Capital Vandalism

David Sokol and Berkshire Internal Controls

2011-04-24T10:02:00.000-07:00

The David Sokol situation has raised any number of issues -- not the least of which is the nature and efficacy of Berkshire internal controls. Interestingly, Sokol discussed them in some detail during his March 31 CNBC interview.

JOE Kernan: There's a lot of, there's other employees as well. This brings up, or begs the question to a lot of people about what Berkshire's internal controls are on employee purchases —
.....
SOKOL: I mean, Warren and (Berkshire CFO) Marc Hamburg furnish us a list of stocks that we are restricted on. Any companies that, you know, that apparently Warren or historically Lou Simpson, or now Todd Combs, or whoever, is invested in, ah, that, you know, we can't ever buy or sell without first contacting Mark. This certainly wasn't one of those companies.....
.......
SOKOL: That's right. In fact, I have no authority whatsoever. I couldn't spend a dollar of Berkshire's money buying, buying a security tomorrow.

It is not publicly known if Berkshire audits the trading activity of its named insiders with respect to companies on the 'list'. But if not, it could be accomplished in a relatively short time. It is reasonable to believe it could be done in a matter of hours -- with the cooperation of insiders, if it hasn't already been done.

Piecing together Berkshire's investment process, it is based on extreme concentration of decision making regarding capital allocation. Buffett (and Munger) make the decisions, with Simpson and Combs running a small portfolio.

Buffett is also famous for what is an unusual decision making style. These are well known and include:

1. Doesn't do auctions or hostile takeovers.

2. Doesn't talk (extensively) without a selling price.

3. Isn't interested in pitches involving publicly traded companies.

4. Extensively uses publicly available financials.

5. Uninterested in the types of work done by most stock analysts.

Of special note is this comment which has been included in his published acquisition criteria for years:

We are not interested, however, in receiving suggestions about purchases we might make in the general stock market.

Considering this as well as the new information that Berkshire uses a control system for public companies based on a list -- the effectiveness of Berkshire's systems in the past are explainable.

If Berkshire insiders refrain from trading in stocks on the list, and given that Buffett/Simpson/Combs are the only decision makers regarding publicly held companies, then the only real possible candidates for "front running" are Berkshire acquisitions of public companies in which Berkshire currently has no position.

Over the last decade, that has included Clayton Homes and Burlington Northern (which would have presumably been on the 'Hamburg' list) which makes for a very short list.

This approach is an interesting variant on the well known separation of duties principle. It is reasonable to assume that Berkshire has established industry standard accounting controls. Their overall thrust is to eliminate the opportunities for insider trading.

Contrast this with a typical asset manager. They have their own analysts, use proprietary data, methods, and processes, and delegate significant parts of the process over a number of employees.

Berkshire's home office has only 20 employees, none of them (except Marc Hamburg) senior executives. I would assume that they are aware of numerous proposals -- so many that it is likely that they would be of little value to typical traders. Among other things, Berkshire is frequently mentioned in the press as a potential savior of a doomed company -- the last hope of imploding companies.

So -- how does this relate to Sokol?

One thought is that Sokol, who has no experience in financial or investment firms outside the totally unique environment of Berkshire, inferred that anything not proscribed by the Hamburg list was fair game. Of course this is speculative, but Sokol's behavior is very difficult for me to explain any other way.

More specifically, he lacks the usual motivation and associated behavior associated with insider trading. He doesn't need the money, and the amounts involved, while significant, are not material to Sokol's personal wealth -- and certainly not sufficient for him to take huge personal risks. More importantly, he made no effort to hide his trading.

His actions are consistent with that of a person that was simply unaware of the significance of his trading. This is not an excuse, but a hypothesis.

The 'Hamburg' process -- a proscribed list of publicly traded securities -- may be a clue to how an intelligent man could behave so recklessly.

Berkshire has a system that explicitly proscribes insiders from trading in specific securities. The also have a principle based standard that no one should do anything that they would be uncomfortable reading about on the front page of the New York Times. Sokol has now had the opportunity to to do exactly that. Whatever else is said, it couldn't have been comfortable.

Normalized Earnings - Berkshire Hathaway 2010 Annual Report

2011-02-26T08:52:00.000-08:00

Warren Buffett is fantastic at making arcane accounting accessible to an average investor. But it can be hard to go from his big picture analogies to the detailed figures that make up the published financials.

This year he introduced an important new metric to the report -- Normalized Earnings. He offers no details on how he came up with the figure, ($12 billion), but it is simply another approach to separate the noise of short term fluctuations from the underlying, core value of the firm.

This figure is another approach to complement the two principle metrics he has always used. That is -- for the short term, operating earnings and for the long term, change in book value (shareholder equity).

Buffett defines normalized earnings as, "... a year free of a mega-catastrophe in insurance and possessing a general business climate somewhat better than that of 2010 but weaker than that of 2005 or 2006." And he has selected a figure of $12 million as his estimate.

He once again discusses the long term (46 years) metric he has consistently shown at the beginning of each annual report -- change in Book Value.

"To eliminate subjectivity, we therefore use an understated proxy for intrinsic-value – book value – when measuring our performance....Yearly figures, it should be noted, are neither to be ignored nor viewed as all-important. The pace of the earth’s movement around the sun is not synchronized with the time required for either investment ideas or operating decisions to bear fruit."

To demonstrate the value of this metric over intermediate time periods, the report (page 5) includes the exact same data aggregated into rolling 5 year periods. This exhibit is striking in regard to the extent to which the figures stabilize and present a much clearer picture of past performance.

This works particularly well for Berkshire, since it doesn't pay dividends. Book value is the aggregate of the entire financial history of the firms -- and includes all capital gains -- both realized and unrealized. And all the exceptions that are typically excluded from operating earnings.

Later in the report, a discussion of operating earning vs net earnings repeats numerous prior discussions:

"Operating earnings, despite having some shortcomings, are in general a reasonable guide as to how our businesses are doing. Ignore our net income figure, however. Regulations require that we report it to you. But if you find reporters focusing on it, that will speak more to their performance than ours."

Net earnings are a GAAP figure that is meaningful for most businesses, but is severely flawed for a firm with a large investment portfolio and atypical derivative contracts. Operating earnings exclude the change in derivative liabilities as well as realized capital gains and losses.

Since 2006, Berkshire has issued a press release with the non GAAP operating figures reconciled with the GAAP net income figures. They have included this statement (from 2007):

"In our earnings summary, we distinguish between what we call “operating earnings” and investment and derivative gains/losses. Berkshire possesses a huge reservoir (about $35.5 billion on June 30, 2007) of pre-tax unrealized investment gains. The cashing of these in any given quarter (or the realization of losses, for that matter) can materially distort net income figures as well as comparisons between periods. We do not wish investors to mistakenly focus on a bottom-line number affected by large investment gains that do not stem from economic accomplishments during the reporting period and that have no concurrent impact on the intrinsic value of the company. Both trends in our operating businesses and their health are best judged by income before all investment gains or losses."

The only thing missing from this explanation is the implicit assumption that the only additional information is the latest quarter's data. Everything else has already been published and presumably included in valuation of the company. Another way of stating this is that over a single quarter, operating earnings are much more appropriate for a firm like Berkshire than GAAP net income. The quarterly press releases stress this both in quarters where the headline net income figure is higher as well as lower than operating earnings.

Page 33 of this years annual report:

This is a GAAP exhibit and reconciles the balance sheet to the income statement -- and illustrates the various items that impact the change in book value other than net income. The largest is 'Other Comprehensive Income" and includes unrealized capital gains -- which is shown in detail on page 33:

Note that over the 3 year period, the largest items - unrealized capital gains/losses and their tax impact - net to a modest figure. This reflects the market crash in 2008 as well as the stock market recovery in 2009 and 2010.

Net income is clearly a better proxy for earning power (for lack of a better term) than comprehensive income. However, it includes realized capital gains/losses and derivative gains and losses. And also remember that GAAP is designed for all businesses in all industries -- and most businesses don't have any derivatives and have modest capital gains/losses.

" After-tax investment and derivative gains/losses were $1.87 billion in 2010, $486 million in 2009, $(4.65) billion in 2008, $3.58 billion in 2007 and $1.71 billion in 2006."(page 27)

The net income for 2010, 2009, and 2008 of $13.0, $8.1, and $5.0 billion, less derivative and investment gains/losses, are the operating earnings of $11.1, $7.6, and $9.6 billion. The three year average net income was $8.7 billion vs average operating earnings of $9.4 billion.

The 2010 operating earnings of $11.1 billion as well as the three year average of $9.4 billion provide a lot of support for the new metric, normalized earnings, estimated at $12 billion.

[end of part 1]

BP -- Relief is Two Weeks Away

2010-07-02T06:02:00.000-07:00

It is likely that two developments during the first half of July could effectively end much of the uncertainty regarding the oil spill. The first is the relief well, which is, according to BP technical executive Kent Wells, proceeding better that anyone could have hoped for.

Since June 17th, when the #1 relief well was drilled to 15,900 feet (measured distance from sea level), the following progress has been made.

1. The 13" casing was set in cement.

2. The remaining distance of less than 2,000 feet has been drilled to within 600 to 800 feet measured distance to the planned intersection point.

3. The distance from the Macondo well has been closed from about 200 feet to about 16 feet.

4. 3 or 4 ranging runs have been completed. A ranging run involves pulling the drill string and attaching a special ranging tool to determine the exact location vis a vis the Macando well.

Remaining tasks include the following:

1. Drill 600 to 700 feet parallel to the Macondo well.

2. Take ranging runs as needed.

3. Stop within 50 feet of the planned intersection and cement the final casing (liner).

4. Intersect the well bore and kill with mud, then cement.

Based on the success of the past two weeks, it is reasonable to expect that the relief well operation will continue to make relative rapid process.

In addition to the relief well, which would end the leakage into the Gulf, the BP subsea containment effort is close to capturing the vast majority of the remaining leakage. The current liminting variable is their ability to process oil brought to the surface.

To that end, BP has all the infrastructure in place to connect the Helix Producer to the kill line from the blowout protector, attached to subsea manifolds and a floating riser, and increase their processing capacity by about 20,000 b/d.

It is likely that this will result in all the oil that can be produced using the current 'top cap' can be processed. If this is done and if the total leakage is less than 45,000 b/d, then the amount of oil leaking into the Gulf will be minimal. In addition, the uncertainty regarding the well float rate will be resolved with a high level of confidence.

According to BP, the only issue regarding implementation of the Helix Producer are high seas from Hurricane Alex. They have said they need 3 days with seas of 3 feet or less (the current waves are in the 6 feet to 8 feet range.

Based on recent history, the BP subsea containment effort has consistently run into delays, so the possibility of problems using experimental technology remains high.

The investment thesis of this is based on the fact that the media is taking an very pessimistic view of the likely outcome of the oil spill. And, there are still risks involved. All the things that have been discussed at length in the popular media could happen. The worst case is not reflected in the current price of the stock.

However, the relatively better outcomes discussed in this post will be discounted sooner rather than later. Take advantage of uncertainty while it is still weighing heavily on this stock with the knowledge that better outcomes are significantly more likely than relatively worse outcomes.
________________________

The primary sources for this are BP and Government press releases. Diagrams modified from BP diagrams. The author has options positions on BP.

Off Topic - A good way to Bicycle in the North Chicago Suburbs

2009-09-30T04:28:00.000-07:00

It is so simple, I can't believe it took me so long to figure it out.

1. Drive with your bike to Sheridan Road.,

2. Park.

3. Ride around on the other side of Sheridan. Toward Lake Michigan.

The older suburbs on Lake Michigan are great places to cycle. On the other side of Sheridan, there is no on street parking (at least in places like Lake Forrest). So, park on the other side of the street and you can bike in a fabulous setting.

These suburbs don't do something gauche like have gates. They carefully filter out the traffic and people by subtle barriers. By the time you get to Sheridan, you have made it. They use all tactics -- one way streets, 3 increasingly more efficient ways of going north/south (I94, 41, Green Bay Road) to discourage through traffic. etc.

I just started biking close to my vehicle since the weather has been shaky lately. This encouraged me to just randomly park the vehicle (too embarrassingly large to admit-but a rental) on an attractive street and just go from there. I keep as close as it seems prudent to the vehicle and just explore.

The streets next to the Lake are very well maintained. The landscaping is immaculate. Very little traffic. This is the perfect place to casually cycle.

From the Archives:

2009-09-21T11:36:00.000-07:00

On May 8th of last year, Richard Kline had this to say to me:

May 8, 2009 at 6:12 am
So cap vandal, there are so many problems with the putative positives you advance here regarding the stress-less tests that I’m going to pass on the rest of that list. But let’s just review:

No one said that most of the $8T in assets in the banking system are bad. The problem is that the concentration of loss is in the major financials which are holding the rest of the system, the government, and the country hostage to their busted dreams. Your rhetorical attempt to stuff the desperate losses of the Big Few under the skirts of the weary solvent many does you no credit.

Your reference to mortgage backed securities and their supposed absence from the system as a cause for relief is misconceived. This is well known, yes: most of that paper was on-sold. —And then the Big Lost Few turned around and wrote CDS swaps against those securities for face or against the bonds of those securities purchasers for face, so guess where the ‘loss’ on those securities will progressively boomerang back to? Now the bulk of those losses haven’t been realized yet because the tranching structures of those MBSs were designed to absorb the first losses internally and on the small players. Which is exactly why the Big Few are putting us through this whole dismal charade of ’solvent today, my friends’ to raise capital _before those swap losses_ are put to them. Think that THOSE exposures were adequately accounted for in these ‘tests,’ my friend? If so, I’m sure that Citi has a slice of preferred they’d love to sell you cheap. Or even dear (I mean why not, the public gets the bill?).

Then there is the matter of securitized LBO debt you haven’t managed to drag into the discussion, quite a lot of which is left on the sometime ’speculation’ banks (which is what they should be called). Think that those are marked to market, especially when the minders of accounting standards were dragooned into ‘mark and let mark’ practices?

In view of these small further matters, without even going into other relevant Concerns, that $6B at Wells, yes that $75 headline ARE COMPLETELY MEANINGLESS NUMBERS. They are numbers for the media and the rubes, but not meaningful estimates of probable losses. If you added a zero on the right end to that Wells raise we might be talking the real money. If it was indeed large private capital standing on the sidelines about to buy in to the six at Wells, I would tell its deployers, Please don’t: start your own clean major bank with it, and make a killing. Although given all the money floating around from the public put to the Big Few which they aren’t investing in the real economy, I suspect that we will have considerable shadow purchases funneld through the hedges to prop up each others equity, here. No smart money is going to buy into Wells, but others in the same boat have every incentive to take public money and quitely support each others’ capital to make the whole show go on.

The problem we have here, my friend, is that the entire core of the financial system has become an aggregated slime mold of formerly distinct Enrons, bloated 100 times larger.

And your assurance that large private capital would ne-eev-eerrrr invest in the banking system again if they were nationalized is . . . music to my ears, that sounds about right. We need a banking system which serves the country, not a greed parade that hollows it out. Most of those folks: they’re working with Other Peoples Money anyway, not their own. That money will flow to real return, and real returns will return to the banking system to attract them when said banking system is sound. Which it is not and will not be so long as sham shows like this ‘fooled yah’ examination are promoted by a government which still, as of today, refuses to regulate the financial industry in any meaningful fashion. And that outcome, my friend, sucks dynamite.

I'm not going to address Richard's points in detail. In fact, as critics go, his post was articulate and representative of the better as opposed to the worse [from my perspective] commenters.

It sounds alarmist today. On May 8th, it wasn't far from the blogosphere mainstream.

That's one reason I quit blogging. I just didn't have the energy to keep up with the shrillness. Plus, some of my premature bullishness started to be confirmed by the markets, and just sitting on my long positions was proving more profitable than trading.

What a difference in 4 months.

I'm Back....

2009-09-15T04:13:00.000-07:00

To my loyal readers, I am back from an extended break.

No one wants to hear, "I told you so." and being right is not a good way to be popular. Still, there are times that you just can't resist.

As far as I can tell, I'm the only financial blogger that praised the "stress tests." The KBW index looks good since May 7th.

So, I'll just say it.

I was right. Find someone else with something good to say about the stress tests from that period, if you can. Or else, a little credit from my critics on "naked capitalism"

Especially those that accused me of hopeless naivete. That plus being oblivious to the facts and an apologist for banking swine.

However, owning long positions for one's own account and acting on one's opinions can provide a certain highly pleasurable reward that is MUCH better than extracting some sort of recognition from the blogosphere.

More on Roubini....

2009-05-12T13:58:00.000-07:00

With regard to the stress test being consistent with the IMF estimates, consider the following from the blog Alea:

Still, it is useful to know whether our estimates are consistent with what has been found by others. Two studies released within the last few weeks essentially bracketed the supervisory estimate. The International Monetary Fund estimated lifetime losses that would imply a loan loss rate for U.S. banking firms of about 8 percent in a stressed scenario. One of the major rating agencies estimated an annual loan loss rate of about 4-3/4 percent in a stress scenario for the next two years. More broadly, our informal survey of the results of a considerable number of private-sector studies and analyst reports published over the past several months generally placed our projected loss rates for key portfolios near the midpoints of the ranges of these independent estimates.

Major Roubini Goof

2009-05-09T19:14:00.000-07:00

Professor Roubini stated that:

The IMF recently estimated that retained earnings (after taxes and dividends) for all US banks – not just these 19 ones – would be only $300 bn total over the 2009-2010 period. The stress tests – instead – assumed much higher retained earnings - $362 bn - for these 19 banks alone for the 2009-2010 period in the more adverse scenario. Since these 19 banks account for about half of US banks assets if one were to use the IMF estimate of net retained earnings for these 19 banks their net retained earnings for 2009-2010 would be $150 bn rather than the $362 bn assumed by the regulators. While the IMF may have been too conservative in its estimates of net retained earnings it appears that regulators may have been too generous to these 19 banks in forecasting their earnings in an adverse scenario.

Professor Roubini should realize that you don't pay taxes on losses, and the funds available for loan losses are much higher than $362 billion. The IMF figure includes dividends, which you don't pay if you are in financial difficulty and loss provisions. In 1Q2008, BAC had about $18 billion in loan losses and pre tax, pre dividend earnings and Wells had about $10 billion. That's $28 billion for the two per quarter or or $224 billion over the two years from these two banks alone. This figure may be way too optimistic, but $150 billion from the two banks certainly isn't.

Some of the banks may have to book huge portions of their pre tax, pre provision earnings but that is a big number. Just consider the $8 trillion in RWA and use a conservative net interest rate margin (say 2% per year) and you end up with $320 billion over the two years.

More on the Stress Test

2009-05-09T13:30:00.001-07:00

As the only blogger that had anything close to unequivocally favorable to say about the stress tests, I did manage to get a few hits, but not many. I suppose people are just sick to death of yesterday's news.

There is no upside in saying anything favorable and to appear to take it seriously is to risk seeming hopelessly naive.

However, I think betting against the Fed/Treasury is a bit naive.

The way to read it is to start backwards. Total 2 year losses of $600 billion. Together with the $400 or so that have already been booked, thats $1 trillion. If these financial institutions have 1/3 of the assets exposed to the "crisis" -- that would put the total at $3 trillion. Or big enough to be in the range of plausibility.

The next step is looking at how the $600 is going to be "funded." I already went through this in the last post, and it seems reasonable.

I read a bit of the RGE monitor (Roubini) and he is heavily invested in his scheme to do a "good bank/bad bank" reorganization. Not a bad idea, but I have a feeling that he simply doesn't understand banks.

In fact, most of the disagreements seem to be people who equate banks with New York investment banks and see the rest of the financial sector as simply an appendage of New York. I tend to see New York and investment banking as a separate business. A lot of it could disappear with no consequence. It already has. The flip side is that the majority of abuses were associated with investment banking and they managed to almost blow up the world financial system.

Investment banks don't make normal loans. The only stand alone investment banks are GS and MS. they have a lot of exposure to securities but not much to loans. They don't do credit cards. They don't deal with retail lending customers. They did facilitate a lot of lending, but no one wants to buy these sorts of products anymore. The so called originate to distribute model.

As far as banks that make loans -- they seem to be making them. I am at a loss regarding whether they should lend more or tighten standards, but they seem to be doing about the right thing. That is, no more really stupid loans. They do seem pretty aggressive about loaning to people that can pay them back -- but those people don't especially want to borrow.

The general playbook of the Treasury/Fed is to subsidize interest rates and force people to either accept zero returns or start taking some risk. This is all they can do and they are doing it in every way imaginable. It is also directionally right as a policy move. In fact, you have fiscal stimulus via deficit spending to go with the liberal monetary policies.

That is the right thing to do directionally, and they seem to be doing a lot of it, which is, for lack of a better word, good.

Berkshire's 1Q Earnings Announcements

2009-05-08T16:38:00.000-07:00

First the basics on how earnings are reported in US GAAP. This is a big picture, non accountants overview. They get split into two parts -- one labeled net income and the other labeled other comprehensive income (OCI). The idea is to put normal stuff in the first bucket or items that have some finality -- like cash losses. The other bucket gets things like unrealized capital gains and losses, which will fluctuate and make it more difficult to see how the firms operations are trending.

This treatment of unrealized capital gains and losses is not in the least controversial. For Berkshire, the infamous long term put options would logically fall into OCI (other comprehensive income) -- since they are intended to be held for over a decade, and quarterly movements are noise.

Instead of trying to change accounting, Berkshire has developed a very simple non GAAP metric that it refers to as operating earnings. Every quarter it puts out a statement opening with operating earnings and reconciling to GAAP. Operating earnings exclude derivatives as well as other financial "bets" like currency trades. They are, in fact, operating earnings, which is really what GAAP net income would like to be, if it weren't trying to be uniform across all businesses.

Right now the volatility of the derivative book they totally overwhelms the changes in the core business earnings. The Berkshire release saves investors and the media from having to make these adjustments themselves.

This quarter was a bit different.

1. The earnings release was a week after the annual meeting.

2. A "preview" of earnings was released, with the emphasis on operating earnings. They were down modestly from $1.9 billion to $1.7 billion. Given the economy, not bad.

3. The final published figures contained additional losses of $2 billion ($3 pre tax). This is based on unrealized capital losses, but since Berkshire has announced that it will sell enough COP stock to get a $600 million tax refund, it labeled these losses as OTTI (Other Than Temporary Impairment) losses. This means that they can be booked in net earnings BEFORE the stock is sold.

4. This huge OTTI clears the decks regarding realized capital losses for the remainder of the year.

The headline numbers should really be Berkshire's non GAAP 'Operating Earnings'. It is the best way to make sense of the results, and any competent stock analyst would perform a similar set of adjustments.

The press never seems to read and report on Berkshire's released operating earnings. This year, it's all that was available when the quarter was discussed at the annual meeting.

Plus, Buffett threw in the kitchen sink by booking the OTTI when 1Q is old, old news. This is as close as you are going to see Buffett come to spinning bad news. Nothing misleading about it, and in fact, it gives a more accurate picture. At least the operating earnings. Taking the OTTI losses as early as possible is something that most CEO's would like to do and Buffett can afford it. Equity markets hate uncertainty and booking bad news ASAP tends to be good for the stock price. Buffett may not care very much, but now the foundations have to sell some Berkshire on a regular basis, and there is an economic motivation to keep the stock price at a fair value.

Ten Reasons the Stress Test doesn't SUCK

2009-05-07T23:11:00.000-07:00

Before anyone gets too critical, they should actually read it. And review the spreadsheet. A good list of the flaws can be found at naked capitalism: Yet More Stress Test Doubts.

This is an alternative point of view.

1. After the extra extraordinary measures taken in the fall, especially the passage of the $700 billion TARP bill, the public needed some documentation. Something beyond Paulson's single sheet of paper. Even if this is just an elaborate back of the envelope estimate, it is a single set of figures in a single document.

2. Define "To Big To Fail"? It has now been done. Any "bank holding company" meaning financial institution with a banking license that has over $100 billion in assets. It's 19 and it includes an auto finance sub (GMAC), a Life Insurer (Met), and a credit card company (American Express). Two investment banks, two hybrids with investment and commercial banking (C, BAC).

3. What do the big 19 have in common? Nothing other than size. Most of the public outcry has been over excesses in New York Investment Banking. Anyone think that USB's Minneapolis based bankers routinely get million dollar bonuses? People should chill with the generalizations. Or maybe just quit calling New York financial activity banking and the people that do it bankers. There is an important distinction that has been deliberately blurred, and community bankers aren't happy about it.

4. It is a very big chunk of the traditional banking system. The two biggest, BAC and WFC have well over 20% market share of insured deposits. I don't mind size as long as it is just vanilla banking scaled nationally. Like the old Bank of America, when they avoided investment banking. A firm like Wells should think about splitting out it mortgage servicing business.

5. Maybe the traditional banking system really isn't the problem. They are only involved with 20% of total lending. Per Jamie Diamon:

Traditional banks now provide only 20% of total lending in the economy(approximately $14 trillion of the total credit provided by all financial intermediaries). Right after World War II, that number was almost 60%.

We have reps for all the players in the 'shadow' banking system. Investment banks that did securitizations. A credit card firm. Brokerages that underwrite bonds.

6. A sense of how things could really play out. People will either agree or disagree, but at least they have some numbers to talk about that are ground up rather then the economic aggregates tossed around by the economists.

7. $8 trillion in assets. An estimate of $600 million in losses. Two numbers that tie into published financials of specific firms. Remember that a lot of assets were sold to non banks. If this is 20% to 25% of the total assets exposed to losses, that corresponds to $2.4 to $3 Trillion that the economists talk about. A lot of the worst stuff was sold off, so the $600 billion figure is big enough to be more than plausible.

8. What about the zillions in level 3, toxic CDO's? Less than 2% of the total.

At the end of 2008, the 19 BHCs held $1.5 trillion of securities, more than one‐half of which were Treasury, agencies, or sovereign securities, or high‐grade municipal debt, and so are subject to no or limited credit risk. Only about $200 billion was in non‐agency mortgage‐backed securities (MBS) and only a portion of these were recent vintage or were backed by riskier nonprime mortgages.

How much hand wringing has there been over this topic when discussing banks? Way too much, it seems. It isn't like there aren't problems, but most of the problem assets aren't owned by banks, and those that are were pretty much written down over the last year and a half. It is a big problem, but one that was sold around the globe. The banks thought they held the best CDO's and they definitely sold stuff that was materially worse then they kept.

9. Just like Japan? There are $60 billion or about 10% of the estimated total losses that have already been booked via purchase accounting adjustments associated with the larger mergers. This includes WB, MER, WM, CW and a few others.

You work through $600 billion in big chunks over a couple of years. As noted above, 10% is done. There is capital in excess of regulatory requirements right now, if needed. This was done using 12/31 data, and over $100 billion has been done during that period. We have 7 more quarters of earnings to use for loss provisions. Finally, there is the $75 billion of additional common equity that is required to be raised.

10. Everyone can apply their own judgment against these figures. However, I think that it isn't the banks. It's the real economy. People might be able to chill about banks and start thinking more about jobs, etc.

Maybe it is just too optimistic. If so, a next step could be to relax capital requirements IF there is strong evidence the economy has turned. The economy is cyclical and there are lags. Do we need to have banks that are capitalized above the regulatory level at the trough of a monster recession? Capital is there for a reason and there are times that you relax the requirements and let the levels drop. If you can NEVER use it, why have it in the first place.

Buffett Succession Issue

2009-05-03T14:11:00.000-07:00

Per Reuters:

Shareholders expressed confidence that Buffett has the succession issue well in hand. Yet, some admit that Buffett is a reason they bought the stock in the first place, and that when he leaves, they might too.

"That will be a time of real terror for a lot of people, and I don't know what I'll do," said Clifford Glassel, 68, a retired product engineer from Red Oak, Iowa who was attending his sixth meeting.

He is splitting his job into three parts. The Chairmanship goes to son, Howard, who will be there to keep tabs on the CEO and CIO. He is currently getting the same sort of training that Michael Corleone got prior to the demise of the Don.

The CEO job is to make sure that the zen form of management remains in place. A single guy with a very small staff to act as an intelligent owner. The CIO's won't get to decide how much capital to invest, just given the excess cash.

However, I expect to see another change. The first thing would be a substantial buyback the moment Warren steps down for whatever reason. The second is a rational dividend policy.

Or better yet, let the stock crater for a week or two and then announce the policies, giving a substantial break to long term, buy and hold owners.

Remember. Buffett outsourced his philanthropy to Bill Gates. Anyone that thinks he will do something stupid with a transition isn't thinking clearly.

Berkshire Meeting - Below the Radar

2009-05-02T18:00:00.001-07:00

The most interesting comment was the following regarding the index equity puts:

He added that the company recently restructured two of its so-called equity put contracts - agreements that give an investor the right though not the obligation to buy a bucket of stocks from Berkshire at a specified date in the future. Those contracts have emerged as a subject of some debate since the stock market's plunge last fall.

Under one of the restructurings, the S&P 500 would have to rise just 13% over the next 10 years for the put to expire worthless. Before that deal, the S&P would have had to rise 72% over 18 years to preclude Berkshire from having to make a payout.

This means, among other things, that the original puts were written at the top -- 1.72 x S&P is getting close to 1500.

More interesting is the backstory. I can only speculate, but lets start with the assumption that no cash changed hands as a result of the restructuring. This would mean that the time value of the puts is negative. Or at least the last 8 years of the puts.

In addition, it would seem like the motivation to do this must have been from the mystery buyer. I don't think Berkshire would initiate restructuring deals that would be advantageous to the counterparty. They do too many deals to go around and ask to renegotiate in a way that is economically disadvantageous to the counterparties.

What it sounds like Buffett is saying is that the strike price was negotiated significantly downwards -- from close to 1500 to below 1000. In exchange for lowering the strike price, Berkshire moved the expiration date forward by 8 years.

The only thing that comes to mind is that the counterparty must have gotten an accounting benefit for the change. The Black Scholes value would surely decrease. Perhaps they are using the derivatives as a partial hedge on, for example, annuity guarantees. If the change in expiration date aligned the derivatives with the underlying risk, maybe there was an accounting benefit.

If the counterparty is a US company, I would think there would have to be some disclosure.

It would also be interesting to know notional value of the derivatives. If they are a significant piece of the total, the Black Scholes value would decrease - falling directly to Berkshire's operating earnings.

Maiden Lane

2009-04-30T00:53:00.000-07:00

The NY Fed has released a lot of information HERE.

Alea comments on Maiden Lane I, so I won't bother. Except to say that it isn't the assets -- look at the whole balance sheet.

Per Maiden Lane III:

ML III LLC borrowed approximately $24.3 billion from the New York Fed in the form of a senior loan (Senior Loan)....

As of October 31, 2008, the Asset Portfolio had a par value of approximately $62.1 billion.

Per Maiden Lane II :

ML II LLC financed this purchase by borrowing $19.5 billion (Senior Loan) from the New York Fed.

As of October 31, 2008, the Asset Portfolio had a par value of approximately $39.3 billion.

These are not great assets. The Fed needs ML III to pay out @ 40% of par and ML III at 50% of par.

The detailed audited year end financials are quite interesting but mostly ramble on about fair value/M2M values. You can see what the assets consist of, but they have a decent chance of paying back the NYFRB with interest.

Are Creditors Sharing the Pain???

2009-04-05T14:44:00.000-07:00

Tyler Cowen's NYT's article, titled, Why Creditors Should Suffer, Too, slides over some fairly common misperceptions. First, the counterparty issue:

The great beneficiaries have been the creditors and counterparties at the other end of A.I.G.’s derivatives deals — firms like Goldman Sachs, Merrill Lynch, Deutsche Bank, Société Générale, Barclays and UBS.

These firms engaged in deals that A.I.G. could not make good on. The bailout, and the regulatory regime outlined by Timothy F. Geithner, the Treasury secretary, would give firms like these every incentive to make similar deals down the road.

First, these are primarily counterparties, not creditors. They bought credit default swaps from AIG on multi sector super senior CDO's. The counterparties used contracts that provided for collateral to be posted based on both the rating of AIG and the market value of the underlying CDO. Because of this, they were largely protected from any deterioration in AIG's financial position. In fact, by the time these were settled, the counterparties held about 50% of the face value of CDO's.

Thanks to an exemption from the Codes automatic stay - which bars all other creditors from terminating contracts with or seizing assets from a firm in bankruptcy - counterparties to derivatives contracts are free to terminate the contracts and then seize collateral to the extent that they are owed money.

It isn't clear what the actual losses are on the underlying credits, but the counterparties were very aggressive in demanding collateral, and may have held enough to completely avoid loss, regardless of AIG's future financial status. So it was not possible to cram down losses to the counter parties on the most problematic AIG CDS's. In fact, it was the continuing demands for collateral that precipitated AIG's initial cash problem in September.

One could argue that the entire credit derivatives market should be eliminated or regulated, but at the time, the counterparties were fully collateralized and had no net risk.

As far as the creditors, they have faced some steep haircuts already. Citi put together a deal to essentially force holders of convertible preferred stock to swap it for equity. Right now, Citi exchange traded debt sells for about 25 cents on the dollar, so to say they aren't sharing the pain isn't accurate. From their press release:

As announced on February 27, 2009, Citi is seeking to exchange approximately $27.5 billion in public and private preferred securities with a commitment from the U.S. Treasury to convert up to an additional $25 billion of its preferred securities for common stock. Assuming full participation of public preferred shareholders, Citi will convert into common shares approximately $52.5 billion in aggregate liquidation preference of preferred shares.

Exchange traded debt for Bank of America is currently selling for 50% of par. These shares sold at close to par within the last year, so the markets see the debt as being distressed. Here are quotes on some BAC issues, which all have a par value of $25:

BAC-W BAC Capital Trust I $13.15
BAC-V BAC Capital Trust II $13.04
BAC-X BAC Capital Trust III $13.44
BAC-U BAC Capital Trust IV $11.11
BAC-Y BAC Capital Trust V $11.47
BAC-Z BAC Capital Trust VIII $11.29
BAC-B BAC Capital Trust X $11.40
BAC-C BAC Capital Trust XII $12.72

The markets are saying that the debt is distressed, and this exchanged traded debt trades frequently and in significant volume. Before encouraging the Treasury to push for some sort of concessions on these issues, don't forget that the original TARP invested public money in BAC preferred, pari passu with the existing preferred issues. If it is necessary to convert shares similarly to Citi, it should be done by all means. However, any debt above this level in seniority would require the more junior debt to take the first loss, and the Treasury needs to make sure that this step is essential.

The equity goes first, then the preferred, and then the senior debt. This is simply the capital structure of the bank, and losses must be taken in order of seniority. This is the case, in or out of bankruptcy.

All debt holders have taken a market loss so far. The idea that they are being sheltered is exaggerated. In addition, the senior debt holders aren't necessarily the enemy. They are pension funds, mutual funds, etc. Protection of the debt holders is, in some respects, an unintended consequence of a bailout, but it may well be fortuitous rather than unfortunate.

FASB Change

2009-04-02T16:53:00.000-07:00

Based on the belief that it is important to go to primary sources, here it is for today's FASB board meeting.

All I will say is that it is complicated and defies summarization.

It clarifies what constitutes an orderly market.

It discusses how to measure and account for OTTI (other than temporary impairment). As complex as this is, don't forget that the income has two components in GAAP -- Income and OCI or Other Comprehensive Income. A huge amount of effort goes into this distinction that is important in theory but much less so in practice. OCI hits the balance sheet. I am a balance sheet type and don't really care so much for this single, arbitrary distinction.

At the March 16, 2009 meeting, Chairman Herz announced that the FASB also would address other-than-temporary impairment issues, in conjunction with the project intended to improve the application guidance used to determine fair values under Statement 157. Proposed FSP FAS 115-a, FAS 124-a, and EITF 99-20-b on other-than-temporary impairments (OTTI) is intended to provide greater clarity to investors about the credit and noncredit component of an OTTI event and to more effectively communicate when an OTTI event has occurred. As proposed, the FSP would apply to both debt and equity securities. The proposed FSP requires separate display of losses related to credit deterioration and losses related to other market factors on the income statement. Market-related losses would be recorded in other comprehensive income if it is not likely that the investor will have to sell the security prior to recovery.

What this means is that a debt security (CDO, for example) can lose value due to either expected credit losses OR other factors including liquidity preferences, market or presumed market changes, etc. The non credit components would be amortized over the remaining life of the instrument. This goes into a new bucket in the OCI statement:

The proposed FSP would result in a new category within other comprehensive income for the portion of the other-than-temporary impairment that is unrelated to credit losses for held-to-maturity securities.

This is similar to the treatment of unrealized capital gains(losses) in the income statement. Presumably, the decision that more securities aren't valued based on orderly markets means that the details of how to account for changes in model valuation are now more important. Hence the linking to OCI and OTTI.

OTTI has to hit regular income. If a firm intends and has the ability to hold a security to maturity, then the market impairment that is not credit related does not go into OTTI but into this new bucket of OCI.

Confused? I'm sure that the intent is to exclude the non credit based piece from regulatory capital requirements.

Derivative Accounting aka M2M Modified

2009-04-02T14:02:00.000-07:00

I have blogged about this a number of times. I have been against the expansion of mark to market accounting for a number of reasons. Here are links/reasons.

1. Mark to market liabilities are an inherent problem. You don't want to do it, because of the GAAP going concern principle, but in for a dime. Most people don't know about this or believe it.

2. M2M is basically derivative accounting.

3. Citi books M2M liabilities. Do people really want to do this? The reason I wrote this is that people seemed to flat out deny that this was being done.

4. An extensive comment on someone else's blog post regarding M2M.

5. A comment on a confusing WSJ article on m2m.

6. GE could, in theory, buy back some of its debt at a discount. Hence the rationale for m2m liabilities.

As a general comment, people are finally starting to say things that aren't blatantly false or stupid on CNBC and in blogs and blog comments.

It's about time.

Time to Start Selling

2009-03-30T12:54:00.000-07:00

It already looks like there are two camps critical of the Treasury plan. Those who think it will fail and those that think it will succeed. Paul Krugman seems to be in both camps -- he thinks it will succeed in making rich people richer and fail to do the job. Now the New Yorker seems to be siding with the problems of success arguments:

It’s conceivable that this plan could work for the funds but fail to save the banks, which will still have lots more bad assets on their books. As long as it works for the funds, some very, very rich people are going to get much richer, thanks to once-in-a-lifetime favorable terms provided by the federal government and unavailable to the rest of us. What then? It will be a few years before this has played out. Maybe by that time the economy will be better, and the country will have calmed down. If not, the dynamic we have seen in the past few weeks will only become more severe, and who knows what kinds of social poison will work their way into the fabric of American life.

First of all, the Treasury will share in profits dollar for dollar with the funds. Secondly, the profits will be taxed in some fashion, at least once, before they can be spent. So the "taxpayers" get more than the rich people.

I have addressed this before, and will just say that the Treasury should be eager to sell parts of their piece to the public, to make it known that it isn't only the ultra wealthy that can make money in this.

Meanwhile, I have a feeling that most writers on this subject haven't fully read or understood the Treasury plan, and would do well to actually read it before writing extensively on it.

Kid's For Cash

2009-03-28T00:30:00.000-07:00

It's obviously the economy, but sometimes something is just so over the top that it needs additional exposure. Per Ian Urbina of the New York Times:

Things were different in the Luzerne County juvenile courtroom, and everyone knew it. Proceedings on average took less than two minutes. Detention center workers were told in advance how many juveniles to expect at the end of each day — even before hearings to determine their innocence or guilt. Lawyers told families not to bother hiring them. They would not be allowed to speak anyway.

Urbina does a solid reporting on this follow up article on the unbelievable corruption in a Central Pennsylvania County juvenile justice system. There is no need to repeat the major facts regarding the case against Mark A Ciavarella. The most disturbing aspect of this is that "everybody knew it". Ciavarella doesn't seem to acknowledge it, even though he agreed to plead guilty in a deal that would give him 8 years in jail.

In what authorities are calling the biggest legal scandal in state history, the two judges pleaded guilty to tax evasion and wire fraud in a scheme that involved sending thousands of juveniles to two private detention centers in exchange for $2.6 million in kickbacks.

But as he pleaded guilty last month and admitted having “disgraced” the bench, Judge Ciavarella denied that payments had influenced his sentencing decisions.

Consider his rather lengthy letter defending his actions from a critical review by his replacement, Chester B. Muroski, in a press release. I expect the facts are much more confusing and convoluted then anyone could imagine.

The prosecutors who worked in disgraced Judge Mark A. Ciavarella Jr.’s courtroom share part of the blame for the injustices he perpetrated on thousands of Luzerne County juveniles, said Marsha Levick, the legal director of the Juvenile Law Center.

Ciavarella said last May he was “wrong” to skip directly to sentencing instead of reading a required reminder of their right to an attorney. Around the same time, Ciavarella, who had presided over juvenile court from 1996 to May 2008, stepped aside as juvenile court judge and appointed Judge David W. Lupas as his replacement. Lupas, who served as district attorney from 2000 to 2008, could not be reached for comment at his chambers Friday.

In addition, Ciavarella’s daughter, Lauren, is an assistant district attorney.

Lauren, 27, followed Ciavarella into the law, and has worked as an assistant district attorney in the Luzerne County district attorney's office since last January.

Lauren needs to get a job without any hint of nepotism. Lupas should go also. Meanwhile, another judge was forced off the bench following a lengthy review for what now sound like laughably minor charges, based on testimony by Ciavarella and court staff under his authority. Meanwhile, Ciavarella is not waiving any of his rights in his attempt to cut the best deal possible.

Ciavarella remained adamant that he did not plead guilty to any charges related to “cash for kids,” embezzlement or extortion.

“We came to [a] plea agreement because we would never agree that [the sentencing] was improper. And that’s why in the plea agreement you don’t see any of that language,” Ciavarella said.

I suppose if you have pled guilty to tax evasion and taking illegal kickbacks, then the fine points regarding whether the cash influenced his decisions can be left to individuals to decide. Perhaps Ciavarella, like O. J. Simpson, could pen a book during his prison stay similar to Simpson's If I Did It.

If there is any justice in this matter, it will be the rather rough justice of a disgraced judge spending time in prison and then endless amounts of time and money defending the civil lawsuits that will arise out of this matter.

The abuse of power and office are shocking and outrageous. I suppose the fact that it was eventually uncovered says something positive about democratic process. People went into a juvenile court without a lawyer expecting to get some sort of deal and ended up in the corrections industry. There is an element of social class (as always) associated with the victims. However, if they watch television, they should know that you never confess and need to lawyer up as soon as possible.

Berkshire Credit Default Swaps

2009-03-27T15:11:00.000-07:00

I dunno what they are being quoted at, but:

March 26 (Reuters) - Berkshire Hathaway Finance Corp on Thursday sold $750 million of 3-year notes in the 144a private placement market, said IFR, a Thomson Reuters service. The notes are unconditionally guaranteed by Berkshire Hathaway Inc (BRKa.N) (BRKb.N). The size of the deal was increased from an originally planned $400 million. Goldman Sachs and Morgan Stanley were the joint bookrunning managers for the sale.

BORROWER: BERKSHIRE HATHAWAY FINANCE CORP*
AMT $750 MLN COUPON 4.00 PCT MATURITY 4/15/2012
TYPE GTD NOTES ISS PRICE 99.767 FIRST PAY 10/15/2009
MOODY'S Aaa YIELD 4.082 PCT SETTLEMENT 4/2/2009
S&P TRIPLE-A SPREAD 282 BPS PAY FREQ SEMI-ANNUAL FITCH DOUBLE-A MORE THAN TREAS MAKE-WHOLE CALL 45 BPS

I don't see how the daily spikes in CDS quotes mean much when the debt markets snarf up $750 million @ 282 bp. They can't get enough of them.

Three Card Monte

2009-03-25T22:27:00.000-07:00

Three card monte comes to mind when considering the Geithner plan. Everybody knows that it is a few years too late to believe in financial alchemy, that there is a subsidy, that there is a valuable, implicit put to grease the deal. Or even more ways the system is/can/will be gamed. However, I'm not buying complexity here -- the subsidy is big and it's right in your face.

I suggest people read the Treasury Plan documents themselves instead of relying on secondary sources which seem lax regarding details. From the "legacy" loan term sheet:

Leverage will be determined on a pool-by-pool basis at the FDIC’s sole discretion, with input from the Third Party Valuation Firm. It is anticipated that the debt to equity ratio will not exceed 6 to 1 for each PPIF. [note: max leverage 4 to 1 for legacy securities]

FDIC will provide credit support for PPIF financing through guarantees of debt issued by the PPIF.

Right now, FDIC backed notes are yielding 22 bps over Treasuries, or about 2 .125% on a 2 year. Thats exactly what Wells got on a recent issue.

Let's work through a simple example, substituting a 2 year loan for roughly equivalent pool of cash flows. Consider this a loan of 100 originated @ 5%, with a payment of 55 at the end of year 1 and 52.5 at the end of year 2.

The pools have deteriorated and 10% will default with no recovery prior to the first payment. The new expected payments are 49.5 and 47.25. The bank has a loan loss reserve of $10. This assumes that the 5% interest rate imbedded in the original loan is still reasonable.

However, vulture investors today are looking to get 20% returns on their now very valuable capital. Without financing, they would have to buy the asset for 74 to get a 20% return.

With 2.125% financing and 6x leverage, they would need about 4.7% to get 20% on their capital. That would put the price of the loan at 90 and change. Not much of a surprise, since the critical valuation assumption is the correct interest rate -- not the default rate. And not much of a surprise since 4.7% is very close to 5%.

This is something that most people aren't getting when comparing so called market prices to modeled estimates. The risk adjusted interest rates have blown out which drive the gap more than the cash flow assumptions.

In the example above, the gap gets bigger with a 3 year duration. So, yes -- there is a big subsidy in the plan. And no, it won't all go to the banks. But the subsidy allows the new, subsidized vultures to turbo charge their bids with very cheap financing.

Maybe this is why the New York Post reported that C and BAC are aggressively buying former AAA mortgage securities that were selling for 30% of par:

But the banks' purchase of so-called AAA-rated mortgage-backed securities, including some that use alt-A and option ARM as collateral, is raising eyebrows among even the most seasoned traders...

One Wall Street trader told The Post that what's been most puzzling about the purchases is how aggressive both banks have been in their buying, sometimes paying higher prices than competing bidders are willing to pay.

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.

If the 30 cent bid is based on 20% returns and 3 year durations, the securities could easily sell north of 50 cents @ 10%, leaving a nice profit for everyone but the seller.

People are assuming that the banks models are heavily biased regarding default and recovery assumptions. But if the securities were originally priced @ 5% and the market price is now based on 20% returns, that would account for major differences.

So to the extent that the problem is the market based price of risk capital, this sort of subsidy will work without an explicit cost to anyone. Financial alchemy. The catch is that the US can borrow a lot and at surprisingly low rates. Right now. Everything the government is doing is based on the idea that they can essentially become the hedge fund of last resort, and borrow low to fund illiquid asset purchases. It works until it doesn't. Let's hope it works.

Treasury Toxic Asset Plan

2009-03-23T22:16:00.000-07:00

I don't get it.

However, it is very possible that this DOES NOT need to work as a prerequisite for an economic recovery. In fact, the best case is if it sort of dies out with minimal participation -- for whatever reason -- as the economy recovers without this sort of help.

Facts:

1. The problem is with the shadow banking system, which is largely gone.

2. This doesn't apply to small banks. Period.

3. There aren't that many toxic assets. Unless someone would like to argue otherwise -- toxic assets are those that are opaque and difficult to value. A bad asset isn't a toxic asset.

4. It applies mostly to investment banks, which were doing huge amounts of securitization, but not much anymore. Legacy assets have no bearing on whether investment banks can sell new securitized loans. The original TALF sounded promising on that score.

5. Non investment banks don't have a lot of non agency mortgage backed securities.

6. FDIC insured banks have only abut $7 trillion in loans. They don't mark whole loans to market. They don't need to sell them.

7. The plan excludes CDO^2 or any mortgage security that holds something other than whole loans.

8. The investment banks may need to dump some securitized loans, but who/what/etc.

Therefore:

I don't see how this could work.

The only example that I can think of is if -- if someone like WFC wants to get rid of Pic a Pay, which already has a 40% haircut, and perhaps book a profit -- then maybe. Most other loan portfolios are booked with a 5% loan loss reserve or something similar.

It seems like this is just for Citi and BAC. Why didn't we just give them the $150 billion.

Suggestion to Obama

2009-03-22T08:29:00.000-07:00

The public isn't happy.

They will be unhappy if the Treasury or Fed loses billions on its loans.

They will be even more unhappy if the Treasury and/or Fed plus "private money" MAKE a lot of money buying toxic assets. Per the NYT, under the headline, "Toxic Asset Plan Foresees Big Subsidies for Investors."

The plan is likely to offer generous subsidies, in the form of low-interest loans, to coax investors to form partnerships with the government to buy toxic assets from banks.

To help protect taxpayers, who would pay for the bulk of the purchases, the plan calls for auctioning assets to the highest bidders.

Assuming the reports are correct, private entities will put up $30 billion, the Treasury $120 billion, and borrow $850 billion. This gives the hedge funds, etc. 5 x 1 leverage. If they make money, it will be considered an outrage.

Get ahead of all of this by offering to sell anyone shares in the Treasury's $120 billion stake. For that matter, offer investors a chance to buy stakes of any/all the treasury bailouts at par. These have to be offered to retail investors in small lots.

I would include entities like Maiden Lane III in this.

Also include a fund of bank preferred stocks.

There are a few risks here. They may prove to be very popular and attract a lot of funds, but every dollar that the Treasury takes in can reduce their borrowing needs by an equivalent amount.

The other is that the investments will have a secondary market and there will be price discovery. A small price to pay to give everyone a chance to bet with the big guys.

They really need to get with it, or they will soon be in a no win position. It is so, so simple to eliminate this threat of a big give away to hedge funds -- by simply offering the same terms to individuals.

One More Time -- Felix Salmon, BRK, CDS's

2009-03-08T21:26:00.000-07:00

Talk about an idea that is immutable.

Berkshire credit default swap rates mean very little. Commenter Alden on Clusterstock

notes that:

CDS are outrageous compared to where the actual bonds of Berkshire are trading. Those bonds are trading at about 225 bps over 5 and 10 yr treasuries. Which although seems a bit high to me for AAA, I think that the absolute yields are fairly low, about 4.25% for the 5 year, 5.25% for the 10. This is favorably compared to GE Capital, which has bonds trading with yields above 10%.

Here are quotes from Friday (click for larger view):

The idea that CDS's are the most accurate and reliable reference point for credit quality is simply conjecture.

Consider another comment:

Given that Berkshire is -- like all insurance companies -- a leveraged financial institution

Once again, not true. First, property casualty companies don't tend to use leverage, unlike some life companies. They fund assets using their own capital and policyholder funds. Nothing close to the type of leverage used by banks or even some of the life insurers. Berkshire with huge amounts of excess capital to support their insurance operations and $23 billion in cash and cash equivalents is remarkably unleveraged.

We will have to see what will happen. One would expect the CDS's to fall into line with the bonds, but a lot of firms have blown up on negative basis trades and the markets are chaotic.

Since Berkshire is the ONLY AAA insurer, it should be obvious that AAA isn't essential to run the insurance operation (excluding the tiny bond insurer).

This was all covered a couple of months ago and the issue disappeared. Even though it is back, the place to look for problems is in the market inefficiencies or manipulation or whatever is driving the CDS markets.

How GE Can Save Itself ?

2009-03-05T22:14:00.000-08:00

GE has some problems. It's capital has a lot of asset ($600 billion) and some of them are going to default. People are anticipating the problem and have already punished the shares and the debt for these potential problems.

GE has another problem. People are selling. No one is buying. Prices are collapsing. This is destroying confidence in GE, setting the stage for higher capital costs, and if the losses are sufficiently high, raising questions of solvency.

GE has an easy and interesting way to correct the imbalance between supply and demand of its debt, improve its balance sheet, book a nice profit if they start taking the capital market theorists at face value. More specifically, the market value of GE debt has plunged. On a M2M basis, this improves GE's capital position, via the arithmetic identity that equity = assets - liabilities. If the liabilities decline, equity goes up -- dollar for dollar.

I am suggesting that GE use its liquidity to buy back any and all debt that is selling close to 50 cents on the dollar. Buy $2 of debt for $1 and the capital position improves by $1. This is identical to simply adding to capital and magically reducing debt by the same amount. Here is an example of some exchange traded debt. This move saves them $2 billion.

Is it realistic? Maybe. I am just scratching the surface with some GE Capital exchange traded debt. They have billions more.

Could they buy it up in the market? They could buy some, but most likely the price of the debt will rise. However, this would help restore confidence in GE.

If you want, think of it as GE selling credit default swaps on its own debt. Only they wouldn't be messing around in the world of derivatives, but in the real market for the underlying.

As far as technical details, they would need some sort of dispensation from the Treasury and SEC to just start buying. In addition, the rating agencies would need to recognize this as unequivocally positive -- which it would be.

People should get their head around the fact that either GE's debt is mispriced OR GE's market based capital is much, much stronger then it appears.

Argue that a GE purchase would just increase the price of the debt means that the market price isn't an accurate estimate of its value. The markets are shallow and erratic. A little buying and the price soars.

Or it means that GE can actually realize billions of dollars of market based capital by just buying underpriced debt.

It can't be both. Logically impossible.

Is Buffett Aggressively Writing Down Utility Bonds?

2009-03-02T13:56:00.000-08:00

Reading through the figures in the back of the annual report, I noticed an interesting item. An even $1.5 billion unrealized capital loss on corporate bonds and preferred stocks. This is a surprise, although I suppose that it is reasonable to say that the market value of the preferreds would have decreased, if they were publicly traded.There were 3 big preferred deals. The Wrigley/Mars financing, the GE $3 billion deal, and the Goldman $5 billion deal. The "fair value" section at the end of the report lists $8 billion in level 3 fixed income securities. These may well be the Goldman and GE stakes.

It is possible that the unrealized losses relate to last year's $2.1 billion purchase of TXU bonds. These table shown above includes only the insurance subs. There are no doubt bonds carried in the holding company or financial subs. The total of $10,230 is less then the total of the 3 large deals. $6.5 Mars, $5 Goldman, and $3 GE.

The TXU bonds included both regular high yield and pik/senior toggle notes. They elected to toggle Oct 31.

These bonds were private placement, and I don't know if there are market quotes. However, they are likely candidates for a haircut.

More on Berkshire Options

2009-03-01T22:03:00.000-08:00

From the Annual Report

Berkshire determines the estimated fair value of equity index put option contracts based on the widely used Black-Scholes option valuation model. Inputs to that model include the current index value, strike price, discount or interest rate, dividend rate and contract expiration date. The weighted averaged discount and dividend rates used as of December 31, 2008 were each approximately 4%. Berkshire believes the most significant economic risks relate to changes in the index value component and to a lesser degree to the foreign currency component. For additional information, see Berkshire’s Market Risk Disclosures.

The Black-Scholes model also incorporates volatility estimates that measure potential price changes over time. The weighted average volatility used as of December 31, 2008 was approximately 22%. The impact on fair value as of December 31, 2008 ($10.0 billion) from changes in volatility is summarized below. The values of contracts in an actual exchange are affected by market conditions and perceptions of the buyers and sellers. Actual values in an exchange may differ significantly from the values produced by any mathematical model. Dollars are in millions.

I think I figured out the source of my estimation error on the index puts. The assumed interest rate is 4% and I thought 5% would be more realistic. However, the shocker was the assumed dividend rate of 4%. The relatively low interest rate and the relatively high dividend rate significantly increases the delta. I am surprised especially by the use of a dividend rate equal to the interest rate.

I suppose there may be conventions regarding what parameters to use in B-S for financial reporting. However, it does seem that the use of fairly stable, fixed parameters based on prior historical data appropriate as an estimate of future volatility, interest, and dividends is appropriate.

This is the first time that the interest and dividend assumptions have been disclosed. I have to wonder if Buffett is trying to throw in the kitchen sink on these. Maybe it was the external auditor's idea.

Berkshire Hathaway - Chairman's Letter

2009-02-28T11:27:00.000-08:00

I was much closer then Gary Ransom.

Me:

Therefore the liability is going to increase by about $2 billion. (note: This was only the index puts, my estimate for total derivative losses was $3 billion.)

Gary:

That means Berkshire could take a fourth-quarter hit on the options, as much as $12 billion, says Fox-Pitt Kelton analyst Gary Ransom.

It looks like the total (index puts, CDS's, misc) is closer to $5 billion. The index put liability was slightly over $3 billion. I'm not going to bother trying to get more precise until the 10k comes out. Gary was close on the overall decline in book value, so he gets points on that.

However, the figures imply that Buffett decided to increase the volatility assumption in Black Scholes. This is significant for a couple of reasons. My thinking is that he should be using a figure that is roughly fixed -- or a 15 year rolling average. He said the following:

The ridiculous premium that Black-Scholes dictates in my extreme example is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probability-
weighted range of values of American business 100 years from now. (Imagine, if you will, getting a quote every day on a farm from a manic-depressive neighbor and then using the volatility calculated from these changing quotes as an important ingredient in an equation that predicts a probability weighted range of values for the farm a century from now.)

Though historical volatility is a useful – but far from foolproof – concept in valuing short-term options, its utility diminishes rapidly as the duration of the option lengthens. In my opinion, the valuations that the Black- Scholes formula now place on our long-term put options overstate our liability, though the overstatement will diminish as the contracts approach maturity. Even so, we will continue to use Black-Scholes when we are estimating our financial-statement liability for long-term equity puts.

Therefore, Buffett INCREASED volatility, even though he believed it was already too high, from an economic perspective.

One other factiod regarding the index puts. When Buffett originally booked them, he thought they were grossly over valued. However, he booked them with no initial income impact. In order to do this, he had to "back into" Black-Scholes parameters that would produce this result. Therefore, the fact that the parameter adjustments will be much lower then others have suggested, one reason is that they started on the high side.

WSJ on Berkshire Index Puts

2009-02-27T17:01:00.000-08:00

The Wall Street Journal commented on the oft discussed Berkshire Hathaway index puts in its 'Ahead of the Tape' column today:

In recent years, the Omaha, Neb., holding company sold what were essentially insurance policies against a long-term decline in U.S. and foreign stocks in exchange for $4.5 billion. When the contracts expire in periods of either 15 or 20 years, Berkshire will have to fork over cash -- possibly billions -- if the indexes are below where they stood when the deals were struck.

The S&P 500 is down about 50% from its peak, and indexes around the world have cratered. Berkshire has to calculate its potential liabilities on the contracts every quarter.

In the third quarter of 2008, Berkshire said its mark-to-market liabilities on the options were $6.7 billion. Since then, stocks have fallen more, and volatility, a key element in valuing options, has soared. That means Berkshire could take a fourth-quarter hit on the options, as much as $12 billion, says Fox-Pitt Kelton analyst Gary Ransom.

I am going to use the WSJ figures and a little common sense to illustrate the economics of the options deal and the fact that the estimate of a quarterly hit of $12 billion is off by greater then a factor of 4. Before we move to simple arithmetic, I would like to point out that the appropriate volatility figure would an estimate of volatility in the future 12 years (plus) of the contracts. Therefore, the fact that we have had high volatility recently should not have much impact on an estimate of future volatility. In fact, I believe that Berkshire picked a relatively conservative (high) volatility estimate when they booked the initial estimates and will continue to use the same estimate until it seems likely that we have had a permanent change in volatility.

As a little background, The notional amount of the contracts is about $36 billion. There are no collateral requirements and no cash will change hands until the first contracts expire in 12 years. They are "European" options and can only be exercised at expiration.

The Berkshire liability is calculated using Black-Scholes and the "delta" is in the low 20% range. Delta is the change in the value divided by the change in the underlying index. For example, if the index decreased 1/4 of its notional value in the 4th quarter or $9 billion, the liability (pretax) would only increase by about 23% of that figure. Therefore the liability is going to increase by about $2 billion.

However, if we want to think about a more rational way to book the options each quarter, I suggest that any change in value be "amortized" by 1/60 each quarter, based on their 15 year life. In that case, the time premium for the option would decrease about $65 million each quarter and an additional 1/60 of the amount the option is in the money would be booked each quarter. This is an estimate of the liability components over 15 years.

Using the same "straight line" amortization, and assuming that the indices finish exactly where they are today, the losses would be booked at $225 million per quarter over 15 years. However, the economics of the deal also include the cash plus the investment income. Showing this and the total net loss (green line) below gives you the economics of the deal with the indices down 50%:

Here you can see that the loss in 15 years is a little over $10 billion. This is based on an assumed return of 6% on the initial premium. The idea of using a "straight line" approach to accounting for the losses is a bit extreme, and may appear unrealistically optimistic. However, I am sure that Buffett would also prefer to book only 1/60 of the time premium if the contracts were out of the money.

The point of this exercise is to look at the options as contracts that amortize smoothly over a 15 year period. Even if the results are extremely unfavorable, like the assumption that indices decline 50% over a 15 year period, the quarterly economic impact isn't particularly significant. In addition, the amount of loss would not be a problem for a company with over $100 billion in capital.

Harley Davidson - TALF

2009-02-27T04:01:00.000-08:00

An iconic american brand.

It seems like people still want them, and they still want to finance them. However, Harley has a finance subsidiary that kept some loans and securitized others. The last successful securitizetion was in 1Q 2008. For almost a year, Harley has had the option of holding loans on its balance sheet or cutting back production.

Harley just borrowed $600 million for "general corporate purposes" @ 15% for 6 years. They need financing to support the additional assets and provide financial stability while they try to get back to something approaching normal. Per the prospectus:

Harley's top line looks about the same as 2007. The big change is the amount of debt. The debt is to support the "receivables held for sale" which are the loans that *would* have been securitized, had that market not collapsed.

The increase in financial receivables held for sale as of September 28, 2008 compared to September 30, 2007 was due primarily to a reduction in asset backed securitization activity in 2008 due to capital market volatility.

Per the prospectus:

...we are working to gain access to the asset-backed securitization market through the Federal Reserve Bank’s Term Asset-backed securities Loan Facility or “TALF” program. We are researching the program and determining how we may benefit from it. Retail motorcycle loans have been included as eligible.

Anyone that wants to can spend some time researching the business. However, it is basically solid and profitable. It is financially "jammed up" by the credit crunch. It has been able to get by just bulking up on financing assets. However, the financing model won't work for long. They need to sell assets on a regular basis or take some other action. They can only park the financing receivables up to a point -- then their balance sheet goes to hell.

That's why the TALF seems like a good idea.

Blog Calculated Risk Questions Stress Test

2009-02-26T15:17:00.000-08:00

The blog, Calculated Risk, has become quite influential. The quality of the data and analysis as well as its accessibility has been outstanding. However, I believe they may be over reacting to possible deficiencies in the Treasury stress test. Per CR via Bloomberg:

Moody’s Investors Service said it’s reviewing all 2005, 2006 and 2007 subprime-mortgage bonds for credit-rating downgrades, covering debt with $680 billion in original balances.

The review reflects an increase in Moody’s expected losses on the underlying loan pools, the New York-based company said in a statement today. Losses for such mortgages backing 2006 securities will probably reach 28 percent to 32 percent, up from a previous projection of 22 percent, Moody’s said.

The ratings firm said that it boosted expected losses based on “the continued deterioration in home prices, rising loss severities on liquidated loans, persistent elevated default rates, and progressively diminishing prepayment rates.”

CR is concerned that the Treasury stress test may include assumptions that are even more optimistic then rating agency's base case.

A loss rate is a default rate times the loss severity of a default. For example, if you have a default rate of 50% and a loss per default of 50%, then you have an overall loss rate of .5 x .5 = .25 or 25%. To get to a loss rate of 50%, you would need an slightly worse then 70% loss rate and a 70% severity on each loss.

If you take the worst pools, this is very believable. However, when we look back at the subprime excesses, the worst tended to be securitized. That is, they were originated with the intention to sell to investment banks as raw material for CDO's. Commercial banks weren't in that business, for the most part. The originated to hold. They may have written a lot of bad mortgages, but they know they were keeping them.

At the very least, they would have tried to keep the better loans and sell the lower quality loans. As I have discussed before, we have two competing models of lending. Originate to distribute/securitize and originate to hold. The former was the provence of investment banks and the latter of commercial banks.

I wouldn't rush to judgment regarding the stress tests. In general, all they can do is rank the banks with respect to capital strength. They really can't do much for investment banks, due to their incredible complexity. As far as commercial banks, they can rank them, draw a line, and take action. That is, identify the basket cases, and sort the likely survivors by strength.

Whatever foolish decisions were made in commercial banks, they weren't creating CDO^2. They are fundamentally different then investment banks, and the attempt to treat them the same doesn't make a lot of sense. Unless they believe the investment banks must be kept around, and the only mechanism is to pretend they are commercial banks -- and then backstop them.

I'm not ready to give up on Obama/Treasury yet.

Join the Board of Directors

2009-02-23T12:03:00.000-08:00

All this talk about banks, but people tend to not know what they don't know. You wanna be a new director of a community bank for a day? The KC Fed has an online course that tells you all you need to know.

This site is built around events occurring at the fictional “Insights Bank and Trust,” a small community bank where you serve as an outside director. An outline of the course is presented to the right. Early parts of the course serve as a prelude to an October board meeting, which will offer information on typical points of discussion for bank directors.

In the early sections, you will learn about your duties and responsibilities as a director (see Corporate Governance) and items to expect as you start the important job of being a bank director. You will also learn about a fraud that occurred at Insights Bank prior to the meeting; this section introduces the topic of operational risk and its controls. Subsequently, you will attend an October board meeting where the focus is on a variety of topics regarding the evaluation of a bank’s financial performance and the management of the risks to its portfolio (credit risk, market risk and liquidity risk).

In each lesson, you will find video scenarios, sample reports and reference materials that are designed to raise awareness and help directors address on-the-job issues banks often face. Printable references, helpful tips and practice exercises may also help you gain confidence to ask pertinent questions and apply new knowledge to meeting bank director’s real-life responsibilities. A list of course topics, practice exercises and supporting “meeting materials” lessons is available from the Reference View.

This is really a good course and people might really find it useful -- like how to set loan loss reserves. Here is another view of the content. Economists and people with a theoretical basis in finance might get a little taste of reality, and perhaps humility. I suppose that's asking too much.

U.S. Bancorp's Davis Rips TARP

2009-02-18T19:57:00.000-08:00

In a local speech at the Thrivent Financial for Lutherans' Business Leaders Forum, US Bankcorp CEO, Richard Davis was candid in his criticism of TARP.

"I will say this very bluntly: We were told to take it. Not asked, told. 'You will take it,' " Davis said. "It doesn't matter if you were there on the first night and you were told to sign on the dotted line before you walked out of the office, or whether in the days that followed, you were told to take it."

Davis went on to say in his talk that while government officials marketed the program as a way to entice banks to lend again, TARP actually was designed to give solid banks like U.S. Bancorp some extra cash to buy weaker banks in the system. U.S. Bancorp did just that late last year when it acquired the assets of two failed banks in California, Downey Savings and Loan and PFF Bank & Trust.

"We were told to take it so that we could help Darwin synthesize the weaker banks and acquire those and put them under different leadership," he said. "We are not even allowed to mention that. ... We were supposed to say the TARP money was used for lending."

However, Davis is just one of many "traditional" bankers that is waking up to discover that the Treasury/Fed programs were not designed with them in mind. Rather, they are being dragged into the mindless nationalization debate that is primarily focused on saving the investment banks and the competing "originate to distribute" (via securitization) model.

Davis woke up in Minnesota to find he had become part of the now hated Wall Street banking cabal. The stock price of his bank has fallen from a high of $35/share in October to $11 today. He also learned that when he was told to take the money, he was also supposed to stick to the story. His lawyers and PR people backtracked today to minimize the damage.

Tuesday afternoon, a U.S. Bancorp spokesman said Davis had misspoke, and meant that because the largest banks in the country took TARP money, U.S. Bancorp and others were forced to do so as well, for competitive reasons.

Clearly the Treasury feels like it is essential to get the securitization part of the credit system running again, but traditional bankers aren't willing to take one for the team -- especially if it means getting railroaded into a nationalization scheme. As a Midwesterner, Davis seems befuddled by the Treasury and the political morass he was clearly not expecting.

___________

In correspondence with the SEC, USB discussed its policy regarding originate to distribute. Other then GSE mortgages, they originate to hold.

Geithner's Most Important plan element least discussed

2009-02-17T03:25:00.000-08:00

The big problems are the big investment banks, not the traditional banks. As a nation, we have had bank problems since the 2nd National Bank. It may not be fun, but people know how to do this.

However, the huge amount of lending through securitization by investment banks is a new issue. Per Geither:

Consumer & Business Lending Initiative – Up to $1 Trillion: Addressing our credit crisis on all fronts means going beyond simply dealing with banks. While the intricacies of secondary markets and securitization – the bundling together and selling of loans – may be complex, they account for almost half of the credit going to Main Street as well as Wall Street. When banks making loans for small businesses, commercial real estate or autos are able to bundle and sell those loans into a vibrant and liquid secondary market, it instantly recycles money back to financial institutions to make additional loans to other worthy borrowers. When those markets freeze up, the impact on lending for consumers and businesses – small and large – can be devastating. Unable to sell loans into secondary markets, lenders freeze up, leading those seeking credit like car loans to face exorbitant rates. Between 2006 and 2008, there was a net $1.2 trillion decline in securitized lending (outside of the GSEs) in these markets. That is why a core component of the Financial Stability Plan is:
A Bold Expansion Up to $1 Trillion: This joint initiative with the Federal Reserve builds off, broadens and expands the resources of the previously announced but not yet implemented Term Asset-Backed Securities Loan Facility (TALF). The Consumer & Business Lending Initiative will support the purchase of loans by providing the financing to private investors to help unfreeze and lower interest rates for auto, small business, credit card and other consumer and business credit. Previously, Treasury was to use $20 billion to leverage $200 billion of lending from the Federal Reserve. The Financial Stability Plan will dramatically increase the size by using $100 billion to leverage up to $1 trillion and kick start lending by focusing on new loans.

This is a major rationale for saving the investment banks. However, this will be a challenge.

1. People got burned badly the last time they bought securitized loans. They won't make the same mistake again.

2. The rating agencies will have to clean up their act. Or perhaps just cut out of the process. If the securities have a Treasury guarantee, the rating agencies aren't needed.

3. The originators of the loans haven't had a paycheck in a while, and may not be around.

4. They have to make solid loans. The demand for loans to buy motorcycles, boats, etc. may be modest. The people most likely to borrow are least likely to qualify.

5. The new securities need to be bullet proof, much simpler, more transparent, and contain more protection for purchasers. A lot of the profit was made by cutting corners in all these areas.

6. If the securities are simpler and the process is controlled by the Treasury, then maybe you don't need rocket scientists making them and costs/fees are significantly lower.

For these reasons, half of it isn't coming back.

However, it isn't much

2009-02-15T08:45:00.000-08:00

From Calculated Risk:

From Barrons

2009-02-14T18:04:00.000-08:00

Barron's Gene Epstein is following up on his spectacularly bad call in the October Cover Story, regarding recovery:

We assume, however, that the Treasury secretary will soon come up with a real plan to get credit to flow more freely. If so, Mike Astrachan, Israeli economist and former Federal Reserve staff member, is so impressed by the signs of turnaround that he thinks growth could resume as soon as the second quarter.

One of these signs was the unexpected 1% increase in January retail sales, reported Thursday, measured in nominal terms. Since overall prices were probably about flat in January, this means real retail sales also rose about 1%. This was right in line with the monthly ICSC/UBS index, which was also up 1% in January. The strength was widespread across sectors, including electronics, food and beverages, and clothing. The most surprising was motor-vehicle sales, up 1.6%.

The increase reverses only a small part of the weakness in retail spending, but it does highlight a potentially revealing pattern. In our Oct. 20 story, we had thought that the fall in energy prices would soon bring a rebound in consumer spending. We proved wrong; the energy dividend was not enough.

But now we see that the steepest drop in sales occurred from June to October, around the time of the energy shock and its effects, and that since October, the weakness was less severe. Real total sales still declined over the past three months.

It was rather obvious at the time that the April tax rebate went into people's gas tanks, and that the pessimism and issues from the commodity bubble were playing havoc with the economy. This final bubble pushed the tottering economy over the cliff. Reversing it wasn't enough to do the job, but it counted for something. In December, the social security COLA was about 5%, putting another $50/month in a lot of retiree's pockets. Lower interest rates cut both ways, and I suppose that retirees are earning less on savings. However, all the programs to lower interest rates are going to start filtering into people's pockets. Any ARM tied to LIBOR or a Treasury Index is going to reset at record low levels.

What does this all mean? About the time that Roubini becomes conventional wisdom, it is time to move on.

More Blather From the Times

2009-02-14T15:27:00.000-08:00

Gretchen Morgensen's Column, The Worst Misstep: Geithner Added to the Doubt, is fundamentally dumb. I have the feeling that she doesn't know if loans are assets or liabilities, and ditto with deposits. However, the half hearted attempt to discuss the arithmetic of bank financial strength isn't the point.

Rather the point is that we need to quit lying and get at a higher truth. To start with the conclusion:

But it will also require transparent, rigorous analysis; candor with the public and investors; and a recognition that lots of debt heaped upon a pile of dubious assets has created a financial nightmare — it’s no more complicated than that.

If you can parse the sentence to determine what is debt and what is a dubious asset, and assume that debt refers to the bank's leveraged capital structure, which includes junior debt (preferred shares) and capital, and dubious assets are the loans and securities that earn interest, then maybe it makes sense.

However, the way to get to this transparent, rigorous analysis is the following:

So here’s a strong first step: the Treasury Department needs to hire out-of-work bankers to conduct what investors call a “burndown analysis” of banks’ financial positions. This is what private investors do as they go foraging for gems hidden amid the wreckage in the banking system.

A burndown analysis, because it is a worst-case exercise, typically requires very pessimistic estimates for loan performance early on and higher-than-average loss estimates for loans in later years.

And then:

A bank’s prospects also derive primarily from its deposits, not its loan book, in such an assessment. To reiterate: Any examination of a troubled financial institution needs to determine what its assets are truly worth, how much can it earn and how much capital it needs to operate at a profit.

But she had already asserted that:

it involves knowing where the economy will be in six months or a year

So, this rigorous analysis involves knowledge of the future, which is inherently unknowable. It also requires knowing short and long term interest rates. I suppose that it is reasonable to assume that the Fed can keep short term rates -- the borrowing costs of banks, low for a while. But what happens if we get some inflation and interest rates on short term rates climb? The banks earn zero or less, since they lend "long" and are funding with deposits.

Meanwhile, the "burndown analysis" tells us that the assets are worth enough less to make the banks insolvent. Banks tend to have capital ratios of about 10% of assets, and need to maintain these levels. Write down the assets by 10% and the capital is gone.

Here is a simple model: Take the peak unemployment rate - 8% times 2 times the bank's assets. If peak unemployment is 15%, then take 15%-8% = 7% ------- multiply by 2 to get 14%. Then multiply that by the bank's assets to get losses.

They are all insolvent under these absurdly simplistic assumptions. This isn't much different then Mr. Roubini's estimates published yesterday in the Times. 14% of the $14 trillion of bank assets gives you about $2 trillion vs. Roubini's $1.7 to $1.8 Trillion.

There is no hidden "truth" that needs to be disclosed. The only thing the markets want to know is how badly the share holders are going to be punished. The markets learned that any new capital was going to come with a high cost, so that sliced the already modest value of financial shares.

Constant repetition of the idea that there is a hidden, true value for assets is idiotic, simplistic, and maybe even dangerous. People may want to know the future of the economy, but it isn't honest and transparent to pretend that you know.

The Banks Are Already Nationalized

2009-02-13T19:54:00.000-08:00

The Banks need to be triaged. Especially the big banks, no?

It has already been done. Note.... all figures are from the FDIC and the percentages are based on deposits @ 6/2008. The banking system has about $13 Trillion in assets and $7 Trillion in deposits. Other then a couple of big outliers, deposits are about as good as anything to denote relative size.

Right now, I am going to concentrate on the 50 largest banks that make up over 50% of total deposits.

20% have essentially failed this year. They have either been taken over (IndyMac) or been forced to merge with most of the cleansing that comes with a traditional failure. Wachovia is about 10%, WaMu 5%, with the others (Countrywide, etc) making up the remaining 5%.

Bank of America and Citi together have about 22% of the remaining deposits. The fact that both of these institutions received the original TARP funds, plus an additional round of funds and asset guarantees means they have been de facto nationalized.

I am astounded at the extent to which the public has taken to the Andrew Mellon sentiment of radical liquidation.

Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate"

"It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up from less competent people.”

It sounds about as good as the dieting fads that involve high colonics. Although Mellon's suggestion wasn't deliberately put into effect, the deflationary spiral from 1929 to 1932 liquidated anyone with debt or leverage.

Citi is in the process of liquidating itself -- trying a do it yourself version of good bank/bad bank. BAC will need enough additional capital to effectively become nationalized.

The New York Times is using Roubini's figures of $1.7 Trillion for bank losses. Since Banks have $13 Trillion in assets and Roubini may be including bank like institutions, the total is maybe 12% or 13% of assets.

It is hard to say where we end up, since we don't know how bad the economy will be, how much real estate prices will fall, etc.

I'd like to make the Sheila Bair the villain here. Wachovia and WaMu were essentially Nationalized. However, instead of sucking it up and bearing the costs, the FDIC pushed them into "mergers." They could have been cleaned up and then run as independent entities. Instead, the idea was to protect the FDIC's modest resources, wipe out the stock holders and the bond and debt holders to varying extents, and give the cleansed entities to other mega mega banks.

OK.... Sheila was on a short leash and couldn't do everything she wanted, although she went along with the mergers without much of a whimper.

Take a look at what Wells did to Wachovia:

They have also budgeted another $20 billion in "reserve build" for 2009. This is essentially write downs at the time of purchase plus the tax refunds -- 1/3 of the $60 billion total gives an after tax figure of $40. I would have to look up WB's asset base, but it is probably in the half trillion range, giving them the full Roubini.

However, Wells didn't give themselves the full Roubini -- and no doubt were thinking that any over estimation of WB losses could be used against their own problems.

JPM did something similar with WaMu. However, BAC actually PAID for the problems in Countrywide and Merrill. If Lewis had insisted on letting them go down before picking up the pieces, he wouldn't be sitting in detention with Citi. Whether picking up valuable deposit bases with "de risked" assets will be enough for JPM and WFC remains to be seen.

People will need to be punished to satisfy the public's blood lust. However, the bottom line is that the government has to move assets to their balance sheet or you get a deflationary spiral immediately. It might sound terrifying, but the only outcome that leaves the economy intact involves avoiding liquidation. It's the same debt, it just gets labeled public instead of private. Or gets the benefit of being treated as if it were public (without actually calling it that .... see the GSE's for an example).

The "us/them" meme doesn't work anymore. Everyone hates paying taxes, even the Treasury Secretary. However, the government gets 20% off the top -- so the extent to which the economy doesn't collapse is doubly good for the taxpayer. Plus they get 1/3 of corporate profits. If it works reasonably well, it is for the taxpayer's benefit, not at his expense. If it doesn't, then we get to do over the 30's.

What is a Bank?

2009-02-13T15:29:00.000-08:00

I'm trying to get at what people are talking about when they keep talking about the banking system. Back in the day, it was pretty easy to figure it out. Banks had buildings with tellers and FDIC insurance. Brokers didn't. No one had ever heard of an investment bank.

It goes back to the 30's. The Glass-Steagall Act.

Mr. Glass: Here [section 21] we prohibit the large private banks whose chief business is investment business, from receiving deposits. We separate them from the deposit banking business.

Mr. Robinson of Arkansas: That means if they wish to receive deposits they must have separate institutions for that purpose?
Mr. Glass: Yes.

Basically that means that if you take insured deposits, you have to get out of the direct investment business. That was then and this is now. Glass-Steagall had a number of restrictive reforms that were inefficient. It also created a safe, regulated sandbox for the average citizens and a less regulated one for those that wanted something different. It was chipped at for years, and is now mostly gone.

Right now, the FDIC insured institutions have about $13 trillion in assets and $7 trillion in loans. The past 5 decades have been primarily a process where more and more transactions took place outside of regular banks. Money Market Funds were started in the early 70's and bought high grade commercial paper. This used to be a staple of banks. Just an example, but the regular banks tended to get "disintermediated."

You had money center banks that were somewhere between investment banks and vanilla banks. Then you had your pure investment banks, your brokerages, and the like.

Regular banks can go bust -- witness the S&L crisis. However, it is a pretty simple business. You "make assets" like loans of various types and fund them with a layer of capital and deposits. Normal people can do this without computers. The did for decades.

Everyone knows that you don't let your vanilla banks get to fancy, and that they need to have an organized process if they fail. Basically, the FDIC comes in, declares it insolvent, turns the deposits (liabilities) and an equivalent amount of cash to another bank, and the depositors are up and running the next day. The FDIC then has the residue, which consist of loans of various quality levels and the collateral that is rounded up from the busted loans.

Then you have your capital markets operations. This stuff is done by investment banks, brokers, etc. Normal people can't understand it. They didn't understand it. It used to be hived off.

However, this is the area that is both failing and difficult. It is also an area that got crammed back into the regulated banking system and supported with taxpayer funds. Why?

Basically because if you tell the public, it's the banking system, they know it is important and can't fail. If you tell them it is brokers and derivative salesmen, they are likely to say no. So, if you want to bail out the capital markets people, regardless of where they are nominally hiding, you have to call them bankers.

Therefore, JPM acquired a huge deposit base, then scarfed up Bear Sterns, then grabbed another huge deposit base via WaMu. City has always been a mess in one way or another, and managed to have a decent sized deposit base, although as a "money center bank" it has been been too big to fail and bailed out once already. But in spite of its deposit base, it never was a regular bank. Then you had Merrill Lynch absorbed by Bank of America. Goldman and Morgan Stanley became regulated banks to grab some TARP funds.

All of a sudden, Wall Street is pretending to be regular banks in order to tap into the bailout funds.

I don't really know if Wall Street is essential to the financial system, but, unfortunately there is a decent argument. So much credit has bypassed normal banks via securitization that you can't say they aren't important. However, it is a stretch to call them Banks, except to confuse the public.

People are going nuts about nationalizing the banks. Anything that was similar to the traditional bank has already been worked over, and the worst are history. Indymac - gone. WaMu - gone. Wachovia -- gone. National City - gone. Not nationalized, but the stockholders were pretty much wiped out, the assets written way the hell down, and moved to someone that appeared stronger.

This is maybe 15% to 20% of the deposit base of regulated banks. So what is it that needs to be nationalized? It is Wall Street pretending to be regular banks. However, they have tended to get so tangled with regular banks that it is hard to sort things out.

Unmerge BAC and MER. Let Goldman and MS keep their TARP loans for another year or two and then pay them back.

The vanilla banking functions can continue without too much disruption. The community and commercial banking functions can be cleaned up easily enough.

The Capital Markets stuff is the real mess, and I have no idea how to really deal with them. However, I would assume that the worst abuses were in the past and there is never going to be anything resembling justice. Once you forget about that, it is just a pragmatic calculation of whether it is cheaper to bail them out or unwind them as quickly and orderly as possible.

How to buy $500 billion in "toxic" assets for$50 billion

2009-02-12T15:30:00.001-08:00

Re: The Treasury plan to use public/private money with up to 10x leverage to buy $500 billion of "toxic assets." The short answer --- you plan on losing the $50. Unlike the other Treasury/Fed proposals, which were set up so for the taxpayer to "come out whole" -- the only way to do this little trick is to plan to blow the money.

Since the entire process is politically toxic, time to consider the option of leveraging what they have by letting go of the constraint of getting paid back. The public mostly doesn't believe it will happen anyway, or don't make the distinction between a loan and spending.

Right now, private investors want 15% to 20% with little risk and what banks have is assets that yield 5% to 10% with a lot of risk.

Here is something that might work:

1. Plan on losing the $50 billion. Set up a choice of structures. The Treasury would take a layer of risk. Like the first 10%. Or let the private investors take the first 10% and the Treasury take the next 20%. Or let the private investors take the first 20% and let the Treasury take the next $30%.

2. One might wonder how the Treasury could afford to take more then 10% "layers" of risk -- but the further up the structure, the lower both the frequency and severity of potential losses. That is, if a private investor was willing to take the first 20%, it must seem viable enough that it has a 50% or better chance of not losing a penny, much less 50%.

3. A lot of the problem assets already have haircuts. If they started out with some subordination and already had writedowns of 10%, 20%, etc. then the Treasury has a lot of losses between it and a payout.

4. This would exclude the worst stuff, like CDO^2, which were too cute by 1/2.

5. Anything resembling a whole loan -- like a bunch of them bundled together, should be a pretty good bet.

6. Loan losses have both a frequency and severity component. That is, X% default, and those defaults produce Y% losses. If X and Y are both 50%, then the total dollar loss is 25%. 0.5 x 0.6 = .25. 1-.25 is .75 or 75% good money. A lot of loans had some subordination built into them, and then the stuff has been partially written down. Yea, people made bad loans, but to get to a 50% dollar loss ratio, 70% would have to default with a 70% loss on each default. Even some of the worst stuff can't be much worse then this. You would have to really try hard to write a portfolio of loans this awful.

Under the 20%/30%/50% option, the most senior 50% piece would be a decent enough credit. The 30% guaranteed piece is as good as the Treasury. This gives the investor 5x leverage, so they don't have to do the best deal in the world to make money.

One might ask what is in it for the banks. This is the big, big question -- since this would involve selling something for less then its apparent economic value. The idea is simply this -- getting rid of "financial reporting risk" is worth enough to motivate the sellers. That is, it doesn't matter what they think it might be worth. The fact that they could be forced to take additional haircuts ever single quarter until things bottom may be enough to motivate them to do deals.

Even more so, any asset that has an economic value higher then its book value would be chomping at the bit to do a deal. In this environment, any asset that would fetch MORE then book value would lead to a write up!

People that think that there are no assets that meet this qualification need to consider the arbitrary nature of a lot of valuation and accounting processes. Lets just assume that overall, the assets are 10% Overvalued today in the aggregate. Given the variance in the valuation process, 20% of the assets could still be under valued. Just assume a distribution with the mean at 90% and a standard deviation of 10%. 1/6 will be over 100%.

Any one want a real world example? Here is one from the Hartford:

Book value is $11.1 billion and market value is $6.8 billion -- or about 60%. Their CMBS's have been written down 40%. It is a little complex, since they use book value for Insurance Capital Ratios and market value for GAAP Capital. Nevertheless, they don't have to sell them, they don't have to fund them, they are planning to hold to maturity, but they need positive GAAP capital to continue to exist in the real world. These things are still paying. They started out with 20% or so initial subordination. If they sold $5 billion at today's market value, that would represent par value loans of $10 billion. The investor would put up $1 billion. The Treasury would insure the next $1.5 billion, and the final $2.5 billion could be financed. If the CMBS's pay out $6 billion, thats 100% profit.

For various reasons, this isn't a doable deal -- but remember that the banks *thought* they were keeping the best stuff and selling off the worst stuff.

The unfortunate reality is that the sellers will be getting cherry picked and will sell their most undervalued assets based on current accounting values. However, given the cost of additional capital -- which is essentially infinity since it isn't available at any price -- it is still an offer that couldn't be refused.

This is just a general approach that makes some sense. It is based on the assumption that there are a decent chunk of assets that need to be booked at a liquidation value that is lower then their economic value. After all, thats what a true toxic or troubled asset amounts to. A busted loan is just a loss and easy to account for.

I don't know if the real banking system has enough bona fide troubled assets to need a buyout program. A portfolio of option arm whole loans is just a bad portfolio -- and there is no gap between accounting values which are liberal and economic values.

The real point of this is that if the Treasury wants private involvement and wants 10 to 1 leverage, they have to take the worst parts of the deals. And plan to lose the $50. The big brains that created the structured crap that is at the heart of this are more then capable of coming up with innovative ways to leverage the Treasury's $50 billion. But it would have to be spent/lost/blown. No free lunch on this one.

Concentration

2009-02-10T21:28:00.000-08:00

Courtesy of the FDIC. This is based on June data and the various merged entities (e.g. Wells + Wachovia) are combined. Here are the numbers:

A couple of trillion out of $7 trillion of deposits. You could do the same thing for assets, etc. and get roughly the same thing. Except Citi relies less of deposits as a source of funding.

Prior to the latest round of mergers, the top 3 would be more like 20% then 30%.

More TARP

2009-02-08T20:15:00.000-08:00

After digging into the report and the appendices, a few things stand out:

1. The biggest complaint is that the pricing was weak on the preferred shares. That was part of the idea, like a shot of adrenaline to the heart. Mainline some capital. It reminds me a little of the overdose scene from Pulp Fiction where Uma Thurmon gets a hypo straight to the heart.

2. They didn't mention that the Treasury gets their return TAX FREE.

3. The terms and conditions were based on the Berkshire/Goldman deal! See footnote 29:

It is customary in corporate legal practice to prepare transaction documents bystarting with documents from another transaction and “marking them up”, and the Berkshire Hathaway papers appear to have been the starting point for Treasury.

All I can say is that it is nice work if you can get it -- just pull another deal off the shelf and fill in the blanks. So what would be called plagiarism in academia is simply "marking them up" in corporate law. Cool.

4. In some ways, excluding pricing, the CPP program had more stringent terms and conditions then Buffett's deal.

The terms of the CPP agreements in most other areas [excluding price] are as good as, and in some cases better than, those in the Berkshire Hathaway agreements, although these other areas are typically less important to investors. Such other provisions include voting rights of the preferred stock, covenants restricting common stock dividends and stock repurchases, exercise period of and anti- dilution adjustments for the warrants, transfer restrictions, representations and warranties by the issuer, conditions to closing, and amendment provisions.

However, the CPP [Capital Purchase Program] missed the single most important Berkshire covenant. Namely the requirement that the top 4 executives hold and continue to hold at least 75% of their personal net worth in GS shares.

On September 28, 2008, each of Lloyd C. Blankfein, Gary D. Cohn, Jon Winkelried and David A. Viniar (each an “Executive”) executed a letter agreement with The Goldman Sachs Group, Inc. (the “Company”) in which the Executive agreed that, with certain exceptions, until the earlier of October 1, 2011 and the date of redemption of all of the Company’s 10% Cumulative Perpetual Preferred Stock, Series G, par value $0.01 per share and having a liquidation value of $100,000 per share (the “Series G Preferred Stock”), (i) the Executive will continue to satisfy the Special Transfer Restrictions (at the 75% level) which are set forth in the Amended and Restated Shareholders’ Agreement and described in the Company’s 2008 proxy statement; and (ii) the Executive, his spouse and any estate planning vehicles will not dispose of more than 10% of the aggregate number of shares of the Company’s voting common stock, par value $0.01 per share (the “Common Stock”), they beneficially owned on September 28, 2008.

In other words, they have to eat their own cooking. This is much better then trying to micro manage executive compensation. Plus, it was a deal they couldn't refuse. How could they possibly object to a deal like this in the middle of a pitch regarding how great the company is, etc. You could argue that they will still be wealthy by conventional standards, regardless of what transpires. However, being investment bankers and all, the fact they are chained to the company has to add to their sense of commitment.

The Treasury is a "free rider" on this part of the deal. They get virtually the same benefit as Buffett without doing anything. However, this would have been great to negotiate on a company by company basis -- had that been the process.

5. The preferred stock of banks, especially BAC and C, has seriously tanked since the CPP was done. However, if the banks survive, it gets redeemed and all is well. If not, there are bigger problems.

More on Congressional Oversight of TARP

2009-02-08T15:47:00.000-08:00

Elizabeth Warren has a blog! Or more specifically, the Congressional Oversight Panel has a blog. They are not happy with Paulson and who is. People are split between the guy being evil and incompetent but I think he had a deer in the headlights look that indicated that he was just over his head. Maybe I'm being too charitable, but I'm not sure it matters.

Their main beef is that Paulson didn't extract enough from the banks in TARP I, and they got a bad deal. They were pretty up front about the injection of capital via preferred shares as being a subsidy. They also used some of the money to bail out AIG and Citi. Not in the original bill and not the best deal. However, the idea that they should have extracted more is simply an opinion -- and not one that everyone shares. If the banks survive and the preferred shares get redeemed, then they will be profitable. One goal was to encourage private capital to follow the government investments. If the terms had been punitive, there would have been no chance of this happening.

Here is their current report. I don't have too much to say, although it is an "open" process, and they show their work product in some detail.

The valuation report concludes that Treasury paid substantially more for the assets it purchased under the TARP than their then-current market value. The use of a one-size-fits-all investment policy, rather than the use of risk-based pricing more commonly used in market transactions, underlies the magnitude of the discount. A number of reasons for this result have been suggested. The Panel has not determined whether these reasons are valid or whether they justify the large subsidy that was created. In addition, the Panel has not made judgments about whether the decision-making underlying these investments was sound. The rationale for the Treasury’s approach and the impact of this disparity will be subjects for the Panel’s continued study and consideration. It is important, however, for the public to understand that in many cases Treasury received far less value in stocks and warrants than the money it injected into financial institutions.

So they are saying that the Treasury overpaid, but they aren't making any judgments just yet. It doesn't take a genius to realize that if private investors are asking 10% and the Treasury is asking 5% for perpetual preferred stock [with a feature that increases the Treasury yield to 9% after 5 years, to encourage repayment]. It looks like a 20% to 40% haircut without spending more then 2 minutes pondering the facts.

The idea of subjecting this to private market benchmarks misses a central point. The idea wasn't to subsidize the banks to help the banks, but rather to help borrowers, potential borrowers, and holders of bank debt, which include pension funds. More important, to the extent that it works, the government gets a cut of every cent of profit. They collect about 1/3 of corporate profits and 15% on dividends. They end up with 18% or so of GNP. If the GNP of $13 trillion is increased by 3% for 2 years, that is $260 billion in tax revenue. Plus, they get the money back. Plus a net spread of 2% or so. A lot of assumptions here, but the counterfactual isn't that difficult to imagine. In the absence of any action, it is hard to believe that things wouldn't be a lot worse.

Continued...

Citi's TARP Report

2009-02-05T23:48:00.000-08:00

Here is 43 pages of worthless, self promoting Citi chat about how they are being good corporate citizens with the TARP funds.

The United States Government has made a significant investment in major financial institutions, including Citi, under the Troubled Asset Relief Program (TARP). Citi understands that TARP is about helping the American people, and supporting U.S. businesses and our communities. Our responsibility is to put these funds to work quickly, prudently, and transparently to increase available lending and liquidity.

This report is the first that we will publish about the activities we are undertaking in connection with the TARP program. It also explains the many other steps Citi is taking to assist American families and individuals who face financial hardship or are at risk of losing their homes.

The trouble with all this is that, among other things, TARP equity investments were not supposed to be simply lent out. Rather they were supposed to strengthen capital ratios to allow banks to increase their loans by a multiple of the capital injection. $1 in capital supports several dollars in deposits and loans.

An even bigger problem is that it is impossible to know which dollars got spent for what. It is being made up out of whole cloth. I would be harsher, but someone made them do it.

As I discussed in an earlier post, Elizabeth Warren, of the Congressional Oversight Committee insisted on accountability. This is what she got.

Just For The Record ....

2009-02-05T22:28:00.000-08:00

Although I agree that the banks needed to get bailed out, or whatever you want to call it, I don't like a lot of things that were done.

1. What's with the concentration? Per the FDIC, there are $13 Trillion of bank assets and the big 4 have $7 trillion! The idea of allowing/encouraging mergers of weaker banks with "stronger" banks is not totally dissimilar to the idea that we were going to pay for the Iraq war with their own oil money. An unrealistic way to do something on the cheap, with awful results. Sometimes it works, but in the S&L crisis, the problem institutions were shorn of their problem assets and then sold off to healthy banks. Now we have to go back and do it after the fact -- the bad bank thing -- partially because no one wanted to pay up initially.

2. What was the idea of combining BAC and MER? As long as a bank does vanilla banking, then scale doesn't change the fundamental nature of the business. Once you start combining traditional banking with a trading and investment banking becomes much more complex. BAC was over the 10% market share rule last year, when it was waived to let them buy (overpay) for LaSalle. Then they were allowed/encouraged to take of Countrywide. Then Merrill. If someone had just told Ken Lewis that he was already big enough -- we would have a pretty healthy mega bank. Instead we have a huge mess.

3. As far as terms and conditions, Buffett insisted that Goldman's senior guys have at least 75% of their net worth in their bank's common stock and not sell as long as he held his preferred stock investment. As long as the senior management is "all in" -- there is some alignment of management and shareholders. Much better then trying to micro manage executive excesses. The treasury should have put an anchor on senior management so if the ship goes down, they are on the bottom along with their share holders.

Over Paid by $78 Billion?????

2009-02-05T20:52:00.000-08:00

The latest from the Congressional Committee that is overseeing TARP:

Elizabeth Warren, a Harvard law professor, said her group estimated the Treasury paid $254 billion in 2008 in return for stocks and warrants worth about $176 billion under the Troubled Asset Relief Program, or TARP.

Where did this figure come from? It is obvious that the Treasury didn't drive a hard bargain. That was the point at the time. The tougher the terms, the more difficult banks would have raising additional capital or repaying the TARP funds. If the Treasury was going to pay the market price, then there was no advantage to doing it in the first place. The entire idea was to lend money on terms that gave the Treasury a nice spread on the investment and relieved the capital strain on banks.
Currently, preferred shares for Bank of America are yielding in the mid teens. Certainly higher then the government deal. However, if the government continues to bail out BAC, then they get their money back. God knows TARP hasn't been much of a success so far, although it is impossible to know what would have happened if the government had just sat around and watched. However, it is grandstanding to claim that a bailout/subsidy to the banking system was a "bad deal." Its not a bug, its a feature.

More on Banks

2009-02-03T23:12:00.000-08:00

[click here for the original spreadsheet with links to the filings]

Back to the big 4 and the so called bad bank.

1. The big four are indeed big. They have $7.5 trillion in assets and $3.3 trillion in loans. Against these loans, they have $87 billion in provisions for bad loans.

2. Loans are never marked to market. Never. Never have, never will.

3. The $7.5 trillion is over a third or more of our total bank assets, on a dollar basis.

4. They have $341 billion in capital.

5. With the current net interest rate spreads, they are making $50 billion/quarter excluding losses.

There is a good case for putting the various structured mortgage backed securities into a bad bank or some sort of holding entity to simply amortize. They can't be sold AND not result in the paradox of deleveraging. That is, the more these assets are liquidated, the worse the ratios of any entity selling.

These isn't much of a case for doing anything with loans.

The 4 banks in question are already bailed out. They have been deemed too big to fail, so thats it. They also have FDIC insurance to allow them to gather as many brokered deposits as they need.

Toxic Assets -- Where's Waldo?

2009-02-01T23:59:00.000-08:00

The New York Times has an article discussing just how difficult it can be to value a CDO, which is representative of what the "bad bank" proposal is up against.

The financial institution that owns the bond calculates the value at 97 cents on the dollar, or a mere 3 percent loss. But S.& P. estimates it is worth 87 cents, based on the current loan-default rate, and could be worth 53 cents under a bleaker situation that contemplates a doubling of defaults. But even that might be optimistic, because the bond traded recently for just 38 cents on the dollar, reflecting the even gloomier outlook of investors.

The bond is backed by 9,000 second mortgages used by borrowers who put down little or no money to buy homes. Nearly a quarter of the loans are delinquent, and losses on defaulted mortgages are averaging 40 percent. The security once had a top rating, triple-A.

The article does a good job picking an asset that is truly difficult to value. Note that no one is saying that normal, whole loans are toxic. They are either good, bad, or somewhere in between -- but everyone understands what they are. The banks segregate non performing loans, and show the provision for loan losses. Everyone thinks these are optimistic, but there is an element of transparency, since it is possible to fairly easily superimpose an alternative judgment. Loan losses lag economic declines, and the reserves will not be adequate until the economy bottoms.

I took a look at the big banks. We now have 4 -- C, BAC, JPM, and WFC. Wells is now Wells plus Wachovia. BAC will include Merrill Lynch and Countrywide. JPM has hoovered up Bear Stearns and Washington Mutual. Total assets for these banks is over $7 trillion dollars.

I pulled figures from the September 10-Q's. I can't find over $100 billion in toxic assets. However, they don't make it easy -- and skimming hundreds of pages of dense SEC filings on a laptop screen isn't a great way to really dig in and do a rigorous analysis. However, this was the general thought process:

1. C is a basket case and already has guarantees for something like $60 billions in assets. They are also splitting themselves up into a good bank/bad bank. They are effectively nationalized and.

2. BAC also has the guarantees for about the same, based on MER's 4Q blowup. In addition, MER already wrote down most of their CDO's in 3Q.

3. JPM says they don't need any money. Most of the Bear assets have a government guarantee.

4. WFC also says they don't need any more money or help. They are showing maybe $20 billion in CDO's. Both Wells and WB were functioning more like traditional banks, so they don't have all the capital markets residue of the others.

Here is a spreadsheet with some summary data. It isn't totally consistent, but is roughly correct.

Major observations -- with $7 trillion in assets, this is a big chunk of the entire banking system. However, there is only $350 billion in tangible equity backing these assets (mostly excluding preferred stock). Now some of the assets are cash or government guaranteed securities, and capital ratios exclude that. Still, there is a lot of goodwill, and not a lot of capital for the assets given the overall uncertainty.

If you exclude C's off balance sheet stuff, there simply isn't the quantity of toxic assets that people are talking about. Bad assets aren't toxic assets. The defining quality of toxic assets is uncertainty.

Excluding C and JPM, I only found $70 billion. Some of the $70 aren't toxic, and I am sure that I missed a lot. If whole loans are excluded, I don't see how anyone could get over $150 billion if you exclude the $120 already hived off in C and BAC. It simply isn't visible to me.

Someone needs to lay out exactly where these assets are on the balance sheets of these four companies. Or come up with a different story. They simply aren't there.

Claim of Originality....

2009-01-30T15:35:00.000-08:00

You read it here first. Financial Reporting Arbitrage.

First, the term, arbitrage. Per wikipedia:

In economics and finance, arbitrage is the practice of taking advantage of a price differential between two or more markets.

People have already used the term regulatory arbitrage or jurisdictional arbitrage, and I won't go into detail on those usages, except to say that they are a generalization of the more basic, literal meaning of arbitrage.

What I am talking about is based on some well known and frequently discussed phenomena. Namely that the accounting value for a transaction can and frequently differs from its economic value. This has been clearly articulated by Warren Buffett as follows:

Accounting consequences do not influence our operating or capital-allocation decisions. When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles
than to purchase $1 of earnings that is reportable. This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable).

This is only one example of accounting conventions deviating from economics. US GAAP has been around a long time, and is fairly robust. It has been able to deal with a general external economic environments that have placed extreme pressure on businesses. It has evolved to work in the real business world, and tends to be more practical then theoretical. And, like most social constructs that evolve from practice, contains certain inconsistencies and contradictions that are unavoidable.

If we go back to Warren Buffett's observation, and accept the fact that it crops up in more situations then simply accounting for acquisitions, or the amortization of goodwill, then consider a manager with the opposite philosophy. The person on the other side of that trade -- who is more motivated to seek accounting earnings then economic earnings.

In a sense, this is hardly news. Managers have tried to game accounting since the Italians developed double entry bookkeeping. However, consider the following -- in order to realize or monetize economic profits, they frequently need to be mediated by an accounting framework. The proposed definition:

In economics and finance, financial reporting arbitrage is the practice of taking advantage of a financial reporting differential of the same or similar economic transactions between two or more valuation frameworks.

A simple and perhaps trivial example of a reporting differential is the differing accounting treatment of corporate debt. Consider a 5%, 10 year fixed rate investment grade corporate debt that could be financed either by a bond issue or by a bank loan. The cash flows on this hypothetical debt are identical. At issue, the financial reporting is identical -- there is no immediate arbitrage opportunity. However, if interest rates rise, the financial reporting value of the bond will decline (assume that it is a listed, traded bond) for the bond owner, remain the same for a loan, and the liability of the firm issuing the debt will remain fixed. A current example of this occurring can be seen with REITs buying their bonds at 10 to 20% discounts from par in order to improve their balance sheets.

At this point, one might wonder what is so unusual about a firm changing their capital structure -- especially since a firm never makes a change without labeling it a benefit. Yet we know that stock buybacks have proven a disaster for financial firms over the last few years. In the above case, the optics of the REIT's balance sheet has improved, but its cash position has worsened and it has less financial flexibility. All they have done is recognize the economics of their bonds, which must be carried at par on their balance sheet.

A more interesting example of financial reporting arbitrage occurred when banks insured CDO's with bond insurers. Banks were forced to mark structured finance products to "market" and the insurers were able to account for them based on modeled loss estimates. As long as the insurers maintained a AAA rating, the banks could report the assets at par and the insurers could report them using their modeled loss estimates. The fact that this didn't work over an extended period of time and included a whole host of problems other then the embedded financial reporting arbitrage makes this example more complex. However, the financial reporting arbitrage was the motivating factor in a lot of the bizarre activity seen a year ago.

Instead of simply developing a new term for age old tendencies, this term points to activity that is at the heart of what went wrong. Arbitrage is a capital market term. Risk free arbitrage can't exist in an efficient market, and any inefficiencies quickly disappear under normal circumstances. However, the aggressive capital markets thinking that began to dominate finance led to innovation that overwhelmed traditional accounting and regulatory practices. Where they couldn't simply be bowled over, they went around traditional institutions, by simply disintermediating those institutions. For example, instead of banks originating mortgage, which they would then hold on their books, independent brokers originated mortgages which were then securitized -- bypassing traditional, regulated lending institutions.

Most of the financial businesses have to deal with inherent mismatches in the duration of assets and liabilities. A typical financial structure is to fund long term assets with short term liabilities. With a positive yield curve and leverage, it is highly profitable. The S&L crisis stemmed from a mismatch in low yielding, long duration assets (5% residential mortgages) and high cost, short term funding (demand deposits with increasing costs). A good deal of enterprise risk management was developed in response to this problem, which focused on nominal interest rate changes driven by inflation. To some extent, huge resources went into a financial Maginot line to protect against this specific risk.

Risk management was inverted and used to determine maximum risk that could be accommodated at a particular price. It was like that was a competition to see who could create the absolute worst AAA credit.

Accounting can't explicitly quantify risk within the confines of a balance sheet or income statement. This is hardly a surprise and people have been dealing with this for a long time and had become fairly adept at it. However, capital markets innovation gave people the tools to deconstruct, rearrange, and re aggregate risk in new ways. Markets became very efficient, not at allocating capital, but at arbitraging the various limitations in financial reporting. A quantum leap from old fashioned fraud, or more recent creative accounting.

And there you have it -- financial reporting arbitrage.

Modest Proposal

2009-01-27T23:30:00.000-08:00

With all the bashing regarding private jets, bonuses, etc. in banking, I have a great idea.

Pay all wages over $30,000/year in toxic assets. Both BAC and C have already designated toxic assets that are backstopped by the Treasury. Simply let the TARP auditors select from those assets, AT CURRENT BOOK VALUE, put them in a pool, and let the employees figure out how to liquidate them to get as much salary as possible out of them.

Since Andrew Cuomo is making noise about clawing back the MER bonuses, just do a deal and give them $4 billion in CDO's.

This would spur some real innovation. The could take their pick and either try to create more elaborate structured securities to sell to someone, or deconstruct them into whole loans and try to sell them, refinance them, do workouts, foreclose and rent. Whatever.

Do something. Or anything to align the interests of the public and the employees.

I would bet they would find a way to extract more then book value out of them.

New FDIC Regulations

2009-01-27T09:00:00.000-08:00

The FDIC is issuing a new regulation that would limit the interest rates PAID by poorly capitalized banks on brokered deposits. It is less then meets the eye -- but it is a start to prevent the absolute worst "zombie" behavior last seen in the S&L crisis. That is, institutions doing a last gasp of lending, trying to lend their way out of insolvency. It was a little different at the time, because S&L's had negative interest rate spreads on their older assets, so if they could only lend enough at positive spreads, it would work. That is, their average interest rate margins would turn positive.

The main points are:

1. The term, zombie banks, that was used by Krugman last week is appropriate for situations where failed institutions that are kept alive by non market forces (S&L - via brokered deposits, Airlines via bankruptcy for example) lead a rush to the bottom and blow up the entire industry.

2. Right now, banks have strongly positive net interest rate margins. Their immediate problem are weak or bad assets and it isn't easy to see how this could be improved by a lot more imprudent lending.

3. The idea of going from no regulation to some regulation seems like a big deal, even if it doesn't make a difference right now.

One other thing that has come up recently is the idea that regulatory forbearance has proven to cost money in prior bailouts. The difference between today's problems and the S&L situation is highlighted by the fact that lack of credit and lending is now considered the major problem. Not continued irresponsible lending.

Why not Nationalize?

2009-01-26T00:54:00.000-08:00

The New York Times discusses nationalization. There is one good reason NOT to do it overtly -- namely the fact that you now "own" the problems in an entirely different way.

Moreover, Mr. Obama’s advisers say they are acutely aware that if the government is perceived as running the banks, the administration would come under enormous political pressure to halt foreclosures or lend money to ailing projects in cities or states with powerful constituencies, which could imperil the effort to steer the banks away from the cliff.

“The nightmare scenarios are endless,” one of the administration’s senior officials said.

Indeed. One advantage of simply bailing out the banks is that they are still available as whipping boys. Once you own them, you own all of their problems. And they need to be merged, downsized, etc. Once you own them and are committed to "creating jobs" -- how do you explain firing thousands of bank workers.

The same dynamic is in play with the auto companies. The absolute last thing the government wants is a jobs program that involves something like building and selling cars. The Japanese can no longer do it profitably (for now). Any direct government jobs programs need to be more like the WPA programs. If the newspapers keep collapsing, a writer's project could be appropriate. Pay bloggers. For example.

Felix Salmon Defends Credit Default Swaps

2009-01-23T19:23:00.000-08:00

After giving Michael Lewis a well deserved thrashing regarding the market for credit default swaps, Felix Salmon then provides a justification for this market:

And yes, there is "a really useful reason for a credit default swap" -- it's pretty much the same as the really useful reason for the existence of equity markets. In the stock market, there are lots of sellers, and lots of buyers, and the public visibility of the market-clearing price creates a lot of value. The bond market, by contrast, has always been much more illiquid: bond investors tend to be buy-and-hold types (remember those pension funds and insurance companies) who buy up bonds at issue and then hold them to maturity. As a result, it can be very hard to short any given bond, or to get a useful bead on exactly what the market-clearing price on any given company's debt might be. Unless you have a liquid CDS market, which is very useful indeed when it comes to price discovery.

The primary purpose of the equity markets is price discovery? I always thought the primary purpose was to raise capital. Or perhaps not only to raise new capital, but to reallocate capital through repurchases and acquisitions.

Even though it is a rather backwards justification of the social benefits of the equity markets, it seems irrefutable that the primary purpose of the bond markets is to assist corporations and governments to finance their activities. The fact that bonds get a credit rating -- which might be useful for something other then buying and selling the bonds per se -- is simply fortuitous, if in fact it is a benefit at all.

The primary purpose of the bond markets is NOT price discovery!

Another example of a benefit is this:

there were the long-term investors -- pension funds [for example] who would sell five-year credit protection with every intention of simply insuring that credit for the full five years, and pocketing the insurance premiums. Those players can't be considered to be speculators...

They certainly weren't supposed to be speculators! However, lets examine a hypothetical transaction. A pension fund decided that they couldn't just buy bonds and stocks -- they decided they HAD to emulate Yale and were sold a portable alpha strategy. Your typical pension fund administrator should not be allowed within 500 feet of an investment banker, based on the same logic that applies to keeping children out of casinos. Part of the a portable alpha strategy is a replicating portfolio. The idea is to use derivatives of various types to replicate a benchmark using part of the cash and then use the remainder to buy some pure alpha from a hedge fund. One type of derivative used are credit derivatives.

In theory, a treasury plus a CDS is equivalent to the underlying bond. So you don't need to buy the real bond, you can buy as much exposure to the bond as you would like by buying a CDS. The premium from the bond and the interest from the treasury would give you as much or more then the underlying bond -- even after fees and expenses. Plus it isn't always easy to buy the exact bonds you might prefer in the real world. You might not be able to find a sufficient quantity of the preferred real bond.

It just so happens that some of the higher yielding bonds with investment grade credit ratings were financial entities like Lehman. Which is why there were a lot of Lehman CDS's floating around. A real bond pro would have understood that any outlier is more likely miss rated then miss priced. Or at least could tell the difference. But our naive pension fund buyers were loading up on the highest yield at any specific rating.

However, more to the point, the purpose of the bond markets is to provide financing to real world entities -- businesses and governments, not to grease the wheels of structured finance. And the idea that ALL the pension funds and endowments were going to do better then average by routing every dollar in cash through investment banks and their structured finance units is beyond naive. After all, even though a lot of financial theory assumes a frictionless world of highly efficient markets, someone has to pay for all the trappings of investment banking.

We haven't begun to see the damage these instruments have caused in pension funds and endowments, but we will soon enough.

As far as the liquidity argument is concerned, exactly how much liquidity has the CDS market provided during the credit freeze? If this were such a liquidity enhancer, then what the hell happened?

One thing that we do know is that people could attempt to short bonds via CDS's in quantities that exceeded the par value of the underlying issues by massive amounts. As great as shorting is, perhaps the limitation of shorting no more then the entire amount of the underlying issue should be maintained.

Perhaps some of the more adventurous pension funds might have tried to actively manage their the credit quality of their bond portfolio by selling these overpriced bonds rather than goofing around with portable alpha.

The flaw with the entire notion that derivatives provide much needed liquidity has been totally discredited by the failure of these markets. Only the most ideologically predisposed theorists could argue with a straight face that, if only we had larger credit derivative markets, the credit markets would have continued to function smoothly.

In fact, we just experienced unprecedented MARKET FAILURE.

The thought that people insist on looking for some higher truth -- like price discovery -- in an environment where markets have massively failed is mind boggling.

They are running out of places to put it .....

2009-01-22T20:47:00.000-08:00

From the Oil and Gas Journal:

MARKET WATCH: Signs of supply cuts raise crude prices
Sam Fletcher
Senior Writer

HOUSTON, Jan. 22 -- The new front-month March contract for crude rallied above $43/bbl Jan. 21 on the New York market among hopeful signs that members of the Organization of Petroleum Exporting Countries are adhering to their pledge to reduce production by 4.2 million b/d from September output.

OPEC sources said Saudi Arabia plans to cut its production an additional 300,000 b/d below its current quota before the group's Mar. 15 meeting. "This shows that the Saudis believe it is imperative to match a lower demand with a lower supply," said analysts at Pritchard Capital Partners LLC, New Orleans.

I'm not sure that oil is going to continue to sink, but over the last year, markets have moved much more quickly then a real physical commodity can adjust.

Overend, Gurney and Company

2009-01-20T22:27:00.000-08:00

From Wikipedia:

After Samuel Gurney's retirement, the bank expanded its investment portfolio, and took on substantial investments in railways and other long term investments rather than holding short term cash reserves as was necessary for their role. It found itself with liabilities of around £4 million, and liquid assets of only £1 million. In an effort to recover its liquidity, the business was incorporated as a limited company in July 1865 and sold its £15 shares at a £9 premium, taking advantage of the buoyant market during the years of 1864-66. However, this period was followed by a rapid collapse in stock and bond prices, accompanied by a tightening of commercial credit. Railway stocks were particularly badly affected.[4]
Overend Gurney's monetary difficulties increased, and it requested assistance from the Bank of England, but this was refused. The bank suspended payments on 10 May 1866. Panic spread across London, Liverpool, Manchester, Norwich, Derby and Bristol the following day, with large crowds around Overend Gurney's head offices at 65 Lombard Street.[5] The failure of Overend Gurney was the most significant casualty of the credit crisis.[6] The bank went into liquidation in June 1866.[7] The financial crisis following the collapse saw the bank rate rise to 10 per cent for three months. More than 200 companies, including other banks, failed as a result.
The directors of the company were tried at the Old Bailey for fraud based on false statements in the prospectus for the 1865 offering of shares. However, the Lord Chief Justice Sir Alexander Cockburn said that they were guilty only of "grave error" rather than criminal behaviour, and the jury acquitted them. The advisor was found to be guilty. Although some of the Gurneys lost their fortunes in the bank's collapse, the Norwich cousins succeeded in insulating themselves from the bank's problems, and the Gurney bank escaped significant damage to its business and reputation.[7]

And Walter Bagot's comments:

The peculiarity in the case of Overend, Gurney and Co.—at least, one peculiarity—is that the evil was soon discovered. The richest partners had least concern in the management; and when they found that incredible losses were ruining them, they stopped the concern and turned it into a company. But they had done nothing; if at least they had only prevented farther losses, the firm might have been in existence and in the highest credit now. It was the publicity of their losses which ruined them. But if they had continued to be a private partnership they need not have disclosed those losses: they might have written them off quietly out of the immense profits they could have accumulated.

And further:

No one in the rural districts (as I know by experience) would ever believe a word against them, say what you might. The catastrophe came because at the change the partners in the old private firm—the Gurney family especially—had guaranteed the new company against the previous losses: those losses turned out to be much greater than was expected. To pay what was necessary the 'Gurneys' had to sell their estates, and their visible ruin destroyed the credit of the concern.

Events/Lessons learned:

1. Founder retired, and company took on more risk.

2. Lost money and in order to raise capital, became a public company.

3. Family provided guarantees on the debt.

4. It did well at first as a public company.

5. It then was under pressure and ask for help from the Bank of England.

6. Help was refused.

7. It collapsed.

8. One contributing factor is that the guaranteer family was publicly bankrupt.

9. 200 additional companies also failed as a result of this.

Citi needs to Disappear

2009-01-20T21:19:00.000-08:00

I'll start and end with the "money quote" and let the readers get this little history first hand.

"I assumed,'' Reed [Citibank chairman in 1992] said, ""when we're paying guys $1 million a year you assume they know what the fuck [they're] doing.''

Some things never change.

Worse then the 30's and 80's?

2009-01-20T20:23:00.000-08:00

The current headlines that our banking system is or will be insolvent and needs to be nationalized is gaining some currency. Today, Roubini made that assertion and Sunday, Paul Krugman referred to the money center banks as insolvent.

Per Wikipedia:

In finance, solvency is the ability of an entity to pay its debts with available cash.

A traditional bank in a fractional reserve banking system funds loans of varying terms with demand deposits. Demand deposits are money in checking and savings accounts, and are effectively debt. They typically hold a small fraction of their total assets (loans) as capital. Since typically loans are for longer terms then the deposits, and since banks have limited capital, they can never pay ALL their debts at once with available cash.

So in this almost trivial and totally obvious sense, banks are never solvent. The entire banking system is designed to manage this inherent mismatch between assets and liabilities. It can get out of whack in several ways. In the 1930's, general price deflation from 1929 to 1933 was between 30% and 40%. The assets or loans of a bank were "upside down." The collateral couldn't be sold for anything close to the stated value of the loans, for simple liquidity reasons, if nothing else. About half the banks failed and half didn't. Yet technically, they were all insolvent in more then the trivial sense that they couldn't pay their depositors in cash immediately.

In the 1980's things were also dire for banking for the exact opposite reason. General price inflation rather then deflation. According to William Issac, former head of the FDIC:

The underlying economic problems of the 1980s were more serious than the economic problems confronting us this time around – at least until very recently. The prime rate exceeded 21%, and the economy plunged into a deep recession in 1981-82, with the agricultural sector in a depression. These economic problems led to massive problems in the banking and thrift industries. The savings bank industry was more than $100 billion insolvent if we had valued it on a market basis, and the S&L industry was in similar condition. A bubble burst in the energy sector, and a rolling real estate recession hit one region after another. Continental Illinois (the eighth largest bank) failed, many of the large regional banks went down (including nine of the ten largest banks in Texas), and hundreds of farm banks failed, as did an even larger number of thrifts. Three thousand banks and thrifts failed from 1980 through 1991, and many others went out of business through mergers.

And there is more. Things could have been even worse:

It could have been much worse. The money center banks were loaded up with third world debt that was valued in the markets at cents on the dollar. If we had marked those loans to market prices, virtually every one of our money center banks would have been insolvent. Indeed, we developed a contingency plan to nationalize them.

However, inflation was tamed, the banks were able to fund their loans at a profit due to falling interest rates, and we all know the history.

The current situation is the exact reverse of the situation in the 1980's -- but a basic principle is that banks are designed to be "unbalanced." One aspect of this is that they go from insolvency in the trivial sense to insolvency in a more tangible sense. If they are sound enough to survive in less extreme circumstances -- then they need to "get to the other side" and it is in the interest of regulators and politicians to apply some judgment regarding how that is achieved.

Krugman Imitates Andrew Mellon

2009-01-19T09:50:00.000-08:00

In today's column, titled Wall Street Voodoo, Paul Krugman adopts at least part of Andrew Mellon's mantra, "Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate," he said. "People will work harder, live more moral lives."

Krugman wants to liquidate the large banks. He starts by creating an example of a hypothetical money center bank:

To explain the issue, let me describe the position of a hypothetical bank that I’ll call Gothamgroup, or Gotham for short.

On paper, Gotham has $2 trillion in assets and $1.9 trillion in liabilities, so that it has a net worth of $100 billion. But a substantial fraction of its assets — say, $400 billion worth — are mortgage-backed securities and other toxic waste. If the bank tried to sell these assets, it would get no more than $200 billion.

So far so good. Not much different then my hypothetical bank balance sheet in a prior postwhere I tried to explain why it is meaningless to say that a bank is "technically insolvent" based on hypothetical mark to market accounting.

It is a little over simplified, since Gotham's toxic assets probably had a par value of $600 billion, had already been written down by $200 billion, and very likely couldn't be sold for $200 billion, since no one that would be likely to buy them wants to own more of them. Krugman's critical assumption is that the current "market value" with poorly functioning credit markets and zero interest in complex asset backed securities is the best estimate of their economic value. Krugman continues:

So Gotham is a zombie bank: it’s still operating, but the reality is that it has already gone bust. Its stock isn’t totally worthless — it still has a market capitalization of $20 billion — but that value is entirely based on the hope that shareholders will be rescued by a government bailout.

I would contend that Gotham isn't a typical zombie bank or institution. Anyone that remembers the true Zombie S&L's knows that they tend to double and triple down on their bets because they have nothing to lose. However, right now people are accusing the so called Zombie -- Gotham -- of refusing to loan out any of the TARP funds. Not the behavior of your typical zombie.

Why would the government bail Gotham out? Because it plays a central role in the financial system. When Lehman was allowed to fail, financial markets froze, and for a few weeks the world economy teetered on the edge of collapse. Since we don’t want a repeat performance, Gotham has to be kept functioning. But how can that be done?

Well, the government could simply give Gotham a couple of hundred billion dollars, enough to make it solvent again. But this would, of course, be a huge gift to Gotham’s current shareholders — and it would also encourage excessive risk-taking in the future.

Here Krugman agrees that we can't just let the financial system blow up. He is saying that Lehman was a mistake but maybe not with Gotham, which is much larger.

A better approach would be to do what the government did with zombie savings and loans at the end of the 1980s: it seized the defunct banks, cleaning out the shareholders. Then it transferred their bad assets to a special institution, the Resolution Trust Corporation; paid off enough of the banks’ debts to make them solvent; and sold the fixed-up banks to new owners.

Not quite so fast -- this misses some critical details regarding what actually happened. First, the government already owned the failed banks, since they insured deposits through the FDIC and FSLIC. They then easily sold the performing loans and took the non performing loans -- see through office buildings were popular at the time -- put them in the RTC, and liquidated them. In the process they liquidated Texas. William Seidman sold it all, as quickly as possible, and drove the prices through the floor. A lot of people still remember and don't have particularly fond memories of this period. But this was only Texas, which at the time wasn't considered too big to fail. Perhaps most importantly, the liquidated assets were empty buildings and becoming less valuable by the day. This is fundamentally different then an asset backed security which is just a piece of paper. Unless you make the argument that the asset backed security, per se, is significantly impacting the value of the underlying assets, there is no inherent benefit of liquidating the paper as opposed to holding the paper. At this point Krugman backtracks and concedes the possible weaknesses in his arguments:

In my example, Gothamgroup is insolvent because the alleged $400 billion of toxic waste on its books is actually worth only $200 billion. The only way a government purchase of that toxic waste can make Gotham solvent again is if the government pays much more than private buyers are willing to offer.

Now, maybe private buyers aren’t willing to pay what toxic waste is really worth: “We don’t have really any rational pricing right now for some of these asset categories,” Ms. Bair says. But should the government be in the business of declaring that it knows better than the market what assets are worth? And is it really likely that paying “fair value,” whatever that means, would be enough to make Gotham solvent again?

Good questions. However, I think it is obvious that these toxic assets simply have to be held to maturity to see what they are worth. Liquidating them serves no purpose other then to drive down all asset prices. Whatever their theoretical market value is today, dumping a lot of them will make it lower. You simply can't liquidate your way out of this without producing a full blown financial panic, which Krugman recognizes.

The government already has trillions of dollars of assets on its balance sheet. Most of these are good money at current price levels and there are reasonable prices that could be paid for the "toxic" asset backed paper -- once again, assuming that today's price levels are reasonable and there isn't significant general price deflation.

So Krugman wants to liquidate Gotham. Fine.

But it is one thing to liquidate Texas and another to liquidate the entire US -- including not just bankers but labor, stocks, all real estate. I don't think the US is ready for the full Andrew Mellon treatment. It was tried once and people still remember well enough not to want to try it again.

Exactly What is a "Toxic Asset"

2009-01-19T09:29:00.000-08:00

Let's start with what a toxic asset ISN'T. It isn't a simple bad asset -- one with no value and no prospects. A bad asset is one that generates no cash, has no resale value, and no prospects. It is worth zero. A stock in a bankrupt company for example, is worthless, not toxic.

Rather, a toxic asset has the following qualities. It is impaired in some fashion. It is worth less then par. In addition, it is difficult to tell what it is worth. It's value is significantly greater then zero, but covers a wide range of values with a great deal of uncertainty. Like an asset that is worth between 20% and 70% of par.

Also, you need to own enough of them that you can't simply write them to zero or sell them for their lowest possible value or whatever a liquidation would produce.

In order to get a reasonable approximation of ultimate value of a toxic asset, you need to hold it to maturity and just see how much cash it generates.

However, you can't afford to hold it to maturity, since the uncertainty is sufficient to ruin your business.

So ......

You can't sell it because there isn't a liquid market for it.

You can't keep it since it is undermining the credibility of your balance sheet.

You can't write it to zero since you would be broke.

If you had enough time, you might be fine, but you don't have enough time.

That is a toxic asset. You can't afford to keep it and you can't afford to sell it. Since keeping it is the "default" you keep it until it kills you. Thats toxic.

The real "crime" of our new toxic assets was their very creation. Once they were created, they became a management problem.

This Stock Tip Needs More 'Splainin

2009-01-18T21:09:00.000-08:00

This might be a little unfair, since Barron's Rountable is caveat emptor and no one should expect a full blown analysis for the $5 cover price.

However, Archie MacAllaster, who had a rather dismal year, recycled one of his 2008 picks - Hartford Insurance Group - HIG. Archie didn't mention that it was a 2008 pick [but Barrons, to its credit, did show a table of all the 08 picks with their predictably awful results].

Next, Hartford Financial Services . It was trading for 17.09 Friday [Jan. 2] [And 13.90 Jan 18th] . The range has been 85.11 to 4.16. How about that? [How about the fact that he recommended it at $82.95?] The yield is a little under 8%. Book value is $41 a share. Earnings in 2007 were $8.25 a share.

Fair enough -- if it was a buy @ $82, its a steal at $14, no? Here is the main problem - his next sentence.

Recently Hartford raised its 2008 earnings estimate to $4.70 to $4.90 from about $4.30 to $4.50. I think they'll make better than $5 and maybe $6 a share in 2009.

True -- Hartford did confirm these earnings estimates. Here is a slide from their pitch:

Note the $.62 cents from a decrease in prior period P&C reserves. Nothing inherently wrong with booking it, but the timing of a reserve release is to a large degree, arbitrary.

The problem with this picture, is that one might think that with rather robust earnings of close to $5/share that the Hartford would be able to maintain or strengthen its capital position. It would be obvious, in fact. But obviously wrong.

Here is the "money" slide from the HIG presentation:

HIG lost $11.6 billion in capital (pre tax) that isn't recognized in their earnings estimate. The recognized portion - the $3.5 billion, is part of net earnings, but the $11.6 is shown as 'Other Comprehensive Income'.

It's a pretax number, but it is big. And it is a reason that The Hartford is selling for 40% of book value.

Archie makes a couple more comments:

The company has given itself all kinds of flexibility.
How so?
MacAllaster: They raised a couple of billion dollars in Europe. They bought a savings bank in Florida. They got some money from the TARP. They won't have any financing problems. Hartford will be 200 years old in 2010. It has $350 billion of assets, and in five or 10 years will have a much bigger net worth than today. Meanwhile, you're buying it around four times earnings.

They don't have all sorts of flexibility because they don't have that much capital to support what Archie refers to as $350 billion in assets.

Fortunately, they have $311 billion in assets @ September, 2008 AND almost half of the assets are in separate accounts. That leaves $12 billion in capital to support the other half of the assets. The $12 billion includes whats referred to as DAC or deferred acquisition costs, which are prepaid expenses. It also includes a tax asset, which will require profits to be useful. Plus some goodwill.

That means they are a bit leveraged with the $12 billion supporting over $150 billion in assets. The $12 billion includes the deferred tax asset and the prepaid expenses and goodwill, which pretty much account for all their capital.

They don't have "all sorts of flexibility" but are rather are a little light on capital with a market that has turned against everyone but short sellers. They should be getting the TARP money, but it isn't finalized yet. And if it is, that fat 8% dividend may disappear as part of the deal.

The accounting for insurers tends to be inherently complex. You have three sets of books (GAAP, Statutory, and Tax). GAAP gives capital a haircut in the balance sheet but doesn't run it through income.

I actually think HIG has a lot of merits as an investment. However, anyone that naively thinks that a firm quoted as making a profit has not lost capital is missing critical fundamentals.

A straight tip is fine, but throwing in the "earnings" without more explanation and referring to a capital stressed firm as "having all sorts of flexibility" is a bit much.

What you get with Hartford is a heavily leveraged bet on the financial markets. If they stabilize and prices increase, it will be a huge winner. If we see more deep declines in asset prices, HIG has big capital issues.

Something intelligent about TARP

2009-01-18T19:58:00.000-08:00

From Michael Santoli in Barrons:

FOR MOST OF LAST WEEK, BEFORE CONGRESS signaled it would release the second $350 billion in financial relief money without a steep political ransom, most every microphone in Washington served as an invitation to some Representative from Gerrymandera to bluster and posture. Before new "TARP" money flowed, he or she would insist, banks would need to detail precisely how the earlier batch of funds had been used for the public benefit.

This might sound like a stringent and onerous demand. But such an explanation, for the largest TARP beneficiaries, could be summed up in a two-sentence letter to the House Financial Services Committee: "Dear Mr. Chairman: Our bank used the TARP funds to continue its existence. Oh, and capital is money, and money is fungible, so therefore every loan we've made and every credit line we've rolled over since the fall has in part been a use of TARP funds."

Finally someone else notes the painfully obvious point regarding the inherent impossibility of tracking specific use of TARP funds, as I posted much less succintly last week.

TARP plugged large holes in the banks' capital bases. The credit mess, as noted here repeatedly, is not a crisis of confidence, but a crisis of capital, complicated by a collapse in collateral values. Honest observers can argue about whether TARP made sense or not, or whether the firms it kept afloat would be better off sunk. But the "They're not lending the taxpayers' money freely enough" mantra is misguided.

It's obvious that a bank isn't going to say that they are desperate for additional capital unless under utmost pressure. The rumor that Jamie Diamon was furious about having to take TARP money strikes me as absurd. Although it makes total sense to SAY that you don't need it, want it, and are furious that they made you take it.

Banks and thrifts have continued to lend plenty. Robert Albertson, chief strategist at boutique investment bank Sandler O'Neill + Partners, detailed in a recent report that banks have persisted in increasing loan volumes.
"Bank lending historically and appropriately contracts during a recession," Albertson writes. "The odd and untold truth is that bank loans have actually been expanding in this one."

I haven't heard a lot of credible claims that solid credit risks can't get loans on good terms. In fact, I am hearing the opposite. That stronger credits are having money pushed at them at favorable rates. Banks certainly have the liquidity to lend. My local branch "tightened standards" and stopped doing HELOCs on second homes for example. But they have said that they have been getting lots of deposits as people have moved money from MM funds to local banks. That people with FICO's in the 600's are having trouble getting new car loans may be a problem, but I'm not really sure if people with less then strong credit scores SHOULD be buying new cars on credit. But that's just a personal prejudice.

While politicians and cable-news shouters whine about "timid banks" sitting on taxpayer cash, they neglect the larger reality that scarce credit has much more to do with the near-disappearance of the non-bank, securitization-enabled "shadow banking" market. This accounts for a couple of trillion dollars in reduced lending capacity, and it won't return soon. The de-leveraging process is ongoing, and is irrevocable -- even by one-party control of Washington riding an impressive President-elect's ascension.

And once again, the money quote. The meta picture is that there is forced deleveraging of the hedge funds, etc. Assets have to be sold, and to prevent a meltdown, when someone reduces leverage, someone else needs to lever up. In this case, it is the Treasury and to some extent, the legacy banking system. They can't replace it one for one, but to the extent they are buying or lending on assets at realistic or even bargain prices, they should do fine. As long as we avoid a total meltdown. But more importantly, facilitating a more orderly unwind of leverage is the only alternative to rapid and potentially catastrophic financial panic.

I would love to have the luxury of letting C or BAC just fail and see what happens, IF it would be possible to have a "do over" without cost. The problem with a panic is that reasonably strong firms get dragged down with the less solvent. An orderly process with adequate liquidity for those that need it and can demonstrate solvency and sufficient time for reasonably strong firms to straighten up their balance sheets is sensible. Anyone that thinks that a panic is a great idea to cleanse the system, ala Andrew Mellon, is simply being reckless or talking their book.

Banks Technically Insolvent?

2009-01-18T18:37:00.000-08:00

Analysts working for RBS, one of several British banks to have received emergency funding from the UK Government last year, told the City that "the domestic UK banks are technically insolvent on a fully marked-to-market basis".

The warning does not mean British banks are about to go bust, because the assessment is purely theoretical, and RBS said the position was "not unusual at this stage in the economic cycle".

Exactly what does this mean? If insolvency on a theoretical "mark to market" basis isn't UNUSUAL, then perhaps that theoretical metric isn't useful.

With fractional reserve banking and a reserve to asset ratio of 10%, then once the theoretical M2M of the assets would wipe out capital. Since all assets except treasuries have taken significant haircuts, then how could they not be "technically insolvent" on a theoretical basis?

Look at a simplified, hypothetical balance sheet:

Assets:      Liabilities:

Loans 10,000            Deposits: 9,000

      Capital: 1,000
   ______    ______

Total 10,000 10,000

Any asset impairment over about 5% puts this balance sheet under stress. Capital ratios to assets would go from 10% to 5% or less.

But lets assume that people think that the impairment is temporary, the deposits are guaranteed, and the interest rates paid on the demand deposits has declined along with short term rates to, say 4%. Let's also say the loans were made at an interest rate of 7%. Lets also assume that 5% of the loans are delinquent. Finally, assume that various fee income offsets the expenses and the only income items are the interest income and costs. In this case, the interest income is 665 and the interest expense is 400 and the net income is 265 before any provisions for loan losses.

Now, give the 5% delinquency rate, lets assume that we write off all 5% with an expected recovery rate of 50%. that would give us a loan loss provision of 250, making the income net of loan loss provisions 15. Or break even.

This could go on for say 3 years and the bank capital would remain flat as the net interest margin offsets the loan losses.

If you tried to sell the loans in a secondary market under stressed conditions, there is no way that you could get close to the 10,000. If the loan loss provision is supportable, under current US GAAP accounting, the bank ISNT INSOLVENT.

The theoretical balance sheet and discussion of income, etc. may be incomprehensible to people that aren't familiar with basic bookkeeping and hopelessly simplified for those that do. However, it is designed to show the impact of leverage on a typical bank and how they are inherently vulnerable to a "run on the bank" without some sort of liquidity backstop, since the (demand) deposits could be all withdrawn more quickly then the loans could be liquidated.

Remember in the US in the Great Depression years of 1929-1933 price levels fell between 30 and 40%. Roughly half the banks failed and half of them didn't. However, ALL OF THEM would have been technically insolvent if they had capital ratios of less then 40%.

So, if every single US bank was "technically insolvent" on a theoretical mark to market basis during the Depression, then should all of them have failed? I think more then enough of them actually did fail. If we demand accounting standards that would have forced every US bank during the depression into insolvency, then I would say that the standards are fundamentally flawed.

Maybe people need to go back and rethink why they believe accounting rules designed for derivatives traders are superior to traditional rules that allowed the strongest banks to survive the US depression of the 1930's.

More Irving Fisher

2009-01-16T00:37:00.000-08:00

Anyone that doesn't think that the Fed simply messed up during the GD (the first Great Depression in the 1930's) as well as the executive branch (lack of fiscal stimulus) should check out the Stamp Scrip writings by Fisher. The idea is that with a shortage of money, scrip would be issued in the denomination of $1, and in order to use it, it had to have a 2 cent stamp affixed every week. At the end of the year, the group issuing the scrip and selling the stamps would redeem the scrip for $1, funded with the proceeds of the stamps. The weekly stamp feature acted as a "tax" on hoarding and the velocity of the script was kept relatively high.

This can only work in a situation where there is significant excess capacity.

Fisher tells a joke that illustrates the concept in an interesting fashion:

A travelling salesman stopped at a hotel and handed the clerk a hundred dollar bill to be put in the safe, saying he would call for it in twenty-four hours. The clerk, whose name was A, owed $100 to B and clandestinely he used this bill for the liquidation of his debt, thinking that before the expiration of 24 hours he could collect $100 from his own debtor, whose name was Z. So this 100 dollar bill went to B, who, greatly surprised, used it to pay his own 100 dollar debt to one C, who (equally surprised) . . . and so on, and so on, all the way down to Z, who, with much pleasure, returned the bill to A, the clerk, who, in the morning, restored it to the salesman. And then did A, the clerk, stand petrified with horror to see the salesman light a cigar with it.
"Counterfeit," said the salesman, "a fake gift from a crazy friend, Abner; but he didn't put it over, did he?"

Man Bites Dog

2009-01-15T21:02:00.000-08:00

This actually qualifies as, for lack of a better cliche, a black swan.

Found on the internet....

2009-01-15T00:36:00.000-08:00

From the archives

Commercial History and Review of 1930
The Economist Feb 14, 1931

United States

"Continuous but orderly deflation in security prices, commodity prices, credit outstanding and in the manufacture, distribution and sale of goods has been characteristic of the past year...Perhaps the most upsetting influence was the severe decline in prices of wheat and cotton both of which fell to the lowest level since 1915, and the reduced output and low prices of corn, tobacco and other farm products...Steel ingot production, according to the AISII was 39.6m tons, the smallest since 1924 and a drop of 27% from 1929...Motor production was estimated by the Department of Commerce at 2.5m vehicles, 38% under 19229 level. Railway freight car loadings were reported by the ARA at 45.8m, a reduction of 13.1% from 1929...Credit deflation and the decline in interest rates and loss of deposits made the year a rather indifferent one for the commercial banks...Federal Reserve Bank policy was one of consistently cheap money. The decline in the New York discount rate began in the autumn of 1929 and for reductions brought the rate down from 4 to 2 percent, the lowest in the history of the Reserve system."

Deflationary Spirals

2009-01-14T20:17:00.000-08:00

Per Irving Fisher in The Debt-Deflation Theory of Great Depressions.

The central idea is that debt liquidation causes deflation which then increases real debt.

The more debtor's pay, the more they owe. He calculates that the debt was paid down by 20%, but in "real" dollars, increased by 40%.

Similar to the well known paradox of thrift, this assertion hangs on a strong, fixed relationship between asset prices and overall price levels.

We have seen a bit of this cyclical behavior already. Some of it is part of any market cycle, but the parts of most interest are where he notes that the money interest on safe loans falls and the money interest on unsafe loans rises. In other words, interest rate spreads increase.

Also of note is that relatively early on, commodity prices fall.

Another interesting point is that he believed that the Fed had a number of opportunities to reflate and didn't take them. He didn't seem to think that it would have been difficult, rather it simply wasn't tried before things got out of hand.

His recognition that you don't get debt levels down by liquidation under extreme circumstances is astute.

I suppose the part I find least convincing is the idea that high debt levels, per se, cause deflation. However, once a spiral starts, high debt levels make it much worse -- of that there is little doubt.

The WSJ Interviews David Swensen

2009-01-13T21:33:00.000-08:00

The Wall Street Journal interviews David Swensen, the influential portfolio manager for the Yale endowment. Swensen is pitching a revised copy of his book, Pioneering Portfolio Management.

WSJ: Does the poor performance of most assets last year suggest you need to tinker with the endowment's portfolio to better withstand another year like 2008?

Mr. Swensen: I don't think it makes sense for an institutional investor with as long an investment horizon as Yale's to structure a portfolio to perform well in a period of financial crisis. That would require moving away from equity-oriented investments that have served institutions with long time horizons well.

He's a smart guy, with good ideas. An endowment like Yale has unique and different objectives then most investors. Everyone says they are in it for the long term, but an endowment is in a different category then individuals or most institutions.

Yale has some huge advantages. It's big enough to afford the best resources. Yet it is "only" $30 billion or so. The reason I use the word "only" is that it is roughly 1/10 the size of CALPERS and there are real limits of scale when dealing with a lot of alternative assets. Just how much money can be put to work in Timber, for example? Not much. Real estate doesn't seem t me to be an asset class per se. It's easy to say now, but it isn't "exposure" to real estate that one should be looking for. Rather it is exposure to a real estate strategy that offers more then just loading up on a commodity.

Based on my earlier post and the endowment interested in total return, time diversification is not, in and of itself, an advantage. This would argue for the type of diversification sought by Swensen.

However, this year the winning alternatives all fell apart in the fall and it suddenly seemed a lot less smart. Emerging markets, betting against the dollar, commodities, etc.

If there really is "excess alpha" out there, Yale is going to be at the front of the line. I'm not sure it exists -- but if it does exist, there isn't a lot of it

I haven't read the book, but the idea of pension funds trying to square the circle by letting investment firms sell them a canned version of Yale's strategy is obviously a fundamentally bad idea.

Money on the sidelines?

2009-01-12T23:56:00.000-08:00

As long as we are talking fallacies -- from John Hussman:

Balances in money market funds are also not “cash on the sidelines.” Securities are simply evidence that money has been intermediated from a saver to a borrower. Once the security is issued, it exists until it matures or is otherwise retired. If I have $1000 “on the sidelines” in Treasury bills, it represents money that has already been spent by the Federal government. If I sell this T-bill to buy stocks, somebody else has to buy it, and there will be exactly the same amount of money “on the sidelines” after I buy my stocks than before I bought them. It is simply a fallacy of non-equilibrium thinking to imagine that money “goes into” or “comes out of” secondary markets in securities.

So maybe we aren't in equilibrium. I think it is possible to say that people or groups that traditionally have x% of their assets in stocks have X% minus something in stocks and a higher then typical allocation to cash. It is also very likely that this ratio could be effected by the fact that stock prices have dropped. Another tautology.

I think part of the problem is that we are thinking of cash as both an asset class and as a medium of exchange. People have also bid up the price of Treasuries and when or if they decide to move on to another asset class, another asset bubble will deflate. At which point some of it will simply evaporate.

A Break from all this financial chatter

2009-01-11T09:48:00.000-08:00

Seems like Mickey Rourke is making his big/last comeback with the Wrestler. I don't really want to see Rourke this way. I prefer to remember his absolutely brilliant performance in the minor role of Teddy, an arsonist, in Lawrence Kasden's Body Heat. Courtesy of youtube, here is the section -- especially from the 1 minute to 2:30 section.

I found the first minute of Bob Seager Music not too great, but Rourke is utterly convincing.

As far as a tie to the financial theme of the blog, his "fifty ways things can XXXX up, and if you can think of twenty five, your a genius. And you ain't no genius."

Caution -- R rated/language.

Modest Proposal

2009-01-11T06:50:00.000-08:00

Given all the whining that we are hearing about the Treasury not getting enough for their TARP money, I have a modest proposal.

Some creative new credit derivatives based on the Treasury positions purchased using bailout money. For example, Maiden Lane III.

Everyone has some exposure to the US Treasury and FRBNY, and should be able to hedge via credit defaults and the Maiden Lane SIV's would be good underlying. The press is uniformly negative about their prospects, which should provide nice premiums to sellers of the swaps.

Even though it is true that you can buy swaps on US Sovereign debt, the additional utility of being able to hedge more specific bailout programs could come in handy for their various counter parties. Like the next round of financial entities that may need a helping hand.

I would personally go long on the Maiden Lane III swaps.

And then there is the secondary benefit of assisting the Treasury in their marks. We are all in favor of price discovery and credit derivatives are highly effective, no?

OK.... Maybe I would settle for a proposition bet on Intrade.

Second Guessing TARP

2009-01-10T19:35:00.001-08:00

There's a lot not to like about TARP, but there is even less to like in this critique by Bloomsberg:

Jan. 10 (Bloomberg) -- Henry Paulson’s bank bailouts, done under “great stress” during the worst financial crisis since the Great Depression, failed to win for U.S. taxpayers what Warren Buffett received for his shareholders by investing in Goldman Sachs Group Inc.

I wasn't aware that the Treasury had the same objectives as Berkshire. Among other things, after finding out that tough love didn't work too well with some of the earlier interventions, the Treasury decided to go easy. Unlike the UK, they are no longer trying to extract a pound of flesh and want to inject capital on relatively favorable terms. They still have a net interest margin of a couple percent, so the easier they make it for the firms to survive, the better their chance of getting their money back at a profit. Note that some of the largest TARP recipients have been able to raise private capital AFTER the TARP injection. Getting private investment after bailout money puts the Treasury in an even more favorable position.

The money quote is this from Nobel Prize winning economist Joseph Steglitz:

“If Paulson was still an employee of Goldman Sachs and he’d done this deal, he would have been fired,” he said

Yes, but the Treasury isn't Goldman. The TARP isn't a profit center, its an effort to stabilize the financial system. Plus, the Treasury gets a little kicker that Steglitz either forgot or conveniently omitted. Namely that the Treasury has a perpetual 1/3 interest in every dollar Goldman earns in the future. Why doesn't someone ask Buffett if he would like to swap out their total respective positions. Buffett's yield and options for the Treasury's yield, options, and future taxes. I think Buffett wouldn't need an hour to agree to this deal -- you would just hear the word, "yes."

Why is Warren Buffett a Cheapskate?

2009-01-10T01:21:00.000-08:00

Warren Buffett was notorious for frugality in his younger years. He has mellowed a bit, but the various stories always make him seem eccentric at best and if one were less charitable, just plain goofy.

One explanation, from the book, Snowball, is:

...a small sum could turn into a fortune. He could picture the numbers as vividly as the way a snowball grew when he rolled it across the lawn. Warren began to think of time in a different way. Compounding married the present to the future. If a dollar today was going to be worth ten some years from now, then in his mind the two were the same.

Most people don't think this way. Everyone knows that when you are young, you can afford to take risks, and as you grow closer to retirement, you need to invest more conservatively. You are effectively diversifying over time. This is one case where what everyone knows is simply wrong.

John Norsted, a paleo blogger, has discussed this at length on his website. Per Norsted,

If there is one thing I would like people to learn from this paper, it is to disabuse them of the popular notion that stock investing over long periods of time is safe because good and bad returns will somehow "even out over time." Not only is this common opinion false, it is dangerous. There is real risk in stock investing, even over long time horizons. This risk is not necessarily bad, because it is accompanied by the potential for great rewards, but we cannot and should not ignore the risk.

Norsted continues:

While the basic argument that the standard deviations of the annualized returns decrease as the time horizon increases is true, it is also misleading, and it fatally misses the point, because for an investor concerned with the value of his portfolio at the end of a period of time, it is the total return that matters, not the annualized return. Because of the effects of compounding, the standard deviation of the total return actually increases with time horizon. Thus, if we use the traditional measure of uncertainty as the standard deviation of return over the time period in question, uncertainty increases with time.

I'll try to make this a bit simpler. An individual typically wants to compound her (his) savings over her (his) working life, and end up with a terminal amount at retirement that is the right number to fund her (his) lifestyle. We care about the final number. In a simplistic example, if a person starts with a fixed sum at age 20 and makes no further contribution, the terminal amount will be the product of the annual returns over 45 years [times the initial investment]. With annual returns expressed as factors, like (1+r1) x (1+r2) x (1+r3) .... (1+r45). r is the return and the number refers to the percentage return in that particular year. Like (1.05) x (1.15) x (1.01) etc. High School algebra: AxB = BxA. The order of the terms is totally irrelevant. The return in year 1 is exactly as important as the return in year 45.

Lets say the r's are selected from a uniform distribution of 2% to 8%. Like drawing a slip of paper out of a hat with an equal number of 2%'s, 3%'s, etc. The average annualized return could be just as easily be 2% as 8% after the first pick. Draw a larger sample and the mean annual return will tend to get closer to 5%. But normal people don't care about their annualized returns. They care about their accumulated dollars. The predictability of their terminal return decreases the longer the series.

In 1948, consider that Buffett could have debated if he wanted to spend an extra dollar on a meal. If he ordered the T bone instead of a burger, that dollar, compounded at 20% over 60 years would amount to $56,000. Even today, a Saudi Prince would balk at $56,000 to upgrade from a burger to a steak.

After his early 20's, Buffett never held a job and never made more in salary then his living expenses. So he really did take his small stake and simply run it up to a huge number. Sort of.

Real life is more complex, but the basic idea is that retirees spend dollars, not annualized returns. Returns are multiplicative, so it doesn't matter how you order the good years and the bad years. Losses in the early years are exactly as harmful as losses in later years.

Norsted does a great job in the cited paper. I am skipping over the nuances and complexity of how this would play out in more complex scenarios, but Norsted discusses them. In addition, these findings are true using the currently maligned normal distribution. Any adjustment for "fat tails" or "black swans" simply strengthen the argument.

What Happened to the TARP? Law Professor Wants Answers

2009-01-09T13:11:00.000-08:00

This from the AP:

"These are powerfully important initiatives," said Harvard law professor Elizabeth Warren. "I'm very pleased that the incoming administration is focused on these issues."

She offered no specific advice on how to free up more credit. "It's going to take a variety of tools," she said. "They may have to move through multiple approaches."

The Congressional Oversight Panel she heads released a report Friday featuring questions about how banks are spending taxpayer money, how the money will combat the rising tide of home foreclosures and Treasury's overall strategy for the rescue.

But Treasury's Dec. 30 response "did not provide complete answers to several of the questions and failed to address a number of the questions at all," said the panel's second report.

The new document cited an Associated Press investigation that found none of the banks was willing to disclose what they were doing with hundreds of billions of dollars* distributed through direct injections of federal money.

"For Treasury to advance funds to these institutions without requiring more transparency further erodes the very confidence Treasury seeks to restore," it said.

Appearing Friday on ABC's "Good Morning America," Warren said that Treasury "didn't put any tracking mechanisms on it."

Like a bank that marks the serial number on bills to foil bank robbers? The treasury put in capital via preferred shares. I suppose banking is inherently confusing because they are in the business of "renting" money. A vanilla bank can also "rent money" from depositors. The idea is that the difference between what they pay to "rent money" [borrow] is less then what they charge to "rent money" [lend].

They also have capital which is measured in money.

It is obvious that some banks would have needed to raise outside capital at a higher cost then TARP money to acquire weaker banks, like the WFC acquisition of WB. In those cases, the weaker banks may well have had to call on the FDIC, so money would have been spent out of one pocket or another [the FDIC is "insurance" like Social Security is "insurance"]. Seems like not a bad outcome.

However, it would be interesting for a bank to look at all activity since they received TARP money and simply segregate those that appear to have the highest social benefit. They could then say that they used the Treasury TARP funds for those activities. Workout some loans -- that's TARP money. Lend to small businesses -- That's TARP money. Etc.

At this point, someone in the press might wonder how one could demonstrate that it was TARP funds that were used for a particular loan. The bank would then say that it's true because they say it's true. The press asks a stupid question. Something is inherently unmeasurable yet the press, Congress, and a Law Professor want it measured. Perhaps it takes an equally stupid answer from a bank to move the discussion to something that makes at least a little sense. I wouldn't want to be that bank -- I'd let someone else go first.

*Note that some banks, in fact, did say something:

JPMorgan Chase, which got $25 billion, said it plans to lend $5 billion to non-profit and health care companies in the coming year.

Maybe they should have said they were going to lend all $25 billion to non-profit and health care companies as well as low income individuals, via credit cards [with interest at 20%+].

The Snowball: Warren Buffett and the Business of Life - Micro Review

2009-01-07T15:15:00.000-08:00

Anyone with a serious interest in Warren Buffett will like this book. Alice Schroder has done an excellent job in "Snowball" and one can find a wealth of information on her facebook page, as well as links to mainstream reviews.

I am going to split my comments into a few sections, and focus on things that may not have been covered in a more typical, balanced book review.

Reasons to read Snowball:

1. His transformation from what we might refer to today as a "nerd" into the uber wealthy, popular business icon is fascinating and inspirational. Thomas Edison, Henry Ford, Buffett, and Bill Gates have made this transformation. It isn't just wealth and it isn't just starting out in technology or with technical expertise [in Buffett's case, security analysis]. It's also capturing the public's imagination and becoming larger then life. Compared to the Gatsby fable, where wealth is created out of the ether by someone with personal beauty and charisma -- bootstrapping one's way to success based on technical excellence and imagination is closer to the authentic American dream. And more accessible, at least in fantasy, to numbers people with more brains then charm.

2. Salomon Brothers. An insider's view of the 1991 Treasury Bond scandal. This section alone is worth the price of the book -- the near meltdown of the investment bank was eeriely prescient of the collapse of investment banking in 2008. The most interesting thing is that at the time, the Fed and Treasury seem oblivious regarding the possibility of systemic risk that might have been caused by its failure.

3. Perhaps it will discourage a few people from trying to casually beat the market averages. Graham warned that an average result easier to achieve then most people imagine and even slightly superior results are strikingly more difficult. Buffett's idea of fun is spending hours devouring annual reports, 10k's, financial newspapers and publications. Unless the idea of devouring the Bond Buyer Daily with coffee sounds energizing, think about indexing.

4. It's exhaustive but not exhausting and well written. Lots of detail, footnotes for those that are interested, and well edited. I found one mistake (very minor). I'm willing to defer to other reviewers opinions on this, but I found it "a good read."

5. A person can learn a lot about running a business from Buffett. People tend to be blinded by his capital allocation skills, but Buffett does a lot of things right that a "ham sandwich" could copy. This is not the main focus of the book, but it is in there. A hint -- think incentives. But in a smarter way then just tossing out zillions in options to senior management. Buffett has spend a significant part of his life figuring out how to use money as an incentive -- with his children, himself, family, and businesses. Buffett is true expert at this, and the examples in the book are more informative then typical B school or psychological perspectives. There was a lot of press about how the TARP plan should have been more like Buffett's investments in Goldman and GE. This could be debated for hours, but for all the rhetoric about corporate perks and jets, the Senate should have just insisted on this stipulation: Require senior management to refrain from selling any shares for 3 years and to hold at least 75% of their net worth in the firm. The auto guys would have just turned around and re-boarded their private jets.

6. Alice Schroder is not only an MBA and a noted insurance security analyst, but:

Schroeder worked as a certified public accountant at Ernst & Young from 1980 to 1991. Until 1993 she was project manager with the Financial Accounting Standards Board.

She not only has a rock solid accounting background, but she also worked at FASB! I would consider a person with that background an expert in not only the practice of accounting, but also the more theoretical nuances of the field. Accounting is the place where real economic activity is translated into figures on balance sheets and income statements. Warren's world.

Whatever passion Buffett reveals regarding social and political issues, he is a zealot regarding issues like amortization of good will and expensing employee stock options. So much of Buffett's life is wrapped up in the decades of financial deals that a biographer who could immediately pick up the financial underpinning of this activity has a tremendous advantage. I don't remember a single line of technical jargon in the bok -- no debits, credits, or accruals. Rather, her descriptions of the economic form and substance of the deals are uniformly spot on. Buffett is a master at making arcane financial concepts sound like ordinary common sense in his annual shareholder letters. Yet I can't enumerate the number of occasions where I have seen people try to discuss those same subjects using a Buffett analogy and end up horribly off key. In Snowball, the descriptions have the feel of a Buffett explanation -- a sort of effortlessness that belies the underlying complexity. [pop quiz: Is insurance float an asset or liability? Hint: Read the paragraph after the second balance sheet in a prior post.]

Jan 5th Barrons - WTF

2009-01-04T11:05:00.000-08:00

Cover Headline -- 'Are Treasury Bonds Safe'

Back Cover -- Full page ad -- ProShares Ultrashort Treasuries (PST and TBT).

I don't see anything wrong with this -- no conflict of interest other then those inherent in print journalism.

It's more of a Mega Market Call. These babies are going through the roof Monday. Watch the prices compared to the underlying net assets. I've already commented on the ultras.

More M2M

2008-12-29T09:56:00.000-08:00

Today's WSJ has another article about M2M that is confusing, to say the least. The journal says that FASB is considering widening M2M to include loans. Per the journal, "FASB taking a more holistic view of accounting for loans, bonds, derivatives and stocks."

Meanwhile, the blog WebCPA noted:

FASB decided to loosen rules that kept banks from accounting for the cash flows they expected from mortgage-backed securities and other assets during impairment tests when they are categorized as available for sale, rather than just as held to maturity.

Note the major disconnect -- The Journal is implying that held to maturity loans might be marked to market. Meanwhile, the FASB is actually modifying rules related to assets held for sale. Huge difference.

The only modification I would propose is to revise the way that credit derivatives indices are used to value structured investments like CDO's. Plus a complete review of the use of credit derivatives as market proxies. As far as the Journal's views regarding "fair value" -- it is safe to say that the world is converging on standards, and US GAAP can't let the IASB be the only body working on this issue.

Accrued Interest Takes on M2M

2008-12-25T06:35:00.000-08:00

Mark-to-Market: Discussion minus the Zealotry is an attempt to get at a reasonable approach to M2M. AI brings up a number of points. Obviously, a lot of examples are didactic and don't reflect anything that is being done now.

Example 2:

Let's say that we have two firms, both have made loans to XYZ Retailer. But one is a bank which has made a traditional loan, and the other is a brokerage which holds a private placement bond. The broker almost certainly has to mark that loan to market, but the bank may not.

And in both cases, the rapid changing liquidity premium in the market place alters the "mark" for this asset. By this I mean, say the retailer is performing reasonably well, and thus the risk of non-payment remains remote. Given the weak economy, its obvious that the risk has increased by some degree, but given the extremely weak liquidity across fixed income products, the larger portion of the assets price decline would reflect liquidity. If the firms don't intend to trade the loan, is the changing liquidity premium relevant?

This is a problem where similar assets are booked at different prices. Here I would note that the bank would typically book the loan as a loan (intended to be held to maturity) rather then "loans held for sale." However, the brokerage's core business is trading and not originating and holding loans or similar assets to maturity. The bank is required to hold an "allowance for loan losses" on its balance sheet, which is an estimate. The broker's private placement bond doesn't trade, so credit derivatives would likely be an input into valuation. Note that there really isn't a direct market price for this asset. You have dueling models, one based on a bank's historical losses, judgment, and bank specific accounting guidance and the broker using a pricing model with the "observable" input being a credit derivative. As AI has noted, the bond price may include a liquidity premium which is clearly inappropriate for an institution that doesn't need or want liquidity -- the bank is simply going to hold and amortize the loan to maturity. If the broker really intends to sell the bond, then it should book to an estimate of today's market price. If the broker intends to keep the bond until maturity, then it has an issue, but not with accounting. From my perspective, you can have two different prices for a similar asset in this situation without a major problem. There might be "financial reporting" arbitrage opportunities. However, no one ever claimed that accounting should adopt modern portfolio theory.

Example 3:

There are other problems. Say you are a bank that has a private loan to a company with traded CDS contracts. Your best mark-to-market estimate would be to price the loan based on the cost of hedging out the credit risk. But in many cases, the CDS and cash bond markets have decoupled. Many bonds are trading a drastically wider levels than the CDS market, owing in part to easier funding of CDS. Take Amgen, where cash bonds are trading at a LIBOR spread of nearly 300bps, but the CDS are around 90bps. On a 10-year loan, that implies a valuation differential of about 15 points!

So here again, we have a situation where two firms can use "market" prices to price non-marketable assets, and come up with wildly different valuations. We hear mark-to-market and assume that the "market" is some kind of observable thing. But that is just not the case.

In this case, if the bank holds it as a loan, m2m doesn't come into play, so it is a moot point. It looks like the CDS market is "broken" in that it doesn't model reality very well. A synthetic bond would yield less then a natural bond. That would imply an arbitrage situation where a firm would sell the synthetic bond or CDS contract and buy the underlying. That is, if markets worked. Which raises the point of why one would consider a "broken" market -- one that violates the arbitrage free assumption -- as a better representation of reality then other estimates.

The idea of taking a real, natural loan and goofing around with a pricing model using credit derivatives seems silly. The firm that owns bonds has to deal with the fluctuation in market price as part of the luxury of owning an asset with a real market price. The bond is a true level 1 asset and has always and will always be booked at the market price. This isn't m2m -- it's just accounting. No one has ever asserted that securities that are traded on an exchange or in a relatively liquid market *not* be marked to market to my knowledge. Here we would have the loan booked at $X (say par), a theoretical pricing model using CDS's that may value the loan at $X + something (but is never used), a real bond selling for a discount in a bona fide market, selling for $Y (say a lot less then par), and a synthetic bond (cash + CDS) that could be purchased for $Z (more then par). In this case it is simple -- ignore credit derivatives. I would like anyone to find examples where a company complained about booking real bonds at market prices. This isn't M2M, it is vanilla GAAP that has been around forever.

AI Concludes:

But what's the alternative? Those that are calling for an end to mark-to-market are out of their mind. First of all, there is no clear alternative. Second, we have enough trouble trusting firms' balance sheets as it is. Imagine if mark-to-market were suddenly suspended!

It's very important to note that booking listed stocks and bonds is vanilla GAAP and has nothing to do with m2m, FAS 133, and FAS 157. No one wants to change this aspect of accounting. Until we can find this straw man, people need to cool their jets.

However, most critics of m2m are people that, say, hold commercial real estate CDO's and don't want to book them at a huge haircut because of a credit derivative index. They tend to have a legitimate beef, since there is a basis differences between their security and the index. There are, once again, dueling models and arguing that credit derivative indices are a market is a stretch. It is one input into a level 2 or level 3 pricing model. To my knowledge, they don't want to book these at par. They have their own models and they don't want to be forced to use credit index based models which may be worse then alternative models. There is a problem in that these critics always want to book higher asset values, and in a declining market, are usually wrong. At this point in the cycle.

Mark-To-Market Liabilities - Citibank

2008-12-24T21:19:00.000-08:00

From Citi's 10Q:

This is impossible to read without double clicking the schedule. So here is the line, and it was $1.3 billion at 12/2007 and $2.2 billion at 9/2008, for 9/2008.

This may or may not be all there is. However, these particular fair value marks aren't counted in Tier 1 Capital. This schedule breaks out the components of Tier 1 Capital and therefore has the figure I'm looking for. Or something close to it.

I like the way the line reads -- attribtable to own (lack of) credit worthiness. I also don't know exactly how one values one's debts to "market". Does one simply look it up as a traded bond? Or is this simply a haircut based on credit spreads from credit derivatives. One could even imagine a bond selling for more then par -- what to do then?

It isn't unreasonable for a firm that has assets like bonds issued by other banks that just got a haircut to want the same treatment for its own debt. It's never that simple and the bond assets might be supported by deposits and the debt stands on its own -- so they couldn't simply sell the asset to buy the debt in the open market. In fact, if they had the cash to redeem the debt, it would probably be at par or par plus call provisions. Really bad companies can do tenders on their own debt for, say 60%. Like Level 3's recent tender.

This is just an interim piece while I figure things out. This is the best I could do in an hour, although I suppose I could have copied a lot of quotes on fair value.

One thing I will say is that this isn't something that Citi seems to want to make easy to understand and find. Actually, there is a HUGE amount of information in these statements. I wonder if management, outside of the financial reporting guys, actually read this stuff.

Financial Buzz Words of the Year - Clawback

2008-12-24T17:36:00.000-08:00

Last year, my favorite was tranche .

The word tranche is French for slice, section, series, or portion. In the financial sense of the word, each bond is a different slice of the deal's risk.

The very notion of taking something that makes (at least a little) sense as a whole -- like a pool of assets, and then slicing them in complex ways that give the slices significantly different characteristics is suggestive of a general approach to life. Tranches of love? Very Post Modern.

The New York Times has a number of candidates in their annual article. I like the word malus (opposite of bonus), fail (as a noun, like a bucket of fail), TBTF ( too big to fail), and recessionista (Originally, someone who favored a recession as ultimately good for the economy.).

The fact that they all need explanations does not particularly recommend them. My vote would be for malus. It turns out that malus has been used in experience rating of personal lines insurance, but not primarily in the United States. Here everyone gets a discount or bonus and a malus would just be called a standard rate or price.

I'm going for something more/better then a simple malus. A clawback. Per investopedia, a clawback is an: .

...obligation represents the general partner’s promise that, over the life of the fund, the managers will not receive a greater share of the fund’s distributions than they bargained for. Generally, this means that the general partner may not keep distributions representing more than a specified percentage (e.g., 20%) of the fund’s cumulative profits, if any. When triggered, the clawback will require that the general partner return to the fund’s limited partners an amount equal to what is determined to be "excess" distributions.

The term clawback captures the mood of the public. They want accountability. They not only want to slash bonuses, but also to recapture the excess and unwarranted bonuses of yesteryear. And further, they don't just want them back -- they want them CLAWED back, which in the best case would include actual blood.

Like something from Kafka's Penal Colony.

"In the Penal Colony" is a story about the last use of an elaborate torture and execution device that carves the sentence of the man on his skin in a script before letting him die, all in the course of twelve hours. As the plot unfolds, the reader learns more and more about the machine, including its origin, and original justification.

I think this just about sums up the mood of the country.

Ultra Smart or Ultra Dumb?

2008-12-24T17:21:00.001-08:00

2008 is the year of the ultra shorts. There is a good article by Eric Oberg in The Street.Com regarding friction and other issues with the ultra ETF's.

I won't repeat any of his observations, but note that the winning strategy is to go short the ultra long and vice versa. Or at least that would have been a winner last year.

Of course, that lets the little guy out who can't borrow shares or is doing it in his IRA. I like the sound of it, also -- Short the Ultra Short to go long and Short the Ultra Long to go short. Would have been a huge improvement over buying and holding these over the course of a year.

A better idea for amateurs would be to avoid leverage.

Financial Blogs of the Year

2008-12-21T16:34:00.000-08:00

1. Calculated Risk

2. Abnormal Returns

3. Accrued Interest

4. Marginal Revolution

5. Naked Capitalism

MTM - More to Come

2008-12-21T13:07:00.000-08:00

I noticed that there are several important, but distinct aspects to the prior post:

1. The facts that the logic of mark to market requires liabilities be handled the same as assets. This conflicts with most people's understanding of mtm, since it is inherently less conservative then current GAAP. Further, they don't believe it is logical, or they don't believe it is being done. The fact that it is being done right now would be useful to further document and highlight.

2. The background of mtm and its cousin, fair value accounting, is rooted in derivative accounting. People always want better accounting and also prefer conservative accounting to lax accounting standards. However, they also tend to not be big fans of derivatives. Unfortunately, mtm has been associated with writedowns which are more conservative -- all else being equal. There is a sense in which people view mtm as conservative which is good, and therefore want to see more of it. Also embedded in this view is a sense that markets are inherently efficient, liquid, and deep. They are the best of all possible worlds regarding price discovery, etc.

The truth is that mtm is Derivative Accounting, at its core. People aren't big fans of leverage, and credit derivatives are particular unpopular among a lot of people.

A lot of people correctly associate derivatives with leverage and speculation. The idea that accounting that was designed for derivatives should be a core principal of all accounting doesn't sound quite so benign. Yet that's were we are heading with Basal II, etc.

3. The case against credit derivatives is much less clear cut then the above. I don't like them in their current form. Its too late to put the toothpaste back into the tube, but tight regulations regarding transparency is a minimum. The more paranoid arguments against CDS's may be true, but aren't necessary to suggest significant reform. In fact, regardless of the truth, speculation regarding organized efforts to short stocks detracts from the strong case that can be made for significant reform simply on its merits.

As a goal, I would like to substitute "Derivative Accounting" for "Mark to Market" and the various "fair value" proposals to be labeled as efforts to reduce capital requirements.

Of course, this isn't uniformly the case, but the general thrust of Basal I and II and fair value reforms has been to put all financial entities on an equal footing. Fair enough, but more then a little of it is a race to the bottom, with banks and insurance companies that are forced to comply with legacy, rule of thumb capital requirements believe they are inefficient and put their firms at a disadvantage. Since there is little chance to regulate the competition, then their best strategy has been to level the playing field, which amounts to a race to the bottom.

Mark-To-Market

2008-12-19T14:55:00.000-08:00

Factoid:

Mark to market applies to both assets and liabilities. That is, in the "fair value" world of Basel, it isn't only assets that get a haircut. Liabilities also. What does this mean? If your debt is downgraded, then it has a lower market value and ergo, you have a windfall profit.

This isn't allowed in vanilla GAAP, which assumes a going concern will pay off its debt at par or no longer be a going concern. The default option has no value for the GAAP Luddites. A lot of people aren't going to believe this or take this at face value. So here is a real world example discussed in the blog, The Treasurer:

Barclays Capital has reported losses on credit market exposures of £2,831m but has then set against this gains on its own debt securities of £852m. In other words changes in market yields of its own securities have caused the mark to market valuation of its own liabilities to fall creating a windfall gain.

It isn't only the Brits that are doing this, per Bloomberg:

Merrill Lynch & Co., Citigroup Inc. and four other U.S. financial companies have used an accounting rule adopted last year to book almost $12 billion of revenue after a decline in prices of their own bonds. The rule, intended to expand the ``mark-to- market'' accounting that banks use to record profits or losses on trading assets, allows them to report gains when market prices for their liabilities fall.

Let's say you run a vanilla derivatives business, selling listed puts and calls on exchange traded stocks. Like the stuff retail investors buy. And lets say that's all you do -- no real world businesses confusing things. Then you want to know your net exposure at today's market value at the end of every day. So far everyone is on board, I assume.

Here is where I think we started getting lost. The various FAS regulations (133 and 157) refer to accounting for derivatives. Some people like the sound of "mark to market" since they think it isn't "mark to fantasy." The rub is that you have to actually have a market that works. It has to be relatively efficient, liquid and deep. Wanting to "mark to market" doesn't magically create a market. Further, and perhaps most important, do we really want to use accounting set up for the derivatives business to represent best practice? I would like to see a lot of the derivative business disappear along with the financial engineering that contributed to the current train wreck.

In the real world, we got into disputes when credit derivatives prices (or alleged prices) were used in asset valuations and the results were very unpleasant. People realized that a firm could go into a downward spiral based on thin, illiquid credit derivative market quotes -- especially when combined with credit rating agencies gone wild with new found zeal. There is more then one variation of this playbook that has been used to grind a firm's stock price to pennies in a few hours. As soon as people figured out that financial firm's financial position was based on their credit rating (collateral), which was connected to their stock price (ability to raise capital), which was tightly linked to CDS spreads -- then a stressed financial firm found it could evaporate in a matter of hours.

Some people were wondering WTF. How could XYZ be AA at 8 a.m. and fail the next day. When they saw the carnage and connected the dots, it seemed to point to the credit derivative Netherworld.

But this is the really galling part of the story. After throwing XYZ under the bus and making handsome profits shorting XYZ's demise, the former long stock holders got a lecture about how credit derivatives are some higher form of truth. And anyone that didn't want the entire business world to be run like a derivative shop was some sort of liar.

And then, given the buzzword of the year, every commenter on every blog gets into a moralistic rant about arcane accounting concepts. Stuff they couldn't even began to understand. I'm not claiming to be an expert here, either. This is genuinely complicated. MTM isn't motherhood and apple pie. Just boring regulations regarding how to account for derivatives.

The point of this post is that most people know a lot less then they think they know about this. The accounting concepts have implications that are counter intuitive - like firms benefitting from a credit downgrade (but only investment banks). There are also other counter intuitive aspects associated with m-t-m, but they will have to wait for another post.

Quantitative Easing?

2008-12-18T21:20:00.000-08:00

The statement from the FOMC meeting included the following:

The focus of the Committee's policy going forward will be to support the functioning of financial markets and stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level. As previously announced, over the next few quarters the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets, and it stands ready to expand its purchases of agency debt and mortgage-backed securities as conditions warrant. The Committee is also evaluating the potential benefits of purchasing longer-term Treasury securities. Early next year, the Federal Reserve will also implement the Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses. The Federal Reserve will continue to consider ways of using its balance sheet to further support credit markets and economic activity.

Let's see if I get this. The spreads between treasuries and other debt are too high -- an effect of the flight from risk. So I can see buying agency debt and mortgage backed assets to increase demand, raise prices, and lower yields. This would help borrowers or potential borrowers. But the treasury buying longer-term treasuries is going to accomplish exactly what? Flatten the yield curve and reduce the costs longer term debt? If the 30 year is at 3%, what more could be accomplished? I don't get it.

However, an attempt to front run any Fed activity could result in investors driving down the price of treasuries. This may be the problem with the "obvious" but obviously wrong strategy of shorting long term treasuries, like TBT.

They used to say, "Never pick a fight with people that buy ink by the barrel". Perhaps one shouldn't short the favored instruments of an agency that buys its ink by the barrel, prints money, and can change the rules mid game. Something to ponder.

Financial Execs to Eat Their Own Cooking

2008-12-18T16:47:00.000-08:00

No reason to do the "me too" posts, but this is too perfect.

Credit Suisse Group AG’s investment bank has found a new way to reduce the risk of losses from about $5 billion of its most illiquid loans and bonds: using them to pay employees’ year-end bonuses.

The bank will use leveraged loans and commercial mortgage- backed debt, some of the securities blamed for generating the worst financial crisis since the Great Depression, to fund executive compensation packages, people familiar with the matter said.

These are the same individuals that signed off on the deals, and gave all the pitches about how it "isn't that bad," etc. Plus, any decent compensation plan has all sorts of deferrals and "golden handcuffs" -- so where better to dump some illiquid assets?

The creativity of capitalism never ceases to amaze.

Buy the Debt, Sell the Stock

2008-12-18T13:11:00.000-08:00

Per the AP, again:

The company now expects to earn between $2.90 and $3.30 per share for the year. A company spokesman said the prediction includes the impact of the recent sale of a portion of its nuclear business. Constellation Energy Group agreed on Wednesday to sell half of its nuclear-power business to Electricite de France SA for $4.5 billion, scuttling a deal struck in September with Warren Buffett's MidAmerican Energy Holdings Co.

Constellation also said it may cut its dividend by 50 to 60 percent to improve cash flow and pay down debt. It last paid a dividend of 47.75 cents in October.

At this point I don't see the advantage of owning the stock @ 24 yielding a little over 3% when you could own the bond, cegpra @ $19, yielding 11%. They would have to increase their dividend 20% a year for 5 years to get back to the 47.75 cents. Meanwhile, their new sense of stewardship which is motivating them to pay down debt can only help the bond rating. If by some chance they got the firm up to investment grade, it would be a windfall for the preferred. If things don't work out as well, the debt is senior to the stock and we know someone would buy the other 1/2 of the nuclear plants.

Another New Low for the 10 Year Treasury

2008-12-18T13:04:00.000-08:00

Per the AP:

The benchmark 10-year Treasury note's price, which moves inversely to its yield, rose more than one full point, pushing down the yield briefly to 2.04 percent , the lowest level since the early 1950s.

Is it time to go short? Say PST, Lehman Ultra Short 7-10 Year Treasuries.

This is too obvious to work. Plus the 10 year has been hitting records all month.

Conference Call

2008-12-18T09:47:00.000-08:00

Which I didn't bother to listen to. Here is a link to their pitch slide.

Everything sounded great except the dividend reduction of 50 to 60%.

With 200mm shares, the current dividend is about $380 million. They offered guidance of $2.90 to $3.30. Plus 6% to 8% compound growth for 5 years.

And they want to cut the dividend of $380 million in half or more? I suppose some dividend reduction is "prudent", etc. Still, this is a utility and a lot of people own it for the dividend.

No wonder the stock price got killed. Management needs to think its commitment to putting some cash in shareholder wallets. People don't really want to wait 5 years for management to earn back the money they blew because of negligence. How about a bonus moratorium or some sense of contrition regarding exactly how awfully they blew it.

They could think really hard before they do this. Or not.

CEG Downgraded by Moody's to Baa3

2008-12-17T20:59:00.000-08:00

Moody's cut CEG's credit rating this morning:

Moody's Investors Service on Wednesday lowered Constellation Energy Group's senior unsecured rating to Baa3 from Baa2 and kept Constellation's ratings under review for possible downgrade. The move follows an earlier announcement that Constellation and MidAmerican Energy Holdings have decided to terminate their proposed merger agreement. Constellation also said it reached a deal to sell a 49.99% interest to Électricite de France. "The rating downgrade incorporates the risks associated with CEG's decision to continue the restructuring of its sizable commodities business as a standalone entity, a near-term liquidity profile that appears weak in light of current volatile market conditions and the ramifications of the sale of a minority interest in its crown jewel assets" said Scott Solomon, Moody's vice president.

Baa is investment grade, but this year, CEG has slipped from Baa1 to Baa3. The crisis that led to the Mid American offer was due to the implication of a credit rating cut to margin requirements for energy derivative positions. From the SEC filing:

The actual amount of collateral that Constellation Energy would be required to post in the event of a multi-notch downgrade fluctuates based on market conditions and contractual obligations at the time of a downgrade. Management also announced an intention to sell the company’s upstream gas business and to sell or recapitalize its international coal and freight intermediation business, all as part of a broad effort to reduce the capital demands and perceived volatility of a portion of the company’s commodities business by reducing exposure to commodities counterparties, releasing a significant portion of posted collateral and monetizing certain derivative positions. Management took these actions after determining in early August that the amount of additional collateral Constellation Energy could be required to post in the event of a downgrade of its credit ratings was greater than previously estimated. On August 11, 2008, in its second quarter 2008 Form 10-Q, Constellation Energy reported the revised estimates of such potential additional collateral posting requirements as of March 31, 2008 at $129 million for a one-level downgrade, $844 million for a two-level downgrade and $3.23 billion for a three-level downgrade. The Form 10-Q also reported that as of June 30, 2008, these amounts were $386 million, $1.37 billion and $4.57 billion, respectively, and as of July 31, 2008, the amounts were $106 million, $681 million and $3.37 billion, respectively.

The "multi notch" downgrade was 2 notches or from Baa1 to Baa3. This is the exact downgrade that occurred today. Per the 3rd quarter 10-Q, the results of a rating downgrade were: 1 level to Baa3 - $171 million 2 levels to Ba1 - $2.2 billion. However, the report later stated:

The estimated collateral obligation amounts above have declined compared to those reported in our quarterly report on Form 10-Q for the quarter ended June 30, 2008. This decrease is due to changes in open positions, price movements, and posting of additional collateral requirements resulting from our credit ratings being downgraded in the third quarter of 2008. As of October 31, 2008, incremental downgrade collateral postings for a one level and two level downgrade have changed to $178 million and $1,865 million, respectively.

It's hard to say where they would be a month and a half later regarding their reduction of this exposure, but with any sort of prudent management and the decline in energy prices, one would hope that the amounts would be materially reduced. From June 30 to October 31, the exposure from a downgrade to to Baa decreased from $4.57 billion to $1.87 billion.

CEG is in a position where it needs to be able to fund a downgrade to "junk" in order for it to maintain its investment grade rating. Not particularly unusual in the credit world where the criteria for a rating is the absence of the possible need for cash, and vice versa.

The CEG energy traders had another month and a half to reduce their exposures, and have the Buffett billion (at the rate of 14%), an immediate infusion of $1 billion from EDF of $1 billion, and the proceeds of the asset sale of an additional $3.5 billion, less whatever they intend to repay.

Moody's has no upside in optimism. However, it is not at all unreasonable to think that any and all issues regarding collateral calls from energy trading are either solved or being solved. Otherwise the board would have been highly imprudent in recommending the EDF proposal in an environment where all attention is being focused on that particular issue.

A ratings upgrade to Baa1 wouldn't seem out of the question -- offering significant upside to the class A preferreds as well as the common stock.

CEG - D Day

2008-12-17T19:25:00.001-08:00

Interesting day. Trading halted, the company announced that it was terminating the MAE deal and doing the EDF deal. The stock responded by flirting with 30 and then falling to 23. It's obvious that anyone hanging around for an auction of the company needed to move on and the remaining arbs went home, leaving little liquidity for sellers.

I don't think the negative market reaction tells us much more then people don't like uncertainty if it doesn't have a cap on the downside. This leaves us with the question, what is the company worth? I don't see the stock doing anything until people regain some confidence that the problems from September have been dealt with in a systematic way. CEG laid out a plan, but people want to see execution.

At the point where CEG can demonstrate some solidity, then it deserves a valuation that more closely reflects the value of its businesses.

I discussed CEG valuation in an earlier post. I even included a spreadsheet for your enjoyment. I had laid out EDF's proposal in another post.

The detailed EDF valuation would be my starting post to get a more in depth view of CEG's value.

Meanwhile, for those that are looking for value in fixed income, the preferred A shares are now yielding 12%, since the .08625 preferred is selling for $18/share ($25 par).

If the company can regain its footing with the $4.5 billion asset sale, today's preferred yield of 12% and the common yield of 7% are generous compared to peers. Personally I think buyers at these prices and better will do well, but it may take longer then anyone wants to wait.

Book of the Year

2008-12-16T17:28:00.000-08:00

False Security: The Betrayal of the American Investor by By Bernard J. Reis New York, Equinox Cooperative Press Inc., 1937

People have a general sense of our current economic situation as parallel to that of the 1930's, in the sense that we are suffering from the unwinding of a credit cycle, speculative excesses of the recent past, etc. The interesting part isn't so much the unwinding of excess. We all know how that story goes. The more fascinating part are the details regarding buildup of those excesses.

Reis lays out an easy to read, systematic indictment of investment excesses during the 1920's, and more distressingly, the details of their failure. The general sense is fat bankers tossing widows and orphans out of the Titanic's lifeboats.

It is also surprising to see the popularity of mortgage backed securities in the 1920's, and their inevitable failure. The current monoline insurers are direct descendants and have proven surprisingly robust in part based on reform to prevent the excesses of the 1920's. Even though they are ruined, MBIA, for example, is still around and still has cash and is still paying claims. I won't bother to argue that they will survive or that their claimants will be made whole -- just that they have proven remarkably robust.

The general themes:

1. Corporate managers self dealing.

2. Insured Mortgage backed bonds.

3. Foreign Bonds (ala today's emerging markets)

4. Investment Trusts

5. Failure of Directors, Trustees, etc.

6. Failure of Bankruptcy and Reorganization to protect investors.

These are all illustrated with detailed examples of the failure to protect individual investors.

I found the popularity of real estate speculation and securitization of mortgages to be the most surprising parallel to today. The financial engineers of the 1920's weren't using arcane financial theory to create instruments of Byzantine complexity. However, they were relying on the basic techniques of slicing up cash flows to appeal to new customers and to relying on the prestige of traditionally sound firms to obtain the confidence needed to sell these new products.

There is no one alive with direct experience as an adult in dealing with the excess/reform cycle of the 1920's - 1930's. However, the artifacts remaining from the reform phase -- primarily financial regulation, is surprisingly intact. It has suffered over the last decade plus, but is surprisingly resistant to change. Most of today's excesses were enabled by simply going around or "disintermediating" the regulated institutions.

This book provides a vivid and concrete view of the events that motivated New Deal financial regulatory reform. In that sense, it fills the void formed by the inevitable loss of institutional experience over time.

The overall sense is an eerie sense of familiarity with the practices of that time period. And a strong belief that no one that had lived through this earlier era would have gone within a mile of a multi sector CDO.

Even better, an extended preview is available on Google Book. It is also available at libraries -- so it fits in perfectly with the new frugality. You can find it here using Worldcat.

From the introduction:

This is in the neighborhood of 15% of GDP in 1930, which would be equivalent to $2 trillion today. In those days a millionaire was rich and a billion was a lot of money.

An interesting aside is that Bernard Reis was an Accountant and and art collector and the executor of Mark Rothko's estate.

Was Letting Lehman Fail a Mistake?

2008-12-16T16:25:00.000-08:00

There are a couple of blog posts today regarding this issue. The Deal argues that it wasn't, for a number of reasons.

I would suggest that letting the banking/financial system collapse is a mistake, and that Lehman was too interconnected to fail. However, prior to the failure of Lehman, there was no consensus regarding when and how to intervene. Paulson and Bernake intervened in BSC and wiped out the stock holders but saved the debt and counter parties. They intervened in the GSE's and saved the debt, but blew up the equity and preferred shareholders (which had the knock on effect of evaporating a lot of bank capital).

All the while, there were huge arguments regarding moral hazard, free markets, the beneficial effects of failure, etc. There was no political consensus to save the financial system from collapse. There was a lot of denial and enough ideology being tossed around to choke a horse. The quasi religious belief in markets was hanging tough.

In fact, we needed a bright line -- a watershed event that would demonstrate the need for massive intervention. Any intervention that worked had the disadvantage of failing to prove it was needed. One could always argue that Bear Stearns would have worked out just fine if we had just let the markets deal with its failure. Ditto for the GSE's, Countrywide, etc.

We had to have evidence of sufficient urgency and severity in the financial system's problems. Something had to fail with severe consequences -- or else the argument that subsidizing/rewarding failure is always a mistake could not be addressed with anything but theoretical arguments.

In a sense, Lehman was perfect, since it was big enough and interconnected enough that its failure was costly. But not fatal. After Lehman, McCain could no longer say the economy is fundamentally healthy. No politician could argue that the only thing the economy needs is less government -- at least in a serious manner.

Something spectacular needed to happen to provide the basis for supporting a bailout. People needed their "come to Jesus" moment. And they got it.

Killing a canary wasn't enough, but you didn't want to blow up the system. Enough of a taste of the "creative destruction" of capitalism to make the prospects of a painful cure seem better then letting the disease run its course.

So, it wasn't a mistake. Maybe not optimal, but letting AIG or C fail would have been much, much worse. Ideally one would want enough intervention to allow an orderly unwind of excesses. But to develop political support, especially in the face of strong ideologically motivated opponents, required a shock. That was Lehman.

CEG/MAE/EDF

2008-12-16T09:47:00.000-08:00

All the news:

1. CEG is leaning toward the EDF offer.

2. MEC said they won't make another bid.

3. Options expire Friday the 19th.

4. The Meeting is Tuesday, Dec 23.

I tend to think that Buffett walks on this one. The CEG board needs to make a solid deal with EDF and make it quickly.

What to do? The company should be worth $35/share, minimum, after the breakup costs. However, the Buffett offer of $26.50 will no longer provide a floor. There will be no bidding war. Among other reasons, they really aren't competing offers. Buffett wants to buy the company and considers it a "bolt on" acquisition for MEC. He isn't interested in investing a lot of capital in Nuclear energy. EDF only cares about Nuclear Power and doesn't seem to be interested in owning a utility.

Management wants to keep their jobs.

No one else has the capital and interest to make another bid for the entire company.

AIG Is Doing What it Said

2008-12-16T01:02:00.000-08:00

As the only blogger that is remotely sympathetic to AIG, based on today's announcement, they have completed most of what they said they were going to do 3 weeks ago. They have taken huge losses on mortgage related assets over the last 4 quarters and moved the assets to government credit facilities. The writedowns give the government a decent chance of coming out whole or somewhat better.

In summary, AIG had two big mortgage related problems, that were only distantly related. In their life insurance unit, they lent securities and invested the money in mortgage related securities. They borrowed $19.8 billion for this credit facility to buy $39.8 billion face value mortgage related securities. In total, the government put up $49.8 billion to buy mortgage related securities with a face value of $111 billion. AIG is now done and won't have to deal with additional write offs on these securities.

Based on their November presentation, the total new bail out consists of the following:

The credit facilities that have a shot at profitability.

$40 billion in preferred stock.

$60 billion loan.

Support for commercial paper program not unique to AIG.

As of November, a big chunk of the $60 billion loan hadn't been drawn.

The way I would think of this is that the insurance businesses are worth more then book value if the balance sheets have been cleaned up. As soon as a business is sold, the sale generates cash AND it means that the remaining businesses need less capital. So I'm thinking the government has a decent shot at coming out even or better.

CEG After Hours - WOW

2008-12-15T22:05:00.000-08:00

The Stock closes @ $27.30. 50,000 shares trade @ $26.80. Thats $25k below the close for that trade. Then this announcement from Bloomberg. The stock moves up to $29. I've taken a 50 cent beat down any number of times, so I don't feel too bad for Mr. 50k shares.

That's the after market for you. Wonder who dumped the 50k shares?

AiG Issues Press Release -- No Headlines

2008-12-15T19:16:00.000-08:00

AIG did a pretty good job of explaining the situation, but it already seems like a year ago, and there are more exciting items to blog. Now it is how AIG get zillions while the UAW gets shafted. A quickie to try to explain the AIG Bailout. This is from an AIG slide as part of the Nov 20 presentation on the revised "deal."

What is really going on is that AIG had already taken writedowns in the $30 billion range on these CDS's. They had also posted collateral in the $30's. The way it was designed to work is that the $70 billion in blue is the nominal amount (par) of the CDS's. About 1/2 of that had already been booked as losses. A similar amount had already been posted as collateral. The problem is that every quarter, there was a lot of hand wringing about how much more should be written down to "market" that, of course, wasn't functioning. A theoretical solution would be to write them down to zero, but AIG doesn't $30-$40 billion to take an immediate hit. So each quarter, another 5%, 10%, or 15% would be written down. AIG might have wanted to just settle up or buy their way out of this exposure, but there was no one with the capital, regardless of value. AIG insisted things weren't that bad, but had and have little credibility on this issue.

The credit facility I keep referring to as a SIV is known by the name Maiden Lane III. Per the National Underwriter:

Maiden Lane III L.L.C., New York, a Delaware limited liability company controlled by the Federal Reserve Bank of New York, has started to buy “multi-sector collateralized debt obligations” that AIG’s AIG Financial Products Corp unit guaranteed with CDS arrangements back when the economy was stronger, according to AIG, New York.
The New York Fed and AIG announced the creation of the $35 billion Maiden Lane III CDS program shutdown entity in November, in connection with New York Fed efforts to replace a 2-year, $85 billion New York Fed credit facility.

Here is a table of the multi sector CDO's from the 3Q 10K:
Since there is no way you can read it as is, you can click on it to view it in full size. This lays out the numbers in a much more understandable way. However, column 3 shows the Net Notional Amount of $71,644,000,000. Column 4 is the "fair value" of the derivative of $30,207,000,000 as of September, 2008 financial statements. That means that AIG had already booked losses of $30.207 billion as of September -- that is, written that portion off.

Per AIG:

Included within that $71.6 billion portfolio (notional amount as of September 30) is approximately $9.8 billion of swaps that were sold as credit protection on "synthetic" securities. The swaps on these synthetic securities are also referred to as "cash settlement" or "Pay As You Go" (PAUG) swaps because they are settled in cash as and when losses are taken.

Here is what AIG says about it in September:

"Cash Settlement. Transactions requiring cash settlement (also known as “pay as you go”) are in respect of protected baskets of reference credits (which may also include single name CDSs in addition to securities and loans) rather than a single reference obligation as in the case of the physically-settled transactions described above. Under these credit default swaps:

• Each time a “triggering event” occurs a “loss amount” is calculated. A triggering event is generally a failure by the relevant obligor to pay principal of or, in some cases, interest on one of the reference credits in the underlying protected basket. Triggering events may also include bankruptcy of reference credits, write-downs or postponements with respect to interest or to the principal amount of a reference credit payable at maturity. The determination of the loss amount is specific to each triggering event. It can represent the amount of a shortfall in ordinary course interest payments on the reference credit, a write-down in the interest on or principal of such reference credit or any amount postponed in respect thereof. It can also represent the difference between the notional or par amount of such reference credit and its market value, as determined by reference to market quotations.

• Triggering events can occur multiple times, either as a result of continuing shortfalls in interest or write-downs or postponements on a single reference credit, or as a result of triggering events in respect of different reference credits included in a protected basket. In connection with each triggering event, AIGFP is required to make a cash payment to the buyer of protection under the related CDS only if the aggregate loss amounts calculated in respect of such triggering event and all prior triggering events exceed a specified threshold amount (reflecting AIGFP’s attachment point). In addition, AIGFP is typically entitled to receive amounts recovered, or deemed recovered, in respect of loss amounts resulting from triggering events caused by interest shortfalls, postponements or write-downs on reference credits."

They disclosed it. However, I will say that I didn't see the $9.8 billion of PAUG CDS's specifically addressed. This is inherently confusing because AIG has chosen to isolate $71.6 billion net notional CDS's on multi sector CDO's as the problem. There are other CDS's that weren't considered a problem, and it wasn't always clear to me which set of CDS's were being referred to in this section of the 10-K. However, the diagram below, from the 10-K, lays out how the credit facility or SIV works. The AIG-FP obligation is for the "Super Senior" tranche - the box on the right. For Multi Sector CDO's, thats the layer that AIG wrote the CDS on. There is $38 billion in subordination -- relating to the dark section on the bottom that is someone else's problem.

For the CDS's on the Super Senior, Multi Sector CDO's, the "Gross Notional" is $108.5 billion. The result of the credit facility is that when it is completed, AIG will have no net exposure. They will have written off the entire amount, sold the remaining assets to the credit facility. Here is my diagram (typo: change the $25 to $30):

The take away from this. First, that Super Senior meant about 1/3 subordination. Secondly, AIG has been writing this stuff off for 4 quarters, and a big chunk of it is gone. Thirdly, the NYFRB has about 75% subordination from the original CDO's, which doesn't sound that bad. Sounds like they have a decent chance to fully recover their money. After all, some people pay off their mortgages, and if not, some of the assets are recoverable. Settling a PAUG CDS on a synthetic CDO may be difficult, but someone needs to drive a good bargain and with the FRBNY, I don't see why it couldn't happen Fifth, this stuff is too complex for normal people. Given the low level of confidence and trust -- people are going to assume the worst. However, one would hope that the WSJ would put a little more effort into it.

AIG Reporting in the WSJ - Atrocious

2008-12-09T21:20:00.000-08:00

I never set out to defend AIG, but this WSJ story is hopelessly confusing. It sounds like what they are trying to say is that there are an additional $10 billion in losses, based unidentified sources, that have not yet been disclosed.

Fine, I suppose. However, then they repeat parts of last month's SIV/bailout. This is not news in any respect, but gets announced as if it hasn't already been reported, booked in AIG financials, etc. The multi sector CDO's that AIG guaranteed via CDS's are being settled in such a way there is no material uncertainty. Just like they announced. As I described in an earlier post regarding the AIG bailout, they are just settling up $65-70 billion in CDS's. Per the Journal:

As of Nov. 25, Maiden Lane III had acquired CDOs with an original value of $46.1 billion from AIG's counterparties and had entered into agreements to purchase $7.4 billion more. It is still in talks over $11.2 billion.

So the SIV is buying $60.3 billion in multi sector CDO's. That's less then $70 billion. The SIV is using a $5 billion investment from AIG, Up to $30 billion in FRBNY loan, and the rest is being written off by AIG. They had already written off most of this, so the new bad news in November was relatively modest.

The problem is that the WSJ staff writers don't seem to understand anything about accounting. The "news" last month was that AIG was going to honor its CDS promises. Once that fact sunk in (if it ever did), the exact mechanism is irrelevant. That is, the counter parties were made whole. If you bought a CDS from AIG on a $10 million multi sector cdo, then you get the $10 million and AIG got the cdo, which it then sold to the SIV at a discount. It doesn't matter if you send the collateral back, mail in the cdo, and then get your $10 million. Or if you keep $5 million in collateral, mail in the cdo, and the remaining $5 million. You had an insurance contract for $10 million, and you got your $10 million. However, the WSJ writers seem to get caught up regarding when the collateral was posted as if that was news.

The only new news is that there may be additional losses. AIG said:

...that exposure has been fully disclosed and amounts to less than $10 billion of AIG's $71.6 billion exposure to derivative contracts on debt pools known as collateralized debt obligations as of Sept. 30

The WSJ writers are also hung up on whether a CDS is a speculative bet or a credit protection instrument. It is obviously both. How many times does AIG need a beat down in print over the same dumb mistake?

There is also some confusion about what I think might be CDS swaps where the purchaser didn't own the underlying. It is impossible to figure out what the journal writers are getting at, but they want it to sound dramatic.

There may or may not be additional AIG losses that haven't been disclosed. However it would not be surprising if AIG's trillion in assets have taken a few hits since the 3Q financials. A coherent discussion by the Journal might have shed some light on it. But breathlessly rehashing last month's news adds nothing.