MonkeyBusinessBlog

Timmy Blows a Gasket!

Wow.  It has been written in the Wall Street Journal today Geithner Vents at Regulators as Overhaul Stumbles.  that Treasury Secretary Tim Geithner blew up at his chief regulators last week in a;

expletive-laced critique last Friday as frustration grows over the Obama administration's faltering plan to overhaul U.S. financial regulation, according to people familiar with the meeting. 

About time he blew up at something.  This whole regulatory overhaul issue really pisses me off.  First of all, I love how it seems every answer to improving financial regulation is to give more authority to the Fed.  Just what exactly did the Fed do this decade, officially or unofficially, to safeguard the system?  Zilch. Nada. Nichts.  Absolutely nothing.  

Geithner, the former President of the New York Fed from 2003, sat there and watched about $1 trillion of asset backed commercial paper , paper backed by AAA rated MBS and CDOs, get created and never asked where $1 trillion of this crap came from.  

Greenspan, and Bernanke?  They sat in the catbird seat and never seemed to question just how the hell savings rates could go negative, incomes could stay relatively flat and somehow the American consumer could keep buying piles of crap every year.

These ass clowns can say all they want but the bottom line is that all the rest of the regulatory agencies take their cue from the Fed and the cue was to not rock the boat.

Anyway, I continue to believe that we do not need a year long power, ass-grabbing, turf battle to give us better financial regulation.  What we need is regulation, free from Congressional and White House meddling, by folks who actually "know stuff".  We need to stop recycling the same 100 or so people that have seemed to get all the top posts for the past two decades.  They, for the most part, have proven that they either lack the knowledge or courage to intelligently regulate their jurisdictions.  And sprinkling in some "new blood" in the form of a few "financial professionals" that managed to run their institutions into the ground the last few years isn't the answer either.  

You want my regulatory framework?  Here's something I wrote in March.  We need about ten to fifteen guys and gals to float about, ask questions to whoever they please and then direct the various regulatory bodies to deal with any "issues".  I call them "Common Sense Czars";

One of the many things going on in Washington is financial system regulatory reform.  I have a suggestion that I have brought up before on this blog.  How about a guy like Paul Volcker or Henry Kaufman gets nominated as the "Common Sense Czar"?  I used to read about how Henry Kaufman used to walk the floors of Salomon Brothers, poking his head in to different trading desks and saying things like, "Hi,I see you guys are up a lot so far this year.  Are those gains realized, or are we still holding risk?  Who's buying the bonds you're selling?  Who are we buying our hedges from?"  Mr. Kaufman was like the "Czar of Common Sense."  He would collect a bunch of this information and figure out if the firm was over-exposed to anything.

Think about how a Common Sense Czar would have approached our current crisis BEFORE it fully developed.  Let's use the year 2006.  If we snuffed out the growing disaster then, we still would have had a disaster, but not life threatening.  Anyway, lets fantasize!

1. First the Czar visits the folks making tons of money "guaranteeing things".  Guys like AIG and Ambac and MBIA and asks the question, "Hi, how are you making your money?"  They would say, "We have this great business where we get paid to use our AAA rating to guarantee bonds that ARE ALREADY RATED AAA!  In fact sometimes we guarantee bonds by writing credit default swaps against bonds that ALREADY have another AAA rated company guaranteeing them!  It's like taking candy from babies!"  The Czar of Common sense does some quick math versus those firm's capital positions and says, "Wow, I guess as long as you don't take a 10-15% loss against this portfolio you don't die.  Still, if the losses ever become significant won't you get downgraded?  If you lose your AAA don't you lose your franchise?"  The guarantors say, "?". 
2. The Common Sense Czar then goes to Freddie and Fannie and asks them, "Hi, how are you making your money?" Freddie and Fannie say that they are a combined mortgage insurance shop and leveraged mortgage investment portfolio.  For the insurance they have private mortgage insurers to mitigate risk (especially the sub prime credit they have guaranteed) and with regard to investments they are in a AAA position on the dodgy credits so they are more than fine too.  The Common Sense Czar does some quick math on Freddie and Fannie's combined $3.5 trillion guarantor book and $1.5 trillion retained portfolio  and says, "Wow, if you take a 2% loss on your mortgage insurance portfolio you lose $70 billion?  You have that kind of capital?"  Freddie and Fannie pick up the phone and call Barney Frank and Chris Dodd!
3. Now the Common Sense Czar has similar calls with the private mortgage insurers and they essentially say the same thing that Freddie, Fannie, AIG, MBIA, Ambac, etc have said.  The Czar of Common Sense does the same quick calculations and arrives at similar conclusions, a small percentage loss on a BIG number wipes these guys out too.
4. The Czar of Common Sense pauses and says, "Man, all these guys with pretty thin levels of capital are relying that these mortgage bonds can't lose money because the ratings companies rated them AAA or AA- at worst.  I need to go visit those guys but before I do that I am going to drop in on Bear Stearns and Lehman Brothers since they are the two biggest underwriters of these bonds.
5. The Czar goes to Bear and Lehman and says, "Hi, how are you making your money?"  The two investment banks tell the Czar that they make their real money from originating their OWN dodgy loans, structuring them and selling them to a variety of investors for a much higher price.  The Czar asks, "How is this possible?"  Bear and Lehman say that through the magic of diversification, they are able to create a very large percentage of AAA bonds that sell for a much higher price than the subprime loans backing them would.  The Czar says, "Hmm, that is interesting.  It all seems to come back to these rating companies.  Oh, by the way, do you guys ever get stuck holding some of these bonds?"  Bear and Lehman say, "Well, we certainly wouldn't call it 'getting stuck'!  But yes, we each have about $50 billion laying around earning us GREAT carry."  The Czar says, "Wow!  How do you guys finance that?  After all, you aren't banks so you don't have retail deposits."  Bear and Lehman tell the Czar, "Oh contraire, we have hedge fund prime brokerage cash.  That money is stickier than the best mom & pop retail deposits.  Besides that, our commercial paper programs are over-subscribed every month!  The last thing we are worried about is funding! The Czar says, "Commerical Paper?  You guys issue CP backed by this stuff?"  "Oh sure, but we don't do THAT much.  You should go talk to Citigroup.  They are doing hundreds of billions, UBS too!"  The Czar makes a note to ask New York Fed President Tim Geithner about this.  Surely he is on top of it.
6. Now the Czar takes a trip out to California to see the subprime giants Ameriquest and New Century.  The Czar says, "Hi, how are you making your money?"  The subprime guys say, "We have thousands and thousands of loan brokers prowling the countryside making the loans that give folks a chance to have things they never had AND make loans that the boys at the Wall Street shops say they need.  We get paid a premium for the loans and we make a lot of fees." The Czar says, "The subprime sector used to be pretty small.  Now suddenly it is very big.  How did that happen?"  The subprime originators say "?".  The Czar asks for a sample of the loans and sees they look pretty horrible.  He then asks the subprime originators, "By the way, what happens if these loans go bad early on.  Don't you guys have to buy them back?  How much capital do you have?"  The subprime guys say, "Oh we have some capital, but not to worry because if guys default we just sell the property and no one takes a loss.  After all, real estate only goes up!"  The Czar says, "Well yeah, but lets just pretend real estate goes down and a lot of these borrowers, especially the ones who are speculators shrug their shoulders and default.  Wouldn't you have to buy all these bad loans back at par?  Do you have enough capital to do that?  Oh, and who regulates you guys?"  The subprime originators answer those two questions by saying, "?" and "?".
7. Now the Czar is a little worried.  It seems like the entire financial system is betting that somehow these loans were magically transfigured from garbage to riskless assets.  It's time to visit S&P and Moody's.  The Czar says, "Hi, how do you make your money?"  The ratings companies say, "Oh, we make lots of money rating all these structured securities.  We are having record earnings every year!"  The Czar says, "Who pays you?"  The ratings companies say, "Why, the issuers of course!"  The Czar is now pale.  He gulps a drink of water and says, "How is it possible to take $1 billion of subprime loans and create $800 million AAA rated bonds?"  The ratings companies say, "Well, diversification of course.  All real estate is local and all economies are local. Real estate prices can never go down NATIONALLY at the same time as we are having a recession and folks are losing their jobs.  Anyway, even if we do have a recession, economies are local and diversified too.  And even if they are not, if we have a recession and the dollar falls, the Arabs, Europeans and Asians will just come in and support real estate prices.  It's all covered see?"
8. The Czar call the President and says, "Houston....we have a problem!"

Good Thing We Got Rid of "Regulator Arbitrage"!

Remember all those stories about how firms like Countrywide and AIG essentially shopped for the easiest regulator the same way a prescription drug addict shops for doctors who will write him a script for Percs? 

Remember how all the "former" investment banks like Goldman and Morgan Stanley used their regulator, the SEC, like a poor junior high-school substitute teacher to get away with all kinds of mischief?

Well, it appears when it comes to risk taking in 2009, Goldman Sachs has managed to do both!  The boys and girls at Zero Hedge (Richie and I are starting to wonder if they are Goldman arch-enemy Deutsche Bank!) have done another fantastic job bringing to light Goldman's approved request to their NEW regulator as a bank holding company, The Fed, to use their OLD regulator, the SEC when it comes to Value at Risk models and limits! Why Does Goldman Need a Fed Exemption For VaR Calculations?

The clue may come from a February 5 letter by the Federal Reserve to Goldman CAO Sarah Smith. The letter had come in response to GS requests for "temporary exemptions from the application of certain aspects of the Board's Market Risk Rules for state member banks and bank holding companies and the Board's general risk-based capital rules for bank holding companies." Basically through the end of 2009 Goldman is basically using non-traditional. SEC approved VaR models as can be seen here:

GSGI has requested that (1) through December 31, 2009, GSGI and Bank be permitted to use certain Value-at-Risk ("VaR") models approved by the SEC... to determine their capital requirements for specific risk under the Market Risk Rules; (2) through December 31, 2009, GSGI and Bank be permitted to use methods approved by the SEC to determine their capital requirements under the Market Risk Rules for those trading assets, including distressed debt and restricted stock investments that the SEC did not require to be included in the VaR-based models of GSGI and Bank; and (3) GSGI be allowed to use methods approved by the SEC to calculate risk-based capital requirements for its nonfinancial equity investments that are subject to the Board's Credit Risk Capital Rules.

Lets translate this because it's real simple.  Goldman wants to be a bank holding company so they will never have to worry about pesky things like liquidity and funding rates ever again.  However, they would still like to be regulated by Mrs. Doubtfire....the SEC.  Splendid.  Like Zero Hedge says, "Mr. Van Praag, the floor is yours....again."

"AIG Bonus Payments? Bailout Funds Used to Bailout U.S. and Foreign Banks???...Lets Go to WWW.FinancialStability.Gov !!

Wow!  So counterparties that received our money in the form of collateral postings, credit default swap tear ups (through the buying of the underlying securities), and return of cash from securities lending is finally out!  Also, we are dealing with the public schtupping that AIG is giving us in the form of $165 million in bonus payments, made yesterday, to employees in AIG's Financial Products Group because AIG was contractually obligated.  Anyway, upon hearing of this new transparency I rushed to www.financialstability.gov , Tim Geithner's cool, new website,  and here is what I found;

This site is coming soon.

On Tuesday, February 10th, Treasury Secretary Timothy Geithner outlined a comprehensive plan to restore stability to our financial system. In the address, Secretary Geithner discussed the Obama Administration’s strategy to strengthen our economy by getting credit flowing again to families and businesses, while imposing new measures and conditions to strengthen accountability, oversight and transparency in how taxpayer dollars are spent. And Secretary Geithner explained how the financial stability plan will be critical in supporting an effective and lasting economic recovery

Damn, still nothing there!  Where did all this transparency come from then?  It came from AIG!! Here it is AIG Counterparty Release.  How heinous is this??!!  To cover the stink of these outrageous bonus payments AIG releases the document that drops the dime on all the counterparties, the biggest being Goldman Sachs, to take our minds off the bonus payments! 

I'm not going to get into the whole counterparty thing.  We have an "AIG" category on the blog that has us explaining the types of trades Goldman was doing with AIG (negative basis trades....great writeup from Richie here from back in September 2008 Investigation Coming For Goldman and AIG? It Should. ) as well as our repeated calls for the government to reveal to the public just who was getting bailed out when we bailed out AIG.  If anything, when you check out the numbers, they still look light.  Additionally, what also needs to be addressed is who helped firms like Goldman "hedge" their AIG exposure through credit default swaps on AIG?  If I AIG was allowed to fail, would those counterparties be able to pay?  If not, who would be wearing the loss?

Other thoughts that strike me on the bonus payments.  AIG and Treasury say that they are contractually obligated to pay these bonuses, as contracts were signed prior to the September, November, December and March bailouts of AIG.  Larry Summers, resident White House economic Over-Lord, says,

"Every legal step possible to limit those bonus payments is being taken by Secretary Geithner and by the Federal Reserve System.  However, the government cannot just abrogate contracts."

Really?  The government just can't abrogate contracts?  I thought it had an entire branch of government that specializes in abrogating contracts.....Congress!!  Don't believe me?  Ask anyone who owns a bond collateralized by a residential mortgage loan!

Lastly in my morning rant. On the last page of the AIG release, you can see that $43.7 billion of our money went to pay off counterparties involved in AIG's securities lending business.  All the big names are there, Barclays, DB, Goldman, BofA, BNP Paribas, etc.  If you remember, securities lending is the business where a company like AIG, who holds lots of stocks and bonds, lends those stocks and bonds out to short-sellers, gets cash as collateral and then invests that cash in a risk free security that earns the lender (AIG) a spread.  Unfortunately, the window lickers at AIG took that cash and invested in AAA rated CDOs.  Ooooops!  I'm just curious about something.  What securities were all those big names borrowing?  Granted, the short selling of stocks is used for a variety of reasons and strategies.  However, much of those strategies are total or partial bets against a companies equity (they could be long bonds, short equities, etc) .  I wonder who all those entities were shorting, since there was such a furor last summer and fall about bear raids on our banks.  How interesting it would be to see how many of the above mentioned banks proprietary trading desks were involved in direct bets against our banks.  Just curious.

From "Market Timing" to Monkeys, There's a Sucker Born Every Minute!

Lets start 2009 with a light, comical risk management lesson.  From our friend "Fletch". 

 

Once a upon a time a man appeared in a village and announced that he would buy monkeys from the villagers for $10 each.  The villagers, seeing that there were plenty of monkeys around, went out into the forest and began to catch them.  The man bought thousands of monkeys for $10 each until the supply of monkeys began to diminish and the villagers stopped looking.

 

The man then announced that he would buy monkeys for $20 each, and the villagers began to hunt monkeys again.  Soon they had captured more monkeys to sell to the man for $20 a piece.  Before long the supply of monkeys became so scarce that is was nearly impossible to find a monkey, let alone catch one.

 

The man then announced that he would pay $50 for each monkey captured.  The man however, told the villagers that he needed to go out of town on business.  The villagers were told to deal with the man's assistant while he was gone.

 

The villagers complained to the man's assistant that the man already owned all the monkeys in the forest and finding new ones was impossible.  The assistant said to the people,

 

"Listen, while the man is away, I will sell you all the monkeys you can take for $35 a piece.  Then, when the man returns you can sell the monkeys back to him for $50."

 

The villagers rejoiced as they took all the money they had already received from the man plus all their savings and bought every monkey the assistant had for $35 a piece.  The next day the assistant snuck out of town and the man and his assistant were never seen or heard from again!

AIG's Risk Management Was "Flawed". Here's a News Flash: So Was Everybody Else's!

The Wall Street Journal has a nice piece on how AIG's "risk management" failed to take into account that on the way to default, AIG might have to post billions of highly liquid instruments as collateral for the credit default swaps with their counterparties.  AIG shouldn't feel too bad because none of their counterparties factored in the risk that AIG would not be able to post collateral!  Don't believe me, go ask Lloyd Blankfein at Goldman.  His risk management policy on AIG was running to his old boss Hank Paulson.  Anyway, reading this reminded me of a piece I wrote back in August, "Warning: This Bank is Protected by ACME Risk Management!"  I wrote it in two parts.  Here is the most relevant part for this discussion;

Lets deal with point two; the power structure of the bank undercut the authority of the risk management group.  I learned a long time ago that most banks believe that risk management is like a child, they should be seen, not heard!  Most banks used risk management like guys you see in your neighborhood that put up a sign on the front lawn, "WARNING, THIS HOME IS PROTECTED BY ACME SECURITY SYSTEMS!"  When you ask, "Hey Fred, can you give me the number of ACME?"  Fred says, "Ah, that sign is just there to keep bad guys away, I don't have a system, it's too damn expensive!"

The bottom line is in almost every bank, you have a head of risk management.  He is a big name and has written a book or two and gets paid a lot of money.  He understands that if the bank doesn't make money, he doesn't make money.  His lopsided payment for current results is just as lopsided as the rest of senior management.  He isn't going to seriously block business lines from "making billions".  What he is going to do is pay a lot of lip service to his risk management responsibilities and make his direct reports look like dopes as they go into battle with the front office, with a false sense of security that the boss has their back.  Once they get played like this a few dozen times, they usually just start playing the game, trying not to get yelled at and praying that nothing blows up so they can get paid for the 80 hour weeks they are putting in.  The next level of risk management consists of smart yet inexperienced twenty six year-olds.  Most of them want to learn what they can, make friends with someone in the front office, and get out of risk management and into trading or sales.  Who can blame them.  The money is (was) great, the job looks cool, and they see how their bosses suffer everyday.  They don't want to be them!

And that's how it rolls, and has rolled for at least twenty five years.  Banks pay lip service to real risk management.  Until they make legitimate changes, which they promise in every crisis, risk management is really just a big scary sign in the front yard without anything behind it.

"BEWARE! This Bank is Protected By The ACME Risk Management System!!

Over the weekend one of our readers was kind enough to send me a article from the current Economist, "Confessions of a risk manager."  Bloomberg News Mark Gilbert has a nice piece on the article this morning titled, "Credit-Crunch Villains Should Own Up, Do Penance". 

In The Economist article, the anonymous senior risk manager from one of the big global banks lays out his "confession" in two parts;

1. How they misread or just missed the warning signals that could have alerted them to the impending crisis.
2. How the power structure of the bank undercut risk managements authority and ability to act more aggressively and actually say NO to the business-line heads or Front Office.

Lets deal with number one first.  The risk manager correctly identified that a serious crisis could develop should the abundant supply of liquidity that the markets had been bathing in since 2001, dry up.  Here is a quote from our risk manager;

"The possibility that liquidity could suddenly dry up was always a topic high on our list, but we could only see more liquidity coming into the market, not going out of it.  Institutional investors, hedge funds, private-equity firms and sovereign-wealth funds were all looking to invest in assets.  This was why credit spreads were narrowing, especially in emerging markets, and debt-to-earnings ratios on private equity financings were increasing. "Where is the liquidity crisis supposed to come from?", someone asked in a meeting.  No one could give a good answer."

Firstly, I give the risk management group credit for even asking the question, "where is the liquidity crisis supposed to come from?"  They correctly identified that the one ingredient that tied supposedly diverse business lines like residential mortgages, commercial mortgages, high yield loans and emerging market debt was the ample supply of liquidity.  Since 2001 (or earlier I guess since the BOJ was running a negative interest rate monetary policy for years before) the amount of liquidity being pumped into the system was just staggering.  Additionally, as our U.S. trade deficits grew, we had $billions and $billions of dollars needing to be recycled into the U.S. from our trading partners.  Even though we were running massive twin deficits, the money always came back right into the financial markets.

Therefore, as time went on, we had an entire financial world building on ever increasing leverage.  We had Fannie Mae and Freddie Mac running on 50-1 ratios, investment banks like Lehman and Bear and Goldman running high-30's to 1, etc, etc.  Commercial banks began relying on this sea of liquidity to put their names as the back stop liquidity bid on billions of Asset Backed Commercial Paper Conduits, as well as creating their own off-balance sheet vehicles like SIVs.  And then of course, we had the explosion in structured product vehicles like CDOs and CLOs.

I believe that it is human instinct to essentially adapt to the world you live in.  Multiple years of liquidity and leverage start seeming to be normal, standard operating procedure.  I know this because I was a skeptic on a number of business lines that relied on leverage very early on.  You keep betting against the tide of what you think is irrational pricing till one day you get tired of being "wrong" and you give the old, "if you can't beat them, join them".  There are very few guys like John Paulson, who see the problem and just stick it out until it eventually folds. 

Anyway, in defense of the risk manager, I can see how the multiple years of liquidity and steadily tightening spreads could make him miss the forest for the trees.  They asked where the liquidity crisis was coming from when they couldn't see that it was going to come from them!  Once the first business line blew (in this case subprime), the bank itself was going to get hit with a liquidity crisis as the back stop liquidity puts and the SIVs came calling for money.  The banks were going to create their liquidity crisis by yanking liquidity to all the leveraged entities it had provided liquidity to, and hence, all the dominos began to fall.  Asset valuations fell, which required margin calls, which produced liquidations, which reduced asset values, which required margin calls..........You get the picture!

Additionally, the risk manager stated that the main risk they overlooked was the misrating of the billions of AAA bonds either backed by subprime or Alt-A mortgages.  They relied on the rating agencies, which as we know now, was a colossal mistake.  Join the club.  The fact is, mortgage underwriting standards had been deteriorating since 1999.  I was at Freddie Mac when the company decided, along with Fannie Mae, to institute a "Fast Doc" program for loans, already in Freddie or Fannie pools, that were going to refinance.  The big originators complained to Freddie and Fannie that during the great refinancing wave of 1998-1999, the GSEs insistence that all refinancing loans go through the same rigorous underwriting process, was slowing down and hurting their business.  The argument was, if a guy had just taken a loan out with you 9 months ago and he wants to refinance, you (Freddie or Fannie) have already wrote credit protection on him, even if his financial situation has deteriorated or the value of the house has declined, as long as he isn't asking for more money, you might as well speed him through and let him refi into a lower rate.  So the GSEs allowed minimal underwriting for refinancing loans, already in a Freddie or Fannie pool.  All that was really required was a title search and a drive-by appraisal to make sure the house was still there!

This process of lowering underwriting standards was like a slow and steady drip on a piece of dry -wall.  Eventually, the dry-wall  just gives way.  By 2005, there were no underwriting standards, especially in the non-agency world.  It was all about real estate valuations.  We had Alan Greenspan himself telling us that all real estate was local.  You might have serious corrections in certain parts of the country, but not the whole country at the same time.  Anyway, we know how it all turned out.  Were the risk managers wrong?  Absolutely, but they had a lot of company.

Lets deal with point two; the power structure of the bank undercut the authority of the risk management group.  I learned a long time ago that most banks believe that risk management is like a child, they should be seen, not heard!  Most banks used risk management like guys you see in your neighborhood that put up a sign on the front lawn, "WARNING, THIS HOME IS PROTECTED BY ACME SECURITY SYSTEMS!"  When you ask, "Hey Fred, can you give me the number of ACME?"  Fred says, "Ah, that sign is just there to keep bad guys away, I don't have a system, it's too damn expensive!"

The bottom line is in almost every bank, you have a head of risk management.  He is a big name and has written a book or two and gets paid a lot of money.  He understands that if the bank doesn't make money, he doesn't make money.  His lopsided payment for current results is just as lopsided as the rest of senior management.  He isn't going to seriously block business lines from "making billions".  What he is going to do is pay a lot of lip service to his risk management responsibilities and make his direct reports look like dopes as they go into battle with the front office, with a false sense of security that the boss has their back.  Once they get played like this a few dozen times, they usually just start playing the game, trying not to get yelled at and praying that nothing blows up so they can get paid for the 80 hour weeks they are putting in.  The next level of risk management consists of smart yet inexperienced twenty six year-olds.  Most of them want to learn what they can, make friends with someone in the front office, and get out of risk management and into trading or sales.  Who can blame them.  The money is (was) great, the job looks cool, and they see how their bosses suffer everyday.  They don't want to be him!

And that's how it rolls, and has rolled for at least twenty five years.  Banks pay lip service to real risk management.  Until they make legitimate changes, which they promise in every crisis, risk management is really just a big scary sign in the front yard without anything behind it.

Monkey Business Credo, "Never Challenge Worse" Moves it Way to the High Yield Loan Market!

Here at Monkey Business we live by the creed, "Never challenge worse."  What does this mean you ask?  It means that when you are in a real bad situation and someone says something like, "The downside risk is negligible FROM HERE.", we take the other side of the trade.  This morning the Financial Times has an article, "Banks Remain Exposed to Risk After Debt Sales."  This shouldn't be surprising to anyone who has paid close attention to the loan sales banks like Citigroup, Deutsche Bank and Royal Bank of Scotland have made to private equity folks like Apollo, Blackstone and TPG. 

The banks, in an incredibly weak position, let the private equity firms (PEs) cherry-pick through their high yield loan portfolios earlier this year.  According to FT, the PEs purchased about $30 billion loans at approximately 85 cents on the dollar.  Furthermore, the banks lent the PEs 80% of the purchase price, with lending rates at sub-market levels.  Two things immediately came to mind for me back when these transactions started taking place.

1. With all the "good loans" cherry-picked, what disasters are left on these guys books?
2. Along with the negative carry associated with lending the PEs dollars at a sub-market rates (and term dollar funding is just as tough to get now as it was six months ago), the banks still maintain risk to the loans should the loans be worth less than the actual capital the PEs have put up.  The banks could hedge this risk in the Credit Default Swap (CDS) market, but thats a lot more negative carry.  Additionally, how much counterparty risk are the banks taking in those transactions?

Here is how to calculate the risk left to the banks on these deals;

• Bank sells PE $1bb loans for $850 million
• Bank loans PE 80% or $680 million
• PE puts up $170 million of capital
• Banks exposure to the loan is anything less than a price of 68-00

Now, in the last big corporate credit meltdown (2002), a price of $68-00 on a senior secured loan was a pretty good floor.  However, this is no ordinary meltdown.  We've broken through every worst case assumption in residential and commercial mortgage lending, why should corporate lending be any different.  After all, these loans were made in the same "frothy" environment.  Also remember, Moody's and S&P were on the job!  That should be enough to make grown men cry.  I am going to re-post a piece we wrote June 25, 2008 to show how scared you should be.  It was titled, "Moody's Scramble to Lock Barn Door Impeded by Fleeing Horses!"

Can't you just picture it?  It's the late 1800's.  Moody's, the credit rating company, is racing with their wagon to the city livery stable.  A call had gone out that the horses are escaping!  Moody's job was to secure the barn door the night before but they were too busy.  See, there was this little party and there was lots of wine, women and song.  They stayed at the party too long and forgot to do their job.  Now in a panic, they are trying to ride hell-bent to the livery stable, but they can't get anywhere near the place because all these damn stray horses (the ones that should be locked in the livery) are running around everywhere blocking the way!

Yes folks, the ratings companies have done it again, this time with syndicated leveraged loans.  There is an article in todays Financial Times, "Issuance Surge Set to Hit Recovery Rates", that outlines how the rating companies failed to take into account many factors, that will help fuel the next credit disaster, corporate loans.  The best part about the FT article is it's essentially written by Moody's!  They issued a report YESTERDAY on the problem!  Here is what Kenneth Emery, Moody's Director of Corporate Default Research, had to say:

"The substantial increase in bank loans average share of total debt will reduce average recoveries for both loans and bonds.  Loans have less junior debt below them which will serve as a drag on recovery rates."

You see, because there was huge demand for senior secured high yield loans in the heady days of leveraged vehicles (2004-2007), in this case Collateralized Loan Obligations (CLOs), banks fed the voracious appetite by issuing as many loans as possible.  This is a problem now.  Why you ask?  It is a problem because by issuing so many loans they messed with the credit capital structure of these highly levered companies.  Senior secured loans sit at the top of say, Burger King's capital structure.  Then comes second lien secured loans, then comes unsecured bonds and finally equity.  When credit losses start occurring this is the order of what part of the capital structure takes LOSSES:

1. Equity
2. Unsecured Bonds
3. Secured Second Lien loans
4. Senior Secured First Lien loans

Do you see the picture?  Senior Secured First Lien loans want as much subordination as possible so when losses start occurring, they are absorbed by guys like unsecured bonds and second liens.  Because banks were incented to crank out senior loans (that's what the gigantic CLO machine wanted), there is a disproportionate amount of senior loans to unsecured bonds.  Hence, the probability for senior secured losses has increased.  According to Moody's, dramatically.  Quoting from the FT article, "On average, first lien senior secured bank loans, the first in the pecking order for payment in default, will recover just 68 per cent on the dollar versus 87 per cent historically, Moody's estimates"

This is Moody's bread and butter!  They've been doing this kind of credit work forever!  It's not like a new product such as subprime or Alt-A home loans, a product where there was little historical data.  It's bank loans and corporate capital structure!!  At Moody's they have there analysts studying this stuff from the first day.  There's tons of data.  They, the ratings companies, knew this was a problem when they rated the CLO structures.  If they would have used a recovery rate like 68%, these deals probably wouldn't get done because who the hell would buy the subordinate pieces?  Nobody!

It gets better.  Quoting the FT article, "Moody's said the picture could change if creditors were able to minimize the decline in issuer's overall worth at the time of default by, for example, forcing distressed issuers into bankruptcy relatively soon after they hit financial trouble."  The problem with this is, Moody's let banks do away with important covenants on their loans, so they could make more of them for the CLO machine!!  They call these loans "covenant-lite". 

Yes folks, this is true.  Covenants are put into senior loans by lenders so if the borrowers do anything that might endanger the lender from getting paid back (things that would weaken debt/coverage ratios, free cash available, etc) the lender can demand immediate repayment.  This is the lever Moody's is referring to when it says credit problems for the senior loans could be mitigated if the senior lender were allowed to drive the borrower to repay them sooner or face bankruptcy.  Problem is, the ratings companies like Moody's, let the lenders and CLO issuers slide by allowing for massive issuance of "covenant-lite" loans.  So much for that.  Again, this is another thing baby ratings analysts learn from the cradle.

Now, here we are at the beginning of a potentially deep recession.  Corporate defaults are projected to top those from 2001-2002, by a lot.  Another perfect storm is brewing.  Moody's better hurry, I think I saw a few of those horses just run by my house!

Did you notice where Moody's put the new floor for senior secured debt?  They put it at 68-00!  That's right where our little at risk calculation ended up!  Furthermore, for anymore proof that things will get far uglier in high yield loans, Deutsche Bank "challenged worse!  Quoting the FT article;

"Deutsche Bank acknowledged that it retained exposure to the original loans, but said that any further losses would be negligible."

That's enough for me!  Good thing the "Gang of Nineteen" short selling ban ended yesterday!

Auction Rate Securities Fail the All Important Honest Abe Test

Who says that our biggest financial institutions are led by witless ding-bats that never seem to learn from past mistakes?  I think a round of applause is in order for Citigroup, Merrill Lynch and very soon, UBS!  After the horrific beating these guys took trying to fight the authorities in the famous pump and dump "Dot-Com" scandal of 2000, Citigroup and Merrill Lynch settled their Auction Rate Security ("ARS") mess with state and federal regulators yesterday in record time.  Combined, they have agreed to buy back approximately $20 billion auction rate securities from retail investors at par, and pledged to help institutional investors unload their securities as well.  Citigroup is paying a $100 million fine (remember when $100 million was a lot of money?).  I'm not sure if Merrill has agreed to a figure.  It is estimated that the writedowns associated with these buybacks could be as much as $4 billion.  Meanwhile, UBS is getting close to a deal where they will buy back billions of ARS and pay a fine, reported to be in the neighborhood of $150 million.  It is also reported that Bank of America is undergoing their "exam" as we speak. 

I have to admit that I am pleasantly surprised that these institutions have seen the error of their ways and are taking their medicine without a fight.  While they might be doing it because they realized that it was wrong to be running a rigged game that seemed to bilk everyone involved, except them of course, it was probably done because the last thing they need is more damaging emails going public and more reputational damage.  Next up on the docket is going to be how do the banks that cleaned out municipalities like Jefferson County Alabama (the county with the highest water and sewer bills in the country) make amends.

I am going to repost part of a piece I wrote a couple of months ago because I feel like it is appropriate given the latest events surrounding ARS.  It was called "A Risk Management Tip From Honest Abe".

Perhaps our country's greatest president, Abraham Lincoln once said, "You can fool some of the people all of the time and all of the people some of the time.  But you can't fool all of the people all of the time."

Now, just to be clear, this isn't a morality lecture and I don't think Honest Abe meant it to be.  Rather, it is a RISK MANAGEMENT lecture.  Here is how it would work:

• Look at every major business line, the ones that are making you all your money.
• When the business model is taking a nickel and selling it for a dime, ask yourself seriously how you are able to do that? 
• The answer may be that you take a lot of risk to do that and that big spread is compensation for taking that risk. Therefore, no one is fooling anyone.
• Maybe you are making that spread because you can buy something at the correct price (meaning the seller isn't fooled) and you can sell it at a marked up price because the buyers can't see and really don't care to do all the work to see if they are buying something too rich.  It happens in the trading of traditional structured product everyday and it's not necessarily a bad thing.  A lot of times the buyers have different performance parameters and as long as you can meet those parameters, they don't care.  This is called, "Fooling some of the people all of the time"  Honest Abe says this is doable so you're ok.
• Now lets look at the auction rate bond market (municipal and student loan agencies).  Here is a case where Wall Street created a product and a process that really relied on fooling the issuers, fooling the investors and fooling themselves.  This is called, "Fooling all of the people all of the time." Ding-Ding!! Honest Abe says you can't do that!

Banks were out selling auction rate bonds to retail investors and essentially representing these investments as good as cash, with a great return.  They were pushing this product retail because the institutional investors, like state pension funds were starting to figure out they were screwed holding billions of this paper.  Anyway, most retail investors quoted in the article didn't even know there was an auction! 

Meanwhile, as the banks are pushing this stuff retail, (late 2007 early 2008) they had a real good feeling that, with the collapse of the monolines, the auction rate debt was going to seize up.  That means no bidders at the next auction.  Not a good thing for the current holders of the bonds, should they want to get out.  Anyway, at the same time that the banks were pushing this paper retail they were warning issuers that the market could seize up.  It appears that the banks were telling the issuers that they should waive limits on penalty rates (like 20%) they would have to pay to make sure that the auction wouldn't fail.  I'm not sure I understand this perverse logic, but many of the municipalities and student loan agencies complied.  My only conclusion was prior to the meltdown (February 2008) the banks would take any bonds that didn't clear the auction on to their balance sheets to make it appear that the auction process was a smooth running machine (another incident of "fooling people").  If the banks were going to take the paper on their balance sheets, they wanted a sky high rate as balance sheet was becoming harder and harder to come by.

In February 2008, the auctions began to fail as big institutional investors stopped buying.  The picture of the "smooth auction process" was smashed.  The banks had fooled themselves too because with all the credit losses and funding problems they were running into, they couldn't bid on the $300+ billion bonds coming to auction.  Not a chance, even with 20% penalty rates.  It was game over.  Institutional and retail investors, who viewed these investments as safe and liquid as cash, were now trapped.  Municipalities and student loan agencies were paying double  digit penalty rates, rates that were not sustainable, and the banks were now open to all kinds of bad press and litigation.  It is still going on today and no one sees an end in sight.

Now, I know hindsight is 20-20 but if I, or anyone else, used Honest Abe's sage advise as my primary risk management tool it would have been hard to bless this product line. 

• Issuers were fooled into thinking that there would always be huge demand for their debt and that the auctions were real auctions (as opposed to the banks running the auction, taking down the debt that didn't get placed, not to mention charging nice fees at every auction).  Issuers exposed themselves to lots of risk replacing plain old fixed rate debt with this floating auction rate debt too.
• Buyers of the debt were fooled into thinking that these AAA instruments were as liquid as cash.  They were also fooled by the "smooth auction process".
• The banks fooled themselves into thinking this little cash cow could go on forever.

This ARS business relied on fooling all of the people all of the time and now it looks like the banks involved are going to be paying a lot of the people, a lot of money, a lot of the time!"

A Risk Management Tip from Abe Lincoln Concerning Auction Rate Debt!

Perhaps our country's greatest president, Abraham Lincoln once said, "You can fool some of the people all of the time and all of the people some of the time.  But you can't fool all of the people all of the time."

I think that this profound statement, beautiful in its simplicity, should be stamped in big gold letters on every floor in every Wall Street bank.  Huge letters that greet you right as you get out of the elevator every morning.  It should also be stamped in every board of directors conference room.  I would also put it on the inside of every bathroom stall, especially in the CEOs private throne.  Try reading the NY Post sports section in peace with that blaring at you!

Now, just to be clear, this isn't a morality lecture and I don't think Honest Abe meant it to be.  Rather, it is a RISK MANAGEMENT lecture.  Here is how it would work:

• Look at every major business line, the ones that are making you all your money.
• When the business model is taking a nickel and selling it for a dime, ask yourself seriously how you are able to do that? 
• The answer may be that you take a lot of risk to do that and that big spread is compensation for taking that risk. Therefore, no one is fooling anyone.
• Maybe you are making that spread because you can buy something at the correct price (meaning the seller isn't fooled) and you can sell it at a marked up price because the buyers can't see and really don't care to do all the work to see if they are buying something too rich.  It happens in the trading of traditional structured product everyday and it's not necessarily a bad thing.  A lot of times the buyers have different performance parameters and as long as you can meet those parameters, they don't care.  This is called, "Fooling some of the people all of the time"  Honest Abe says this is doable so you're ok.
• Now lets look at the auction rate bond market (municipal and student loan agencies).  Bloomberg News has a great piece today titled, "Wall Street Sold Auction-Rate to Investors as it Warned Issuers."  Here is a case where Wall Street created a product and a process that really relied on fooling the issuers, fooling the investors and fooling themselves.  This is called, "Fooling all of the people all of the time." Ding-Ding!! Honest Abe says you can't do that!

The Bloomberg article points out that banks like UBS (I'm really starting to feel for those poor bastards!) and Bank of America were out selling auction rate bonds to retail investors and essentially representing these investments as good as cash, with a great return.  They were pushing this product retail because the institutional investors, like state pension funds were starting to figure out they were screwed holding billions of this paper.  Anyway, most retail investors quoted in the article didn't even know there was an auction. 

Meanwhile, as the banks are pushing this stuff retail, (late 2007 early 2008) they had a real good feeling that, with the collapse of the monolines, the auction rate debt was going to seize up.  That means no bidders at the next auction.  Not a good thing for the current holders of the bonds, should they want to get out.  Anyway, at the same time that the banks were pushing this paper retail they were warning issuers that the market could seize up.  It appears that the banks were telling the issuers that they should waive limits on penalty rates (like 20%) they would have to pay to make sure that the auction wouldn't fail.  I'm not sure I understand this perverse logic, but many of the municipalities and student loan agencies complied.  My only conclusion was prior to the meltdown (February 2008) the banks would take any bonds that didn't clear the auction on to their balance sheets to make it appear that the auction process was a smooth running machine (another incident of "fooling people").  If the banks were going to take the paper on their balance sheets, they wanted a sky high rate as balance sheet was becoming harder and harder to come by.

In February 2008, the auctions began to fail as big institutional investors stopped buying.  The picture of the "smooth auction process" was smashed.  The banks had fooled themselves too because with all the credit losses and funding problems they were running into, they couldn't bid on the $300+ billion bonds coming to auction.  Not a chance, even with 20% penalty rates.  It was game over.  Institutional and retail investors, who viewed these investments as safe and liquid as cash, were now trapped.  Municipalities and student loan agencies were paying double  digit penalty rates, rates that were not sustainable, and the banks were now open to all kinds of bad press and litigation.  It is still going on today and no one sees an end in sight.

Now, I know hindsight is 20-20 but if I, or anyone else, used Honest Abe's sage advise as my primary risk management tool it would have been hard to bless this product line. 

• Issuers were fooled into thinking that there would always be huge demand for their debt and that the auctions were real auctions (as opposed to the banks running the auction, taking down the debt that didn't get placed, not to mention charging nice fees at every auction).  Issuers exposed themselves to lots of risk replacing plain old fixed rate debt with this floating auction rate debt too.
• Buyers of the debt were fooled into thinking that these AAA instruments were as liquid as cash.  They were also fooled by the "smooth auction process".
• The banks fooled themselves into thinking this little cash cow could go on forever.

Therefore, if I'm on the board of directors for one the big banks, I don't need to read the latest risk management book from John Hull.  I just have to look at the wall where Abraham Lincoln's immortal words are stamped in BIG gold letters, and say, "Looks like I'm trying to fool all of the people all of the time.  Shut it down!"