Hunter has posted notes taken by one of the attendees on his blog.
The notes seem relatively accurate, but I thought I'd point out, what I believe, were the chief takeaways from the Roundtable:
There are a lot of opportunities to make money after a fairly long drought in the distressed space;
As in typical value investing (consistent with Graham & Dodd), the key to making better returns is to identify inefficiencies in the market;
There are many more players, and more cash, looking to participate in the distressed market, making it harder to find good opportunities (not impossible, harder);
Europe is one place where there are opportunities. There really hasn't been much of a distressed investing market in Europe until now, and there was a great deal of leverage employed there;
The bankruptcy laws of the UK, Germany and the Netherlands are attractive to distressed investing;
The laws of France, Spain, and Italy are less creditor friendly and, therefore, not very attractive for distressed investing;
In the US there ARE opportunities. They require a lot of work - sometimes to find a situation where there is no point of entry (the debt has increased in price or isn't available to purchase) - so you HAVE to, in effect, be willing to drill a lot of dry holes to find a gusher (to use an oil industry analogy);
Distressed debt investing requires similar skills to private equity, but a completely different mindset. One of the panelist mentioned a situation where a PE professional was having difficulty wrapping his mind around projecting a deteriorating situation (they are used to projecting growth in revenues and/or margins - declining margins are antithetical to typical PE investing);
It definitely helps to bring new money to a distressed situation;
The most attractive opportunities are good companies that have bad balance sheets;
Sometimes the current management may not be able to get the most return from the business and a management change is required. Being able to identify THESE situations will generally provide the greatest inefficiencies (and, therefore, risk/reward ratio); and
Distressed investing is part of the overall market place. If the economy gets worse, then their investments may lead to significant losses (this is not a riskless business).
I thank HBSCNY for putting this roundtable together and White & Case for hosting it.
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The International Monetary Fund recently released its World Economic Outlook (subtitled Crisis and Recovery) and its Global Financial Stability Report (subtitled Responding to the Financial Crisis and Measuring Systemic Risks).
That seems to be the attitude in the news and in Washington lately.
Even Jon Stewart has gotten in on the act. In response to a comment by John Thain that he had to pay his best people, Stewart (on the Daily Show) shouted "You don't have best people. You lost $27 Billion. Do you live in bizzarro world?"
Even the President has gotten headlines by questioning banker compensation. The New York Times reported yesterday that "Mr. Obama also needs to deflect a growing populist outrage over sky-high pay among banks and other companies on the public dole."
All of the outrage being spewed at the "bailout" of the banks misses a basic point: it's an investment, not a handout! The financial institutions are not on the "public dole."
While it is true, if the supported banks fail, the government's recovery will be significantly less than the amount invested; the idea is to prevent the banks from failing.
The government has purchased non-voting preferred stock paying a dividend. The intent is for the banks to refinance and redeem the preferred, giving the money back to the government on top of the dividends paid while the preferred was outstanding. Some of the banks have also had to give warrants to purchase stock, giving the government participation in any upside.
Since the government, and we the people, have a vested interest in the survival of the banks the government invests in, the statements expressed are not particularly well thought out.
In fact, we want the banks to prosper and grow. We should not be demanding actions that could hamstring them and/or prevent their success.
A significant portion of the losses taken by the banks/investment banks receiving capital injections from the government are paper losses. A large part of these losses will turn out to be real, but some of the losses have been booked based on current markets, which are not functioning properly. The assets underlying those losses may in fact be worth significantly more than current market values. If that is true, then the government should get its money back faster.
While some areas of these banks clearly performed miserably, other areas were profitable. The bankers in those businesses need to be compensated.
Clients for many of the services provided by the investment banks are loyal to the banker, not the institution. If the banker leaves (and, contrary to some perceptions there is ALWAYS a market for people who bring business), the business leaves with him/her. That's why it's important to pay some of these bankers.
It's difficult for outsiders to conceive sometimes, but in investment banking, and in some other areas of finance, bonuses are multiples of salary, not fractions. If you cut a bonus to 50% from 500%, that's significant, but it's still a bonus.
Rick Bookstaber, on his blog, posted this last week, where he gives a clearer explanation of how people in the investment banking world are paid. He points out that the bulk of employee compensation is paid in bonuses, even for lower level staffers. One commenter questioned whether the practice continued after the investment banks became public companies. It has.
As for things like stadium deals, as a Mets fan I'm not particularly enamored of Citi's name and I find the logo for the first year of the field uninspired. That said, it's a marketing decision. Somebody at Citi felt branding the ballpark with Citi's name would bring greater recognition to the bank, and, presumably, profitable business. It might be a good idea for someone at Citi to revisit the analysis and present it to the proper people; but I don't think Congress should be focusing on such issues, as obvious as they may be.
The idea of Congress getting involved in banking decisions is beyond scary. The Soviet Union fell because of that kind of central planning.
The current problems don't mean the capitalist system has failed. There have been mistakes made, but it's not an indictment of the whole system.
Shakespeare's play, Henry VI, has the famous line: "The first thing we do, let's kill all the lawyers."
Let's not kill the bankers. We need the banking system to work so capital can flow and businesses can start running properly again. Then the government can get back its money, pay down the increased debt, and we will be that much closer to normalcy.
This has been a difficult year for most people (pretty much everyone who wasn't short). Hopefully 2009 will be better, although we are certainly in a mess.
When I initiated this blog, I discussed how fear and greed are driving factors in our markets.
The Federal Reserve and the Treasury are now trying to deal with the tremendous fear in the markets today by creating a mechanism (a $700 Billion mechanism) to absorb the shocks to the system and restore confidence to the markets.
I consider myself a capitalist. I believe that markets work, in the long term.
I believe that situations like this, however, require a party to step in to allow markets to work properly - and prevent panic selling from overwhelming and eliminating demand.
While some parties to the discussion are focused on blame and punishment, I don't believe we have the luxury of dealing with that now.
I believe intervention is necessary, and urgently so.
Given that it's an election year, there has been the typical rhetoric by some politicians pointing the blame for the current crisis on the other party.
Let me be clear. NO ONE PARTY IS TO BLAME!
I attended a cocktail party last Wednesday thrown by one of the large international banks for high yield and leveraged loan professionals. There was much discussion about what caused the current crisis.
One of the people I spoke to pointed to the Fed's reaction to the March 2000 Internet bubble as the cause. His point was that the easy money policies of the Federal Reserve, designed to minimize the recession in 2001-02, caused the housing crisis and led to today's problems.
He is, in my opinion, absolutely right that the easy money policies contributed. The key word is contributed.
In reality, this crisis was created by a confluence of factors. The overused term "Perfect Storm" is an apt description of what we are dealing with.
I will post more of my thoughts on this over the next few days. Please feel free to contribute to the discussion.
It's a sad, and apparent end, to a 158 year old firm.
Together with the news of Merrill being purchased by Bank of America, and AIG in a search for capital to avoid a downgrade, the markets on Monday will be highly volatile (obviously).
This item, from FT's Alphaville, reports on changes that are in the works at the Financial Accounting Standards Board ("FASB", the entity that sets the standards in the US for Generally Accepted Accounting Principles - or "GAAP") that may well kill the off-balance sheet entities that have been blamed for much of the credit crises of the last eight months.
While creative minds at the leading investment banks and accounting and law firms may resurrect Special Purpose Entities, their use as off-balance sheet mechanisms seems doomed.
Of course, accounting rules change over time, and these discussions may not yield any results, but we probably won't be hearing about new SIVs and (off-balance sheet) SPEs for some time.
It’s hard to get excited when there’s so many acronyms flying around. But the bottom line is that the FASB last week tentatively voted to remove the QSPE concept from FAS 140.
Now before you get partying, a little background.
Qualified Special Purpose Entities (QSPEs) are vehicles sometimes used for off-balance sheet securitisations, and as such, have come in for quite some flak over the past few months.
The QSPE enshrines the idea that in securing off-balance sheet or “sale treatment” for assets, the bank or originator must have given up control of those assets.
Yet when SIVs hit trouble, and the banks that spawned them were prompted by reputational concerns to step in and help out, the supposedly “sold” assets came back on board those institutions’ balance sheets.
Explains the FEI blog, the QSPE concept has also been criticised by some because the restrictions prohibiting the management of underlying “sold” assets (unless pre-specified in the securitisation documentation) were seen to have hampered the ability of lenders, say, to modify mortgage terms to help borrowers avoid foreclosure in the light of the credit crunch.
In cases where restructuring did occur, with the originator also acting as the servicer often making these calls, in what sense have the assets really been “sold”?
The blog links to the details of the board meeting held last week at the Financial Accounting Standards Board, the US standard setter. In the meeting the FASB considers changes to when vehicles can be “derecognised” or transferred off balance sheet.
The issue of QSPEs has been on the FASB’s agenda since back in 2005, but has been stepped up since last summer. As board member Larry Smith is quoted as acknowledging:
For five years now we’ve struggled with application of [FAS] 140 [and] the fundamental question related to servicer discretion. We said, it’s almost impossible to structure a vehicle with the objectives the board had in mind when they created QSPEs: that is, an entity that has no decision making whatsoever relative to the run-out of these assets.
The latest draft of simplified guidance on asset transfer is expected in the second quarter.
What next then?
Credit Suisse analyst David Zion noted the FASB’s move to eliminate the QSPE concept and warned that changes, which could see a new rule by the end of the year, may mean more assets coming back onto corporate balance sheets.
Eliminating QSPE’s, along with other changes the FASB will discuss in the coming weeks may end up bringing more assets back on corporate balance sheets—along with the debt from the securitizations. However, the Board is considering allowing the assets and liabilities of certain entities to be shown on the company’s balance sheet in a new way; a “linked presentation” where both may be shown together on the asset side of the balance sheet (i.e., the liabilities are treated as a contra asset).
Either way, adds Zion, investors require better information on what companies may have parcelled off in such vehicles. Current disclosures are inconsistent and incomplete.
And next up for potentially burgeoning balance sheets, the FASB is set to discuss FIN 46R, the accounting rule that covers everyone’s favourite - the variable interest entity (VIE), an acronym which hit the headlines - thanks to another round of banking disclosure - in February.
Says Zion:
The FASB could decide to change how companies determine if they control a VIE (focusing on more qualitative factors) and force companies to reconsider whether or not the VIE stays off balance sheet more often than they do today, changes that could land more off-balance-sheet activity back on balance sheet. We plan to follow these developments and follow up with future reports on off-balance-sheet accounting. Stay tuned…
One might wonder why, with all the activity in the markets (okay, EXTREME volatility), I haven't had much to say.
That would be a bit misleading. I've been a little busy, but I plan on catching up over the next week or so.
I had a great time over the last few weeks refreshing and updating my skills by taking a class in distressed security valuation at NYU's Stern School of Business. Unlike Professor Altman, the Adjunct Professor that taught the class is a practitioner (hedge fund manager) - and I'm not sure that he would appreciate my mentioning his name, so I won't. He also brought in a top bankruptcy attorney to instruct us on the current law and to give us a better feel for the restructuring process; and what an investor in distressed securities needs to be aware of.
Both teachers were excellent speakers, passing along important information with good humor and letting students feel at ease with their down to earth styles.
As I mentioned in my post on Professor Altman's class, the learning experience at Stern is remarkably different from my tenure 20 years ago. Certainly that is to be expected, but the information that is now easily available over the Internet significantly improves the students' education (while raising the expectations of their work product). The changes in technology have also made it easier for students to really become engaged in the classes.
Back in the early 1990s, I was very involved in the restructuring business at Deloitte (in the valuation practice) and I participated in two of the week-long seminars conducted at NYU's Law School by the late Larry King. These seminars gave me an excellent understanding of the bankruptcy law at the time. I also travelled to the Bankruptcy Judges Conference in San Antonio where there were numerous useful lectures, and opportunities to network with other restructuring professionals.
Of course, I also took Professor Altman's Bankruptcy and Reorganization class while I attended NYU.
All of those learning opportunities, however, were related to the old Bankruptcy Law.
I now feel much more comfortable with the changes made to the Bankruptcy Law in 2005. As I mentioned in an earlier post, I expect there to be significant growth in the distressed/restructuring markets over the next few years. This course has updated my skill set to better identify, and profit from, the upcoming wave of opportunities.
Bottom line, I've been focusing on learning the past few weeks (in addition to my more normal activities). I expect to be writing more regularly, at least for the next few weeks.
In this article from Reuters, there is a pretty good discussion of how the credit contagion happened (subprime/CDOs/SIVs/Monolines/etc.).
Unlike some commentators, journalists, bloggers, etc., Reuters gives a fairly good account of how the situation evolved from a cascade of bad assumptions:
"The CDO folks, who were cut from the same cloth as CDO professionals all around the Street, who didn't treat bonds as real things but treated them as mathematical abstractions, blew up the bond insurers the same way that the same kinds of guys at Merrill (Lynch) and Citi caused major explosions in their firms," said Mark Adelson, a consultant at Adelson & Jacob Consulting in New York.
"These (banks) and the ratings agencies and the monolines (bond insurers) tend to be comprised of a lot of youthful, bright individuals who lack real-world experience," Dobish said. "They're not going to remember back 20 years ago."
Rob Haines, senior insurance analyst at CreditSights in New York, said: "They all got it wrong."
In my opinion this is a much better explanation of what happened. Incentives were set up to create a situation where it was easy to lose sight of the assumptions underlying all of the formulas.
Fraud played a part, which seems to have been primarily situated at the origin of the mortgages, but intent - in my opinion, at least - was NOT there.
The article alludes to the continuing effects of markdowns (a reduction of bank lending capacity - exposing borrowers who need more credit).
There are lots of moving pieces in this storm, and I don't believe there are any certainties as to where we end up.
Exogenous factors such as the Private Equity/Hedge Funds that raised large amounts of capital to take advantage of such a crisis, and the Sovereign Wealth Funds represent large pools of capital that could prevent prices from dropping too low (I expect a game of chicken as the funds vie to see who can hold out longest before buying in).
The impact of Credit Default Swaps on the markets is also unknowable. If banks hedged loans with counterparties that can't perform, there would be more markdowns. Nobody really knows what the exposure is (there have been numerous attempts to estimate it, but it's impossible to account for those situations where there is regular settlement of contracts).
I'm glad that there are some articles that are now noting the impact of systemic defects as opposed to blaming individuals or organizations.
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As I pointed out earlier this week, one undefined risk to the health of the financial markets is the potential impact of credit default swaps. These securities are used by banks, hedge funds, and other large institutions to hedge, and speculate on, the potential for default by one or more companies.
There are two specific risks:
The number and value of actual defaults that are insured with the product could lead to significant losses to the insuring parties, reducing their capital and, consequently, their ability to fund economic activity (thus slowing the economy); and
The potential for defaults by insuring parties and the impact of these defaults on the insured parties (who may have used the swaps to hedge the risk of default, and who would then have an unexpected exposure).
Both of these risks are difficult to quantify given the opacity of the CDS markets. The bigger risk to the overall financial system is, I believe, the potential for defaults by insuring parties (counterparty risk).
Counterparty risk is, for many products, limited through the use of daily settlements. Most of the CDS market is, however, traded over-the-counter in private transactions. Regular settlement for private transactions is limited.
It would be very difficult to resolve a significant number of counterparty defaults, should they occur. When Long Term Capital Management failed, the Federal Reserve had to step in to help sort out the situation. In that case there was one large defaulting party. Should there be significant defaults in the CDS markets, it is unlikely that the risks would be contained in one or two entities. The complexity of cleaning up multi-party defaults would likely provide a much greater challenge than that posed by the CDO/sub-prime mess.
There is the potential, if there are a significant number of counterparty defaults, that there could be a cascade of failures by banks, hedge funds, and other large institutions.
This article, from The Business Times of Singapore (via HedgeWorld), presents some reasons why searching for a scapegoat for the sub-prime/SIV/liquidity crisis is foolhardy and destructive.
I guess you can guess that I agree with most of the article.
This evening CNBC broadcast a discussion, moderated by Maria Bartiromo, between CNBC's Charlie Gasparino and David Ruder (former SEC Chairman and the William W. Gurley Memorial Professor of Law Emeritus at Northwestern).
Mr. Gasparino was arrogant, belligerent, and rude. He appeared to have come to his, rather simplistic, conclusion; and simply wanted to use Professor Ruder as a piñata as he castigated the Securities Exchange Commission.
Mr. Gasparino, rather than discussing his thoughts with Professor Ruder, chose to prove who could display the worst manners and speak loudest. That was a good strategy if his goal was to win, because his position was idiotic (at least he never managed to make a valid point to explain how his position made practical sense).
Mr. Gasparino, like most of his colleagues, was educated as a journalist. His knowledge of the securities industry is, primarily, second-hand as he has written about the markets for a number of publications. I don’t know why CNBC gives its "bully pulpit” for a reporter, like Mr. Gasparino, to present his opinion as fact. While he may be an expert at obtaining and reporting facts, his ability to analyze and present coherent arguments relating to economic/business issues is minimal (if it exists at all). Somehow, the FT manages to present reporters that can analyze and argue.
Apparently the old maxim of “those who can do and those who don’t teach" (no offense meant to Professor Ruder, he has done both so he is a "doer") has to be extended for Mr. Gasparino to include: “and those who can’t teach, report.”
Mr. Gasparino's position, as I understand it, is that the SEC should have stepped in to regulate the ratings agencies (S&P, Moody's, Fitch, etc.); thus preventing the agencies from issuing AAA opinions on CDO and other derivative products that later defaulted (how they would have been able to identify the problems given the opaque nature of what the agencies do is, to me, unclear). While he seems to recognize that Congress never gave the SEC that authority, he believes (or "a lot of people on 'The Street'" believe - unnamed sources, priceless) using that as an excuse for the lack of action is a "cop out."
He states that, given the New York City crisis in the '70s, the "dot coms," Enron, and Worldcom, the SEC should have known to go after the ratings agencies. He believed that the SEC should have found a way to "use a back door" to regulate the ratings agencies.
He seems to believe that, had the SEC kicked and screamed to expand its duties, Congress would have given in. His lack of insight into politics is unbelievable!
While there are many holes in Mr. Gasparino’s arguments, the most obvious to me is how do you pay for it?!
Where would the money come from to expand the size of the SEC to take on more responsibility?
Congress does not have much of a record for creating safeguards prior to a crisis (and it's hard to blame the SEC for not uncovering the frauds at Enron and Worldcom). Giving an agency new authority without prompting is, I believe, unusual. Raising an agency's budget to exercise that authority (and any consequent increase in taxes) would not be popular. Even after SarBox, I don't believe that the leaders of the SEC believe they have sufficient funding and resources for their existing responsibilities.
The SEC, itself, was created as a result of the 1929 crash. People of that period could have pointed to the 1907 crisis (much discussed recently in relation to the current crisis) when asking why did it take so long. Of course, the Federal Reserve System was established after the 1907 crash (in 1907, J.P. Morgan led the rescue).
It’s always annoying when critics come out of the woodwork to ask why the government didn’t step up to protect the “little guy” – whoever that is. It is usually the same people who, in more normal times, get angry over having the government looking over their shoulders.
I believe that Mr. Gasparino would be more comfortable in Beijing. The Chinese markets are regulated to a degree where the penalty for corruption, when prosecuted, is death. The Chinese markets, at their present stage, don't have dangerous derivative products (or the benefits that they provide in transferring risk). He wouldn't like it there for long though; China's leaders appear to be intent on integrating free financial markets into their system.
The complexity of our markets has increased beyond what was contemplated in the past. Over time, different regulatory authorities have been created for specific purposes (like the CFTC and the SEC); and there are now products that are regulated by nobody, or by more than one regulator. We need to overhaul our market regulatory system so that we maintain our position as the world’s preeminent country for financial markets (assuming London hasn’t overtaken us already).
In my opinion, we need regulation; but we still need investors to take personal responsibility for their actions.
My question for Mr. Gasparino is, given that he has had a "bully pulpit," why didn't HE get on a soapbox to address the issue.
The ratings agencies were known, by all of the institutions that are involved, to have some level of conflict (although there is some expectation that the agencies would lose their influence because of the "reputation risk" if they were found to be prostituting themselves). The investors in the securities under discussion (Collateralized Debt Obligations, Collateralized Loan Obligations, Asset Backed Commercial Paper, etc.) were sophisticated investment firms. Those firms are motivated by profit (as are their employees). They chose to accept both the ratings and the risk (in anticipation of rewards).
My conclusion, at least for now, is that bubbles are a necessary evil of our free market economy. I cannot see any way that risk can be eliminated, nor do I believe that it should be.
There are all sorts of arguments for how we can modify our regulatory system to address the weaknesses exposed by the recent/current crisis. Ascribing blame, except for criminal acts, is a waste of time and, generally, results in witch hunts (anyone remember Joe McCarthy?).
A number of SIVs did make sense. Commercial banks offered their corporate customers the chance to finance their receivables through SIVs. In those cases, the bank was able to earn a fee for managing the SIV, the companies were able to retain more of the value of the receivable, and the bank didn't need to include the funding provided to their clients on their balance sheet (they were able to effectively work with no capital requirement).
The companies would sell their receivables to the vehicle. The funds would be provided by the jointly owned SIV (which would have little, if any equity). The SIV would be funded by issuing asset backed commercial paper (ABCP). The receivables, however, would generally have similar maturities to the paper backing it; so if the ABCP market dried up, the assets could be quickly run off to liquidate the SIV.
The first SIV was structured by Citi in 1988. Since then the structure became more popular and morphed into the structure shown by Portfolio.
Moody's recently published a report entitled Archaeology of the Crisis. I think it's definitely worth a read.
Given that Moody's is one of the agencies that many blame for, at least, part of the crisis, it is commendable that the report somewhat addresses the agencies' failures. Unfortunately, as is frequently the case, these failures are more obvious after the fact than they were prospectively.
Specifically highlighted is how loan originators, subprime loan borrowers, and market intermediaries were incentivized to provide limited information to other parties (including the rating agencies).
Also highlighted is the effect that differences in assumptions by market participants, particularly in relation to the definition of liquidity, had in the crisis. This disconnect was especially present in assumptions about how ratings do (or don't) reflect the market risk of a security (a "market-risk judgment") in addition to agencies' credit judgment (based on analyses of financial statements and the ability to pay).
The problem of how to consider the liquidity (defined, in this case, as a sufficient number of buyers and sellers), particularly over time, of securities (particularly unseasoned structured securities) is certainly significant.
The report also identifies the mark-to-market approach for valuation as one of the causes of the credit crisis. I have been concerned about the impact that financial reporting has been having on markets. It has been the financial equivalent of the "observer effect" where the measurement of the value of securities effects the value of those securities.
Accounting is supposed to provide information. It is designed to measure and report on asset values; not to impact those values.
There has been a tremendous amount written about the credit crisis; its origins; who's to blame; potential solutions, etc. Some of this has been excellent; some, not so much.
I am still trying to catch up and provide, perhaps, my own observations.
In the mean time, Gillian Tett and Paul J. Davies of the FT wrote a particularly good article in December that's worth a look. That paper continues to provide insightful information and analyses.
Bill Gross and Paul McCulley, of PIMCO, are also providing good insights that are available here and here.
One thing that I continue to find troubling is that so many of the holders of effected securities (ABCP, CDOs, etc.) seem surprised that it was possible for them to incur losses on their investments. The perception of increased risk for increased return seems to have eluded them.
Perhaps their surprising losses were due to fraud on the part of those who sold the securities to them. I'm sure we'll learn more about this in time.
The entire structured world and the banking system will likely be examined, to various degrees, as the situation in the markets becomes clearer.
It was well known in the financial world that risk was being priced at unusually low cost. Spreads on lower grade securities were squeezed as demand for higher returns apparently outweighed the fear of associated risk.
Given that the positions of many SIVs and conduits have been taken onto the balance sheets of the financial institutions associated with them (CitiGroup being the largest example), there will (appropriately, in my opinion) be a reexamination of what types of entities should be subject to regulation and how their assets and liabilities should be presented on financial statements.
On the other side, however, is the question of what constitutes an "accredited investor" and/or who should be allowed to make the decisions to purchase specific investments.
Personally, except for cases of fraud, I am offended by investors that claim to be sophisticated (the definition of "accredited investor" is an attempt to clearly state who is sophisticated), until they incur a loss.
It's understandable that people/institutions don't want to lose money, but I think it's childish to claim ignorance when investments generate losses.
These parties want to have access to all of the wizardry the financial houses can devise, but not the ones that lose money (I'd like that too, if only the world worked that way).
Perhaps the SEC and other regulators should consider a licensing exam to purchase unregulated investment products instead of assuming that having assets/income makes investors qualified to understand what they are buying.
Agents have to be licensed, why not their customers? It should generate a more sophisticated group of investors, whether or not they pass the test.
I, at least, think it's an intriguing idea.
People and institutions that were defrauded should be protected, but I have a problem with rewarding laziness and/or stupidity. Sophisticated Investors are supposed to be able to understand the risks involved in what they purchase and to be able to bear the burden of any related losses (which is why the Securities Act has an asset/income definition).
The ratings agencies, who are being picked on as the implied regulators, made their own mistakes. They always stated that investors should not rely on their ratings; and almost everyone knows that they are compensated by the issuers.
There was never a solid explanation of how M-LEC (the Master Liquidity Enhancement Conduit) would have been structured (without guarantees from the supporting banks it would have had a hard time funding the purchase of SIV assets, even the "best" of those assets).
In the end, I believe, the idea of M-LEC helped to stabilize the markets (in that, without the expectation of some plan, the markets would have been less stable).
Apparently there was no way to make the economics of the structure attractive to both the participants in the Super-SIV and the SIVs that were supposed to be saved.
Actions by the banks themselves (taking the SIV assets onto their balance sheets) seem to have dealt with the problem.
The banks have been able to attract capital from other sources to keep their balance sheets in order.
A lot has happened over the last month. I will attempt to add my point of view to the areas that I think are worthy of discussion. Please feel free to agree (or disagree) using the "Comments" link below.
I find the idea of a borrower bailout extremely interesting. I agree with Fed Vice Chairman Kohn's statement that the moral hazard related to acting is less of a problem than not acting and allowing innocent bystanders bear some portion of the cost.
What I find particularly interesting, however, is the part that fraud and sloppiness seems to have played in the sub-prime crisis.
One source that they relied on in their analysis was a report put out by BasePoint Analytics, LLC. BasePoint's analysis found that up to 70% of mortgage early payment defaults can be linked to a significant misrepresentation on the original loan application.
Fitch conducted their own analysis using a very small sample of early defaults from 2006, many of which had what appeared to be strong credit characteristics. Fitch reviewed the loan files for the sample and found problems with more than half! Some of these problems were technical (borrower's balance sheet and income didn't support the level of stated income) and some of them were close to fraud (receiving credit for being "authorized" to use other people's credit - the credit agencies have stopped raising FICO scores for this method of "credit enhancement").
If fraud played such a large role in the current crisis, I don't think it's the borrowers that the government should be looking to bail out.
I suggest that you read the report if you find this subject at all interesting.
Given the potential cost to the US taxpayer, I would expect most US citizens to have some interest.
I think everyone reading this has heard about the turmoil in the credit markets that became incredibly obvious this summer.
Now we're seeing a domino effect as fears run rampant.
While I was well aware of Special Purpose Entities (SPEs) and other off-balance sheet structures generally, it wasn't until this summer that I heard of Structured Investment Vehicles (SIVs). A SIV is a special type of SPE (aren't acronyms great?).
Recently we heard that some banks, with the support of the Treasury Department, were creating MLEC (a sort of "Super-SIV"), however no specifics were ever announced (and may not have been agreed). Of course this didn't stop bloggers and columnists from coming out with their opinions on it (mostly negative). I merely voiced the opinion that I didn't see how it would work unless there were specific guaranties made by the institutions creating the entity. I am in favor of giving market players an opportunity to figure out what they own so they can clean up the mess.
I have some specific comments to make about one recent column, but more on that later.
Merrill Lynch shocked the market with $8.4 billion in write-downs last week, $4.9 million more than they had estimated on October 5th. Why did this happen?
Rachel Beck of AP wrote an article today that may answer that question.
These white papers, which I am in the process of reading (but which are described by Fitch Ratings in a very timely report), provide guidance to auditors on how to interpret recent, and not so recent, statements and interpretations by the Financial Standards Accounting Board and the AICPA, principally FASB-157, FIN 46(R), and CON 7 . Fitch also notes that IAS-39, issued by the International Accounting Standards Board, is being employed by some financial institutions.
If you have trouble sleeping, I highly recommend that you read the FASB documents. It might give you nightmares, but you might understand what the financial institutions are actually saying in their filings (a lot of this is relatively arcane, but the original pronouncements can provide a sort of Rosetta Stone).
While quarterly reports are not audited, it is apparent that the new guidance led several institutions, including Merrill Lynch, to make more conservative estimates in anticipation of the year end audit. It is highly likely, in my opinion, that when Merrill made their original estimates they had not yet read (and/or implemented) the October 3rd guidance.
In a way, it appears that E. Stanley O'Neal lost his job over the timing of a change made by a new audit industry governing body. Of course the magnitude of the losses might have created the same environment, even if they had been part of the pre-announcement. Reports, however, seem to point to concerns due to the huge difference from the initial estimate within such a short period of time.
Oh well. He got a good severance package.
I'm really looking forward to reading/skimming these documents together with the SEC filings to get a better picture of actual exposures (at least what is disclosed).
I figured it would be better to provide this information now and give readers a chance to make their own assessments rather than waiting for me to read all that material.
Enjoy. If nothing else, I highly recommend that you read Rachel Beck's article and the Fitch report.
I have created this Blog to publish my views, thoughts, etc. on the markets and the issues (like fear and greed) that I think are worthy of discussion. I hope that you will be willing to provide your thoughts in response, and that you will let me know what you think and what, if anything, I missed.
