Monday, June 30, 2008

Barclays and Lehman? Seriously?

I've heard some crazy Lehman rumors in my time, most of them true, but the rumor du jour circulating about Barclays evaluating a take-under of Lehman may take the cake.  Lehman received yet another drubbing in the market today for seemingly no reason, ending the session below $20, an eight-year low.  Bloomberg reported that this particular beatdown in the stock was attributed to speculation among traders that Lehman was going to sell itself at a below-market price to some bank.  Reuters claimed that one version of the rumor pointed at Barclays buying Lehman at $15.  Although referred to as a "take-under", if the stock continues its spiral downward at this velocity, $15 will appear to be a very attractive premium by the end of the week.
When I first hear a crazy rumor such as this one, I instinctively instant message or call every trader I know and ask if he's heard the rumor, thus contributing to the spreading of the rumor without really knowing the origin or having any facts to support the supposition.  As I spent all day today in a courtroom hoping I wouldn't end up as a juror on a one-month murder trial, I didn't have a chance to engage in any rumormongering.  Inspired by the strict instructions handed down by the judge for the murder trial, I have decided to look at the evidence before jumping to any conclusions:
I would like one of the rumormongers out there who actually believes this one to explain to me why a bank that just raised nearly $9 billion in capital because it had one of the lowest Tier 1 ratios of any European bank, would immediately spend that fresh cash to acquire a US investment bank caught in a vicious death spiral.  Barclays is already in the US investment banking business.  There is just too much overlap for the deal to make any sense from an operational perspective, which would imply that Barclays is interested in scooping up Lehman's assets at a discount.  Yeah, I thought that was funny too.  Who knows what those assets are really worth?  Maybe David Einhorn, but he's not telling until he's finished covering his short.  
From Lehman's perspective, it makes absolutely no sense that Dick Fuld would be looking for an opportunity to sell the bank at $15 a share a mere three weeks after he just raised money at $28 from a slew of supposedly savvy institutional investors.  That would absolutely put the final nail in Lehman's credibility coffin.  Because if Mr. Fuld was shopping the bank around at $15, the implication would be that Lehman is having counterparty or liquidity problems.  In that case, it would be better to wait for the opportunity to buy Lehman at $2 with the Fed promising to take the first $30 billion in losses. 

Auction Rate Securities Failures Lead to Lawsuits and Deja Vu

Last Thursday, Massachusetts regulators filed a lawsuit against UBS alleging that the bank gave conflicted advice to customers in the auction-rate securities market.  As it became increasingly apparent that the auctions were going to fail when institutional investors started bailing in droves, UBS cranked up the sales pitch to retail customers, attempting to steer them into these "safe and liquid" securities.  Massachusetts has obtained emails where the auction-rate securities were referred to as a "huge albatross" coupled with emails urging managers to "mobilize the troops" to shovel the securities down unsuspecting individual investors' throats.  According to the Financial Times, many more lawsuits related to auction-rate securities will follow.  Anyone who is shocked by these obvious conflicts of interest was more than likely born in the 80's and busy with prom plans the last time Wall Street settled charges for conflicts of interest. 
At the turn of the century we had analysts like Henry Blodget and Jack Grubman.  The former slapped "strong buy" ratings on stocks that he thought were dogs, while the latter rated telecom firms a "strong buy" to get his kids into exclusive pre-schools.  The enthusiastic ratings were concocted solely for the purpose of winning more investment banking business from the companies.  They clearly were terrible investments as nearly all of the stocks that these crack analysts rated as "strong buys" went bankrupt.  Investors were mad.  Regulators produced conflicting emails, and fines were paid.  
When economists talk about cyclicality of markets, they are usually referring to the business cycle.  Investment banking is a cyclical business in the sense that banks typically perform very well when the economy is doing well, and poorly in a recession.  What I find fascinating about Wall Street is that it suffers from regulatory cyclicality as well.  Part of this must stem from the compensation structure.  Bankers, traders, salesmen and analysts are paid extremely well in good times and therefore are easily susceptible to crossing ethical boundaries in order to squeeze the last penny out of their bonus checks.  When you are paid millions of dollars in bonuses over the course of the boom in the cycle, it is much less painful when you are laid off, particularly if the bank ends up paying the fines.  While the good times are rolling, investors are happy.  All of the giddiness grinds to halt when the market turns and investors starts losing their shirts.  They hire lawyers, and file lawsuits.  Regulators don't want to look stupid, so they follow with their own lawsuits and enforcement actions.  Banks appoint scapegoats, fire them, pay the fines and swear they will never do it again.  The slate is wiped clean and the cycle begins again.  Will Wall Street ever change?  Or will we be experiencing deja vu all over again after the next bubble bursts?   

Friday, June 27, 2008

AIG Will Absorb $5 Billion in Losses From Securities Lending Unit

AIG plans to absorb $5 billion in losses for a dozen insurance units after their securities-lending accounts suffered $13 billion of write-downs related to subprime-mortgage exposure.    AIG will also inject an undisclosed amount of capital into some of the subsidiaries.  Investors, in general, never want to see the words "undisclosed amount of capital" in a press release.  An "undisclosed amount of capital" usually means that the amount is so large that the company is terrified of having that number plastered all over the front page of the Wall Street Journal.  Incidentally, does anyone else remember that AIG predicted in March that the worst-case scenario for losses from these "temporary write-downs" was $900 million taken over a period of years?  Or that it was merely $2.4 billion in May?  In my post about AIG's earnings release in May, I made an offhanded comment about how the company would be in serious trouble if its estimates for losses continue to double every month.  Here we are a month later with the company absorbing actual losses of $5 billion.  How much worse can it get given that the company has a $550 billion CDS portfolio?  I'm not sure investors want to wait around to find out. 

Thursday, June 26, 2008

Wachovia Takeover Speculation Heats Up

The rumors concerning potential suitors for Wachovia continue circulate.  Wells Fargo?  JPMorgan?  Anyone?  The speculation has intensified since Wachovia disclosed on Tuesday that it had hired Goldman Sachs to evaluate its loan portfolio, leading many to speculate that it had hired the investment bank to find a merger partner.  Wachovia would be an ideal takeover candidate, if it weren't for one big stinky problem: the "pick-a-pay" mortgages sitting on its books.  Wachovia paid $25 billion for Golden West in 2006, roughly $15 billion more than book value at the time.  Wachovia is left with $120 billion in option arm loans which includes $3.5 billion in deferred interest as of the quarter ended 3/31/2008.  Deferred interest is interest that the borrower has yet to pay because he has opted to pay the minimum amount required by the lender, thus the catchy name "pick-a-pay".  The borrower is not off the hook, he is merely deferring his liabilities.  Under GAAP accounting rules, Wachovia can book this amount as interest income, although it shows up on the cash flow statement because the company has yet to collect the cash.  How much of this deferred interest will Wachovia actually ever collect?  That is highly dependent on the delinquency and default rates of the loans, which are growing significantly due to falling housing prices across the country. 
According to Wachovia's 10-K, 59% of the "pick-a-pay" loans were based in California, 10% in Florida, and the remainder in various other parts of the country.  To summarize, nearly 70% of Wachovia's option arm portfolio is concentrated in two states where home prices have plummeted in the past year.  So Wachovia has $90 billion in exposure to borrowers in California and Florida who are making minimum payments more than likely because they could never afford a fully amortizing mortgage, and are probably now underwater on their mortgages.  According to Housing Wire, performance on Alt-A mortgages significantly deteriorated in May.  The 2006 vintage of Alt-A loans saw 60+ day borrower delinquencies among first liens reach 21.22 percent in May, up 10% in a single month.  The 2007 vintage saw 60 day delinquencies up 22% to 18.55%.  My guess is that Wachovia has seen its own delinquencies surge since the last quarter ended and realized it finally needed to take significant action.  This is why Ken Thompson, the ex-CEO who was a staunch defender of the Golden West acquisition, was given the boot in early June.  The company, which STILL has not written down the $15 billion in Goodwill from the Golden West acquisition, finally realizes that the loans are impaired, the acquisition was a big mistake, and Wachovia has not taken enough in reserves against potential losses.  What will Goldman conclude after its analysis?  Does any investor was to buy these assets?  My guess is that Wachovia will be forced to take an enormous, eye-popping loss if it sells the "pick-a-pays".  Furthermore, I don't think any bank will buy Wachovia until it can rid itself of the risky loans.  Wachovia is already trading at a significant discount to book value, so it is clear that investors are bracing for some very bad news.  But have they prepared for the worst? 

Lennar Posts Disappointing Losses Again

Lennar, the second-largest US homebuilder, posted a second-quarter loss of $121 million.   Around 60 cents a share out of the 76 cents a share in losses was attributed to more write-downs, indicating that the company is still losing money selling houses.  Revenues declined by 61%, deliveries dropped 60% and new orders fell 45%.  The average price of a Lennar home fell 8.1% to $274,000 from a year ago and sales incentives rose 11% to $48,700 per house, up from $43,700.  If you didn't think it could get any worse than this, well, you're wrong.  The company issued a gloomy outlook, claiming that it expected further deterioration in the housing market.
A few glimmers of hope could be gleaned from the data if you are an optimist.  Lennar's cancellation rate was 22%, an improvement from the 29% rate a year earlier.  The backlog of homes under contract and not yet sold did fall 56% to $1.25 billion, indicating that the company was working through its inventory.  I still maintain that the homebuilders are in for a world of hurt with some bankruptcies down the line.  While I'm not issuing any downgrades on the stock because I've believed all the homebuilers have been a sell for some time, maybe I can just add it to my conviction list.   

Goldman Downgrades Citigroup With Conviction

Analyst William Tanona issued a few downgrades this morning that sent financials into yet another tailspin.  In particular, Mr. Tanona added Citigroup to its "Americas conviction sell" list, Goldman's version of the America's Cup of short-selling targets.  Mr. Tanona claimed that Citigroup will more than likely suffer roughly $9 billion in write-downs and will be forced to cut its dividend and sell more assets.  He slashed his earnings for Citi and Merrill from previous forecasts of small profits to large losses and lowered his rating on the entire brokerage sector to "neutral" from "attractive."  I'm not sure what Mr. Tanona considered particularly attractive about the brokerage sector before his downgrade today.  If anything, the brokers look far more attractive today at a 20%-50% discount to where they were trading just a few months ago.  Other than a rash of brokerage firm downgrades, much of the negative news that has been released recently was mostly anticipated by investors.  Investors expected the monolines to be downgraded and anticipated massively dilutive capital raising schemes by the banks.  Dividend cuts?  We knew they were coming.  Rumormongers knew that Lehman was hiding something.  The only thing that has really changed since the market hit its lows in March is that the "Worst Is Over" monkeys have stopped banging their cymbals.  Needless to say, I agree with Mr. Tanona that Citigroup remains a sell, even at these depressed levels.  Furthermore, I admire his conviction. 

Wednesday, June 25, 2008

Fed Leaves Fed Funds Target Unchanged At 2%, Signals Higher Rates Ahead

The Federal Open Market Committee decided to keep its target unchanged at 2% today.  You can read the full text of the statement released by the Fed here.  The Fed emphasized that continued increases in the prices of commodities and other indicators of inflation expectations contributed to uncertainty about the inflation outlook.  More specifically: "Although downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased."  I wonder if the increased indicators of inflation expectations have anything to do with the Fed keeping interest rates at 2% as just about every other Central Bank in the world is raising rates (most recently India yesterday with its second hike in a month)? Nevertheless, the Fed appears to have ended its quest to bailout the banks and is now poised to raise rates.  Will increases in inflationary signals outweigh the negative economic data to force the Fed's hand?  It's bound to be a very close call.   

Countrywide Sued As Shareholders Vote To Approve Merger With Bank of America

Both the California and Illinois attorney generals' offices plan to sue Countrywide for engaging in deceptive lending practices.  It's unclear how the attorney generals managed to come up with this brilliant plan on the exact same day.  Perhaps it was timed in an effort to attempt to derail Bank of America's proposed merger before it's too late.  However, Countrywide's shareholders just approved the takeover, realizing they would need Bank of America's deep coffers to pay for all the litigation.
The Illinois lawsuit alleges that the company engaged in "unfair and deceptive practices."  Illinois officials say that Countrywide relaxed its underwriting standards, put together loans with risky features and used marketing and sales tactics that motivated employees and brokers to push loans regardless of whether borrowers had the resources to repay them.  Meanwhile, the California attorney general is accusing Countrywide of misleading advertising and other unfair business practices to trick borrowers into taking on risky home loans they didn't fully understand.  
Both the Illinois and California lawsuits fairly accurately describe the entire mortgage industry for the past three years.  Every lender relaxed its underwriting standards, otherwise it would not have been able to compete with all of the bozos pumping no-doc, negative am, interest only and option arms.  Without a doubt, Countrywide was the worst offender, if you're going to base the competition on sheer volume.  But if the attorney generals are attempting to make a statement, they might as well sue them all.  
Why regulators failed to notice the mortgage industry's deceptive practices from 2005-2007, I have yet to understand.  It was constantly reported in the newspapers.  Anecdotal stories about people purchasing homes with no doc loans and option arms were reported nearly every day in the financial press.  Did regulators actually believe back then that people understood negative amortization?  Is it only now becoming clear because default rates are soaring due to falling home prices and the lack of ability to refinance into yet another risky mortgage?  I understand that regulators need to appear vigilant in going after the worst offenders.  And I'm certain that much evidence will be presented that proves that brokers preyed on the financial ignorance of the average American negative amortization mortgage borrower.  What I'm uncertain of is how going after Bank of America, who will own Countrywide on July 1st barring any unexpected events, will help alleviate the foreclosure crisis.  Bank of America is already on the hook for Countrywide's poorly performing mortgage portfolio.  Allowing the bank to remain solvent so that it can provide banking services in this extremely tight lending environment is a much better alternative.  

Construction Loans At Small Banks Concern Regulators

According to the Wall Street Journal Property Report, regulators have grown concerned over the $280 billion in outstanding construction loans to condo developers and home builders sitting on small banks' balance sheets.  Of particular concern is the practice of putting interest that will be paid into an "interest reserve" and then paying themselves out of the reserve until the loan becomes due or the property generates cash flow, thus masking potential problems with the loans until they blow up.  The FDIC is on alert for banks that are not coming clean about problem loans.  A potential hint that a bank has been using interest reserves to hide delinquencies is a large jump in the percent of nonaccruing loans from one quarter to the next without any prior buildup in the percent of delinquent loans.  The banks draw from the interest reserve until the reserve runs out and then they must reclassify the loan as nonacrruing, without ever noting that it was delinquent.  For example, ANB Financial, the failed Bentonville, Ark bank had 2.8% of loans delinquent in the fourth quarter of 2007 followed by 39.6% of nonaccruing loans in the first quarter of 2008.  The ironically titled Integrity Bank had 13.5% delinquent loans in the fourth quarter of 2007 followed by 35.1% nonaccruing loans in the first quarter of 2008.  Integrity Bank has stopped using interest reserves on loans used only for purchasing land without immediate plans for construction and loans on projects that have been delayed or abandoned.  Well, that's a relief.
It is very interesting that banking practices that have more than likely been business as usual for years can be used to mask potential problems during a major downturn.  I'm certainly not a bank accounting expert but I can see how using interest reserves was viewed as a perfectly reasonable practice when delinquency rates and default rates were low.  Unfortunately, when lax lending standards finally caught up with the industry, it became yet another loophole that banks could utilize to delay reporting the inevitable.  It is practices like these that have investors terrified and lead to suspicion about what other surprises are lurking on bank balance sheets. 

Tuesday, June 24, 2008

WaMu, Wachovia Resort To Desperation

Once the bread and butter of Washington Mutual's core business, negative amortization loans are going the way of the dodo bird, the company announced last week.  In a brilliant PR move, the announcement to discontinue negative amortization and "flexible payment" loans was buried in the ninth paragraph of a press release WaMu issued on June 18th touting an additional $1 billion assistance fund for troubled mortgage borrowers.  The press release did not indicate what the company planned to offer as assistance to its credit card account holders.  Through its ill-timed purchase of Providian Financial, WaMu entered the business of credit card lending to questionable borrowers in 2005 at the peak of the bubble, and has aggressively increased its credit card accounts since.  No surprise that WaMu has the highest proportion of overdue loans among the top 15 providers.  Given how lousy WaMu's timing has been, I suppose it is also not surprising that it took WaMu a year into the credit crisis to figure out that maybe, just maybe, it should stop offering negative amortization mortgages.
Meanwhile, Wachovia has apparently given up trying to solve its own "pick-a-payment" mortgage problem and has hired Goldman Sachs as an adviser.  I imagine that Goldman may take one look at Wachovia's loan portfolio and immediately short the stock.  Wachovia's hiring of Goldman has started the rumor mill once again that some white knight will come along and rescue Wachovia.  JPMorgan is always considered a likely contender, but I'd bet against it.  Wachovia, after all, is still a $17 stock.  When it gets to $2 and comes with a $50 billion loan guarantee from the Fed, maybe Jamie Dimon will start negotiating.  
Goldman was more than likely tapped by Wachovia not only because it has managed to avoid damage suffered by its competitors, but possibly also for arranging the restructuring of Cheyne Finance, the $7 billion SIV that collapsed last year.  If any bank knows what to do with a bunch of underperforming assets, it should be Goldman Sachs.  More than likely, Goldman's solution for Wachovia will mirror what they just pulled off with Cheyne.  Just spin it all off into another investment vehicle and make sure that Goldman gets paid a portfolio management fee after marking the assets down significantly.  Nice gig if you can get it.

Home Prices Fell 15.3% in April

The Case-Shiller home-price index dropped 15.3% from a year earlier, a 1.4% decline from March.  All of the 20 cities in the index showed a year-over-year decrease in prices, with Charlotte, North Carolina posting a decline for the first time.  However, prices in eight cities actually rose from the prior month, perhaps indicating a bottoming trend in a few markets such as Cleveland.  Then again, can prices go any lower in Cleveland?  Cleveland is a market where you can buy a house for $1.  If you don't believe me, here's the   link that shows 477 properties for sale for under $10,000 in Cleveland.  Other markets where prices rose slightly from the prior month were Boston, Chicago, Denver, Dallas, Portland and Seattle.  Markets where prices rose the most during the bubble continue to show precipitous declines.  These markets include Las Vegas, Los Angeles, Miami, San Diego, San Francisco and Phoenix.  For more specific details, you can download an excel spreadsheet here.  If you wonder about the future direction of home prices, you can check out this interactive map on which shows how foreclosures are spreading across the country.  

Worldwide Inflation Fears Intensify as China Raises Iron Ore Prices By 96%

Chinese steelmakers agreed to pay Rio Tinto up to 96.5% more for their iron ore supplies this year.  This was on the heels of China's unexpected increase in gasoline and diesel prices by 17% on Friday.  Although these drastic measures will drive up costs for cars and machinery, they should reign in demand for energy use.  Proving once again that our government officials fail to read the paper, Congress believes that speculators are responsible for high energy prices and is contemplating putting strict limits on trading in energy futures by investment banks, pension funds and other financial investors.  How regulating energy speculation is going to curb China's demand for energy as its economy continues to fire on all cylinders mystifies me.  More useful legislation would be to force the Chinese to buy all of GM and Ford's surplus SUV's, Hummers, and F-150's.  After all, GM is so flummoxed by its inability to sell Hummers that it has actually stooped to hiring Citigroup to advise it on what to do with the failing division.  While Citigroup could certainly use the investment banking fees for the simple job of telling GM to shutter or sell the division, perhaps it can also convince GM to buy a leveraged loan or two in the deal.
Forcing the Chinese to buy US cars would help fulfill their insatiable demand while assisting GM and Ford to unload their bloated inventories of gas guzzlers that US consumers no longer desire.  Although my suggestion to Congress may seem absurd, it makes about as much sense as suing OPEC and banning speculation, which were their ideas, not mine.
In domestic inflation news, Dow Chemical is raising prices by 25% to pass through its surging costs for energy and raw materials.  This follows a 20% price hike that began June 1st.  Dow's price increase were caused by "the continuing relentless rise in the cost of energy and hydrocarbon feedstocks."  Now that one of the largest chemical manufacturers in the world is raising prices as if it were a Vietnamese rice importer, can the Fed continue to avoid the "volatile" food and energy component of the CPI report?  Unfortunately, I think they will, but it is a dangerous economic proposition. 

Monday, June 23, 2008

BCE Buyout Back on the Table. Maybe.

Last Friday, Canada's top court over-turned a prior lower Canadian court's ruling that had halted the once record-breaking BCE buyout.  The BCE buyout is now free to move forward without any legal hindrances.  Hindrances of another variety, however, remain.  The lower Canadian court's ruling was a huge surprise, and came as a big relief to the lenders who were balking at terms on the financing packages that they had agreed to during the height of the private equity boom.  Saved by an unexpected legal ruling, the lenders breathed a big sigh of relief and returned to the task at hand:  Figuring out how to get rid of all the other leveraged loans already languishing on their books.  Now that the buyout is back on the table, the tense negotiations have resumed.  The lenders are asking the private equity investors to kick in more equity and accept more onerous terms on the financing.  I do enjoy the mainstream press' constant use of the term "onerous" in reference to the lender's new requests for tighter covenants.  The more likely scenario is that the original terms of the financing package were laughably lax and were cobbled together in about five minutes by bankers looking to cram through another leveraged buyout.  Those bankers have more than likely been laid off for not doing enough due diligence on billions of dollars worth of leveraged loans that are now trading below par and sitting on their former employers balance sheets.  If you are a new reader of Mock The Market and you require further mockery of the BCE saga beyond the scope of this story, please refer to my prior posts on the subject: BCE Buyout on the Rocks and BCE Buyout on the Rocks - Part II.  Rest assured, however, that this is not the last opportunity I will have to mock the BCE debacle.

Tensions in Nigeria Negate Saudi Promises To Increase Oil Output

Saudi Arabia promised to increase output by 200,000 barrels to 9.7 million barrels a day.  The Saudi's reassurances of supply increases put nary a dent in price of crude.  Problems in Nigeria,  where attacks last week on Chevron and Royal Dutch Shell pipelines knocked out 375,000 barrel a day of production, have negated the affects of the Saudi increase.  According to the Financial Times, Nigeria now pumps less than 1.5 million barrels a day, its lowest level in 25 years.  This production level is a million barrels less than Nigeria's capacity.  Nigeria, once Africa's largest producer, is now in second place behind Angola.  Once known only for being experts at fighting a never-ending civil war, Angola was granted membership to OPEC in December 2006.  Being the number one African producer of oil should finally give the Angolans something to cheer about.  Let's hope they use the proceeds wisely. 
In addition to declines in Nigerian oil production, production from Russia, Mexico, and the North Sea has fallen by 1.5 million barrels a day since the beginning of 2007.  When put in context of declines in other major oil producers' production capabilities, the Saudi increase appears to be for public relations purposes alone.  Furthermore, skeptics wonder whether Saudi Arabia actually can pump more oil.  As I noted in my last story about soaring crude oil prices , "peak oil" theorists believe that the world's production capabilities have peaked and that the major oil fields, particularly in the Middle East, are in decline.  Continuing evidence of production declines are troubling to say the least and lend support to the argument.  The price of crude remains stubbornly high, despite many sophisticated investors' cries of a bubble (see Barron's and George Soros.)  In fact, according to the Commodity Futures Trading Commission,  the net speculative position in WTI crude futures is actually short.  This is contrary to all of the cries currently bandied about accusing speculators for the high price of oil.  If speculators are shorting oil, how much higher would the price be without their sales?  "Peak oil" believers, who until very recently were considered a bunch of kooky alarmists, are being joined by more mainstream market participants in fearing the worst.  

Friday, June 20, 2008

S&P Puts GM, Ford, and Chrysler on Negative Ratings Watch

As if investors needed another reason to weep on this unhappy expiration Friday, S&P decided it was as good a time as any to contemplate downgrading the US auto sector.  The negative outlook comes on the heels of a warning from Ford this morning that its losses are expected to widen for the full year and that it planned to delay its new pickup truck.  Earlier in the week, GM, Ford, and Chrysler warned that June auto sales are coming in around 20% below already lowered estimates.  Even CarMax, the US used car dealer, warned that traffic at its stores had weakened significantly since late May, causing its shares to get pummeled.  Chrysler lowered its full-year forecast for US car sales from 15.5 million to 12.5 million.  Needless to say, S&P has enough evidence upon which to base its decision.  Perhaps the only thing keeping the auto stocks from going to zero today is the unflappable Mr. Kerkorian, who still wants to pay $8.50 for shares in Ford.  He disclosed earlier in the week that his stake in the firm had grown to 6.5%.  As I mentioned in an earlier piece about Ford, most new car sales are purchased with financing of some sort.  With lenders tightening the reigns, it is much harder to obtain financing whether that is an auto loan from the beleaguered GMAC, a credit card from the struggling Citigroup or a home equity line of credit from Washington Mutual (I wouldn't even bother calling).  The house-as-an-ATM phase in our economy is officially over and now it is starting to be reflected in the economic data.  It appears as if the the message is finally starting to sink in to market participants that the current economic malaise may be worse than originally anticipated.  We will more than likely retest the lows from March when the "worst was over."  I hope everyone is wearing a hard hat. 

The Drumbeat of Ominous News Continues As MBIA, Ambac Downgraded

In a widely anticipated event, Moody's finally succumbed to mounting criticism from everyone in the investment community and downgraded MBIA and ABK.  MBIA's rating was cut five notches and ABK's three.  Moody's retained a negative outlook on both insurers.  Serious questions remain about the relevance of Moody's ratings system since just about everybody in America already knew that MBIA and ABK were not AAA worthy. 
Moving from the obvious to even more obvious, Citigroup's CFO announced on a conference call with analysts yesterday that the company would be taking further "substantial" write-downs for subprime morgages, leveraged loans, and other garbage in the second quarter.    Furthermore, the bank could face another credit value adjustment from its exposure to the aforementioned bond insurers.  As if that weren't enough, worsening consumer credit quality could have a meaningful impact on Citi's results for the rest of the year. 
Not to be left out of the headlines, Wachovia announced it was liquidating an investment fund called Ultra Short Opportunities due to an 18% loss this month.  This fund was marketed as an alternative to a money market fund as it had a short duration and was supposed to offer a slightly higher yield with a similar risk profile.  In retrospect, I'm certain that the fund's investors are sorry that they tried to get an extra couple of basis points while risking an 18% loss in one month.  I smell a lawsuit.
UBS can't seem to stay out of the headlines either.  Former UBS-private-banker-turned-Justice -Department-canary Bradley Birkenfeld claims he helped UBS clients hide $20 billion in assets from the IRS.  Mr. Birkenfeld insists that his actions were common among his former colleagues at UBS.  UBS has suffered considerable losses in its investment banking arm.  It was dependent on the private banking arm to maintain its reputation.  This investigation may prove to be a bigger problem for the bank than its subprime losses.

Thursday, June 19, 2008

Mortgage Insurer Triad Guaranty Finished, Alt-A Mortgage Lender Thornburg On The Brink Again

Triad Guaranty, the mortgage insurer, has announced that its negotiations with Lightyear Capital LLC to form a new mortgage insurance company have been terminated.  The company will cease writing new business, lay off employees, and run-off its existing book.  Formerly a Freddie Mac approved mortgage insurer, Triad was suspended from doing new business with Freddie in May because it no longer met mortgage insurance eligibility requirements.  Triad appealed the decision, but Freddie has denied the appeal.
In other similarly alarming mortgage industry news, Thornburg Mortgage Inc. said in a filing with the SEC that its survival is in doubt.  The company has also been subpoenaed by the SEC over the restatement of its 2007 results.  Thornburg stated in the securities filing that "recent adverse developments in the mortgage finance and credit markets has adversely affected our business, our liquidity and our stock price" raising doubts over the company's ability to continue as an ongoing concern.  Given that the company was forced into a massive restructuring that caused it to narrowly avert bankruptcy in April, this news is somewhat surprising.  The company raised $1.35 billion two months ago, restructured its obligations, got a stay of execution from its repo lenders and completely diluted the shareholders.  The fact that they are again suffering from liquidity problems is a testament to how poorly their assets continue to perform.  It is also an ominous sign for the rest of the market.     

Former Bear Stearns Hedge Fund Managers Arrested By FBI

Ralph Cioffi and Matthew Tannin, the managers of two collapsed internal Bear Stearns funds that were the first casualties of the credit crisis, have been arrested by the FBI.  In a sign of what may result in a rash of criminal indictments, regulators have shown they are serious about doling out the punishment to those responsible for investor losses.  I find it interesting that they would start with these two guys.  According to the Wall Street Journal, prosecutors are zeroing in on an email that Mr. Tannin sent to his senior colleague Mr. Cioffi, indicating his concerns that the markets for the structured products they held as investments were "toast."  He also suggested they consider shutting down the funds.  Mr. Cioffi responded and suggested that the two meet to discuss his concerns.  The two apparently met, discussed the issues and decided Mr. Tannin's concerns were unfounded.  However, Mr. Cioffi did withdraw $2 million of his own money from one of the funds in March, which would contradict his assertion that he felt the funds were on solid footing.  Four days after their supposed meeting, Mr. Tannin told investors in a conference call that he was "quite comfortable" with their holdings.  In the weeks that followed, investor redemptions and margin calls forced them to dump positions into an unfriendly market and wiped out the funds.  While it is certainly true that these two guys are guilty of being terrible investors, I certainly hope the Feds have more than this email to base their case.  Frankly, if you are managing other people's money and you never worry about the markets moving against your trading positions, you're in the wrong business.  It's not that I don't think these guys should suffer if they truly misled investors, I just have a hard time believing they are were the worst offenders on the long list of those who used the credit market boom to deceive investors.  It seems as if much more egregious conduct occurred during the boom that should be prosecuted.  Should everyone involved in securitization of subprime and Alt-A mortgages be investigated for baking unrealistic default rates into the pie?  What about all of those AAA ratings on securities that are now trading at distressed levels?  Don't the ratings agencies need to be investigated for misleading investors?  How about every mortgage broker that steered an unsophisticated borrower into an unsuitable mortgage because he received higher fees on those types of products?
I, for one, will be interested to see whether two guys who managed funds that were supposed to be complex and sophisticated can get away with claiming they were too stupid to see the storm building.  Wall Street will be nervously awaiting the result of the this trial as well, perhaps while cleaning out their email boxes...  

Wednesday, June 18, 2008

Rogue Traders and Level III Assets, What's the Difference?

Morgan Stanley suspended a credit trader today for mismarking his trading positions to the tune of $120 million.  The company was forced to take a "negative adjustment" related to erroneous valuations of his positions.  Morgan Stanley's CFO, Colm Kelleher, was quick to point out that the firm discovered the error and took swift action by suspending the trader.  A suspension may seem harsh for a high school senior headed into final exams (please refer to the movie "Risky Business" if you doubt me.)  However, on Wall Street, where traders are compensated based on their trading profits, a suspension seems a bit weak.  Personally, I'd go after any compensation the trader had received in the past.  Call me crazy for thinking that people shouldn't get paid ridiculous sums of money for phantom profits.
This rogue trading incident, although meager compared to the SocGen fiasco caused by Jerome Kerviel earlier in the year, brings to light a much larger issue:  How trustworthy are the marks on investment banks portfolios of assets?  Banks claim to have highly sophisticated risk management tools in place to make sure that risks are adequately quantified and that prices are indicative of where assets trade in the marketplace.  In light of the recent inaccurate pricing of assets at Morgan Stanley, Merrill Lynch, Credit Suisse, Toronto-Dominion, and SocGen, it is clearly an issue that banks struggle with and should cause investors to wonder how many other rogue trading incidents are occurring right now that have yet to come to light.  Based on anecdotal evidence from personal experience working at investment banks, traders who mismark positions are typically asked to leave, and the embarrassing losses are generally buried into earnings and never disclosed.  They become much harder to hide when there are no earnings to offset the losses.  My guess is that we'll be hearing more of these sorts of incidents in the ensuing bear market.    
A bigger issue still is the assets on investment bank balance sheets that are currently classified as Level III, or assets that have no observable prices or even observable inputs in the market.  Much has been made of this issue recently as banks have been scrutinized for moving formerly somewhat liquid assets into this accounting classification as prices dried up.  While nobody is accusing banks of purposefully mismarking Level III assets (well, other than the accusations hurled at Lehman Brothers by David Einhorn, which turned out to be true) many wonder if the prices are anywhere in the neighborhood of their true value.  Is there any difference between a price that a trader invents to pad his own pocket purposefully and a price that a bank invents because no other prices are available?  One is pure deception, while the other is a best guess with some unknown probability of being in the ballpark.  If there is a difference, does it really matter?   

Mortgage Applications Fall as Interest Rates Jump

The Mortgage Bankers Association reported an 8.8% decline in its index of applications.  The purchase index decreased 4.4%, while the refinancing gauge lost 15%.  The average rate on a 30-year fixed loan rose to 6.57% from 6.24%, while the rate on a 15-year fixed increased to 6.14% from 5.78%.  Interest rates on one-year adjustable mortgages jumped to 7.22% from 6.87%.  I find this last data point to be particularly interesting.  The yield curve is steep, short term interest rates in the bond market are still much lower than long term rates, yet banks are offering ARMs at much higher rates than 30-year fixed loans.  Why the discrepancy?  Banks can still securitize 30-year and 15-year fixed rates and sell them to Fannie and Freddie.  However, with the freeze in credit markets, they can't unload ARMs, so they must carry them on their balance sheets.  But with no room on their bloated balance sheets, they charge an ARM and a leg (pun intended) if borrowers want an adjustable loan.  According to the MBA, the share of applicants seeking variable-rate loans fell to 9.7% last week.  Seriously, who are these people who are trying to get a variable rate loan with a higher interest rate than a fixed?  More importantly, who are their mortgage brokers?  I would be very interested in hearing the sales pitch:

Borrower:  So, why wouldn't I just get a 30-year fixed?

Mortgage broker:  An adjustable is much better.  You need to lock in now before rates go higher.

Borrower:  But won't the adjustable rate just go higher when rates go higher?

Mortgage broker:  You don't understand.  The rates will adjust lower when interest rates go down.

Borrower:  But I thought you just said rates are going higher.

Mortgage broker:  They are, but when they go lower, your adjustable will adjust lower.

Borrower:  Can you show me some estimates of what my payments will be based on a few interest rate scenarios?

Mortgage broker: (laughing)  Don't be ridiculous!  Mortgage math is very complicated.  You need complicated models to figure this stuff out.  You have to trust me on this.  Do you think I would've survived in this business for this long if I didn't care about relationships with my customers?

Borrower:  I know sonny.  I'm your grandmother.  I'm happy to see your business has been flourishing.

Mortgage broker:  Just sign right here.  Great!  Now, let's start talking about a cash-out refi...

FedEx, Morgan Stanley, Fifth Third Bank Contribute To Market Gloom

FedEx reported a fourth quarter loss of $241 million on rising fuel costs and a write down of its Kinko's unit.  The company provided a bleak outlook for the rest of the year, lowering its estimates for first quarter and stating that earnings would be difficult to predict due to sagging demand coupled with volatile energy prices.  Somebody please call Bernake and let him know that when companies start mentioning volatile commodity prices as a reason for lack of predictability in earnings, he has not achieved his goal of "price stability" regardless of what the core rate of inflation indicates.  
Meanwhile, in banking news, Morgan Stanley reported a 57% decline in earnings on a 60% drop in revenues and Firth Third Bancorp announced it will raise $2 billion of convertible preferred shares and slash its dividend to raise its tier 1 capital ratio to 8.5%.  It is becoming apparent to the market that Goldman's earnings report yesterday was a aberration.  Somehow through savvy trading (and apparently an increase in risk according to the Financial Times Lex column today), Goldman has managed to avoid suffering major losses.  On the same day that Goldman proved its trading prowess through its earnings report, analysts from the firm released a research note claiming that banks may need to raise another $65 billion in capital.  Perhaps Goldman's good earnings proved to the market that those guys know what they are talking about, and bank stocks promptly took a beating.  The sell-off looks likely to continue today as investors become more and more aware that the worst is not over for US banks.  Delinquencies are rising, assets are deteriorating, and continued weakness in the housing sector shows no signs of abating.  The Fed's hands are tied now that inflation is rearing its ugly head.  I offer a small suggestion to the remaining banks who need to raise capital: you may want to get that offering circulating ASAP.  I have a sneaking suspicion that if you wait for the other $60 billion in capital to be raised before you get your act together, there may not be any left for you.

Tuesday, June 17, 2008

Goldman Reports Earnings

Goldman posted net income of $2.09 billion, or $4.58 a share, on revenues of $9.42 billion for the second quarter.  Although this was a decline from the previous year's quarter, it beat analysts' lowered expectations and it actually reported earnings instead of losses, in contrast with Lehman.  The firm said the 29% drop in fixed-income revenue was affected by $775 million of writedowns and credit market losses.  The amount of write-downs and credit market losses seems remarkably small relative to other firms and the size of Goldman's balance sheet.  But given how little information investors can glean about investment banks portfolios, they must trust that management is appropriately marking positions.  Revenues from commodities were higher, although the firm does not provide a breakdown between commodities, fixed-income and currencies, which are all lumped together.  The firm also trimmed its holdings in commercial and residential real estate, and leveraged loans, reducing its level III assets from $96 billion to $78 billion.  
How did Goldman have such a solid quarter while rival Lehman was busy puking assets and taking write-downs?  Part of it must come from the commodities business, where Goldman has been the most vocal about predicting ever higher prices for oil.  They are clearly bullish on commodities, which has absolutely been the right call.  Goldman is also a more diversified financial services firm, with other departments offsetting losses when one area suffers.  Goldman's shares currently trade at a significant premium to other investment banks and perhaps this quarter's earnings report justifies some premium.  But the outlook for investment banking, which is a cyclical business, remains murky at best, particularly with the Fed poised to reverse its recent banking-friendly easy-money policy. 

Headline PPI Up 1.4% in May, Housing Starts Fall

Rising food and fuel costs contributed to a 1.4% spike in May PPI, although the core rate remained subdued at up .2%  Americans who choose to regularly purchase food and fuel are not surprised by the spike as they come face to face with rising costs daily.  Although the Fed officials who were busy leaking their views yesterday to the Financial Times about rate rise expectations being overplayed may have wished they would have waited for the PPI report before opening their traps.  The Fed is going to need to tighten sooner rather than later.  The bond market seems to know this better than Bernake and his cronies. 
Meanwhile, housing starts fell 3.3% to a 975,000 pace, from a revised 1.008 million in April, the lowest level in 17 years.  Building permits also declined by 1.3% to a 969,000.  Yesterday, the National Association of Homebuilders released it builder sentiment index, which at 17, was a record low.  Rising foreclosures and delinquencies in mortgages make it nearly impossible to imagine a turn around in sentiment.  Naturally, the homebuilders are pleading for tax incentives and other bailouts from our Government.  Because when all else fails, our government can be counted to on to concoct something "stimulative" and expensive to help prop up our sagging economy.

Monday, June 16, 2008

Lehman Reports Losses AND Higher Compensation Expenses

The Wall Street Journal's Marketbeat has a a nice summary of the Lehman Brothers conference call, where CEO Dick Fuld and his new and improved management team presented the details of the anticipated $2.87 billion loss.  Mr. Fuld reiterated his disappointment in the results and vowed that the firm had all the necessary steps in place for a turn-around.  It was the same rhetoric we've heard from the firm in the past with some updated details outlining where the risks remain on the balance sheet.  Lehman did unload $147 billion in assets, reducing its gross assets from $786 billion to $639 billion and gross leverage from 31.7 times to 24.3 times at May 31st, prior to the impact of the capital raising.  That is reassuring news for some, although what remains in the company's investment holdings may not be so comforting to others.  Lehman specifically discussed mark downs on its positions in SunCal and Archstone, two ill-fated real estate investments which were profiled in a Wall Street Journal article a week ago.  Calulated Risk summarized the article and provided some worthwhile insight.  According to the conference call this morning, Lehman is currently valuing these investments on its balance sheet at $3.4 billion.  Whether these positions will be marked down further is highly dependent on a turn around in the real estate market.  The SunCal investment is particularly dependent on the Southern California real estate market rebounding so that land values can start to increase again.  However, according to the LA Times, median home prices in Southern California declined again in May.  Lehman's investment in the apartment REIT Archstone was orchestrated at the peak of the market and publicly traded REITs have been pummeled since.  Clearly both of these investments may need to be marked down again. 
The most interesting part of the conference call, in my opinion, was that not a single analyst questioned why Lehman's compensation expenses rose to $2.3 billion, compared to $1.8 billion in the first quarter of 2008.  Barring some sort of unforeseen miracle, the company will most likely post losses this year on top of greatly diluting shareholders, and yet it appears as if the company is still accruing bonuses and paying out cushy severance packages?  At the end of February, Lehman had roughly 28,000 employees.  Assuming that the average salary per employee is a generous $150,000, the company should not be accruing more than around $1 billion per quarter in compensation expenses.  The explanation that I'm certain will be offered to those questioning the thought of awarding bonuses despite such horrendous performance?  "Retaining talent."  Because you wouldn't want all of those talented employees to run off to the other investment banks that are actively recruiting?  Nobody is hiring on Wall Street and layoffs will more than likely continue so something tells me the talent isn't going to run away.  Investment banking is a cyclical industry with extremely highly compensated employees who get significant upside during the upswings in the cycle.  Furthermore, it's not a commission-only business, everyone gets a nice, cushy salary.  It's amazing that investors are willing to tolerate high compensation packages for such lousy performance.

AIG Gives Sullivan the Boot, Replaces Him With Former Citibank Executive Willumstad

AIG's board took decisive action over the weekend in order to quell anger from its largest investors.  In a three hour meeting, AIG's board axed CEO Martin Sullivan and replaced him with Chairman Robert Willumstad, a former President and COO of Citibank.  Mr. Willumstad, who left Citibank after being passed over for the CEO position for Charles Prince (who has since been booted), is highly regarded by many in the banking industry and will hold both Chairman and CEO posts at the insurance company.  While I agree that it is impressive that Mr. Willumstad left Citigroup about two years before the former financial bellweather began its rapid unraveling, I have to wonder how useful his consumer finance experience will be in managing AIG's enormous credit default swap portfolio, the source of AIG's significant losses from past two quarters.  Furthermore, Mr. Willumstad has been Chairman of AIG's board since 2006.  One has to wonder yet again what corporate boards are supposed to do, other than approve excessive executive compensation packages, if they are somehow not aware of what lies on their own company's balance sheets.  Why did AIG's board need to wait for regulatory probes and angry letters from shareholders before taking "decisive" action?  Mr. Willumstad's focus will now shift to deciphering and paring down the risks embedded in AIG's $1 trillion balance sheet.  Something tells me that AIG's investors are in for more surprises in the near future.

Friday, June 13, 2008

What's Behind the Curtain at GE?

The market is bouncing nicely on this Friday the 13th, after weeks of disappointing news.  Shareholders of GE, however, are wondering why their stock isn't joining the party.  Investors' concerns may be exacerbated by the fact that financials are experiencing a fairly decent uptick after weeks of bloodletting.  As I mentioned before in previous posts about GE, the supposed bellweather of the economy is actually a financial firm masquerading as a industrial conglomerate.  How do I dare to say such blasphemy?  As evidence, I offer up GE's balance sheet:  $683 billion out of $838 billion in GE's total assets reside in GE Capital.
Is it conceivable that weakness at GE Capital could potentially force GE to seek external funding? If you consider GE to be a financial firm, and take a look at the capital raising frenzy among other financials, it's hard to ignore the question.  I have mentioned in the past that I was concerned about the lack of transparency offered in GE's financials, specifically related to assets on the balance sheet labeled as "other" without any further description.  GE Capital's most recent 10-Q provides virtually no transparency into the details of its investment holdings.  It only clearly states that GE Capital holds $683 billion in assets and $624 billion in liabilities, $198 billion of which is short term financing.  Could GE potentially have a funding issue?  Sure, if investors started to question the financial performance of GE Capital's underlying assets.  Let's take a quick look at those assets.
According to GE Capital's 10-Q for the March 31,2008 quarter, the bulk of GE Capital's assets were $417 billion in loans.  The only detail GE provides about its loan portfolio is delinquency rates (all of which were materially higher) and that $9.3 billion of the loans were "related to consolidated, liquidating securitization entities."  Anyone out there who knows what that actually means gets a gold star.  GE Capital also had $84 billion in "other" assets, with no accompanying detail.  For further information about GE's loan holdings and "other" assets, one must go to the year-end 10-K, which is outdated information, but offers a few clues as to the composition of assets.  Rather than provide an entire itemized list, I will highlight the parts that would concern me if I were to consider an investment in the company.

From GE Capital's 2007 10-K, some areas of concern about the then-$385 billion loan portfolio:
  • $73.7 billion of the loan portfolio were Non-US residential mortgages, 26% of which were IO's with teaser interest rates on high LTV loans (at inception).  
  • $27.3 billion were non-US auto loans.
  • $22 Billion in infrastructure loans and leases, $11.6 billion of it tied to commercial aircraft leases. 
  • $39.8 billion in real estate.
  • $10.2 billion in "other."  No detail.
  • $19.7 billion in total leveraged leases.  GE states that it is allowed to deduct the interest expense accruing on nonrecourse financing related to leveraged leases.  Just ask KeyCorp how well that worked out for them.  I'm not saying they did not account for it correctly, but I'd ask a few questions.
From GE Capital's 10-K, some highlights from the $83 billion in "other assets":
  • $40 billion in "investments".  No detail.
  • $17 billion in real estate, mostly commercial properties.
  • $1 billion in "Other."
  • $4.8 billion in "Other".  Not sure why this "other" was different from the other "other," but in my opinion you can't create a subcategory called "other" when you are attempting to describe "other" assets.
The highlights are screaming "mortgages! autos! aircrafts! other! other! other!"  I don't profess to have spent days analyzing the information, just a few hours.  Maybe someone with the time and patience to do a more thorough analysis can offer some further insight?  But if you still want to buy the stock without a more thorough analysis, despite the opacity of the balance sheet, be my guest.  We'll get together and discuss it after GE's next earnings report, or pre-announcement, which ever comes first.

Foreclosures Rise 48% in May, Bank Repossessions Double

According to RealtyTrac, foreclosure filings rose 48% from a year ago and bank repossessions more than doubled in May.  The number of national foreclosure filings grew 7% from April, while the nationwide rate of default warnings increased 1% from April.  The rate of foreclosures is clearly still increasing, offering no respite for the housing market or investors in mortgages.
Nevada, California and Arizona posted the highest foreclosure rates in the US and New Jersey entered the top 10.  California and Florida accounted for nine out of the top 10 metro foreclosure rates for the second month in a row, with Stockton in the lead.  The deluge of unwanted foreclosed properties continues for beleaguered mortgage lenders as they repossessed 73,794 houses in May, pushing total REO's to 700,000.  
A quick back of the envelope calculation, (using $200,000 as a median price) would suggest that lenders repossessed $14.8 billion in defaulted properties in May, and $140 billion in total thus far, using RealtyTrac's numbers.  These totals may actually be conservative due to the high concentration of foreclosed properties in California, where medians are much higher than the rest of the US.  Assuming that the rate of repossessions per month stays constant for the next year, lenders are looking at repossessing an additional $177 billion in properties.  Since lenders never planned on being in the property management business and are burdened with properties they can't offload in the current environment, they will look to sell properties in bulk auctions and continue to slash prices to move inventory.  That implies that home prices will continue to decline, default rates will march higher, and recovery rates on defaulted mortgages will decline.  Recent action in bank stocks is evidence that investors are finally awaking to the dismal fact that the worst may not be behind us.  

Thursday, June 12, 2008

KeyCorp Raising $1.5 Billion in Capital, Slashing Dividend 50%

KeyCorp announced it was raising $1.5 billion in new equity and slashing its dividend by 50% to shore up its balance sheet as it will be forced to take a $1 billion charge to earnings.  Providing further evidence that banks have concocted a myriad of inventive ways to lose money, KeyCorp's $1 billion loss is not the result of write-downs related to mortgages or soured construction loans.  No, these losses are the result of KeyCorp's choice to use questionable accounting related to the tax treatment of its leveraged lease portfolio.  A federal court ruled against KeyCorp's tax treatment and now it must change their method of accounting for its entire leveraged lease portfolio. 
Warren Buffett has a famous quote that Wannabes, myself included, reference when markets are unraveling.  The phrase is slightly altered every time, yet the message remains crystal clear and portentous:  "When the tide goes out, we find out who's been swimming naked."  Everyone's a genius in a bull market.  When the market falls apart, we start to discover what was hidden for years by the rising tide of bullishness.  The easy credit of the last few years attracted a significant amount of skinny dipping.  Now that the bullish tide has receded, we're left with the ugly truth.

Lehman Demotes CFO and Removes COO, Fuld Will Do Everything

In a desperate move to regain credibility from investors, Lehman has demoted Erin Callan from the CFO position and removed Joseph Gregory from the COO post.  Dick Fuld will remain as CEO.  Herbert McDade will succeed Mr. Gregory and Ian Lowitt will take over for Ms. Callan.
Ms. Callan had a reputation for downplaying Lehman's problems. She denied issues with Lehman's balance sheet and dismissed assertions from Lehman's detractors that the company was not marking its inventory of mortgages realistically.  Taking a firm stance only works if you are right.  Once the company needed to raise capital and take an unexpectedly large loss, essentially admitting that it had been playing around with prices, her credibility was toast.  I understand why Mr. Fuld is now taking desperate measures to restore faith in his company.  But blaming it all on the CFO and COO may not work.  Investors have to ask themselves: What was Mr. Fuld doing while Ms. Callan and Mr. Gregory were supposedly busy wrecking the firm?  Mr. Fuld is well reputed for pulling a rabbit out of a hat during the last credit crisis of 1998.  My hunch is, the story this time around will not have a happy ending.  

Wednesday, June 11, 2008

SocGen Knew of Fictitious Trades Months Before Trading Scandal

According to court documents seen by the Financial Times, Societe Generale knew that Jerome Kerviel, Rogue Trading King, was using fictitious trades several months before the bank lost $7.6 billion.  An internal accounting auditing committee raised concerns about Mr. Kerviel's use of fake transactions in April 2007, but the bank took no action.  Apparently, the outcome of the SocGen/Kerviel case now hinges on determining whether Mr. Kerviel used a "virtual trade," which was tolerated, or a "fake trade," which was most definitely not.  If you can tell the difference between the two, well, I suggest you go volunteer to help with the ongoing investigation into the incident. 
SocGen has claimed in the past that Mr. Kerviel concealed losses on futures positions by fabricating fictitious offsetting trades that were undetected until January 18th.  Upon its discovery, SocGen was forced to puke enormous positions into a market that was not in a buying mood.  Even the Fed was suckered into a 75 basis point emergency easing, which it must certainly regret to this day.  According to the Financial Times, Vincent Guyot, a controller at SocGen, told the police that anomalies discovered in March 2007 indicated that some of Mr. Kerviel's operations amounted to "real fake trades which had no economic significance."  Guillaume Selnet, one of Mr. Kerviel's lawyers countered with: "From the moment when an accountant says, 'We have detected fictitious trades' this becomes more than negligence.  It looks like complicity.'  SocGen's lawyer, Jean Veil, maintains that SocGen was deceived: "The ingenious explanations of Mr. Kerviel, which were falsehoods, deceived the controllers."
Perhaps we can speculate a bit about how this trial might play out in court....

Selnet:  You say you are ze risk manager?

SG Inspector: Oui!  I am also ze Chief Inspector!  Zat is very important title.

Selnet:  When did you first dizcover ze fictitious trade?

SG Inspector: Non! Zey were not fictitious trades!  Zey were fake trades!

Selnet:  What is ze differance?

SG Inspector: We know fictitious trade!  Fake trade we do not know! Very Big Differance!  You idiot!  Mr. Kerviel is great genius.  He fool even ze most careful inspector!

Selnet:  When you question Mr. Kerviel about fictitious trade, what did ze man say that was so, how to say, ingenius?

SG Inspector:  He say emphatically 'Zat is not real trade, zat is fictitious trade!'

Selnet:  And you accepted zis response?

SG Inspector: Yes, you see, ze man was a genius!  Had he said ze trade was fake and not fictitious, we might have caught him!  But he never slip up!  Not once!

Selnet:  In January, when you dizcover zat ze trade was fictitious, and not fake..

SG Inspector: Non!  It was fake and not fictitious!

Selnet:  Is that not what I just said?

SG Inspector:  Non!  You say fictitious and not fake!  You see the trades were fake!  Not fictitious!  We were all tricked!

Selnet:  Yes, I am beginning to see...So what did ze man say zen in defense of zis horrible deceptive trickery?

SG Inspector:  He said 'Sir, zat is not my trade!'  And when I say 'But whose trade can it be?'  He say 'Ze man's name is Nick Leeson.'

Selnet: Did you attempt to find zis Leeson character?
SG Inspector:  Yes.  And as a good inspector, I find him and call.  

Selnet:  What did ze man say?

SG Inspector:  First he say zat Kerviel is genius.  Then he say he'd be happy to dizcuss ze situation further, but he requires a $50,000 deposit for his motivational speeches.
Selnet:  Sacre nom d'um chien!

SG Inspector:  Yes, zat is when I knew we had beeg problem....  

India Raises Interest Rates, China Tightens Lending

Central Banks around the world are taking decisive action to combat the threat of rising inflation.  The Reserve Bank of India raised the over night lending rate to 8.0% from 7.75%, two months ahead of its next scheduled monetary policy meeting.  Yesterday, China's Central Bank ordered Chinese Banks to set aside more reserves to curb credit growth, causing a rout in Chinese stocks.  Additionally, the Bank of Canada unexpectedly failed to lower interest rates, citing inflation fears.  What Central Banks are increasingly growing concerned about is facing a situation similar to what is happening in Vietnam, where inflation has already spiraled out of control.   CPI in Vietnam surged 25.2% in May, due to the global spike in food prices, rice in particular.  The Central Bank has responded by raising interest rates significantly and allowing the currency to devalue.  I'm not quite sure what all the fuss is about.  If Vietnam wanted to solve its problem of rising inflation, it could simply exclude food and energy from its CPI report.  After all, that is what the US policy makers view as the solution to our rising CPI problem.  Although Bernake has recently pulled his head out of the sand to make a speech about inflation, he has yet to pull the trigger on interest rates.  Could it be because he knows that an unexpected increase in rates may put the nail in the coffin of a few too many financial institutions hanging on for dear life, dependent on an agreeable Fed?  Bernake's speech delivered Monday night had a special message for banks, cleverly veiled by indecipherable Fed- Speak:  Get your act together, raise a capital cushion, the bailout party is over, rates are going higher!

Lehman Met With Koreans For Capital, No Deal Struck

Yet another rumor about Lehman that has been bandied about in recent weeks turned out to be true.  Lehman had "advanced talks" with potential Korean investors and failed to reach a deal immediately before the $6 billion capital infusion announced Monday, the Financial Times reported.  Lehman executives "ran out of time to complete negotiations on the terms of the transaction in which the institutions would have taken a stake."  After insisting over and over again that it didn't need capital, somehow Lehman ran out of time to secure funding?  Let me do a Wall-Street-style interpretation of that statement for my less skeptical readers.  Lehman was trying to quickly stuff the investment down the Koreans' throats before it announced it had lost $2.8 billion this quarter.  I'm not necessarily saying Lehman's head honchos lied to the Koreans about the company's impending losses, I'm only implying that they knew the stock would be absolutely punished on the "unexpected" news and they had to get the deal completed beforehand.  
Two of the potential investors mentioned who have since denied any involvement in the talks were Kookmin Bank ( aka "We kooky, but not that kooky to invest in Lehman.") and Woori Finance Holdings (aka "We worry about Lehman investment.")  According to the Financial Times, any deal struck would've given Korean institutions access to Lehman's capital markets expertise, granting Lehman access to the Korean groups' balance sheets in return.  The Koreans seemed to have realized at the last moment that their balance sheets deserve a significant premium to Lehman's capital markets expertise.  Maybe after hearing that the only line item that showed an increase in Lehman's financial results this quarter was compensation costs, which leapt 22%, the Koreans may believe their toilet paper deserves a significant premium to Lehman's capital markets expertise.  

Tuesday, June 10, 2008

Bernanke Changes His Tune

In a speech delivered at the Boston Fed yesterday, Bernanke hinted that he may be finished bailing out the US banking system, and would like to refocus on his actual job: preventing rampant inflation from destroying the US economy.  In what was interpreted by many as hawkish comments, Bernanke stressed that the Fed's focus has shifted from worries about an economic slowdown to concerns about inflationary expectations.  Frankly, I am glad that others are pros in interpreting Fed-speak, because Bernanke stumped me this time.  The direct quote:  "The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing from growth as well as inflation."  Huh?  An erosion of longer-term inflation expectations?  Doesn't "erosion" imply a decrease in inflationary expectations, which he is looking to resist?  Furthermore, according to spell-check, "unanchoring" isn't even a word.  But if those with a better command of the English language claim he's being hawkish, that's perfectly fine with me.  It's the right thing to do, albeit late.  Maybe the US can get away with Latin American style inflation, rather than Zimbabwe sytle inflation.  That may not be a comforting thought, but in the relative world, it's not too shabby.  

UBS Poised for More Losses, Executives Selling Rights to Buy Shares

UBS is scheduled to take more losses on its mortgage holdings, as prices for these securities have worsened dramatically in the past few weeks.  It is too bad that the deterioration of the UK mortgage market and the supposedly AAA-rated garbage that UBS still carries on its books couldn't wait until UBS had completed its 15.96 billion Swiss franc capital-raising extravaganza.  The results of the rights issues will be announced Friday, and apparently it is still on track to succeed.  Some UBS executives and board members have actually been selling their rights to buy shares, attempting to decrease their holdings in the beleaguered bank.  From an investor's perspective, I don't blame them; I'd be looking to unload that turkey out of my portfolio too.  However, this does not inspire confidence in the rights issue which is being offered at a discount to the market price, although the magnitude of that discount decreases day after day with the slumping stock price.  I personally lost confidence in UBS when I read Bloomberg magazine's terrific account of how UBS lost buckets of money in the past year.  
According to the Bloomberg story, in 2005, UBS spun off its extremely profitable (at the time) fixed-income proprietary group into a hedge fund that had access to cheap funding from UBS and collected 3 and 35 in management fees from its parent.  The former investment banking chief, John Costas, saw those fees and liked them.  He was appointed the new head of the hedge fund spin-off called Dillon Read Capital Management (DRCM).  His investment banking replacement, Richard Jenkins, formerly head of equities, and Simon Bunce, the new fixed income chief, apparently had no risk management experience.  To make up of for his short-comings, Jenkins hired the consulting firm Mercer Oliver Wyman, a unit of Marsh & McLennan, to review the business.  The consultant's conclusion?  UBS needed to get in the CDO business.  Jenkins did what any shrewd investment banking chief would do when taking advice from a consultant from an insurance company that was, at the time, being accused of violating a slew of insurance and investment regulations.  Jenkins got in the CDO business.  Although the bank already had significant CDO and mortgage exposure through DRCM, Jenkins beefed up its CDO warehousing unit, where loans were purchased and securitized into CDO's.  The CDO unit decided that securitization didn't provide it with enough risk, so it purchased $50 billion super-senior AAA CDO's to hold as investments.  They were AAA-rated, so really, did anyone need to do any more due diligence?  Besides, the consultant said it was a good idea, so why question it.  Two thirds of UBS's losses in 2007 came from the CDO unit. Not to be outdone, DRCM kicked in several billion in losses once the credit markets crapped out.  Even the cash management unit of the treasury lost $2 billion due to $30 billion in investments in US asset-backed securities.  I used to trade money markets so I know it is extremely difficult to lose that kind of money trading cash management products.  UBS somehow managed to overcome incredible odds to put up these numbers.  Given the magnitude of mismanagement and lack of risk controls, I can't wait to hear the results UBS reports on August 12th.

Monday, June 9, 2008

Pending Home Sales Unexpectedly Rise, Proving Every Dead Cat Has Its Bounce

The pending home sales index unexpectedly rose in April by 6.3% to 88.2 from the previous month.  Lawrence Yun, chief economist for the NAR, claims that this is due to an increase in bargain-hunting in areas where home prices have declined significantly.  The pending sales index, which is based on signed contracts for previously owned homes was 13.1% below the level of 101.5 in April 2007.  Pending sales in the Northeast decreased by 1.9%, while sales in the Midwest, South, and West all increased by 13%, 4.6%, and 8.3% respectively.  The NAR is forecasting existing home sales to reach 5.4 million this year and 5.74 million in 2009.  Based on those estimates, Mr. Yun may be campaigning for the head post at the National Association of Delusional Home Sales Optimists.  I'd like to point out to Mr. Yun that April existing home sales pointed to an annual pace of 4.89 million homes.  I'm wondering where the extra 500,000 units are going to come from to fulfill his estimates.  Those who are actually interested in purchasing a home in this dismal and uncertain economic environment are asking:  Can't we all just get a loan?  The banks are more than willing to comply, provided you have real assets, real cash for a hefty down payment, a real job, and maybe a kid or two for collateral.  5.4 million homes sold this year?  Time to throw another dart at that dart board...  

Lehman Posts $2.8 Billion Loss, Ups Capital Raising Plan to $6 Billion

Lehman Brothers announced that it expects to report a $2.8 billion ($5.14 a share) loss and increased the amount of capital it will raise to $6 billion.  The official earnings report will be released on June 16th, where the company will provide details to its investors - those who chose to remain - as to how exactly they managed to lose all that cash.  Remember two weeks ago, when analysts were estimating a $300 million loss, and the company was only going to raise $3-$4 billion?  The numbers get bigger and bigger every week, giving credence to the fundamental belief by doubters of Lehman's future that the investment bank's management doesn't really have a handle on the value of its bloated assets.  CEO Dick Fuld said he was "very disappointed."  But went on to say that "with our strengthened balance sheet and the improvement in the financial markets since March, we are well-positioned to serve our clients and execute our strategy."  So why didn't Lehman make a bundle of money this quarter if the financial markets improved so much since March?   Either it was underestimating its losses last quarter, or its fortunes are no longer tied to the improvement in financial markets.  Neither explanation is comforting.  Several analysts believe that Lehman can't survive as an independent company and will be taken over by a commercial bank.  Seriously, which of the commercial banks is in the market for a large acquisition involving swallowing $700 billion or so of assets, many of them involving interpretive pricing on MBS, ABS, and derivatives, on its balance sheet?  Although Lehman reduced its leverage to around 25:1 from 31:1, that is still too much leverage for a commercial bank, meaning the bank would need to allocate significant amounts of capital against the new positions.  Given that banks are puking their own positions and begging for money from investors to shore up their own balance sheets, what bank in its right mind would risk an acquisition right now?  JP Morgan and Bank of America are still suffering indigestion from their acquisitions of Bear Stearns and Countrywide respectively.  Wachovia and Washington Mutual are getting pasted by losses in their huge loan portfolios.  Wells Fargo wouldn't risk pissing off Buffett by tarnishing its image as a conservative bank who avoided underwriting many of the toxic no-doc loans that other banks found too irresistible. Lehman will have to go it alone, which I know is how they want it to be.  The question remains:  Will they make it?   

Update on capital raising:  Lehman priced $4 billion in common at $28 a share and $2 billion in convertible preferred.  The shares were oversubscribed, much like Lehman's last convert that it issued on April 1, 2008.  Lehman, at the time, insisted it didn't need to raise capital, but did it to shore up confidence.  The issue was a big hit with investors, who gobbled up the convert, which was convertible into common at a price of roughly $49.87.  The good news is, if you liked the last convert, and didn't hedge by shorting stock against it, you can just dollar cost average down and maybe not look like such a jackass.  It's gotta bounce sometime. Right?  

Friday, June 6, 2008

AIG, National City Face Probes By Regulators

AIG is facing an SEC investigation into how it accounted for its credit default swaps tied to subprime mortgages.  The investigation was more than likely triggered by the discovery in February of "material weakness" in AIG's accounting for these derivatives by auditors.  As an aside, I must take a moment to praise AIG's auditors for finding suspicious accounting before a company's bankruptcy announcement.  They really have come a long way since Enron.  AIG tried to defend its accounting by blaming the mispricings on "unpredictable markets" during the credit crunch.  But the auditors and the SEC seem to think the mispricings are related to "it'll all come back, so we'll just mark it here" syndrome, also known as "marking to whatever the hell I think it's worth" disorder, in addition to "we're AIG so we do whatever we want and then pay fines to settle charges" disease. A good friend of mine who is in the insurance industry told me once that he believed that AIG was run by a bunch of crooks.  This was back in 2005, when Maurice "Hank" Greenberg was booted out of the CEO post during AIG's last accounting scandal.  I believed my friend's assertion when I read that Hank Greenberg refused to share the fancy bathroom on his private jet with anyone other than his wife and his fluffy white Maltese dog named Snowball.  Clearly, that man had something to hide.  Apparently, the crookedness didn't disappear with Mr. Greenberg. 
In Midwestern regulatory investigation news, the Wall Street Journal has reported that National City has been put on probation by federal regulators.  NCC has entered into a confidential agreement with the Office of the Comptroller of the Currency at some point in the past month.  The confidential agreement will allow the bank to work with regulators to address its financial problems without "triggering alarm among depositors."  Perhaps some of those depositors may be alarmed now after they woke up this morning and read the Wall Street Journal's report.  The terms of the agreement weren't detailed, the report merely indicated that the OCC will urge the bank to maintain adequate capital and improve lending standards.  Apparently, a handful of other banks are operating under similar agreements or MOUs (memorandum of understanding.)  I'm not sure what this action means beyond assuming that lending standards will be tightened even further at banking institutions that are already suffering from the mortgage/commercial real estate/construction loan debacle.  If nothing else, having banking regulators hanging around the office and breathing down your neck all the time should make bank managers rethink ever allowing lending standards to drop as drastically as they did in the past few years.  

Lehman Brothers Seeks to Raise $5 Billion, Move Up Earnings Report Date

A Bloomberg report this morning claims that a "person" insists Lehman is now upping the amount of capital it intends to raise to $5 billion from the previously reported $3-$4 billion.  Who is this person?  It could be my cat, given how much speculation has occurred around Lehman's financial situation.  Furthermore, the same or another "person familiar with the matter" has informed Reuters that Lehman may release its second quarter results earlier than originally planned.  Apparently, Lehman is sick and tired of all the speculation about its financial condition and believes that releasing its earnings report early will quell investor unease.  Alternatively, Lehman may actually be having problems with counterparties not wanting to trade with it and believes that once the company comes clean and trading partners see that the situation is not as bad as the rumors, confidence will return.  That strategy did not work for Bear Stearns, who moved up its earnings report for the same reason but never made it to the date to report its "profits".  Those "profits" were based on a belief announced by the CEO right before Bear failed, that book value of the company was still roughly $80 a share.  Now that the Fed synthetically owns $29 billion in securities that no dealer on Wall Street would touch with a 10-foot pole, and JP Morgan has taken a $9 billion after-tax charge to account for the acquisition, one must question Bear's pricing of its portfolio.  How close to reality were those prices anyway if nobody wanted to buy securities that equaled nearly all of Bear's supposed "book" value?  Similar doubts currently swirl around Lehman.  They may or may not be cleared up at the earnings conference call, says a person only slightly familiar with the matter.

Unemployment Rate Leaps to 5.5%, Payrolls Decline by 49,000

Proving yet again that my one year old is better at forecasting the unemployment rate, economists collectively missed the mark by a wide margin in their estimates that the unemployment rate would merely uptick to 5.1%  Instead, the unemployment rate leapt by the most is two decades.  While a 5.5% unemployment rate is not necessarily the death knell for the US economy, the trend higher poses a conundrum for our friendly monetary policy makers at the Fed.  After running off at the mouth about the risks of inflation to signal their intent to end the easy-money bank bailout scheme, they may need to change their tune again.  Bernake's insistence that the current economic environment did not resemble 70's style stagflation may be true, but we may be entering a new period of 2008-style stagflation.  That would be food-hoarding-$5-gas-paying-negative-equity-just-lost-my-job-as-mortgage-broker-can't-pay-the-loan-I-sold-myself-last-year style stagflation.  While those who remember scheduling several hours into their day to wait around in line for gas in the 70's know that things can't possibly be that bad this time around, younger folks may not be so sure.  Where'd my shiny new condo with the granite countertops go?  Why didn't my stock portfolio return a riskless 8% this year like my money manager promised?  Most importantly, what traders want to know is the following:  Why do they insist on reporting that stupid unemployment number on a Friday when I am hungover from the night before and hate everybody I work with?  I know I told you "I love you, man" last night, but that doesn't mean I'm going to give you a good market today.  Get lost!

Thursday, June 5, 2008

Mortgages in Foreclosure, Delinquency Rates Rise in First Quarter

The percentage of loans in the foreclosure process at the end of the first quarter rose to 2.47% of all mortgages outstanding on one-to-four-unit properties, up from 2.04% in the fourth quarter, according to the MBA's National Delinquency Survey.  Loans entering the foreclosure process rose to .99% from .83% in the fourth quarter.  6.35% of all loans were at least one payment past due in the first quarter, up from 5.82% in the fourth quarter.  According to the report, California, Florida, Arizona and Nevada drove the increases representing 62% of the foreclosures started on prime ARM loans in the first quarter and 49% of the foreclosure starts on subprime ARMs.  About 20 states experienced drops in the number of foreclosures starts.  Michigan, Ohio and Indiana who led the charge in foreclosure filings recently saw an encouraging drop in foreclosure starts in the first quarter.  This may be an indication that a bottom has been reached in some of these states.  In Detroit, for example, you can literally buy a house for $1, or, if you are a professional flipper and you're still in business, some banks will pay you thousands of dollars to take foreclosed properties off their hands.  So, yes, I'd call that a bottom.  In California, on the other hand, where median home prices are still significantly higher than overall US medians, and inventories of unsold homes continue to rise, prices should continue to fall until buyers begin to view them as cheap.  They may be more affordable than they were a year ago, but they aren't cheap yet.  In Florida, Arizona, and Nevada, the inventory of unsold condos will take many years to work off, signaling a continuing rise in foreclosure activity.  When I can buy a condo in Miami for $1, we can start talking about a bottom.      

TPG and Goldman Offload Alltel to Verizon for $28.1 Billion

Verizon has agreed to purchase Alltel for $28.1 billion, allowing private equity investors TPG and Goldman to flip their purchase just seven months after taking the wireless telecom firm private in a $27.5 billion deal.  Verizon can now boast of being the largest US wireless carrier, besting AT&T who currently holds the title.  Why would Goldman flip its investment for such a meager premium so soon after it purchased Alltel?  Because, along with Citigroup, it wound up stuck with the bulk of the leveraged loans used to finance the deal when credit markets soured.  Perhaps Goldman was willing to accept rotten returns in its private equity arm in order to lose the debt taking up valuable space on its balance sheet.  TPG can move on to pursue other deals at today's discounted private equity prices without having to worry that its investment in Alltel will suffer further due to its mountain of debt.  Citigroup's Vikram Pandit will need to take the guys at TPG and Goldman out to dinner.  If only it were this easy to get rid of the rest of the $400 billion in assets that Citi is looking to sell. 
Update on the deal specifics: TPG and Goldman are actually getting decent returns on this deal.  Verizon is paying $5.9 billion for Alltel's equity (TPG & GS put up $4.6 billion in equity to do the deal), and assuming its debt for $22.2 billion.  $13.8 billion of Alltel's term loans will be purchased at full face value, while $5 billion in short term bridge loans will be purchased at a 4% discount to face value.