The Meat Grinder, and a Few Basis Points of Shame

Today's "must read" is a long piece from Michael Osinski in NY Magazine about developing the software that become the Wall Street standard for modeling CDO's.

“You put chicken into the grinder...and out comes sirloin.”

"Allow me to expand Professor Gesiak’s analogy a bit: For deals with non-agency loans—that is, not Freddie or Fannie—in addition to the sirloin that comes out of the grinder, there is a small percentage of offal. By running that offal through the grinder again, in effect bundling together all the pieces from various deals that absorbed the default risk, we then created some andouille and some real dog food. The rise in price of the sausage over the offal more than compensated for the unsalable leftovers. That junk typically couldn’t be sold and stayed in-house, eventually becoming known as a “toxic asset.”

Mr. Osinski, now an oyster farmer, feels a palpable twang of guilt - not full blame, but what he describes eloquently in the language of The Street as "a few basis points of shame."

"Last month, my neighbor, a retired schoolteacher, offered to deliver my oysters into the city. He had lost half his savings, and his pension had been cut by 30 percent. The chain of events from my computer to this guy’s pension is lengthy and intricate. But it’s there, somewhere. Buried like a keel in the sand. If you dive deep enough, you’ll see it. To know that a dozen years of diligent work somehow soured, and instead of benefiting society unhinged it, is humbling. I was never a player, a big swinger. I was behind the scenes, inside the boxes. My hard work, in its time and place, merited a reward, but it also contributed to what has become a massive, ever-expanding failure. For that, I must make a mea culpa. Not a mea maxima culpa, mind you, but some measure of responsibility, a few basis points of shame. Give my ego a haircut."

The entire piece is well worth the twenty minutes it will take you to read it.

-KD

Quote of The Day

"This guy should be in a retirement home doing Sudoku. His funds have blown up twice. He shouldn’t be allowed in Washington to lecture anyone on risk.” -"Black Swan" author Nassim Taleb on Myron Scholes, creator of the options pricing Black-Scholes formula. via Marion Maneker

If you missed my pieces this week on the developing PPIP plan, go back and read them now:

1) The PPIP is a Scam

2) PPIP Details Emerge

3) The Fallacy of Seller Financing

4) Phish Meets Finance

-KD

Annnnnddd..... It's GONE! - Consult The Chart!

South Park is world class - brilliant.



"We can put that check in a money market mutual fund, and we'll reinvest the earnings into foreign currency accounts with compounding interest annnnnnnnddd it's GONE!"





"Well you don't GET 90 Trillion dollars, but The Chart says that's what it's worth"

Phish meets Finance

Every morning I wake up, check a variety of blogs and news sources, and then go to the gym. While listening to my Ipod, I frequently find inspiration in unexpected lyrics. Today's source is the unlikely "Wolfman's Brother," by Phish:

The telephone was ringing - I handed it to Liz. She said:
"This isn't who it would be, if it wasn't who it is."

The bizarro-Descartisian concept that "this isn't what it would be if it wasn't what it is" echoed in my head - as I'd read a post not thirty minutes earlier by Felix Salmon of Conde Nast Portfolio.com. Salmon commented on the concept of the PPIP discovering market prices for toxic assets (emphasis mine):

This is certainly, then, the government's position: the public-private partnerships won't be able to pay a premium on the grounds that the FDIC is taking all their tail risk; on the contrary, the toxic assets are simply trading on an illiquidity discount right now, thanks to the lack of available financing. Since the FDIC is stepping in to provide the financing, the prices which come out of this scheme will be reliable market prices.

This I think misses a crucial point: the whole reason why the banks are in such trouble right now is that they provided an enormous amount of low-cost tail-risk financing to the buy-side, in the form of super-senior debt, leveraged loans, and the like. Most of us, looking back on the excesses of the 2005-6 era, reckon that the market price of loans which can be leveraged very cheaply is not a "true market level" at all, but rather something fake and bubblicious.

The fact is that no one with purely commercial motives would ever extend financing against these toxic assets on anything like the terms which the FDIC is making available. So I'm not at all convinced by Bair's protestations that this scheme is going to be a great means of price discovery.

The government clearly thinks that it needs to inject capital into the banks, in order to prevent a systemic meltdown. That's fine, but I'd be much happier if it did so transparently, rather than trying to pretend that all of its operations were taking place at true market prices.

Salmon's point echoes one I made recently - that the sellers of these toxic assets could have made this very same deal a year ago, with no government involvement. They didn't do this because they didn't want to take the risk on providing the financing with the toxic loans as collateral since as Salmon said, no one with commercial motives would do that!

This isn't what market prices would look like if they didn't have the backstop of almost free leverage and a backstop from the government! " This isn't what it would be, if it wasn't what it is!"

On a related subject, there has been some chatter reacting to a NY Post article which explained how Citi and BAC, which are supposed to be trying to get toxic assets off their book, have been out-bidding hedge funds in an attempt to BUY more of these assets.

"Recently, securities rated AAA have changed hands for roughly 30 cents on the dollar, and most of the buyers have been hedge funds acting opportunistically on a bet that prices will rise over time. However, sources said Citi and BofA have trumped those bids."

My question, which no one seems to be asking, is "Who is selling these assets at 30c on the dollar?" It's not the big banks right? We can agree on that? After all, the reason we need the PPIP in the first place is because the banks refuse to sell the assets at market prices - clearly, even, Citi and BAC think 30c is cheap - as they are buying at those levels. Oh - and I guess the problem isn't a lack of liquidity either - there are clearly willing buyers at 30c. The problem must be a lack of liquidity at 80c. So who wants to get out at 30c? This brings to mind something I wrote about less than 3 weeks ago, citing an excerpt from The Secret History of Bear Stearns' Collapse. Quoting my own blog post now:

"There is a fantastic segment about the valuation of the CDO portfolio, where the managers get marks from multiple Wall Street dealers. While most counterparties valued the assets at 98 cents on the dollar, Goldman Sachs provided a valuation of 50. At first it seems that GS is the bad guy, accused by a former BSC exec of trying to mark the portfolio lower in order to profit on a short position GS had. However, Goldman's Gary Cohn explained the real story:

"He (Cohn) then shared an anecdote about a conversation he'd had with Nino Fanlo, one of the founding partners of KKR Financial Holdings, a specialty finance company started by KKR, the private equity shop. After Goldman sent out the marks in the 50¢ to 55¢ range, Fanlo called Cohn and told him, "You're way off market. Everyone else is at 80, 85." Cohn then offered to sell Fanlo $10 billion of the paper at his 55¢ price and encouraged him to sell that in the market to all the other broker-dealers at the higher prices they claimed to be marking the paper at. In other words, Cohn was offering Fanlo a windfall: buy at 55 and sell at 80. "You can sell them to every one of those dealers," Cohn told Fanlo. "Sell 80, sell 77, sell 76, sell 75. Sell them all the way down to 60. And I'll sell them to you at my mark, at 55, because I was trying to get out. So if you can do that, you can make yourself $5 billion right now."

Cohn had been trying to sell the securities at 55 for a period of time and people would just hang up on him. A few days later, Fanlo called Cohn back. "He came back and said, 'I think your mark might be right,'" Cohn said. "And that mark went down to 30."

We know how that worked out for Bear Stearns...

-KD

Seller Financing

Wow, I didn't realize how apt the Buffalo Springfield quote ""There's something happening here. What it is ain't exactly clear" I used yesterday was for the PPIP. After lying awake last night tossing and turning over the realization that the sellers of the questionable assets are the ones financing the trade (with an FDIC guarantee of course) it's becoming clear to me.

The reason seller financing (without risk) is such a troubling concept when applied here is that it basically proves that the problem wasn't that the sellers needed the proceeds from the asset sales (because they are not getting the proceeds - they are financing a large portion of the trade) or that the sellers didn't have the capital to offer financing - the problem was that the asking price was definitely wrong. Now, for almost 18 months, we've been saying that the problem is that the sellers had a value (say 80c) for the assets, and the buyers disagreed on the proper value (they thought it was more like 30c). It's clear that the sellers KNOW they are wrong about their asking valuation. How? let's step back to July, 2008 when Merrill Lynch sold its CDO portfolio to Lone Star.

In that transaction, MER sold the CDO portfolio for roughly 20c on the dollar. But there was a catch - MER also provided the financing for 75% of the trade on a non-recourse basis to LoneStar, with the CDO portfolio as the collateral. This isn't as complicated as it sounds - what it means is that LoneStar put up 5c on the dollar, and MER loaned them 15c, to get to the 20c sale price. If the CDO's turned out to be worth nothing, LoneStar would lose 5c on the dollar (its entire investment), and MER would have effectively sold its portfolio for 5c on the dollar. If the portfolio ended up being worth 20c or more, LoneStar would reap the profits, and MER would have recognized a 20c sales price.

Contrast this to the PPIP, where the seller (let's use Citi as an example) sells its assets for, say 84c. As we went through the math yesterday, the PPIF will put up 6c, which will be matched by another 6c from the Treasury. The remaining 72c will come from FDIC guaranteed financing - but as I realized in my edits last night, the FDIC is not lending money - the seller is not receiving the 72c. The seller is LENDING the 72c to the buyer (by buying FDIC backed debt from the buyer, collateralized by the assets in question!) So, why do we need the FDIC at all? Why do we need Geithner's master plan? Why couldn't the seller have just done this in the first place - just like MER did last summer? Some people said there wasn't enough capital to soak up the assets. That's bullshit - Geithner's plan isn't creating any capital - all its doing is taking the risk from Citi and transferring it to the FDIC/taxpayer.

So, if the assets bought by the PPIF turn out to be worth less than 84c, Citi doesn't eat the loss, because the FDIC has stamped its guarantee on the box full of crap (there's that Tommy Boy quote AGAIN for you). This brings us back to my assertion that Citi knows full well that the crap isn't worth 84c. If they really truly believed that the assets were worth 84c, they'd be happy to provide a non-recourse loan to the buyers in order to finance the purchase of the assets, and the FDIC/Treasury/Geithner guarantee would be unnecessary! Perhaps this is why the detail of the seller financing was buried in the details of the plan.

The fact that this new plan's main offering point is that the FDIC is taking the risk that the selling banks didn't want to take is all the evidence we need that the problem wasn't a lack of liquidity, lack of capital, lack of confidence, or a temporary dislocation - it was that the sellers have been asking too high a price for the assets, and they know it. So, won't an auction of the assets result in an accurate and fair market price? Well, I already illustrated several ways that process could be bastardized, and I'll leave you with one more, a quality post today from Steve Waldman's Interfluidity Blog, where he explains why PIMCO and Blackrock may be so eager to participate in this program:

"Consider a hypothetical asset manager, PIMROCK. PIMROCK reviews a pool of loans held by the bank J.P. Citi of America, and its analysts determine they are worth 30¢ of par value. The bank holds them at 80¢ on its book. PIMROCK agrees to put down $10B to purchase loans from the pool at 82¢ thrilling stock markets everywhere. It was all just a bad dream!

Under Geithner's plan, PIMROCK's $10B permits a $10B equity investment from the Treasury. Then the FDIC levers the whole thing up, providing $6 of debt for every one dollar of equity. So, $140B of bad loans are lifted from J.P. Citi of America, nearly $90B of which is sheer overpayment to the bank.

Of course, as cash flows evolve, PIMROCK's $10B is wiped out entirely, as is the Treasury's investment. The FDIC gets repaid in a bunch of securities worth about $50B, taking a $70B loss. But...these were real market prices, Geithner or his successor will argue. Our private partners lost everything. There was no subsidy here.

Meanwhile, taxpayers will be out around $80B.

Why would PIMROCK go along with this? Because they feel it is their patriotic duty to work with the government for the good of the financial system, even if that involves accepting some sacrifices. And because they hold $100B in J.P. Citi of America bonds, and they've received assurances that if we can get the nation out of the financial pickle it's in, there will be no haircuts on those bonds. "Shaking hands with the government" means that nothing ever has to be put in writing."

-KD

Details Emerge - The PPIP

"There's something happening here. What it is ain't exactly clear"
- Buffalo Springfield, For What It's Worth

A comment on my previous post, "The PPP is a Scam" asked me to do a follow up post now that the details are out. First off - I want to take this opportunity to clarify that I am not offering any sort of recommendation to buy or sell any type of security on this blog - and everyone should do their own research before trading. That said, I am certainly doing my best to provide accurate information and insightful analysys.

Now, the details are out, and the plan is officially called the PPIP - the Public Private Investment Program. The key difference between what I wrote about yesterday based on initial reports, and what the actual plan contains, is that the max leverage will be 12-1, not 30-1.

Don't be confused by the quoted 6-1 leverage in the plan press release - the way it works is this: The government will form up to 5 investment groups. Each PPIF (that's Public Private Investment Fund) will bid on packages of bonds. Let's say KidDynamiteCapital bids 84c on the dollar for $100MM in bonds, and we're the winner. The FDIC would provide 6-1 leverage (how? we'll get to that in a minute), which results in $12MM in equity which needs to be committed - which will be split between KDCapital and the Treasury (from TARP funds). Thus, KDCapital can buy $84MM in bonds with $6MM in equity, which is 12-1 leverage.

The strangest part of all of this is the FDIC's involvement. As I mentioned yesterday, the FDIC doesn't have this kind of money to commit. If you read the Treasury's white paper on the PPIP, they explain exactly how the FDIC will offer this funding, and this is the important part:

"The new PPIF would issue debt for the remaining $72 of the price and the debt would be guaranteed by the FDIC. This guarantee would be secured by the purchased assets."

In other words, KDCapital would the turn around and issue $72MM worth of bonds with an FDIC guarantee on them! How does the FDIC guarantee the bonds I'm selling? Simple - they use the toxic assets in question as collateral! If this makes your head smoke, or reminds you of my favorite applicable Tommy Boy quote: "Hey, if you want me to take a shit in a box and mark it guaranteed, I will - I've got the time" - well then, you're probably using your brain.

The next question is, who wants to buy my KDCapital bonds - and what interest rate would I have to pay to raise capital? That remains to be seen. The harder question is how can the FDIC provide this insurance when it clearly lacks the assets to cover the liabilities - when AIG did this we called it criminal. The concept of the FDIC providing a shadow guarantee on debt used to purchase questionable assets by using the underlying questionable assets as collateral really doesn't make much sense to me, but it almost confuses me into submission. I guess it's the theory that a guarantee doesn't cost you anything if you don't have to use it - we'll see. The FDIC will charge a "fee" for providing this insurance. What's also interesting is that the Treasury already has a program to guarantee debt issued by financial institutions - the TLGP (temporary liquidity guarantee program).

I'm interested to see what kind of interest rates the market demands on these FDIC guaranteed PPIF bonds. Back in November, GS sold 3 year notes under the TLGP at a cost of 200bps over comparable treasuries. I found this interesting at the time, as the market clearly prices in some risk (200 bps worth!) even though the Treasury is guaranteeing both its own debt and GS's debt issue. Other institutions have also used the program, with JPM issuing its own short term notes under the TLGP at a spread of roughly 121 bps over treasuries. We'll have to wait and see how the market likes this FDIC version of the TLGP, backed by toxic assets.

Obviously, the key will be in making sure that, as I explained yesterday, the banks who are selling the assets are in no way able to fund or interfere with the PPIF's, or to somehow bid on any of the paper themselves. Hopefully, by limiting the number of participating PPIF's, the government will be able to keep the process Kosher. There are a number of stipulations included to try to ensure that this is the case (ie, "Private Investors may not participate in any PPIF that purchases assets from sellers that are affiliates of such investors or that represent 10% or more of the aggregate private capital in the PPIF."). Unfortunately, if the process is on the level, the banks may still find themselves disappointed in the bids they receive - which has been the problem all along. And so it goes.

EDIT: ok - I just finished this post and I'm already editing it, because I read a comment on Paul Kedrosky's blog that said "The selling bank provides seller financing by purchasing FDIC-guaranteed debt issued by the buyer. $6 from the buyer + $6 from the Treasury + $72 from the selling bank to purchase FDIC guaranteed debt from the buyer = $84 paid for assets with a face value of $100."

I went and dug around some more in the Treasury Fact Sheets, and found this:

"Consideration paid to Participant Banks in exchange for purchased Eligible Asset Pools will be in the form of cash or cash and debt issued by the PPIFs. PPIF debt will be guaranteed by the FDIC."

For some reason, this bothers me greatly... The bank selling the asset is financing the sale by lending the PPIF money collateralized by the very assets they are selling. The problem with this is that if the assets turn out to be worth less than the banks think, the banks don't eat it - the taxpayers (via the FDIC) do.

I guess maybe it doesn't really matter who lends the money (translation: buys the PPIF debt) does it? The method where the banks make the loan without really having the risk bothers me so much more though.

EDIT 2: Ok - I think I figured out why this is bothering me so much: when the seller (The Bank) provides the financing (translation: buys the PPIF debt), it means they don't actually get the sale price for the bond... Instead of getting $84MM, they only get $12MM - the rest is received when the bond matures. If the bond actually has value, the PPIF pays the seller (the Bank) back. If the bond was as worthless as the market thought, the taxpayer (FDIC) pays the seller back. Of course, if the seller doesn't receive the money when it sells the bonds, there's that much less beneficial effect, and that much less capital that the seller has to redeploy via new lending - so the benefit has to be less than if the PPIF sold debt to the marketplace. If the purpose of the plan is to "get banks lending again," wouldn't we rather have the banks actually receive all the money for the assets they are unloading NOW, rather than receiving 1/6th of the sale price?

I'll try to close this post once and for all by restating the most important point of why I think the FDIC's involvement here is a bastardization: the purpose of the FDIC is to protect bank liabilities, not to protect bank assets. The deposit you have at the bank is a bank liability. The debt a bank purchases (or a mortgage it writes) is a bank asset. This entire program is basically a reversal of the purpose of the FDIC.


-KD

The Private Public Partnership is a Scam

Yeah - why mince words? The soon to be announced Private Public Partnership (let's call it the PPP!), which aims to get bad assets off of bank balance sheets, will be another royal reaming for the U.S. taxpayer. Let's start with the details, from a NY Times article:

"To entice private investors like hedge funds and private equity firms to take part, the F.D.I.C. will provide non-recourse loans — that is, loans that are secured only by the value of the mortgage assets being bought — worth up to 85 percent of the value of a portfolio of troubled assets.The remaining 15 percent will come from the government and the private investors. The Treasury would put up as much as 80 percent of that, while private investors would put up as little as 20 percent of the money, according to industry officials. Private investors, then, would be contributing as little as 3 percent of the equity, and the government as much as 97 percent."

Just to restate that simple math: an investor will put up as little as 20 percent of 15 percent of the purchase price of the assets! Right away this should set off alarm bells for anyone thinking this will be a solution, as I've said numerous times already: YOU CANNOT SOLVE A LEVERAGE CRISIS WITH MORE LEVERAGE! Yet, Tim Geithner is proposing to do exactly that, by offering over 30-1 leverage to the buyers in this plan.

But wait - it gets better. Who is providing the leverage? The FDIC - a fund who is ALREADY overlevered to the point of insolvency! The FDIC providing funding right now is analogous to AIG writing insurance it couldn't possible cover. The FDIC has less than $50B in assets, and trillions in liabilities it is already insuring. Now, in a perfect world, it would be nice if the FDIC, relying on funds collected from its member banks, provided the financing. However, that is also a complete bastardization of the purpose of the FDIC: the FDIC doesn't exist to protect the banks' ASSETS - it exists to protect the banks' LIABILITIES - in other words - the deposit you put in the bank. Yes - that deposit is a liability for the bank. Now, I am still confident that if and when the FDIC needs more money, the Fed/Treasury will give it to them, and I think that's the right thing to do to protect depositors and avoid the literal collapse of our deposit banking system - so let's just consider the FDIC and the Treasury one and the same for the purposes of this post - it's not an oversimplification. Another simple proof of this point is the question "Where will the FDIC get hundreds of billions of dollars to fund this PPP if they have less than $50B?" Answer: the Treasury.

So, where were we: oh yes - getting the assets off the banks' books by levering up potential buyers 30-1. Yves Smith at Naked Capitalism weighed in on the subject already, with an example a reader left her in comments from a previous post. You can see my comments on that thread, as well as a number of crafty ways to scam the PPP from other readers, but I'll give you a few simple examples here:

Let's say you're SpankBank, and you have $100B in assets on your books marked at 80c on the dollar. The problem continues to be that the market is valuing these assets at 20c on the dollar, while you're insisting that there is just a temporary market dislocation, and that the assets will prove to have more value.

Enter the PPP: SoCal Asset Management (SCAM), a hedge fund, is feeling generous, and offers SpankBank 75c on the dollar - or $75 Billion for the pile of assets. Of course, SCAM only has to put up 3% of that, as Geithner's magic financing committee takes care of the rest of it. So SCAM puts up $2.25B, gets government funding via the FDIC, FED, Treasury, FCC, FDA, and whatever other corporations the Treasury wants to throw in the middle to confuse the taxpayers - and now SpankBank only has to take a $5B hit on these assets ($80B mark - $75B sale price).

Wait - you say - why would SCAM do such a thing? Ah-hah - herein lies the rub: there are a number of ways for them to be potentially isolated from losses.

1) SpankBank could fund SCAM directly, providing all the capital. SpankBank would be happy to do this - eating the $2.25B loss on the seed funding, and the $5B loss on the asset sale, instead of the $60B loss they'd have if they sold the assets at market prices. The Taxpayer would eat the loss between the overpaid purchase price and the ultimate value of the assets at maturity. Fortunately, I hope even Tim Geithner and Barney Frank are smart enough to figure this out, and would clearly disallow it. (quick side note - for all the Geithner fans who say "stop picking on the guy, he's only had a few months to work this out" - Geithner was the head of the NY Federal Reserve when Bear and Lehman blew up - it was his JOB to do these talked about "stress tests" BEFORE the banks blew up to prevent exactly what happened. Thus, I have no faith in his ability to solve a problem he was SUPPOSED to be responsible for preventing.)

2) SpankBank could offer SCAM cheap protection (ie, write them CDS!) on the assets SCAM purchases! This is still a win for SpankBank, and will also result in a win for SCAM, as they've been purchased (in reality "been given") protection on the assets. Again, the Taxpayer eats the losses. Quick numerical example: SCAM buys protection on $10B of the assets from SpankBank, for a nominal cost of, say $1B. At maturity, if the assets turn out to be worth only 50c on the dollar, SCAM will have a $5B payout on the protection it bought, and will realize a $4B gain on their "hedge" ($5B payout - $1B cost). Subtract their $2.25B investment, and they have a healthy gain. SpankBank is still happy to do this, because their loss on the CDS protection which they basically gave away at below market rates pales in comparison to the loss they would have taken on the underlying assets - the loss that is now eaten by, you guessed it - the Taxpayer! Did Geithner think of this? Who knows - what would probably happen is that Barney Frank would figure out the scam in 10 years and impose a retroactive 90% tax on employees of SCAM.

3) We can get more creative and more devious: SpankBank could form shell corporations to buy assets from IdiotBank, and IdiotBank could reciprocate by overpaying for assets from SpankBank. The two firms structure complex off balance sheet vehicles that look like private companies, and the Taxpayer eats all the losses.

4) A commenter on Yves' post (Anonymous, 3/21 9:20pm) proposes basically this - no CDS needed:

In the simplest version, some entity buys $100B face MBS from SpankBank at price of 80%. 3% down, 97% financed means that they put down $2.4 billion.

BAC gets $80B cash.

The next day, BAC buys the structure back from the entity for $2.5 billion (this can be done via total return swap, if needed).

The entity has made $100 million for a day's work.

SpankBank has an purchased an option on the spread between the income on the mortgages and the cost of financing.

For $2.5 Billion, SpankBank has transferred all price risk to the taxpayer and taken out $80B in cash.

It gets even better... SpankBank is clearly incented to have it's SCAM corporation bid as high as possible for the assets, since Uncle Tim is eating 97% of the losses! So imagine what happens if SCAM bids Par (100%) on the assets - then SpankBank actually books a gain!

The ultimate question is, will the government be smart enough to prevent any and all potential gaming/scamming of their program. I don't think I'm out on a limb when I say that if recent history is any indicator, the answer is a resounding "NO." The money will find a way to beat the program - it always does.

I want to close with another great comment from the Naked Capitalism post (Anon, 3/22 11:34am):

"The problem is one of perception.

1) The government wants to give the banks as much as $1 trillion from taxpayers

2) Banks have nothing worth anything remotely close

3) Taxpayers are not going to take a direct transfer with nothing in return

3) Treasury tries to concoct a scheme that will get the blessing of or at least confuse the media (CNBC, WSJ, etc.) that hides this direct transfer. Hank Paulson tried this and managed to give away several hundred billion dollars with praise from the likes of CNBC, WSJ and CNN.

4) In Geithner's scheme, the Treasury lies to the taxpayer and says that the price has been set by the private sector and the taxpayer has the potential for upside.

5) Bottom line, taxpayers fork over $1 trillion to the banks and get maybe $200 billion back in five to ten years."

-KD

For The Win!

I hate to bump complete morons like Congresswoman Corrine Brown off the top spot on my blog, but this video, courtesy of CNNSI.com's Hot Clicks, is simply remarkable:

-KD

Congress

With Congresswomen like Corrine Brown (D: Florida), is it any wonder we have problems?



If you're not tilted enough yet, read this piece from NakedCapitalism on the Merrill Lynch writedowns that BankOfAmerica was complaining about...

Happy Spring!

-KD

Dilbert and Other Stuff

Somehow, Dilbert still manages to remain tremendously on point.

First, from Barry Ritholtz's blog:

and then, from my friend, Bones:

As for the whole AIG debacle, the issue has certainly struck a chord in the media and the public , as it was widely covered yesterday and today. Clusterstock has a nice shot at Larry Summers, who, in classic two faced political style, trumpeted the sanctity of contracts (ie, AIG's bonus agreements), and how the government shouldn't meddle with them... unless of course it comes to mortgage cramdowns - because those contracts aren't really contracts in Larry's Land. One point I want to make is that it's ridiculous to play the "the government shouldn't be involved in altering contracts" card now - it's a little too late for that. I'm certainly in favor of the government keeping their paws out of private enterprise, but they are waist deep right now.

Another issue I wanted to highlight from last week was the second round in the verbal financial cold war between the US and China. China lobbed some dud missles at us last week:

“We have lent a huge amount of money to the United States,” Wen said at a press briefing in Beijing today. “I request the U.S. to maintain its good credit, to honor its promises and to guarantee the safety of China’s assets.”

“China is worried that the U.S. may solve its problems by printing money, which will stoke inflation,” said Zhao Qingming, a Beijing-based analyst at China Construction Bank Corp., the country’s second-biggest lender. “If the U.S. can make sure this won’t happen, then China will continue to invest.”

Hey man - whatever you want. As we said before, we'll have Hillary take a crap in as many boxes as you want and write "GUARANTEED" on them. I'm kinda shocked that China still doesn't seem to get it: there are three potential outcomes here:

1) they keep buying our debt until they finally realize they can't support the ponzi scheme and everything collapses.
2) we default on our debt
3) we print money to pay off our debt - this is the most likely scenario.

So, YES, Zhao Qingming - we're gonna print money to solve our problems - no matter what Hillary tells you.

Finally, I think Barry Ritholtz did an excellent job synthesizing a view I've been trying to enunciate for a while now, regarding the paradigm shift that bullish analysts seem to be missing:

"After watching Bernanke last night on 60 Minutes, I still believe he has it backwards. He started the interview expressing his thoughts that they first have to stabilize the financial system and then everything will be ok and a recovery will ensue and that once Wall Street is fixed, Main Street will follow. However, it’s Main Street that is the crux of the problem, they have too much debt and that’s leading to the lack of mortgage, credit card, etc… repayments. While the banks were ridiculously leveraged also, the banking system gets ‘fixed’ once consumers start paying their bills again. With the TALF trying to get banks lending again and other various gov’t steps, the gov’t is trying to put Humpty Dumpty back together again, the Humpty Dumpty that borrowed too much, spent too much and didn’t save enough."

I translate that additionally to mean that the problem isn't that banks aren't lending - it's that they've now adopted reasonable lending standards and we lack for qualified borrowers. We saw this same thing back in December with GMAC.

-KD

AIG Bonuses - Can ANYONE defend this?

Again, this is from the NY Times, not The Onion:

"Despite being bailed out with more than $170 billion from the Treasury and the Federal Reserve, AIG is preparing to pay about $100 million in bonuses to executives in the same business unit that brought the company to the brink of collapse last year."

Huh? April Fools day is two weeks away - so that's not it. This story absolutely boggles my mind and boils my blood. I'm on fucking BAJUNGI tilt.

Look, I worked on Wall Street for nine years. I'm sympathetic to the fact that bonuses will still be paid to some employees at firms who are receiving government funds. It's not the ideal situation, and one could certainly argue that even if you worked for a division of these firms that did make money, you should be screwed anyway because if we, the taxpayers, hadn't bailed out your firm, your company would go bankrupt and no one would get bonuses. However, this is one case where the "we still need to reward talent" argument can still POTENTIALLY be made.

In AIG's case, however, that argument is null and void, yet their CEO, Edward Liddy, is still clinging to it when justifying payments to the very guys who blew up our financial system with incompetent and irresponsible behavior!

"Mr. Liddy defended the need to continue paying bonuses if A.I.G. was going to unwind the rest of its disastrous mortgage-related business at the lowest possible cost to taxpayers. “We cannot attract and retain the best and the brightest talent to lead and staff the A.I.G. businesses — which are now being operated principally on behalf of American taxpayers — if employees believe their compensation is subject to continued and arbitrary adjustment by the U.S. Treasury,” he wrote Mr. Geithner."

So, just so I have Liddy's view straight: the guys in AIG's financial products division, which played the key role in AIG losing NINETY NINE BILLION DOLLARS last year - are the best and brightest talent? FUCK YOU EDWARD LIDDY! And don't give me any bullshit about contractual obligations (which they mention in the article). If we didn't give AIG over a hundred and fifty billion dollars (does it seem like a real number when I actually write the words out like that?) in protection, they wouldn't be able to pay any bonuses.

I can't even think of a relevant analogy to Edward Liddy calling the guys in AIG's financial destruction division the best and the brightest. I guess it's like if you were having work done in your home, and the workers took a giant crap right in the middle of the floor, and you decided to pay them MORE money to clean it up, because no one else was qualified to clean it up.

Maybe I should be mad at Barney Frank again, for not imposing sensible conditions when we dished out the money in the first place.

In yet another unrelated example of why more government involvement is bad, the New Jersey Board of Cosmetology and Hairstyling wants to take away your right to wax your pubes. Thanks to The Bracelet for alerting me to this potentially disastrous law change that could result in all sorts of dangerous black market Brazillian bikini waxings, or worse, gigundous hairy beevs.

-KD

Lawyers, Guns and Money

I was fortunate enough to see the late, great Warren Zevon live in concert a few times while I was in college. When it comes to poetic storytellers, Zevon is right up there with Bob Dylan among the best of them. Most people are familiar with the legendary "Werewolves of London," but there's another song from that album (Excitable Boy), Lawyers Guns and Money, that's the peak of poetic simplicity, and also extremely relevant to our current global financial situation.

Well, I went home with the waitress, the way I always do
How was I to know she was with the Russians, too

I was gambling in Havana - I took a little risk
Send lawyers, guns and money; Dad, get me out of this

I'm the innocent bystander, Somehow I got stuck
Between the rock and the hard place
And I'm down on my luck
And I'm down on my luck
And I'm down on my luck

Now I'm hiding in Honduras - I'm a desperate man
Send lawyers, guns and money, the shit has hit the fan

Interestingly, I just found out that Lil Wayne has a song out now, called "Pussy Money Weed." Although Lil Wayne's "song" is not nearly as elegant as Zevon's masterpiece, I find it fascinating that only "money" stood the 30 year test of time between the writing of "Lawyers, Guns and Money," and "Pussy Money Weed."

Lil' Wayne replaced Zevon's essentials, lawyers and guns, with his own equivalent: pussy and weed. We can debate the merits of this replacement, (in fact, I could probably write 1000 words about the rankings chosen by Zevon and Lil Wayne respectively: with Zevon having money third in his rankings, and Lil Wayne placing it right behind "pussy" in the hierarchy) but one thing is certain: money is still money.

It's always about the benjamins, baby, which also may explain how someone as ignorant as Crazy Wackjob Maxine Waters managed to land a job on the House Financial Services Committee - she needed to lobby for her peeps. (also, WSJ article here).

Finally, on the issue of The Stimulus, something about this attempt in California to "sell" transit stimulus funds is irking me intensely.

-KD

p.s. - I strongly recommend Zevon's "Learning to Flinch," album.

Not Even Close

This morning we get more details of how AIG threatened the Fed with financial Armageddon if we the people didn't fork over another gajillion dollars.

As quoted in Bloomberg:

“What happens to AIG has the potential to trigger a cascading set of further failures which cannot be stopped except by extraordinary means,” said the presentation by New York-based AIG. “Insurance is the oxygen of the free enterprise system. Without the promise of protection against life’s adversities, the fundamentals of capitalism are undermined.”

The only problem is that this is exactly the OPPOSITE of how to maintain the fundamentals of capitalism, where good financial decisions are rewarded, and irresponsible financial decisions have a price to pay. And that's all I'm gonna say about that right now.

NakedCapitalism had a guest post which I liked because, well, it said exactly what I've been saying for a while now.

"The problem isn't falling asset prices, it's not rising foreclosures, it's too much debt."

"At the end of the day, flushing more debt through the system is the only lever policy-makers know how to pull. Lower interest rates, quantitative easing, deficit spending, it's all the same. It's all borrowing against future income. Each time we bump up against recession, we borrow a bit more to keep the economy going. With garden variety recessions, this can work. Everyone wants the good times to continue, so no one demands debts be paid back. Creditors accept more IOUs and economic "growth" continues apace. If it sounds like Bernie Madoff's Ponzi scheme, that's because it is."

Thomas Friedman also just figured out what I've been saying for about 18 months now - that we've had a paradigm shift in our borrowing/consumption model.

Finally, HolyTaco brings some light to our Monday morning with "Recession Friendly College Courses." "Leveraging of big titties for financial success," will surely be the most popular course.

-KD

Roses

"I know you like to think you're shit don't stank, but lean a little bit closer your roses really smell like poo poo poo." - Outkast, Roses

I have a memory seared into my head from my old friend Brian's rehearsal dinner, where his future brother in-law got the karaoke started by ripping through a killer rendition of Roses, by Outkast, featuring the uncensored line above, as grandparents and other relatives looked on with  somewhat bewildered expressions.

Lately, the phrase has come to mind in thinking about JP Morgan.  Back in September, people were saying JP Morgan and Bank of America had been anointed as the survivors amongst the big banks.  I never understood why people thought BAC was invulnerable, which it clearly wasn't, but perhaps JPM's partnership with the Fed in the BSC buyout made people think that JPM was invincible.

This week, Bloomberg published a story about JPM's massive OTC derivatives business, and I was shocked that there wasn't one mention of RISK in the article!  Instead, it focuses on the massive fees JP Morgan earned on it's derivatives business, and notes, "The bank held $87.7 Trillion worth of outstanding OTC contracts as of September 30th, more than the next two banks, Citigroup and Bank of America combined."

Hmmm...  Hey JPM - you think your shit don't stank?  Look folks - when you hold 87 TRILLION in notional over the counter contracts, you have some unhedgable risks - and volatility across asset classes like we've seen makes it virtually impossible to avoid some sort of significant losses.  I'm pretty surprised that no analysts (Hey Meredith Whitney - WHERE ARE YOU?!!?) have torn this apart. 

Then today, I hit up Bloomberg.com to check on the afternoon's stories, and I find this abomination from Barney Frank:

"Frank, a Massachusetts Democrat, said today he will seek legislation to "make it illegal for anybody to securitize 100 percent of anything."  The "phenomenon of securitization" is a large part of the problem in the housing market, Frank told reporters at a briefing in Washington."

Now here's the real problem:  Barney Frank, Chairman of the House Financial Services Committee, believe it or not, is not an idiot.  So when he spews such asinine comments as the one above, it's really, really scary.  

The problem, Barney, isn't securitization - there is nothing wrong with transferring the risk from those who do not want it to those who do want it.  That's what financial markets are very good at.  If the government wants to be involved, and we've seen recently that the government definitely wants to be involved - they should be regulating the BUYERS of the securitized products - those are the ones who are essentially lending the money to the homeowners (in the mortgage securitization example).  You need to make sure that the LENDER doesn't lend more money than he can afford to.  You need to make sure the BUYER of the securitized product (aka, the lender) doesn't buy $1B of the products with only $50MM of equity.  See, if you did this, then you wouldn't need to bail them out afterwards!  Voila!

-KD

Long and Strong

Today I bring you three more readings - each of which is relatively lengthy.

James Quinn does a pretty thorough job providing a plethora of evidence attempting to illustrate the paradigm shift in the behavior of the American consumer - and why the spending habits we're used to will not return for many years.

"There's a lady who's sure
All that glitters is gold
And she's buying a stairway to heaven

When she gets there she knows
If the stores are all closed
With a word she can get what she came for

Ooh, ooh, ooh, ooh, ooh
And she's buying a stairway to heaven

Led Zeppelin – Stairway to Heaven

She was buying the stairway to heaven using her home equity line, but now that she is underwater on her mortgage she tried to pay using her Amex card, but her credit score had dropped to 600 and they cut her credit line in half. The stairway to heaven isn’t as easy to achieve as it used to be. Barney Frank and Nancy Pelosi feel bad for the lady. They are going to borrow against your children’s future tax dollars and give them to the lady, so she can buy that stairway to heaven. By making this deal with the devil, the corrupt politicians running this country have put us on an escalator to hell. A straight shooting blunt President from last century described what would destroy America.

“The things that will destroy America are prosperity-at-any-price, peace-at-any-price, safety-first instead of duty-first, the love of soft living, and the get rich quick theory of life.”

Theodore Roosevelt"

Quinn's piece is not nearly as wingnut right wing as that quote sounds - and it's certainly worth reading for what I believe is accurate, unbiased data. I had to quote that whole opening, because he went with a great segue from the great Led Zeppelin quote to an even better and more applicable Teddy Roosevelt quote.

After you're done with Quinn's annihilation of the retailers, check out "The Secret History of Bear Stearns' Collapse, from CNN, excerpted from House of Cards: A Tale of Hubris and Wretched Excess on Wall Street by William D. Cohan

There is a fantastic segment about the valuation of the CDO portfolio, where the managers get marks from multiple Wall Street dealers. While most counterparties valued the assets at 98 cents on the dollar, Goldman Sachs provided a valuation of 50. At first it seems that GS is the bad guy, accused by a former BSC exec of trying to mark the portfolio lower in order to profit on a short position GS had. However, Goldman's Gary Cohn explained the real story:

"He (Cohn) then shared an anecdote about a conversation he'd had with Nino Fanlo, one of the founding partners of KKR Financial Holdings, a specialty finance company started by KKR, the private equity shop. After Goldman sent out the marks in the 50¢ to 55¢ range, Fanlo called Cohn and told him, "You're way off market. Everyone else is at 80, 85." Cohn then offered to sell Fanlo $10 billion of the paper at his 55¢ price and encouraged him to sell that in the market to all the other broker-dealers at the higher prices they claimed to be marking the paper at. In other words, Cohn was offering Fanlo a windfall: buy at 55 and sell at 80. "You can sell them to every one of those dealers," Cohn told Fanlo. "Sell 80, sell 77, sell 76, sell 75. Sell them all the way down to 60. And I'll sell them to you at my mark, at 55, because I was trying to get out. So if you can do that, you can make yourself $5 billion right now."

Cohn had been trying to sell the securities at 55 for a period of time and people would just hang up on him. A few days later, Fanlo called Cohn back. "He came back and said, 'I think your mark might be right,'" Cohn said. "And that mark went down to 30."

Cohn said the market changed dramatically through the course of the year. "We marked our books where we thought we could transact because some of this stuff wasn't transacting," says Cohn. "We sold stuff at 98 and marked it at 55 a month later. People didn't like that. Our clients didn't like that. They were pissed."

Finally, check out Michael Lewis's lengthy Vanity Fair piece on Iceland.

"I spoke to another hedge fund in London so perplexed by the many bad LBOs Icelandic banks were financing that it hired private investigators to figure out what was going on in the Icelandic financial system. The investigators produced a chart detailing a byzantine web of interlinked entities that boiled down to this: A handful of guys in Iceland, who had no experience of finance, were taking out tens of billions of dollars in short-term loans from abroad. They were then re-lending this money to themselves and their friends to buy assets—the banks, soccer teams, etc. Since the entire world’s assets were rising—thanks in part to people like these Icelandic lunatics paying crazy prices for them—they appeared to be making money. Yet another hedge-fund manager explained Icelandic banking to me this way: You have a dog, and I have a cat. We agree that they are each worth a billion dollars. You sell me the dog for a billion, and I sell you the cat for a billion. Now we are no longer pet owners, but Icelandic banks, with a billion dollars in new assets. “They created fake capital by trading assets amongst themselves at inflated values,” says a London hedge-fund manager. “This was how the banks and investment companies grew and grew. But they were lightweights in the international markets.”

The parallels to the United States are startling.

Lewis then explains how Iceland put itself on the map in the early 70's, by transforming their fishing industry:

"Fishermen, in other words, are a lot like American investment bankers. Their overconfidence leads them to impoverish not just themselves but also their fishing grounds. Simply limiting the number of fish caught won’t solve the problem; it will just heighten the competition for the fish and drive down profits. The goal isn’t to get fishermen to overspend on more nets or bigger boats. The goal is to catch the maximum number of fish with minimum effort. To attain it, you need government intervention.

This insight is what led Iceland to go from being one of the poorest countries in Europe circa 1900 to being one of the richest circa 2000. Iceland’s big change began in the early 1970s, after a couple of years when the fish catch was terrible. The best fishermen returned for a second year in a row without their usual haul of cod and haddock, so the Icelandic government took radical action: they privatized the fish. Each fisherman was assigned a quota, based roughly on his historical catches. If you were a big-time Icelandic fisherman you got this piece of paper that entitled you to, say, 1 percent of the total catch allowed to be pulled from Iceland’s waters that season. Before each season the scientists at the Marine Research Institute would determine the total number of cod or haddock that could be caught without damaging the long-term health of the fish population; from year to year, the numbers of fish you could catch changed. But your percentage of the annual haul was fixed, and this piece of paper entitled you to it in perpetuity.

Even better, if you didn’t want to fish you could sell your quota to someone who did. The quotas thus drifted into the hands of the people to whom they were of the greatest value, the best fishermen, who could extract the fish from the sea with maximum efficiency. You could also take your quota to the bank and borrow against it, and the bank had no trouble assigning a dollar value to your share of the cod pulled, without competition, from the richest cod-fishing grounds on earth. The fish had not only been privatized, they had been securitized."

He concludes with a comment that sounds to me like he's talking about America:

"When you borrow a lot of money to create a false prosperity, you import the future into the present. It isn’t the actual future so much as some grotesque silicon version of it. Leverage buys you a glimpse of a prosperity you haven’t really earned."

-KD

Readings

I didn't even bother to write about the bailout of the bailout of the bailout of AIG, because I don't know what else to say - it's an utter disaster. There is a very sweet sense of irony about their former CEO Hank Greenberg suing the company though.

Niall Ferguson wrote a piece in The Australian that touches on a theme I've hit on multiple times previously:

"There is something desperate about the way people on both sides of the Atlantic are clinging to their dog-eared copies of Keynes's General Theory. Uneasily aware that their discipline almost entirely failed to anticipate the crisis, economists seem to be regressing to macro-economic childhood, clutching the multiplier like an old teddy bear.

The harsh reality that is being repressed is this: the Western world is suffering a crisis of excessive indebtedness. Many governments are too highly leveraged, as are many corporations. More important, households are groaning under unprecedented debt burdens. Average household sector debt has reached 141per cent of disposable income in the US, 156per cent in Australia and 177 per cent in Britain. Worst of all are the banks in the US and Europe. Some of the best-known names in American and European finance have balance sheets 40, 60 or even 100 times the size of their capital. Average US investment bank leverage was above 25 to 1 at the end of 2008. Eurozone bank leverage was more than 30 to 1. British bank balance sheets are equal to a staggering 440 per cent of gross domestic product.

The delusion that a crisis of excess debt can be solved by creating more debt is at the heart of the Great Repression. Yet that is precisely what most governments propose to do."

Barry Ritholtz has a good post illustrating a key part of what's wrong with managed account compensation. In short, he tells of two brokers who managed customer money for a major firm. The brokers are compensated on a percentage of assets under management, but they get paid a different rate depending on how the assets are allocated (ie, if the assets are in cash, they get paid less than if they are in stocks.) These specific brokers did a great job getting their clients out of stocks and into cash in early 2008, resulting in only minor losses for their clients. However, they brought in less fees as a result, and were penalized by their firm - receiving a lower percentage of their profits for the next year. Completely absurd, and another reason I don't think MER will be the gem that BAC thinks it stole - that business model is somewhat dead.

Paul Kedrosky notes the irony in Cannacord Adams' decision to stop publishing its list of Best Ideas. I mean, talk about a contrarian indicator!

Finally, a long piece from Tim Duy on economists and their faith in financial engineering. He includes a money quote from Yves Smith of NakedCapitalism:

"...What is amazing is the degree to which Bernanke has been unable to process what has happened over the last year and a half. It isn't simply that he is trying to restore status quo ante; he seems to see the only possible operative paradigm as the status quo ante. Worse, he has a romanticized view of it too.

We had a massive stock market bubble, followed by an even bigger asset orgy, with housing at the epicenter, but plenty of other types got dragged along with it. Having asset appreciation fueled by debt is NOT how a healthy economy operates. It is going to take some time for the excesses to work themselves through..."

Oh - and in case you were wondering if this is the bottom....

-KD