaster - For Now
This post first appeared on Minyanville.
Lehman Brothers (LEH) certainly won't go down without a fight.
Facing pressure to raise capital amid mounting losses and a plummeting stock price, CEO Dick Fuld announced a plan today to keep the investment bank afloat.
The company released its third-quarter results a week ahead of schedule to quell concerns it would become the latest casualty of the worst financial crisis since the Great Depression. Fuld also detailed plans to reduce exposure to mortgage-related assets, which continue to erode in value.
According to the Wall Street Journal, the last 3 months are evidence of ongoing turmoil in the credit markets and Lehman’s struggle to remain solvent:
Lehman Brothers (LEH) certainly won't go down without a fight.
Facing pressure to raise capital amid mounting losses and a plummeting stock price, CEO Dick Fuld announced a plan today to keep the investment bank afloat.
The company released its third-quarter results a week ahead of schedule to quell concerns it would become the latest casualty of the worst financial crisis since the Great Depression. Fuld also detailed plans to reduce exposure to mortgage-related assets, which continue to erode in value.
According to the Wall Street Journal, the last 3 months are evidence of ongoing turmoil in the credit markets and Lehman’s struggle to remain solvent:
- Net losses of $3.9 billion on $7.8 billion in write-downs.
- Dividends cut from $0.68 to $0.05 per share, which should save almost $500 million per year.
- Spinoff of “the vast majority” of its real estate exposure into a separate public entity, to be completed in the first quarter of next year.
- Plans to sell 55% of its investment management business, specifically its coveted stake in asset manager Neuberger Berman, to generate over $3 billion.
The poor results reflect not only steep losses, but also dramatically slowing revenue from ongoing operations. Investment banking revenues were off 45% and investment management income was 25% lower than the same period last year.
These are undoubtedly dire times from Lehman, who faced -- and overcame -- similar pressures in the aftermath of the Long Term Capital Management crisis in 1998. Despite reassurances from trading partners like Goldman Sachs (GS) that clients are keeping their cash with Lehman, many on Wall Street fear the end is near for the 158-year-old brokerage.
Fuld, on the other hand, reassured investors on this morning’s conference call that the initiatives will enable the company to continue operations as an independent company.
Remarkably absent from the heated debate over Lehman’s future is discussion over whether the latest round of write-downs and asset sales represents the long-awaited “kitchen-sink” quarter, where the bank expunges all its bad assets to wipe the slate clean. Hopeful investors have been clamoring for such a recognition of losses since the credit crisis began last year, but to no avail.
What once began as a mortgage crisis became a credit crisis, then a financial crisis, and has now become a full-fledged economic crisis. The effects are reverberating around the increasingly connected global economy, from Korea to Pakistan, Mexico to Thailand, as one timezone's evening news flash is another's morning dose of disaster.
Time -- which by all accounts is the only way to heal the wounds of our battered financial system -- is the one option not readily available to troubled firms.
Lehman may succeed in averting disaster for now - but it may only be delaying the inevitable.
Tuesday, September 9, 2008
Who Will Survive Hedge Fund Bloodbath?
This post first appeared on Minyanville.
After their worst year in decades, hedge fund managers are struggling to convince investors their high fees are worth the risk.
The Wall Street Journal reported this morning that the industry's collective influence may be weakening, as some funds are resorting to fee cuts to keep investors from withdrawing their money.
Most hedge funds charge a flat fee of 2% of assets under management, plus an incentive bonus of as high as 20% of profits. The idea is that hedge fund employees are best-of-breed: The chosen few deft enough to outmaneuver the market and rake in big profits.
But the events of the past 12 months have proven that whippy markets, government intervention and bank failures can cut even the savviest of investors off at the knees. Traders can hardly leave on a Friday without wondering what large financial institution(s) may not exist come Monday morning.
Hedge fund managers are charged not only with generating returns on an absolute basis (i.e. a pure percentage gain), but insulating investors from market risk. A common metric to evaluate the market risk of a given investment or portfolio is beta, which measures the correlation of the asset (or group of assets) to the broader market. A beta of 1 means a stock moves in lockstep with the major indices, while a measure of -1 means it moves inversely to the market.
The best hedge fund managers can generate strong returns with a low beta, keeping its investors' exposure to broad market risks at a minimum.
As one hedge fund analyst explained to me,
“The whole industry and fee structure is predicated on superior risk adjusted returns in comparison to the broad securities markets. There were plenty of funds out there who
were just generating excess returns by use of leverage and concentrated positions. These funds are now being exposed.
They were generating superior returns on an absolute basis, but have now been exposed as having generated poor returns on a risk-adjusted basis. These funds will go away, and capital will naturally flow to those that have consistently generated good risk-adjusted returns over a long period of time.”
Our recent -- and now long gone -- period of easy money and mispriced risk meant funds that ignored this mantra rolled the dice and made out like bandits. In some cases, literally.
Now, with the implosion of Caryle Capital earlier this year due to hugely levered bets on Fannie Mae (FNM) and Freddie Mac (FRE) mortgage bonds, as well as high-profile losses at funds run by such bulge bracket firms as Goldman Sachs (GS) and Morgan Stanley (MS), a weeding-out process of weak funds is well underway.
The beneficiaries are likely to be those best of breed: The managers who can successfully navigate even the toughest of markets. It's a task, however, that's easier said than done.
After their worst year in decades, hedge fund managers are struggling to convince investors their high fees are worth the risk.
The Wall Street Journal reported this morning that the industry's collective influence may be weakening, as some funds are resorting to fee cuts to keep investors from withdrawing their money.
Most hedge funds charge a flat fee of 2% of assets under management, plus an incentive bonus of as high as 20% of profits. The idea is that hedge fund employees are best-of-breed: The chosen few deft enough to outmaneuver the market and rake in big profits.
But the events of the past 12 months have proven that whippy markets, government intervention and bank failures can cut even the savviest of investors off at the knees. Traders can hardly leave on a Friday without wondering what large financial institution(s) may not exist come Monday morning.
Hedge fund managers are charged not only with generating returns on an absolute basis (i.e. a pure percentage gain), but insulating investors from market risk. A common metric to evaluate the market risk of a given investment or portfolio is beta, which measures the correlation of the asset (or group of assets) to the broader market. A beta of 1 means a stock moves in lockstep with the major indices, while a measure of -1 means it moves inversely to the market.
The best hedge fund managers can generate strong returns with a low beta, keeping its investors' exposure to broad market risks at a minimum.
As one hedge fund analyst explained to me,
“The whole industry and fee structure is predicated on superior risk adjusted returns in comparison to the broad securities markets. There were plenty of funds out there who
were just generating excess returns by use of leverage and concentrated positions. These funds are now being exposed.
They were generating superior returns on an absolute basis, but have now been exposed as having generated poor returns on a risk-adjusted basis. These funds will go away, and capital will naturally flow to those that have consistently generated good risk-adjusted returns over a long period of time.”
Our recent -- and now long gone -- period of easy money and mispriced risk meant funds that ignored this mantra rolled the dice and made out like bandits. In some cases, literally.
Now, with the implosion of Caryle Capital earlier this year due to hugely levered bets on Fannie Mae (FNM) and Freddie Mac (FRE) mortgage bonds, as well as high-profile losses at funds run by such bulge bracket firms as Goldman Sachs (GS) and Morgan Stanley (MS), a weeding-out process of weak funds is well underway.
The beneficiaries are likely to be those best of breed: The managers who can successfully navigate even the toughest of markets. It's a task, however, that's easier said than done.
Fed Pushes Fannie, Freddie Shareholders in Front of Train
This post first appeared on Minyanville.
The effects of this weekend’s dramatic power grab in Washington are rippling through the financial markets - and the pundits are arguing about who was right and who was wrong about the Fannie Mae (FNM) and Freddie Mac (FRE) bailout. In the meantime, federal regulators are quietly doing damage control.
Small banks will see large chunks of capital wiped out from equity losses in Fannie and Freddie - but they can now get in line for the government dole.
In seizing the embattled mortgage giants, the Treasury Department shoved common shareholders in front of the train, reaffirming they’d bear the brunt of future losses. As with the Bear Stearns takeover, the Federal Reserve and the Treasury dealt with the moral hazards of risky investments by simply punishing common shareholders and bailing out debtholders.
The countless financial institutions holding Fannie and Freddie preferred stock must now act as the second line of defense for the money of our trading partners, allies and certain well-connected institutional bond investors.
Preferred shareholders have no voting rights, but they stand in front of common shareholders in terms of dividend payments and the right to recover their investments in the event of liquidation. There had been speculation that Washington would go easy on preferred holders and protect their dividends, and, by extension, the value of preferred shares. Since most holders of these assets were other financial institutions, the logic went, the Treasury wouldn't put undue stress on an already troubled group.
The Treasury’s bailout plan doesn't protect preferred shareholders, as evidenced by the steep drop in the value of those shares today. However, various financial regulators are prepared to step in and assist small banks with significant exposure to Fannie or Freddie via investments in preferred shares.
FDIC chairman Sheila Bair tried to diffuse the situation by claiming that “Across the industry, banks do not have significant exposure to GSE equity securities.” But since the FDIC also neglected to include collapsed mortgage thrift IndyMac on its list of potentially troubled financial institutions just weeks before it went bust, her assertion shouldn’t carry much weight.
Sovereign Bank (SOV) isn’t likely to be comforted by Bair’s soothing words either, as losses on the bank’s Fannie and Freddie preferred stock could erase almost a year’s worth of earnings, according to analysts at Credit Insights. JPMorgan (JPM) is also likely lose money on similar holdings, although even if it’s entire $1.2 billion investment is wiped out, the hit would represent less than 1% of its tangible capital.
Capitalist ideals go right out the window during times of crisis. Unprecedented financial calamities result in unprecedented government intervention.
It's anybody's guess as to how long it will be before markets are allowed to find a true bottom, to experience true price discovery and thus establish a true foundation for recovery. Until then, investors should try to relish being a part of some of the most historic financial events in the past 80 years, while preserving capital for the inevitable opportunities that lie on the ever-elusive other side of the abyss.
The effects of this weekend’s dramatic power grab in Washington are rippling through the financial markets - and the pundits are arguing about who was right and who was wrong about the Fannie Mae (FNM) and Freddie Mac (FRE) bailout. In the meantime, federal regulators are quietly doing damage control.
Small banks will see large chunks of capital wiped out from equity losses in Fannie and Freddie - but they can now get in line for the government dole.
In seizing the embattled mortgage giants, the Treasury Department shoved common shareholders in front of the train, reaffirming they’d bear the brunt of future losses. As with the Bear Stearns takeover, the Federal Reserve and the Treasury dealt with the moral hazards of risky investments by simply punishing common shareholders and bailing out debtholders.
The countless financial institutions holding Fannie and Freddie preferred stock must now act as the second line of defense for the money of our trading partners, allies and certain well-connected institutional bond investors.
Preferred shareholders have no voting rights, but they stand in front of common shareholders in terms of dividend payments and the right to recover their investments in the event of liquidation. There had been speculation that Washington would go easy on preferred holders and protect their dividends, and, by extension, the value of preferred shares. Since most holders of these assets were other financial institutions, the logic went, the Treasury wouldn't put undue stress on an already troubled group.
The Treasury’s bailout plan doesn't protect preferred shareholders, as evidenced by the steep drop in the value of those shares today. However, various financial regulators are prepared to step in and assist small banks with significant exposure to Fannie or Freddie via investments in preferred shares.
FDIC chairman Sheila Bair tried to diffuse the situation by claiming that “Across the industry, banks do not have significant exposure to GSE equity securities.” But since the FDIC also neglected to include collapsed mortgage thrift IndyMac on its list of potentially troubled financial institutions just weeks before it went bust, her assertion shouldn’t carry much weight.
Sovereign Bank (SOV) isn’t likely to be comforted by Bair’s soothing words either, as losses on the bank’s Fannie and Freddie preferred stock could erase almost a year’s worth of earnings, according to analysts at Credit Insights. JPMorgan (JPM) is also likely lose money on similar holdings, although even if it’s entire $1.2 billion investment is wiped out, the hit would represent less than 1% of its tangible capital.
Capitalist ideals go right out the window during times of crisis. Unprecedented financial calamities result in unprecedented government intervention.
It's anybody's guess as to how long it will be before markets are allowed to find a true bottom, to experience true price discovery and thus establish a true foundation for recovery. Until then, investors should try to relish being a part of some of the most historic financial events in the past 80 years, while preserving capital for the inevitable opportunities that lie on the ever-elusive other side of the abyss.
Thursday, September 4, 2008
JPMorgan Slinks Away From Swaps
This post first appeared on Minyanville.
Savvy mortgage-backed securities traders weren’t the only ones that blew up the Wall Street lab during the credit boom.
Their colleagues at the other end of the trading floor -- equally adept at turning low yielding, safe debt into risk-laden toxic waste -- made big bucks peddling complex interest rate derivatives to municipalities. Now government officials are crying foul and claiming bankers duped them into making investments they didn’t fully comprehend.
Ignorance, in fact, is nothing approaching bliss.
Alabama’s Jefferson County is on the brink of bankruptcy after financial “advisors” at JPMorgan (JPM) convinced it to refinance more than $3 billion of fixed rate debt into adjustable rate bonds, using interest rate swaps as a hedge against higher rates. According to Bloomberg, the bureaucrats now claim they didn’t understand the arrangement, relying instead on their bankers who pocketed a cool $100 million in fees for arranging the transactions.
Interest rate swaps (are supposed to) allow debt issuers to offset the risk of variable rate bonds increasing in cost if interest rates should rise. The swap, coupled with the variable rate bond, is designed to smooth out any interest expenses in the event rates start moving in the wrong direction - namely up.
In the case of ill-fated Jefferson County, not only did rates move against it, but the swaps that were supposed to act as hedges backfired. When fears bond insurers Ambac (ABK) and MBIA (MBI) wouldn’t be able to make good on their obligations rocked the once-placid municipal bond market earlier this year, yields on Jefferson County’s bonds spiked from 3% to as high as 10%. Meanwhile, roiling credit markets meant the swaps, purchased for the very purpose of protecting against higher rates, didn’t do their job.
Now the Justice Department is investigating whether JPMorgan and other Wall Street banks gouged Jefferson County and other unsophisticated administrators on fees, jamming them into complex debt arrangements that hadn’t been properly stress tested.
JPMorgan announced today that it’s exiting the business altogether, claiming selling interest rate swaps to government borrowers is no longer a reliable revenue center. That could stem, in part, from the fact the financial services company may be on the hook for billions in defaulted debt if it can’t successfully keep Jefferson County from becoming the largest municipal bankruptcy since Orange County, California went bust in 1994.
The business of concocting and selling complex structured finance transactions is in shambles. Models didn’t properly account for the sort of comeuppance the credit markets have experienced in the past 12 months, as multi-standard deviation events are occurring with alarming frequency.
In all likelihood, similar to the mortgage business that’s reverting back to its boring, low- yielding roots, the love affair between municipalities and Wall Street will take years to mend.
Savvy mortgage-backed securities traders weren’t the only ones that blew up the Wall Street lab during the credit boom.
Their colleagues at the other end of the trading floor -- equally adept at turning low yielding, safe debt into risk-laden toxic waste -- made big bucks peddling complex interest rate derivatives to municipalities. Now government officials are crying foul and claiming bankers duped them into making investments they didn’t fully comprehend.
Ignorance, in fact, is nothing approaching bliss.
Alabama’s Jefferson County is on the brink of bankruptcy after financial “advisors” at JPMorgan (JPM) convinced it to refinance more than $3 billion of fixed rate debt into adjustable rate bonds, using interest rate swaps as a hedge against higher rates. According to Bloomberg, the bureaucrats now claim they didn’t understand the arrangement, relying instead on their bankers who pocketed a cool $100 million in fees for arranging the transactions.
Interest rate swaps (are supposed to) allow debt issuers to offset the risk of variable rate bonds increasing in cost if interest rates should rise. The swap, coupled with the variable rate bond, is designed to smooth out any interest expenses in the event rates start moving in the wrong direction - namely up.
In the case of ill-fated Jefferson County, not only did rates move against it, but the swaps that were supposed to act as hedges backfired. When fears bond insurers Ambac (ABK) and MBIA (MBI) wouldn’t be able to make good on their obligations rocked the once-placid municipal bond market earlier this year, yields on Jefferson County’s bonds spiked from 3% to as high as 10%. Meanwhile, roiling credit markets meant the swaps, purchased for the very purpose of protecting against higher rates, didn’t do their job.
Now the Justice Department is investigating whether JPMorgan and other Wall Street banks gouged Jefferson County and other unsophisticated administrators on fees, jamming them into complex debt arrangements that hadn’t been properly stress tested.
JPMorgan announced today that it’s exiting the business altogether, claiming selling interest rate swaps to government borrowers is no longer a reliable revenue center. That could stem, in part, from the fact the financial services company may be on the hook for billions in defaulted debt if it can’t successfully keep Jefferson County from becoming the largest municipal bankruptcy since Orange County, California went bust in 1994.
The business of concocting and selling complex structured finance transactions is in shambles. Models didn’t properly account for the sort of comeuppance the credit markets have experienced in the past 12 months, as multi-standard deviation events are occurring with alarming frequency.
In all likelihood, similar to the mortgage business that’s reverting back to its boring, low- yielding roots, the love affair between municipalities and Wall Street will take years to mend.
Manhattan Restaurants Feel the Pinch
This post first appeared on Minyanville.
It appears the city that never sleeps has finally succumbed to the economic slowdown, and it’s not just the neon “Recession Special” sign outside Gray’s Papaya.
According to the New York Times, Manhattan's restaurants are rejiggering menus with a thrifty bent, slimming down lobsters and even printing wine menus in euros to attract, well, Europeans, looking to take advantage of favorable exchange rates.
Some of the chefs interviewed noted small tweaks, like swapping out jumbo lump crab meat for regular lump crab meat (half the cost) or shiitake instead of morel mushrooms. Others expected more drastic changes, like limiting the amount of complimentary bread a table can order. Freeloaders may soon have to resort to more traditional methods.
Restaurateurs are even taking tips from another beleaguered industry group: the airlines. Similarly pressured by rising commodity prices and flagging consumer spending, carriers are resorting to slick tactics to stay afloat.
In addition to baggage charges, pillow charges, beverage charges and slashing routes, the likes of United (UAUA), Continental (CAL) and Delta (DAL) are notorious for overbooking and banking on no-shows to keep the planes just barely full. Now, you may be able to expect the same thing when showing up for your 7pm reservation. It makes more sense for a restaurant owner to have customers wait at the bar, even appeasing them with free drinks, if it keeps the tables turning all night.
With average meal prices dropping and diners less inclined to opt for that top shelf cocktail or the surf and turf, restaurants are getting creative to maintain their already slim bottom lines. Prix fixe prices are falling, portions are shrinking, bar menus are growing, happy hours are getting longer and combo specials are becoming more ubiquitous. The well-known Blue Water Grill is even serving half-price seafood nibblets after 10pm to try and lure in late night noshers.
Wait a minute, happy hours are getting longer? In that case, bring on the recession!
It appears the city that never sleeps has finally succumbed to the economic slowdown, and it’s not just the neon “Recession Special” sign outside Gray’s Papaya.
According to the New York Times, Manhattan's restaurants are rejiggering menus with a thrifty bent, slimming down lobsters and even printing wine menus in euros to attract, well, Europeans, looking to take advantage of favorable exchange rates.
Some of the chefs interviewed noted small tweaks, like swapping out jumbo lump crab meat for regular lump crab meat (half the cost) or shiitake instead of morel mushrooms. Others expected more drastic changes, like limiting the amount of complimentary bread a table can order. Freeloaders may soon have to resort to more traditional methods.
Restaurateurs are even taking tips from another beleaguered industry group: the airlines. Similarly pressured by rising commodity prices and flagging consumer spending, carriers are resorting to slick tactics to stay afloat.
In addition to baggage charges, pillow charges, beverage charges and slashing routes, the likes of United (UAUA), Continental (CAL) and Delta (DAL) are notorious for overbooking and banking on no-shows to keep the planes just barely full. Now, you may be able to expect the same thing when showing up for your 7pm reservation. It makes more sense for a restaurant owner to have customers wait at the bar, even appeasing them with free drinks, if it keeps the tables turning all night.
With average meal prices dropping and diners less inclined to opt for that top shelf cocktail or the surf and turf, restaurants are getting creative to maintain their already slim bottom lines. Prix fixe prices are falling, portions are shrinking, bar menus are growing, happy hours are getting longer and combo specials are becoming more ubiquitous. The well-known Blue Water Grill is even serving half-price seafood nibblets after 10pm to try and lure in late night noshers.
Wait a minute, happy hours are getting longer? In that case, bring on the recession!
Tuesday, September 2, 2008
Merrill, Lehman Say: Let the Liquidations Begin!
This post first appeared on Minyanville.
While the broader markets appear to have tunnel vision with respect to the price of both crude and stocks, the latent mortgage crisis continues to tie up human -- and financial -- capital throughout Wall Street.
Lehman Brothers (LEH), whose negotiations to sell a piece of itself to Korea Development Bank are now confirmed, is trying to unload its still-bloated residential and commercial loan portfolios. With the debt markets effectively closed and equity markets punishing its stock price, the troubled investment bank is now being forced to liquidate real assets to repair its balance sheet.
Merrill Lynch's (MER) recent sale of distressed collateralized debt obligation for pennies on the dollar led this trend. Capital must still be raised, and financial firms will be increasingly forced to comb through their balance sheets for assets to put on the block.
The Wall Street Journal reports CEO Richard Fuld’s firm is establishing a so-called good bank/bad bank structure to rid itself of a chunk of its more than $65 billion in real estate-related assets.
Under the plan, Lehman would split the assets into 2 groups: The "bad" ones would go into an entity to be spun off to shareholders and private investors; the good ones, it'll keep.
Lehman is also considering what part of the sale, if any, it will finance itself. As with the Merrill transaction, where Merrill loaned the buyer, Lone Star, 75% of the purchase price, its unlikely Lehman will find a willing buyer without retaining a significant portion of the risk.
Liquidations are gaining steam across asset classes. Whether its complex mezzanine CDO tranches or foreclosed homes, banks and other financial institutions are running out of capital-raising options. After months of trying to ride out the credit crunch by ignoring the true extent of their losses, firms are being forced to hack off wounded sections of their balance sheets just to stay alive.
Delinquencies continue to rise on all types of consumer debt, and -- despite a brief drop in record-high fuel prices -- household budgets are still stretched. As more real losses are realized, cash must be raised to fill the gap.
Flocks of scavenging investors (vultures who feed on sellers motivated by necessity rather than rationality) have been quietly raising money to take advantage of this very situation. And while a few ventured in early and paid for their boldness, the patient ones are just beginning to spread their wings.
While the broader markets appear to have tunnel vision with respect to the price of both crude and stocks, the latent mortgage crisis continues to tie up human -- and financial -- capital throughout Wall Street.
Lehman Brothers (LEH), whose negotiations to sell a piece of itself to Korea Development Bank are now confirmed, is trying to unload its still-bloated residential and commercial loan portfolios. With the debt markets effectively closed and equity markets punishing its stock price, the troubled investment bank is now being forced to liquidate real assets to repair its balance sheet.
Merrill Lynch's (MER) recent sale of distressed collateralized debt obligation for pennies on the dollar led this trend. Capital must still be raised, and financial firms will be increasingly forced to comb through their balance sheets for assets to put on the block.
The Wall Street Journal reports CEO Richard Fuld’s firm is establishing a so-called good bank/bad bank structure to rid itself of a chunk of its more than $65 billion in real estate-related assets.
Under the plan, Lehman would split the assets into 2 groups: The "bad" ones would go into an entity to be spun off to shareholders and private investors; the good ones, it'll keep.
Lehman is also considering what part of the sale, if any, it will finance itself. As with the Merrill transaction, where Merrill loaned the buyer, Lone Star, 75% of the purchase price, its unlikely Lehman will find a willing buyer without retaining a significant portion of the risk.
Liquidations are gaining steam across asset classes. Whether its complex mezzanine CDO tranches or foreclosed homes, banks and other financial institutions are running out of capital-raising options. After months of trying to ride out the credit crunch by ignoring the true extent of their losses, firms are being forced to hack off wounded sections of their balance sheets just to stay alive.
Delinquencies continue to rise on all types of consumer debt, and -- despite a brief drop in record-high fuel prices -- household budgets are still stretched. As more real losses are realized, cash must be raised to fill the gap.
Flocks of scavenging investors (vultures who feed on sellers motivated by necessity rather than rationality) have been quietly raising money to take advantage of this very situation. And while a few ventured in early and paid for their boldness, the patient ones are just beginning to spread their wings.
A Housing Solution that Focuses on (Gasp!) Houses
This post first appeared on Minyanville and our sister site Cirios Real Estate.
Every once in a while, the most important news story of the day is the one the Wall Street Journal allots a mere 200 words.
In a move that will soon be greeted with quiet mutterings of “I should have seen this coming,” British Prime Minister Gordon Blair announced today a shift in the focus of initiatives aimed at reviving the ailing housing industry, and by extension the rest of the economy.
Until this point, much of the government-directed efforts to fix broken housing markets -- both here and abroad -- have focused on the mortgage side of housing transactions.
This should come as no surprise, as Wall Street banks like Goldman Sachs (GS), Merrill Lynch (MER), Lehman Brothers (LEH) and Bear Stearns -- er, JPMorgan (JPM) -- had staked their reputations -- and balance sheets -- on those mortgages.
Foreclosure prevention has attempted to preserve the integrity of the loan by extending its ability to keep generating cash for the lender. If a family or 2 were helped in the process, all the better. But with trillions of dollars in securities propping up the world's financial system based on unreliable monthly payments from struggling American consumers, the mortgage was saved in favor of the property itself or its inhabitants.
HOPE NOW and Project Lifeline have been our bureaucrats’ best effort at keeping people from being kicked out of their homes. Anecdotally and by the numbers, the results have been less than awe-inspiring.
As part of a larger economic reform package, Brown is taking a decidedly different approach. Any homeowner behind on his mortgage and facing the risk of repossession will have his situation evaluated by a “money advisor,” who, according to the Guardian, will determine whether nor not the loan is worth salvaging.
If this guru of the economically unfeasible gives the thumbs-down, the borrower gets a rescue package; the government gets the house. A housing association or other publicly funded group can then lease the property back to for the former homeowner or otherwise rehab the property for new tenants.
The lender can either be made whole or can retain some of the risk (and therefore potential return) in the property, staying in the game a bit longer.
This focus on the raw asset -- the house -- rather than on a flimsy deed of trust represents a step in the right direction in the "war on foreclosures." The mere fact that Washington (and London) are dipping their tentacles this deep into housing markets should rightly disturb anyone with even half-hearted capitalistic ideals - but some government plans are better than others.
The problem with mortgage-focused foreclosure prevention is that it prolongs a borrower’s agony by keeping him in a loan he or she should never have taken out in the first place. The house itself bears the brunt of this strategy's shortcomings, since homeowners forgo maintenance, landscaping, trash removal and other value-preserving services to survive another month.
By stepping in and taking control of the property before the copper pipes can be ripped out and the repossession process can further erode the home's resale value, the plan could slow some of the economic hardship and community decay caused by abandoned, vandalized homes.
Although the business of buying and selling distressed mortgage assets -- including bank-owned homes -- is hacking its way through the world of troubled properties, the scale of the problem and the challenging nature of the transaction itself mean that the crisis will take years to work through.
If the government is going to use taxpayer dollars to try to get us out of this mess, land banks and direct funds for rebuilding communities isn't a terrible place to start.
It sure beats bailing out Wall Street.
Every once in a while, the most important news story of the day is the one the Wall Street Journal allots a mere 200 words.
In a move that will soon be greeted with quiet mutterings of “I should have seen this coming,” British Prime Minister Gordon Blair announced today a shift in the focus of initiatives aimed at reviving the ailing housing industry, and by extension the rest of the economy.
Until this point, much of the government-directed efforts to fix broken housing markets -- both here and abroad -- have focused on the mortgage side of housing transactions.
This should come as no surprise, as Wall Street banks like Goldman Sachs (GS), Merrill Lynch (MER), Lehman Brothers (LEH) and Bear Stearns -- er, JPMorgan (JPM) -- had staked their reputations -- and balance sheets -- on those mortgages.
Foreclosure prevention has attempted to preserve the integrity of the loan by extending its ability to keep generating cash for the lender. If a family or 2 were helped in the process, all the better. But with trillions of dollars in securities propping up the world's financial system based on unreliable monthly payments from struggling American consumers, the mortgage was saved in favor of the property itself or its inhabitants.
HOPE NOW and Project Lifeline have been our bureaucrats’ best effort at keeping people from being kicked out of their homes. Anecdotally and by the numbers, the results have been less than awe-inspiring.
As part of a larger economic reform package, Brown is taking a decidedly different approach. Any homeowner behind on his mortgage and facing the risk of repossession will have his situation evaluated by a “money advisor,” who, according to the Guardian, will determine whether nor not the loan is worth salvaging.
If this guru of the economically unfeasible gives the thumbs-down, the borrower gets a rescue package; the government gets the house. A housing association or other publicly funded group can then lease the property back to for the former homeowner or otherwise rehab the property for new tenants.
The lender can either be made whole or can retain some of the risk (and therefore potential return) in the property, staying in the game a bit longer.
This focus on the raw asset -- the house -- rather than on a flimsy deed of trust represents a step in the right direction in the "war on foreclosures." The mere fact that Washington (and London) are dipping their tentacles this deep into housing markets should rightly disturb anyone with even half-hearted capitalistic ideals - but some government plans are better than others.
The problem with mortgage-focused foreclosure prevention is that it prolongs a borrower’s agony by keeping him in a loan he or she should never have taken out in the first place. The house itself bears the brunt of this strategy's shortcomings, since homeowners forgo maintenance, landscaping, trash removal and other value-preserving services to survive another month.
By stepping in and taking control of the property before the copper pipes can be ripped out and the repossession process can further erode the home's resale value, the plan could slow some of the economic hardship and community decay caused by abandoned, vandalized homes.
Although the business of buying and selling distressed mortgage assets -- including bank-owned homes -- is hacking its way through the world of troubled properties, the scale of the problem and the challenging nature of the transaction itself mean that the crisis will take years to work through.
If the government is going to use taxpayer dollars to try to get us out of this mess, land banks and direct funds for rebuilding communities isn't a terrible place to start.
It sure beats bailing out Wall Street.
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