Thursday, March 26, 2009

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 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...



Pauly said...

Bonus points for Wolfman's reference.

Unknown said...

good articles of late dude. love your view on these economic issues. much more interesting than poker hands which anyone and everyone whos ever played poker seems to be blogging about.

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