Over the Counter

Idiots' Poker

Fri, 14 Nov 2008 17:44:08 GMT

Michael Lewis, author of Liars' Poker, wrote this long piece on the subprime business - describing with gusto the mistakes involved and tracing the rot back to the decision by John Gutfreund to take Salomon Brothers public back in the 1980s.

He and the other partners not only made a quick killing; they transferred the ultimate financial risk from themselves to their shareholders. It didn’t, in the end, make a great deal of sense for the shareholders. (A share of Salomon Brothers purchased when I arrived on the trading floor, in 1986, at a then market price of $42, would be worth 2.26 shares of Citigroup today—market value: $27.) But it made fantastic sense for the investment bankers. From that moment, though, the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished. The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith. No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers...

This is far from the first time I've heard the suggestion that partnerships - or other forms of employee ownership - might be the way forward for the financial sector. The UK's mutual building societies spent decades being humdrum, unexciting, unambitious - and solvent. Then they all demutualised, as more than one recent conference attendee from a major bank pointed out to me, and what happened to them? To Abbey National, Bradford & Bingley, Halifax, Midland, C&G, Alliance & Leicester, Woolwich, and, of course, Northern Rock? Bought up or shut down, almost to a man. And the Co-operative Bank is still the ninth largest in the country - and seeing rising profits and minimal writedowns, not to mention rejecting bailouts. I'm not trying to write off the public limited company altogether. But which lines of business are still dominated by employee-owned companies or partnerships? Lawyers, doctors, dentists, undertakers - all areas with little physical capital, but where human capital, trust and reputation are key. Where you need physical capital - in manufacturing, for instance - tapping the equity market is indispensable. But isn't it now becoming increasingly obvious that easy access to vast amounts of (apparently) freely flowing capital -through the equity or the wholesale markets - has in fact been a huge temptation, rather than a boon, for banks? I was joking when I described the original TARP (now of course completely changed) as "Mr Paulson seizing the means of production". But I'm now coming round to the view that a bit more of "the common ownership of the means of production, distribution and exchange" might not be such a bad thing for the financial sector.

Don't have nightmares

Fri, 14 Nov 2008 17:06:03 GMT

Barry Ritholz reprints this extraordinary map - how many homes are underwater (worth less than the outstanding mortgage debt) in the San Francisco area. California was at the heart of the bubble (do bubbles have hearts) - especially the more rural counties of the Bay Area. Andrew Cuomo, scourge of bankers, seems to be preparing to prosecute anyone at a government supported bank with a bonus of more than $250k for "fraudulent conveyance". There are new waves of bad news about to break for hedge funds (down $100 billion in the last month) and CDOs. And, apparently, doubt over whether the FDIC loan guarantee is really a guarantee at all. Apart from that everything's fine.

The taps are still running

Mon, 10 Nov 2008 12:58:33 GMT

...for AIG, which is reportedly close to a second bailout loan - this one smaller ($60 billion rather than $85 billion for the one it replaces) but with a longer maturity, and, crucially, without the punitive Libor plus 850bp interest rate. Felix Salmon has spotted something in the description:

Securities lending is meant to be a no-risk operation. In a repo operation, the long-term owner of a stock -- in this case, AIG -- will sell it to someone who wants to short it, and charge them interest. They then subsequently buy back the stock at the price they sold it for; the interest is pure profit. AIG, however, seems to have gotten spectacularly greedy. It took the proceeds from the stock sales, and instead of putting it somewhere safe, invested it in RMBS. Which are now worth 50 cents on the dollar.

$20 billion of that bailout is going to buy those illiquid RMBS. Meanwhile, the Washington Post has spotted something that went almost unnoticed at the time - a $140 billion tax exemption for merging banks. There used to be a limit on writing off previous years' losses against this year's profits for tax purposes - specifically, there was a limit to the extent you could do it with the losses made by a company that you have since acquired. (Otherwise you could buy loss-making companies really cheaply, simply in order to write off your profits against their losses, and come out well ahead of the game). Well, not any more.

The sweeping change to two decades of tax policy escaped the notice of lawmakers for several days, as they remained consumed with the controversial bailout bill. When they found out, some legislators were furious. Some congressional staff members have privately concluded that the notice was illegal. But they have worried that saying so publicly could unravel several recent bank mergers made possible by the change and send the economy into an even deeper tailspin... Lawmakers are now looking at whether the new notice was introduced to benefit specific banks, as well as whether it inappropriately accelerated bank takeovers. The change to Section 382 of the tax code -- a provision that limited a kind of tax shelter arising in corporate mergers -- came after a two-decade effort by conservative economists and Republican administration officials to eliminate or overhaul the law, which is so little-known that even influential tax experts sometimes draw a blank at its mention.... The notice was released on a momentous day in the banking industry. It not only came 24 hours after the House of Representatives initially defeated the bailout bill, but also one day after Wachovia agreed to be acquired by Citigroup in a government-brokered deal. The Treasury notice suddenly made it much more attractive to acquire distressed banks, and Wells Fargo, which had been an earlier suitor for Wachovia, made a new and ultimately successful play to take it over.

To give them their due, I would guess that this was a sincere attempt to help the banking industry rather than a cynical exploitation of "a good day to get out anything we want to bury" in order to push through a profitable but unpopular change. And it's unlikely that the decision will be reversed now - the WP quotes one lawyer comparing being "anti-bailout" now to being "anti-war" on September 12 2001. The deeper question is: should we really be encouraging bank consolidation? We've already got a fair number of banks that are too big to fail. How much bigger do you want them to get?

Weapons of mass innocuousness

Fri, 07 Nov 2008 14:05:48 GMT

The efforts to bring in central counterparty clearing for CDS (deadline - end of this month) aren't a bad thing, but it's hard not to see them as a solution without a problem. The last few weeks have seen CDS tested in the US (Fannie and Freddie, Lehman, WaMu) and in Europe (Landsbanki, Glitnir, Kaupthing) without any dire consequences - although there are suggestions that the auctions showed CDS to be a less than perfect hedge.

Lost at sea

Tue, 04 Nov 2008 17:12:26 GMT

Last week we looked at the problems that the lack of credit was causing in the shipping industry - today the FT reports that they are getting worse:

Since short-term dry bulk charter rates fell 71.9 per cent in October, traders and shipowners have worried that traders might be caught out by the speed and severity of the fall...London-based, New York-listed Britannia Bulk, which has been hit by its exposure to speculative FFA trading, put its British operating subsidiary into administration on Friday. It is the first quoted shipping company to suffer such a blow during the current downturn.
Duncan Dunn, senior director in the futures division of London’s Simpson, Spence & Young shipbrokers, said the market’s rapid fall would have left anyone betting on upward movements needing to make substantial payments...The market uncertainty stems partly from the complex chains of transactions in the market and the lack of clarity about different companies’ FFA trading.
It is widely expected that hedge funds could be particularly badly hit.

Lack of transparency, poor risk management, unexpected volatility, huge exposures - all sounds very familiar.

A continuing complete lack of surprise

Mon, 03 Nov 2008 17:04:16 GMT

The WSJ today reports that

as many as 1,800 publicly held institutions could apply for government investments in coming weeks, out of concern that failing to do so could make them losers in a banking sector reshaped by the Treasury's $700 billion rescue plan

. Ironically, a few weeks ago there were worries that seeking government aid would be stigmatised, because it would make people think "if that bank's asking for aid it must be on its uppers." Now, though -

due in large part to efforts by Treasury, banking lobbyists and legal advisers to sell the TARP... institutions across the U.S. worry that if they don't try for the money, the market will judge them as too unhealthy to qualify, or lacking the savvy to deploy cheap government capital on acquisitions and investments.

In other words, if the food's all free, and you see someone sitting down without a plate in front of them, you start wondering if perhaps they're too sick to walk over to the buffet.

More on the bailout

Fri, 31 Oct 2008 15:56:51 GMT

Barney Frank is incensed to discover that, if you give people a lot of money to spend on whatever they feel like, they will spend it on whatever they feel like:

"I am deeply disappointed that a number of financial institutions are distorting the legislation that Congress passed at the president's request to respond to the credit crisis by making funds available for increased lending," Rep. Barney Frank, a Massachusetts Democrat, said in a statement...

The banks are not exactly cowed into submission.

Take the Winston-Salem, N.C.-based BB&T Corp. (BBT). During a conference call that dealt with the bank’s third-quarter results, Chief Executive Officer John A. Allison IV said the bank “will probably participate” in the bailout program, accepting federal infusions. Allison didn’t say whether the federal money would induce BB&T to boost its lending. But he did say the bank would probably accept the money in order to finance its expansion plans, The Wall Street Journal said. “We think that there are going to be some acquisition opportunities – either now or in the near future – and this is a relatively inexpensive way to raise capital [to pay the buyout bill],” Allison said during the conference call...Zions Bancorp will also use the money “to take advantage of what we would expect will be some acquisition opportunities, including some very low risk FDIC-assisted transactions in the next several quarters.”

Bailouts and mergers

Mon, 27 Oct 2008 15:25:49 GMT

In the FT today, the story of a startling merger approach: Lloyd Blankfein apparently rang Vikram Pandit last month to trail his coat for a takeover.

[sources] added that the conversation was brief as Mr Pandit rejected the proposal at once. A deal would have been structured as a Citi takeover of Goldman. In spite of the slide in Citi’s shares, its market value around the time of Mr Blankfein’s call was $108bn, roughly double Goldman’s capitalisation...

If nothing else, it's an example of just how desperate things were getting before the US government announced TARP. But Goldman Sachs? The bank that came out best - or at any rate least worst - from the subprime fiasco, seeking to tie up with Citi and its eleven-figure writedowns? What exactly was Blankfein so worried about?

End of a long week

Fri, 24 Oct 2008 17:39:23 GMT

Poor macro figures, especially in the UK, and the equity markets are falling fast again. Also: AIG wants more cash:

AIG may need more than the $122.8 billion now available to the New York-based insurer, Chief Executive Officer Edward Liddy said Oct. 22. The company, which agreed Sept. 16 to turn over majority control to the U.S. in exchange for an $85 billion loan, got access to an additional $37.8 billion this month. AIG's latest balance was revealed yesterday by the New York Federal Reserve, and is up from $82.9 billion a week ago...The financial-products unit that caused most of the firm's losses ``is a big black hole.''

Probably not the best time to start reading Nouriel Roubini. Oh well:

``We've reached a situation of sheer panic,'' Roubini, who predicted the financial crisis in 2006, told a conference of hedge-fund managers in London today. ``There will be massive dumping of assets'' and ``hundreds of hedge funds are going to go bust,'' he said. ...``Systemic risk has become bigger and bigger,'' Roubini said at the Hedge 2008 conference. ``We're seeing the beginning of a run on a big chunk of the hedge funds,'' and ``don't be surprised if policy makers need to close down markets for a week or two in coming days,'' he said.

Sounds disturbingly probable. See, for example, here: Hedge funds worldwide posted record monthly losses in September, according to Eurekahedge Pte., as short sale bans and client redemptions amid the credit crisis hurt funds including Citadel Investment Group Inc. The Eurekahedge Hedge Fund Index, which tracks 2,431 funds that invest globally, declined 4.7 percent, preliminary figures from the data provider show. The drop is the biggest one-month loss since it began collecting data in 2000 and the index, down 7.9 percent through September, is set for its worst year on record... Good news, on the other hand: oil is still falling - that means cheaper fuel and so cheaper food. So while we may see a lot more stories like this in the months ahead
Stocks plunge on recession fears
we might see slightly fewer stories like this
Why the price of 'peak oil' is famine.

Thinking about recession

Fri, 24 Oct 2008 12:12:17 GMT

The UK is probably now in one, and the markets are reacting accordingly. Goldman Sachs hit the headlines with its promise to sack 10% of its employees - over 3000 people - even though it's about the only major bank still to be making profits, and even though its 'fast-burnout' approach to managing its staff means that all it needs to do is cut back hiring and wait for staff numbers to plummet. But it does lead rather neatly on to this study from 2005 (via Chris Dillow) - people are not more likely to lose their jobs in recessions. (People in general, that is - people at major investment banks, yes.) The rate of "separation" remains pretty much the same - between 3% and 4% a year in the US (unfortunately the study is US only). Instead, what happens is that the rate of formation of new jobs slows down - people are losing their jobs all the time, recession or not, but during recessions it takes longer to find a new one. Our mental images of recessions consist of factories closing down and people being thrown out because those are what we remember from histories of the Great Depression, and because that's what makes it on to the news now. But you can't take a memorable picture of a manager in an office looking at a budget and deciding to get by with a team of nine, rather than hiring an extra person - yet, it turns out, that's what causes the unemployment. It's a problem of generalisation: we tend to form an image of what is happening at a national level, and then assume that everyone's personal experience echoes that. So during the Sixties everyone was a hippie and loved the Beatles (or the Stones). During a war everyone is in the thick of the fighting. During a boom everyone prospers; and during a recession everyone has their job threatened. But human experience is a lot lumpier than that. For a lot of people, the Sixties were pretty much like the Fifties - bad food, bedsits and skiffle bands. As seen in Band of Brothers, Capt. Richard Winters went through the close-quarter fighting of the Battle of the Bulge as an infantryman and never fired a single shot. During the long boom of 1997-2005, every year one in seven jobs in the UK private sector were destroyed. And, during a recession, your job is no less safe than at any other time. Unless, as I say, you work for a major investment bank.

The devil went down to Wall Street

Thu, 23 Oct 2008 14:52:19 GMT

Remember back in July - "One analyst expressed concern that her firm's model did not capture half of the deal's risk, but that 'it could be structured by cows and we would rate it'"? Yes, I thought so. Well, the rating agencies were getting slated by Congress yesterday, and among the bits of evidence cited by chairman Henry Waxman was this gem, from Moody's CEO Ray McDaniel at a meeting in September 2007:

The following day, a member of the Moody’s management team commented: We heard 2 answers yesterday: 1. people lied, and 2. there was an unprecedented sequence of events in the mortgage markets. As for #1, it seems to me that we had blinders on and never questioned the information we were given. … As for #2, it is our job to think of the worst case scenarios and model them. … Combined, these errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue.

Of course, the essential point about all those stories of deals with the devil is that someone generally ends up getting cheated. Faust got a date with Helen of Troy, and Robert Johnson got the ability to play great blues guitar. What did Moody's get?

The devil went down to Wall Street

Thu, 23 Oct 2008 14:52:19 GMT

The following day, a member of the Moody’s management team commented: We heard 2 answers yesterday: 1. people lied, and 2. there was an unprecedented sequence of events in the mortgage markets. As for #1, it seems to me that we had blinders on and never questioned the information we were given. … As for #2, it is our job to think of the worst case scenarios and model them. … Combined, these errors make us look either incompetent at credit analysis, or like we sold our soul to the devil for revenue.

Of course, the essential point about all those stories of deals with the devil is that someone always ends up getting cheated...

The ripples go on spreading

Wed, 22 Oct 2008 13:40:49 GMT

Calculated Risk notes that the credit markets are looking healthy - or at least less catastrophically ill. Interbank rates and CDS spreads more or less echo that. But all is not well - the corporate bond market is in freefall, John Jansen writes; so is the European government bond market, according to the FT today; and Yves Smith pulls up a suggestion that we might be about to enter an emerging-market currency crisis as well.

Is it working?

Tue, 21 Oct 2008 11:34:24 GMT

There seems to be an unusual sort of story surfacing these days - good news. The equity markets are no longer plunging as steeply as they did a few weeks ago; interbank borrowing rates are improving (the infamous Ted spread is falling, though it's still at levels that would have been unthinkable before last month); and CDS spreads are coming in slowly but steadily.

Regulation and its discontents

Thu, 16 Oct 2008 18:14:20 GMT

Politics blogger Matthew Yglesias has been reading the textbook Macroeconomics by Krugman and Wells, and comes across this "check your understanding" question:

A con man has a great idea: he’ll open a bank without investing any capital and lend all the deposits at high interest rates to real estate developers. If the real estate market booms, the loans will be repaid and he’ll make high profits. If the real estate market goes bust, the loans won’t be repaid and the bank will fail—but he will not lose any of his own wealth. How would modern bank regulation frustrate his scheme?

Ah, how indeed... Also, more on the American fair value war, and thoughts on German regulatory arbitrage.

Incentives still matter

Wed, 15 Oct 2008 16:56:44 GMT

according to this study (via Alea) from the Goethe University in Frankfurt: it wasn't inability but misconceived bonus schemes that drove the crisis in the securitisation market.

We believe that incentives in banks and in financial value chains are at the core of the problem. Incentive misalignments tend to lower the quality of financial products, thus destabilizing asset valuation. Moreover, incentives misalignments tend to raise the leverage of financial intermediaries. Both effects undermine transparency about asset quality and risk positions of financial intermediaries. This cocktail inevitably destabilizes financial markets...

Counting the cost

Tue, 14 Oct 2008 15:50:12 GMT

"And so the system broke down, the empire collapsed, and a long, sullen silence settled over the galaxy, disturbed only by the pen-scratchings of scholars as they laboured into the night over smug little treatises on the value of a planned political economy." - The Hitch-Hiker's Guide to the Galaxy The latest totals of subprime writedowns and capital raising provide food for thought: writedowns now total $592 billion and new capital raised (whether through shares, bonds or other means) $443 billion. If some forecasts are right, that first figure has some distance still to climb. Funny - the Fed predicted that we'd only see mark-to-market losses of $475 billion... Lars Toomre notes the head of BaFin, Jochen Sanio, saying that Lehmans' collapse caused $300 billion of damage outside the US. (No details on how that total was reached, unfortunately.) And radical calls to ban off-balance sheet accounting, restrict bank investments, cut leverage to under 50%, level the CME and Nymex and ban derivative trading - from Felix Rohatyn and Charlie Munger.

Worth every penny

Fri, 10 Oct 2008 12:16:39 GMT

Attention is shifting to the influence that governments (UK and, probably, US as well) will have on executive pay. See here, for example:

One concern about the Treasury’s bailout plan is that it calls for limits on executive pay when capital is directly injected into a bank. The law directs Treasury officials to write compensation standards that would discourage executives from taking “unnecessary and excessive risks” and that would allow the government to recover any bonus pay that is based on stated earnings that turn out to be inaccurate. In addition, any bank in which the Treasury holds a stake would be barred from paying its chief executive a “golden parachute” package.

And in a startling report today, the NY Times reports that this could be a dealbreaker. US banks might refuse government assistance if it meant they couldn't pay their executives quite as much:

Britain’s plan also hinged on the willingness of several of the largest banks — Royal Bank of Scotland, Barclays and HSBC Holdings, among them — to sell preferred shares to the government. It is not clear, administration officials said, that the largest American banks would agree to this, particularly given the restrictions on executive pay.

Again, comment seems unnecessary.

Real economy impacts

Fri, 10 Oct 2008 11:05:38 GMT

Good and bad news on the effects of the crisis on the real economy - specifically, the shipping business. Good news first, from Felix Salmon - the Baltic Dry Index, which measures the cost of shipping freight, has fallen 79% since May.

...a Panamax ship, the Dong Sheng Ocean, is rumored to be taking iron ore from the Persian Gulf to China for free. I think this is good news, actually. Shipping costs have for the past couple of years been a serious constraint on international trade, and if they stay low, that's a helpful lubricant in terms of the real global economy. It's clearly the non-financial sector which is going to pull us out of this recession...

No, after you.

Thu, 09 Oct 2008 17:50:57 GMT

Earlier this week, as you know, Bob, Citi and Wells Fargo were almost at daggers drawn over who would walk away with Wachovia.

“We saved Wachovia from collapsing,” Mr Pandit said, according to people who were present. “We have to be compensated for that. That is like somebody buying a $2 ticket, winning $10 . . . and somebody says, ‘I am going to come and steal it away from you for two-and-a-half bucks.’ ”

(You tell 'em, Vikram.) Now? The ardour seems to have cooled. Now that both suitors have had a chance to go through the books, they're starting to think twice, Yves Smith says.

History lesson

Thu, 09 Oct 2008 12:19:01 GMT

Eighteen months ago, Moody's announced that it was upgrading Icelandic banks like Kaupthing to Aaa, because it reckoned that they had an effective guarantee from the Icelandic govenrment. This made a lot of people very angry and was widely regarded as a bad move. Well, everyone was right. Moody's was right in saying that if Kaupthing got into trouble the Icelandic government would step in to help. And everyone else was right when they worried that, maybe, a nation of only 300,000 people might not be able to do very much about it... From our March 2007 article:

"We used to steer clear of putting more complex structures before Moody's for rating, as it tended to be more difficult to convince it to look at structures as we do," says one London-based structured credit desk head. "Now that we know we can include high-yielding credits in baskets without worrying about ratings, we'll probably be approaching it a lot more."

Oh, good.

Pointing fingers

Wed, 08 Oct 2008 11:45:54 GMT

"So your vast financial conglomerate has just been saved from certain ruin by an $85 billion bailout from the US taxpayer. What are you going to do next?" "We're going to Disney World!" Or, rather, the St. Regis Resort, Monarch Beach, CA - try their Collapsing Financial Behemoth discount package at just $370,000. This one is all over the media... Congress has understandably seized on this colossally bad piece of PR as a stick to beat AIG with in hearings this week. There's also this - apparently the SEC's own inspector general edited his report on the Bear Stearns collapse to make the commission look better. To be honest, even the edited version was still pretty damning.

Lenders of last resort

Wed, 08 Oct 2008 10:10:06 GMT

The UK bailout is going ahead - £50 billion in two tranches will go into buying UK banks' preferred shares. There's also £200 billion more in an expanded special liquidity scheme, and the prospect of a government guarantee for medium-term bank debt, details to be confirmed. Paul Krugman approves:

Unlike the Paulson plan, this sounds as if it makes sense. However, given the strong financial linkages among the world’s economies, I wonder how much Britain can do on its own. Let’s see what the plan actually looks like; if it’s good, it can be a model for US emulation, and for the eurozone too if they can get their act together.

The funding glut

Tue, 07 Oct 2008 17:12:55 GMT

The Fed's finally managed to pour more money into the markets than they can soak up - yesterday's vastly increased TAF auction was undersubscribed. (Undeterred, the Fed's planning an entirely new intervention - in the commercial paper and unsecured lending markets.) There's no sign of an easing in interbank lending costs - Libor rocketed up again today. And there are reports that RBS, Lloyds and Barclays - the UK's three biggest banks - are calling for a £15 billion bailout. That's £15 billion each. Warren Buffett is still sanguine, buying into GE despite rumours (via Felix Salmon) that it's on the brink of bankruptcy.

An interesting distinction

Mon, 06 Oct 2008 16:43:34 GMT

Sunday: German chancellor Angela Merkel says "we want to tell savers that their money is safe - the government guarantees that". Did she really mean it? The BBC has been investigating, and, apparently, she did not. It was just a political statement...

The government has been seeking to clarify her remarks amid concerns that Britain would have to follow suit to stop savings ebbing away from British banks. But the BBC understands she was making a political commitment that savers would not lose money, rather than guaranteeing unlimited 100% protection. The prime minister's spokesman said: "Our understanding of the situation is that the German government will not be bringing forward legislation for a legally-binding guarantee of bank deposits."

Presumably the full sentence would have been something like "we want to tell savers that their money is safe - the government guarantees that - but we can't because it isn't actually true."