The Bailout Keeps Getting Bigger and Badder

According to the Wall Street Journal, our top economic officials are busy trying to come up with The Plan that will save our banks.  In order for The Plan to work it must be definitive.  It cannot be piecemeal, like a bailout here or there, followed by a guarantee or two.  In order for the financial system to be stabilized, markets must believe that The Plan will work, after many prior disappointments.  The best way to accomplish this feat of calming markets is to continually leak news to the press that includes larger and larger numbers every day.  If an $819 billion stimulus package won't do it, then we have to start talking about a $1 to $2 trillion "bad bank."  But wait, the markets only rallied 3% on that news.  Cue the leaks with a $4 trillion estimate.  The Plan du jour involves buying a portion of banks' bad assets and offering guarantees against future losses on some of the remainder.  By Monday, I'm certain that this two-part plan will have morphed into a three-headed monster, but I digress...  

The government "bad bank" would buy assets that have already been marked down heavily.  Although this implies that the assets will be taken off of the banks balance sheets at their current marks, we're still not really sure if those marks are anywhere near the ballpark.  Only time will tell how much this will ultimately cost taxpayers, or, as some incurable optimists have posited, how much money we'll make on trading the biggest hedge fund in the history of the world.  The remainder of the "toxic assets" would be covered by a type of insurance against future losses.  According to the article "banks have probably given these assets an overly optimistic value because they plan to hold them." The loss guarantees will be similar to those already granted to Bank of America and Citigroup, with the government and banks sharing the future losses.  Additionally, the Treasury is also likely to inject more capital into banks.  We are covering as many bases as we can.

Today's Heard of the Street Column asks "What if nearly half of US banking assets turn out to be bad?"  Goldman Sachs analysts are estimating that troubled assets could exceed $5 trillion, if defined as assets that could show a loss rate close to, or above 10%.  This number represents roughly 40% of the $12.3 trillion in total assets of US commercial banks.  The article includes a nifty, but alarming, chart from Goldman detailing holdings and losses on troubled US assets excluding securities/loans held by wholly government-owned entities (it is unclear to me if that includes Fannie or Freddie):

       

If there is a silver lining in any of this, it is that the rest of the world seems to be in the same pickle, except much worse off.  Governments around the world are busy crafting plans to save their own banking systems, offering guarantees and bailouts.  Ultimately, the question as to whether any of these plans will work boils down to whether the market believes that a country has the resources to cover the cost of a massive bank clean-up.  If markets lose faith, then you wind up with a situation like Iceland, with a crumbling currency that leads to a collapsing financial system followed by a failed government.  

In Alphaville today is an interesting chart assembled by Dresdner that depicts bank liabilities relative to GDP for the Eurozone/G10.  It should be somewhat reassuring to know that at least in terms of leverage, the US (a little over 100%) looks relatively sane compared to, say Ireland (over 400%.)  Those who worry about a currency crisis in the US (as I do at times) should be heartened by the information in Dresdner's analysis.

    

Option Arms Defaults Mirroring Subprime

The Wall Street Journal has a good article about rising option arm defaults, accompanied by a nifty graph.  Nearly $750 billion option ARMs were issued from 2004 to 2007, allowing many with good credit scores to lie about their incomes and obtain mortgages to purchase properties that they couldn't afford.  The issuers of these types of loans currently reside on a distinguished list of mortgage lenders who are now no longer with us: WaMu (seized by FDIC, punted to JP Morgan) Golden West Financial (bought by Wachovia at the high, sunk Wachovia which was nearly seized by FDIC, then saved by Wells Fargo,) IndyMac (seized by FDIC) and Countrywide (bought by Bank of America for about $4 billion more than it should've paid.)  

Option ARMs, as a quick recap, were a mortgage product that allowed the borrowers to choose between a variety of payment options every month, the lowest of which was often less than the monthly interest due, causing the loan balance to grow (known as "negative amortization.")  Eventually the loans recast, principal and full interest becomes due, and the payments balloon.  Holders of these mortgages cannot afford to make the new higher payments and they become delinquent.  As of December, 28% of option ARMs were delinquent or in foreclosure, according to LPS analytics, up from 23% in September.  An additional 7% have been taken back by the lenders.  By comparison 6% of prime loans have problems (so far.) Problems with subprime are still worse, with over half of subprime loans delinquent, in foreclosure, bank-owned properties in December.  According to Goldman Sachs analysts, nearly 61% of option ARMs originated in 2007 will eventually default, assuming a further 10% decline in home prices.  Even this may be an optimistic estimate as many of these mortgages have yet to recast (see graph number two below), and housing prices continue to decline and could drop more than 10%.

Option ARMs are no longer originated as the lending community has finally figured out that perhaps it is not a good idea to allow a borrower to decide how much he should pay on his debt obligations.  Furthermore, lenders have determined that it is also silly to underwrite a loan without checking to see if a borrower actually has a job, or some income, or maybe a valuable asset or two and isn't just making stuff up on his mortgage application.  The honor system apparently doesn't work in mortgage finance.  Good social experiment, although I would've preferred that be it conducted in a lab and not cost our economy so dearly.  Finally, even if there was a lender out there that was still willing to underwrite an option ARM, I believe that congress has outlawed them, albeit about four years to late to make a difference.  

The following graph from today's Wall Street Journal article depicts option ARM delinquencies compared to subprime.  Note that neither of the two have leveled off at all, and just continue at ever steeper trajectories.            

This next graph also from the Wall Street Journal was included in a post I wrote in August entitled "Option Arms Chart Signals Looming Disaster."  The graph shows the percentage by which borrowers' payments will jump once their mortgages are recast.  One can easily conclude that delinquencies will only increase sharply as payments jump higher and borrowers are incapable of refinancing or selling their homes.

Stimulus and More Bailouts

The House passed the $819 billion stimulus package.  The bill extends unemployment insurance benefits, expands access to health care for the unemployed and allocates $125 billion for public education (plus many many extras).  While the size of the stimulus, which almost equals the entire cost of annual federal spending under Congress's discretion, may seem shocking, it is chump change compared to the numbers flying around concerning the "bad bank."  According to the Wall Street Journal, Government officials are discussing spending ANOTHER $1 to $2 trillion to help restore banks to health.  One of the proposals, involves seeding the "bad bank" with $100 to $200 billion in TARP funds and then borrowing as much as $1 to $2 trillion by issuing debt.  If this proposal comes to fruition, I would highly recommend a new moniker: Big Bad Leveraged Bank.  It would be sort of like combining all of the stupidity from the past few years, into one big ugly operation run by the government, and then piling on some leverage for good measure.  Sure this proposal is bound to make bank stocks rally, but it scares the living daylights out of me.

Meanwhile, the bailout du jour involves credit unions.  Federal Regulators guaranteed $80 billion in uninsured deposits and injected $1 billion of new capital into the largest of these wholesale credit unions, US Central Federal Credit Union of Lenexa, Ka.  According to the WSJ, the vast majority of regular credit unions are financially sound, however, a few of the wholesale or "corporate" credit unions were invested in mortgages (uh oh).  The corporates are owned by the retail credit unions and provide services to the retail credit unions.  Consequently, a failure of the corporates would affect the nearly 90 million Americans who hold deposits at credit unions.  As of November, five of the largest institutions posted unrealized losses on their investments of $11.6 billion, up from $9.4 billion just a month earlier and double the level of last May.  When the aforementioned US Central chose to take a $1.2 billion writedown by permanently recognizing some unrealized losses, regulators (The National Credit Union Administration) grew concerned and felt the need to take action.  The $1 billion in new capital into US Central came from the NCUA's $7 billion insurance fund.  Simple math tells me that the insurance fund now has $6 billion left and the industry has over $10 billion in unrealized losses, much of which will likely end up being real.  The NCUA better work fast to get included in the TARP.

    

The Lembi Real Estate Empire Falling Apart

The Wall Street Journal property report has a fascinating article today detailing the current woes of the Lembi Group, one of San Francisco's largest owner of apartment buildings.  The Lembi Group, (led by Walter Lembi, son of Frank, the company's founder) recently handed over 51 buildings to UBS and is currently working to refinance approximately $1 billion in short term loans, some of which are securitized (Hello CMBS?  I'd like to introduce you to some more defaults.)  The various loans come due within the next six to twelve months, leaving Walter Lembi, managing director of the firm, scrambling to find solutions that don't involve losing the fortune that his father accumulated over 60 years.  Handing over the 51 properties to UBS released Mr. Lembi from a $400 million personal guarantee, although he is subject to other guarantees.  According to the article, Mr. Lembi will not be able to strike similar deals with other lenders (deed in lieu of foreclosure) as the UBS transaction has used up corporate losses that offset tax liabilities.  If he cannot negotiate extensions on the other loans, he will more than likely lose the buildings to foreclosure. 

   

The story about the Lembi Group is a fine future business school case study in everything that was wrong with the insane lending environment of 2004-2007.  I wrote about the Lembis in March 2008 in a post entitled "Is Frank Lembi the Next Harry Macklowe?"  (apparently so) where I marveled at the insanity of borrowing up to 95% of a building's purchase price to buy $1 billion worth of property that would yield negative cash flow for a significant period of time.  The company's strategy relied on converting rent controlled units to market rate units and then refinancing or selling at a higher price.  For those unfamiliar with San Francisco tenant laws, converting rent-controlled properties to market rate units is about as easy as finding a commercial real estate lender who will give you a 95% LTV loan TODAY.  In other words, if you are a landlord with a deadbeat tenant who is operating a well-known crack and prostitution ring out of his rent-controlled apartment and he hasn't paid rent in seven years, you would still face serious obstacles getting him evicted in San Francisco. 

If you ignore the many minor yet foolish components of the Lembi Group's plan for San Francisco multi-family real estate domination, there was only one major glitch to the strategy:  Since the Lembis outbid most competitors by roughly 20% for nearly every multi-family property on the market in San Francisco from 2003-2007, they were mostly responsible for pushing up multi-family property prices to unsustainable levels (i.e. prices no sensible investor who uses actual math would pay as opposed to a ponzi schemer).  When you are the only bidder at a 2% cap rate, and your lenders come knocking, who do you expect to outbid you for your crappy rent-controlled building?  Why any lender ever agreed to hand over so much cash on such ridiculous terms is a whole other story; one which I seem to tell nearly every day in my postings.

The funny part is that the San Francisco rental market is actually fairly strong.  Vacancy rates are low, and rents are expected to remain somewhat stable.  Owning a multi-family property in San Francisco shouldn't have to end in foreclosure and won't for those property owners who didn't pay too much and aren't suffering from the deathtrap that is negative cash flow.  But if you're leveraged out the wazoo and need to sell something into this market, then frankly, this was a disaster of you and your lenders' own making.  Nevertheless, Mr. Lembi blames everything on "the disturbance in the marketplace.  Nobody could've predicted this train wreck" he is quoted with in the article.  Except that many people did predict it.  Even a random blogger.  Most predictable train wreck ever!

Earnings Highlights 1/28/2009

• Wells Fargo reported a quarterly loss of $2.55 billion on a 4% revenue decline from a year ago.  Additionally, Wachovia, which Wells Fargo stole out of the arms of Citi and the FDIC, lost $11.17 billion in the fourth quarter, due to loan losses and investment write-downs.  Wells Fargo's stock is up sharply on the news, following the merciless pummeling it received in last week's bank stock rout, indicating that investors still have no idea how to value bank stocks in the current environment.  Yours truly included.

•   Boeing announced fourth quarter net income declined to a loss of $56 million, reflecting the now-settled machinists strike.  Revenues for the quarter declined 27% to $12.7 billion.  The company also issued muted guidance of $68 to $69 billion in revenue for 2009 and earnings per share of $5.05 to $5.35 a share.  This was below analysts estimates.

• AT&T posted earnings of $2.4 billion, down from $3.14 billion a year earlier.  Revenue rose 2.4% to $31.1 billion, roughly in line with analysts estimates.  AT&T said that it added 2.1 million net new subscribers in the quarter, ahead of analysts estimates.

• Legg Mason posted a loss of $1.5 billion, much higher than analysts' estimates.  The company was forced to take a $1.2 billion writedown in the value of tis hedge-fund business.  Assets declined 17% in the quarter to $689 billion.  Investors withdrew $77 billion, indicating that the balance of the asset decline was attributed to further losses on its portfolios.

• In the "holy smokes" department, ConocoPhillips lost a whopping $31.8 billion on previously disclosed one-time charges.  If you pay no attention to the massive one-time charge (related mostly to a $25.4 billion goodwill write down), earnings were $1.9 billion, beating analysts estimates.  Revenue declined 18% to $44 billion.  

AIG VP Sentenced to Four Years While AIG FP's Get Bonuses

The former vice president of reinsurance of American International Group was sentenced to four years in prison for his role in a fraudulent scheme to manipulate AIG's financial statements.  The evidence showed that two sham transactions increased AIG's loss reserves by a total of $500 million in 2000-2001.  The VP and his four co-defendants were all convicted on all counts presented against them in the 16-count indictment.  The Judge found that AIG's shareholders lost between $544 million and $597 million as a consequence of the defendants' fraudulent scheme.  Can you believe it?  $500 million in losses to AIG's shareholders?  And these guys only got four years?  They should go to prison for life!  For life!

The timing on this news story could not have been better.  For it happened to hit the tape yesterday, the same day that Bloomberg reported that employees in AIG's financial products division were awarded $450 million in retention bonuses, post government bailout.  The financial products group was responsible for $34 billion in losses, as well as bringing one of the world's largest financial institutions to its knees, begging for a government bailout.  Since the aforementioned defendants were initially charged with their hideous crime in 2005, that cost AIG's investors a pittance of $500 million, AIG's market capitalization has declined by around $150 - $200 billion.  Meanwhile, Hank Greenberg, former AIG CEO who was in charge when the accounting fraud was perpetrated, is jetting around with Snowball, his trusty dog, writing pleading letters to the Wall Street Journal, interviewing with Maria Bartiromo, and desperately trying to wrest control of his failed insurance conglomerate from the government.  

While I certainly believe that perpetrating accounting fraud should always lead to prison, I have to admit that I'm slightly sympathetic to these particular defendants.  For their accounting shenanigans pale in comparison to the damage wrought by reckless stupidity and greed.  Hopefully, for their sakes, they stopped reading the Wall Street Journal in 2005.  

Equity Futures Perk Up on "Bad Bank"

US equity futures are decidedly higher this morning.  Most of the rise, which occurred after the closing bell yesterday, can be attributed to news leaking out about plans to form a universal "bad bank", owned by US taxpayers, that will be managed by the FDIC.  The bad bank would purchase "toxic assets" from banks, manage them, limit losses to the taxpayer, and administer spankings whenever appropriate.  The market loves this idea because the banking system finally has a place to deposit all of that garbage that it didn't know what to do with.  The situation is remarkably similar to the Mobro 4000 giant garbage barge that floated around New York in 1987, that nobody was willing to take.  Congratulations Sheila Bair, you are officially commander of Mobro-Redux 2009.

My biggest and only issue with the bad bank is determining the prices on the toxic assets.  I really hate the idea of a large transference of risk from the capital markets to the taxpayer, particularly if the taxpayer is going to take assets off of the banks' balance sheets at prices equal to or higher than where the banks are carrying them on their books. It's handing a gift to shareholders and firms who, frankly, don't deserve it, given all of the mayhem the credit crisis has caused for the rest of the economy.  Alternatively, I would prefer it if the FDIC just prepared itself more fully for large scale banking liquidations like the RTC held in early 1990's.  The RTC did not pay to acquire those assets, consequently, the cost to the taxpayer was minimal.  I believe it's important to protect depositors and the financial system from more turmoil, but the burden of poor investment decisions made by many very highly compensated people should be borne by those who made those decisions as well as those who took the risks of investing without performing adequate due diligence on their investments.  It's the way the capital markets were created.  Equity loses first, then debt, in that order.  If the taxpayer needs to step in, it should take the losses last.  Granted the US taxpayer is already in bed with the banking system, so at this point it is merely protecting its own investments, but now we're just talking about shuffling money around from one money-losing entity to another.

I don't profess to have the answers to the complicated problem of the morass we are in.  But I prefer the idea of backing new banks that are not burdened by toxic assets and the lazy boards or crappy management that allowed some of these banks to get into so much trouble to begin with.  Something was rotten at the core of many of our largest financial institutions.  Helping to create new institutions rather than supporting the status quo is a plan I would support. 

 

The Ponzi Report

Yet another alleged financial fraud was revealed yesterday when a New York financier, Nicholas Cosmo, head of the $300 million (well, maybe) Agape World investment fund, turned himself in to authorities to face charges.  Mr. Cosmo was MIA when the news of the alleged ponzi scheme hit the tape, leading authorities to wonder if he was hatching a complicated scheme to skip town.  For those of us who are amused by the ludicrous attempts of these financier clowns to evade authorities, Mr. Cosmo's uneventful surrender was a huge disappointment.  No melodramatic suicide note (ala Samuel Israel?)  Can't we at least get another fake mayday call and plane crash (like that boob Marcus Schrenker?)  

What I find most interesting about Mr. Cosmo is that he was convicted of a federal charge of felony fraud and swindle in 1999 and sentenced to 21 months in prison.  However, according to Agape's website, the firm was founded in 1999 in order to make commercial bridge loans, construction loans and the like.  Since Mr. Cosmo was not released from custody until August 2000, he was apparently structuring deals from prison while serving time for felony fraud charges.  Although potential investors had expressed their concerns, somehow this goon managed to raise $300 million from people who didn't seem to care that he was a convicted white collar criminal.  Or perhaps this was just a minor detail when weighed against guaranteed returns of 13% to 15%?  

No doubt many more of these money-making schemes that will be revealed as frauds soon enough.  Perhaps investors will perform more due diligence in the future before throwing their money at anything with purported double digit returns.  Until the next bubble, of course. 

Headline Earnings News 1/27/2009

A gaggle of US companies reporting earnings.  Here are some of the highlights:

• Verizon posted a solid earnings report - net income rose 15% on reduced charges, rising margins and continued growth in its wireless and broadband segments.  Net income was $1.24 billion up from $1.07 billion on $24.65 billion in revenue.  Results met analysts expectations.  More importantly, Verizon did not announce another round of layoffs.  The job market can breathe a huge sigh of relief following yesterday's announcement of 76,000 job cuts in one day for US and European companies.   

• DuPont swung to a loss in the fourth quarter.  The large chemical company reported a $629 million loss, compared with net income of $545 million in the previous year, on revenue of $5.82 billion, a 17% decline year over year.

• Corning announced a 65% plunge in fourth-quarter profit and plans to cut 3,500 jobs or 13% of its workforce.  The maker of liquid-crystal-display glass and fiber-optic equipment posted net income of $249 million down from $717 million last year, on a 32% sales decline to $1.08 billion.  The company warned that it hoped to break even in the coming first quarter.  Analysts had been expecting earnings of 19 cents a share.

• After yesterday's close, American Express announced $172 million in net income for the fourth quarter, a 79% decline year over year on an 11% revenue decline to $6.51 billion.  The company reported rising delinquencies and write-offs, but set aside less to cover credit losses than in the year ago period.  Executives at the firm claim that the company set aside large amounts last year and felt they should be adequate to cover future credit losses.  AmEx is basing its credit loss estimates on an 8.5% unemployment rate.

• Delta reported a fourth quarter net loss of $1.4 billion.  Nearly $1 billion of the losses were linked to merger costs and fuel hedges that lost money due to the decline in oil prices.  The airline, however, expects to be profitable in 2009 and anticipates cutting another 6% to 8% in capacity after the 11% reduction in the second half of 2008. 

Headline Financial News 1/26/2009

• Pfizer is plunking down $68 billion ($33 in cash and .985 per share) to purchase Wyeth.  This values the Wyeth at $50.19 a share versus Friday's close of $43.74.  Pfizer is cutting its dividend in half, laying off 10% of its workforce, and reported a 90% decline in fourth-quarter profit.  Remarkably, Pfizer was able to convince a bank consortium to commit to $22.5 billion for debt financing.  Who says banks aren't lending?  If you already have $20 billion or so laying around, banks are more than willing to lend you another $20 billion or so.

• Speaking of banks not lending, the Wall Street Journal has an article showing that bank lending has declined for most large banks receiving TARP money between the third and the fourth quarter.  Critics claim that this is proof that the "TARP has failed" while others say that banks wouldn't have lent a dime in the fourth quarter without the TARP.  I'll let my readers decide which is closer to the truth.

• Caterpillar is planning to cut 20,000 as fourth quarter profit fell 32% on a steep drop in demand.  The company also issued a weak outlook.

• Smurfit-Stone, North America's second largest maker of corrugated packaging filed for Chapter 11 bankruptcy protection in the face of declining demand and heavy debt payments.    

• Speaking of Chapter 11, the Financial Times has a good article discussing how liquidation risks have grown due to the lack of availability of "debtor in possession" financing in the US.  US companies face a greater risk of liquidation as previous big providers of DIP financing, such as GE Capital, have left the business pushing up the cost of this type of financing.  DIP financing is necessary to get companies through the Chapter 11 reorganization period.  The article makes the case that an increase in liquidations are likely to lead to more job losses and a more protracted economic downturn.   

• The Car parts sector is looking for a $10 billion federal bail-out, because it never hurts to ask. 

• Possibly the worst news I've read all morning:  Goldman is canceling its annual Davos World Economic Forum party which is usually a real humdinger.  Really horrible news.  I'm not at all surprised that it was reported on the front page of the Financial Times. 

Souring Stuyvesant Property Investment Portends More CMBS Pain Ahead

Back in late 2006, when commercial property investors liked to swing it around, Tishman Speyer, in cahoots with Blackrock and Calpers, paid $5.4 billion for a huge block of apartment buildings in Manhattan.  Known as Peter Cooper Village and Stuyvesant Town, the complex of 11,200 apartments was originally built for veterans returning from World War II.  It was rumored to have turned into a great place to take advantage of rent-stabilization in Manhattan if your grandparents happened to keep their apartment after moving on to a nicer house.  Tishman Speyer's plan was to force out those who were illegally paying below-market rents, renovate, refurbish and rent out the properties at much higher prices.  Metlife, who sold the properties in 2006 was probably just looking to lighten its real estate load in what it perceived as an inflated Manhattan property market.  The insurer dumped its own monikered Metlife Building in 2005, also to the overeager Tishman Speyer.  When the Stuyvesant deal was originally announced, many commercial real estate investors marveled at the price, which implied a 2.5% cap rate (i.e. crazy).  I speculate that the shrewd negotiations between Tishman and Metlife may have gone like this:

Metlife: We have another property to show you.  How do you feel about Stuyvesant Town?

Tishman:  Love it!  How about $4.5 billion?

Metlife:  Seriously???

Tishman: Ok.  We'll pay $5 billion.

Metlife:  Now stop that!

Tishman:  $5.4 billion, but that's our final offer.

Metlife: Ok!  Ok!  You're done.  Just stop raising your bid for the love of God!

The Wall Street Journal reports today that the apartment complex is running behind its financial plan and will run out of money to pay its $3 billion mortgage in six months, according to a report released by Fitch Ratings.  As of January 15th, the project's interest reserve was $127.7 million down from $400 million when the property was purchased.  A separate general reserve fund used to renovate apartments is "completely depleted."  The private company has said in the past that it expected to fund more capital as needed.  But Tishman declined to comment.  Admittedly, it seems hard to imagine that Tishman, Blackrock, and Calpers would choose to allow the partnership to default and let the lenders seize the buildings.  But times are tight so it is a risk.  Injecting further money into this venture would be politically difficult for Calpers in particular, as its investment fund is suffering from major losses and it faces the near certainty of having to hike rates for California public employees.  Imagine having to pay more into your retirement fund because the boobs managing the money happened to invest in a bunch of illiquid land deals, soured private equity funds, and a HUGE apartment building in Manhattan? 

In any event, the situation is coming to a head within the next few months.  For the market's sake, I certainly hope that we're not looking at a foreclosure auction of 11,200 Manhattan apartments.  Frankly, I'm not sure who on earth would be interested in bidding on this beast of a property and where they would find financing in this market.  Maybe give Ben Bernanke a call?     

Thain and Montag to Leave Merrill Amid Bonus Controversy

The Financial Times reported this morning that Merrill accelerated bonus payments by a month, doling out billions in compensation just three days before stuffing Bank of America with a huge loss.  Here's a quick timeline just as a refresher:

• December 5th - Shareholders of both banks approve merger.
  
• December 8th - Merrill's comp committee approves accelerated bonuses.
• December 29th - Bonuses paid to Merrill employees
• January 1, 2009 - Merrill/BofA deal closes.
• January 20th, 2009 - Reports confirm that Merrill had a $21.5 billion operating loss in the fourth quarter and the government provided BofA with additional funds plus a massive guarantee on over $100 billion in Merrill's garbage.

I'm a little fuzzy on what happened between December 8th and December 29th.  At some point Ken Lewis discovered the loss, informed the government that he wouldn't go through with the purchase, and received a bailout to close the deal and avert a possible collapse of the financial markets.  In between all the negotiating, you'd think that Mr. Lewis could've found some time to issue a stop payment on all the bonus checks.  Clearly, somebody somewhere should've issued a stop payment.  Obviously, Mr. Thain was not in a position to do so because, well, he's either criminally insane or just a criminal.  But holding a special board meeting to accelerate bonus payments right before you inform your acquirer that it's gonna need a bailout from the government because you happened to puke yet another $15 to $25 billion or so is inappropriate, as well as, perhaps, fraudulent?  I don't know.  I'm struggling to find the right words.

In any event, Mr. Thain, who up until this morning faced a bright future at BofA, has been asked to leave.  Mr. Montag, the man who pocketed $40 million just for showing up for four months of work last year, is also being shown the door.  No word yet on their severance packages, but I'm thinking $50 million a piece ought to do it.  Right?

Update:  Tom Montag is not leaving Bank of America as I initially erroneously reported.  He will continue to run Global Markets (into the dirt) and report directly to Ken Lewis.  Apologies for the confusion.

Weak Economic Data Persists, Microsoft Surprises Market

Housing starts fell 15.5% to a seasonally adjusted 550,000 annual rate, after dropping 15.1%  in November to 651,000.  November was revised slightly higher from an original 18.9% drop, but seriously, who cares?  When the numbers are falling off of a cliff, does it really matter if the drop is 15% or 18%, the result is still the same: UGLY.  Year over year, housing starts were an astonishing 45% below the level of construction in December 2007.  Building permits decreased 10.7% to a 549,000 rate.  Economists were expecting permits to decline by .8%, so a huge miss in expectations.  As I've stated before, due to the significant supply/demand imbalance in the housing market, builders need to stop building houses for awhile until the housing inventory levels stabilize.  Go build a few bridges or fix an interstate.  Just stop building new houses.

Jobless claims jumped 62,000 to 589,000.  The four-week average of new claims remained unchanged at 519,250.  Speaking of people filing for unemployment, somebody at Microsoft had too much coffee this morning and decided to announce earnings before the opening bell, instead of after.  Microsoft announced it will cut as many as 5,000 jobs over the next 18 months.  Revenue for the quarter ended December 31 was up 2% to $16.63 billion, while earnings slipped to $4.17 billion or 47 cents a share, from year-earlier earnings of $4.71 billion, or 50 cents a share.  Analysts were expecting earnings of 49 cents a share on sales of $17.08 billion.  The company also neglected to offer profit and revenue guidance, citing market volatility.  In other words, much like everyone else, they have absolutely no idea what's going to happen in the coming year and don't even want to hazard a guess.  But just to be on the safe side, they are cutting costs.  Consequently, the stock is getting a beatdown.  

Apple Beats Earnings and Other Tech Highlights

Forget gold, the only store of value in this market is the iphone.  The economy can't be all bad if consumers are still choosing to spend hundreds of dollars on a fancy iphone when they can get a stripped down cell phone for free.  Apple gave a much-needed boost to the market by posting solid earnings and offering decent guidance for the current fiscal quarter.  The company reported net income for the quarter ended Dec. 27, 2008 of $1.61 billion or $1.78 a share.  Apple noted that it expects earnings of 90 cents to $1 a share on revenue of $7.6 billion to $8 billion, somewhat below consensus estimates, but not horrible, which is considered fabulous news in this economy.  Still, Steve Jobs' health problems are a big risk for investors, particularly as the company is now being prodded by the SEC for disclosure issues related to his health.  More than almost any company, Apple's success hinges on Mr. Jobs' unique vision and leadership skills.    

Meanwhile, over at Ebay, things aren't looking as rosy.  One would think that a brutal recession would cause more and more consumers to buy used crap from random people online rather than anything that's for sale at Neiman Marcus but Ebay shoppers are pulling back.  The company lowered guidance for the first quarter.  Revenues are now expected in the range of $1.8 billion to $2.05 billion, with earnings expected in the $.21 to $.23 range, far below analysts estimates.  Note to analysts:  Throw a few more darts at that dart board and try again. 

Intel and Microsoft announced cost cutting measures.  Intel plans to consolidate manufacturing and close 5 factories which will affect 5,000 to 6,000 employees.  Microsoft, set to report earnings today, is expected to announce cost cutting measures as well.  Analysts expect the company to reduce full-time positions and cut contract workers and outside vendors.  This from a company that has roughly 90% margins and massive cash pile-ups every quarter because it doesn't know what to do with all that money.  But that will be the theme for the year:  Cut some costs, hunker down, and try to survive the brutal downturn.  

Broadway Partners Defaults, Causes Turmoil in CMBS

The Wall Street Journal's Property Report has a great article today detailing how complicated (translation: ugly) a CMBS deal can get when a default is involved.  At the center of the new turmoil in the CMBS market is Boston's famed Hancock Tower and Broadway Real Estate Partners, one of the poster-children of the debt-fueled commercial real estate binge that based its investments on unrealistic cash flow assumptions.  I wrote about Broadway back in April 2008.  Broadway had extended its short-term loan on several properties and was looking for creative new ways to raise capital.  At the time, I enjoyed analyzing and speculating about the impending fissures in the commercial real estate market which was still viewed as immune to the credit crisis.  During the peak of the credit boom, I had often wondered why on earth anyone would buy an illiquid asset with a significant amount of short-term financing that carried much higher rates than the sub-3% cap rate from the property.  What was I missing?  Why did the math just not make sense to me?  Was my abacus just not calibrated correctly?

The answers to my crazy questions are quite clear now as deal after deal struck in 2007 is winding up in complicated angry negotiations with lenders and investors.  Broadway's recent default on the loan tied to the Hancock Tower, and other buildings, will certainly keep the lawyers gainfully employed.  Complicating the matter, the $700 million loan was securitized into mezzanine debt split between nine investors, including Five Mile Capital, BlackRock, RBS (now part of the UK government), Lehman (now bankrupt), and State Street (still kicking, just a really bad day in the market yesterday.)  At least State Street didn't buy the mezz debt because it thought it was a nifty investment, State Street seized the collateral from Lehman after Lehman defaulted on a repo.  What makes this whole kerfuffle somewhat interesting, particularly to the lawyers, is that the foreclosure process is not straight forward in a mezzanine deal.  The property is to be appraised and those investors who are the most junior according to the appraised value, get to decide whether to foreclose.  With commercial real estate values plummeting, and very little property actually changing hands due to a lack of financing, finding an appropriate valuation for the property that everyone can agree on is perhaps not so easy.  Consequently, determining who is the junior creditor who has control over the foreclosure is disputable.  And dispute they will.              

What's Wrong With Bank Stocks

Sure, State Street had horrible earnings and is getting taken out to the woodshed.  And yes, Meredith Whitney is bashing bank stocks again and who has been more right than her about the sector in the past year?  Not to be outdone, another two-bit, "me too" analyst from FBR is also out with some negative comments about the sector, but I can't imagine anyone cares what he has to say.  Because really, if you are choosing today as the day to inform the public that bank dividends might not be safe, and that Bank of America might need more capital, after it's already been bailed out by the government and is trading at $5, and you didn't even see that one coming, well, then anything negative you have to say about the sector should be deemed as bullish.  So what's the real story here?  Why are options traders paying through the nose to buy winger puts in every American bank stock on inauguration day?  The answer lies across the pond. 

Royal Bank of Scotland down 70%. Today.  Lloyds down 57%. Today.  Barclays, who snubbed its nose at government money a few short months ago down 40%. Today.  The UK's largest bank stocks are headed to zero as the market is anticipating a full fledged bailout of the banking sector.  I return to the same question that I asked the other day:  What, if anything, is bank equity really worth?  I don't know the answer.  I don't think anyone does yet.  But with the largest bank stocks trading like call options, investors are taking a good hard look around at the remaining banking landscape and asking why every bank stock shouldn't be trading in the single digits.  If it's still a $50 stock, look out below.

Merrill- Gone But Not Forgotten

Although the Bank of America/Merrill deal is done and should be old news, many angry questions remain about how this government-backed-merger-debacle was completed without informing stakeholders (i.e. BAC shareholders, Merrill's board, US taxpayers) of some crucial details.  For example, how is it that Merrill Lynch managed to lose $15 billion in the fourth quarter, but conveniently only after Bank of America shareholders approved the deal? Here's another good one:  Why did Mr. Thain waste Merrill's last board meeting on December 8th to plead for a $10 million bonus, when he perhaps should've mentioned the $15 billion hole in Merrill's finances?  Nevermind, that one was rhetorical.  Oh wait, I have another one:  Why, for the love of God, was J.C Flowers paid $20 million for his "expertise" to advise Bank of America on the Merrill purchase, when his "extensive due diligence" somehow overlooked said $15 billion in losses?  But wait, there's more:  How did the Fed get roped into guaranteeing credit derivatives positions as part of its $138 billion guarantee to Bank of America? How about:  Why did Bank of America learn of the losses from Merrill's transition team and not John Thain?  Better yet: Why does Bank of America care about retaining any of the senior clowns from Merrill?  Didn't they already run the company into the ground?  Are they really going to threaten to leave?  Who cares?  Let them go start their own business using their own money.  Some of these guys that have milked their free career calls to the max and bled shareholders dry in the process should have to go out on their own and risk their own capital for once.  

What I have the hardest time understanding as I read all of the gory details of what went down in the past couple of weeks that led to the government ultimately stepping in and allowing Merrill to live, is how on earth John Thain has not been hung out to dry.  Frankly, I couldn't believe how the press, shareholders and the SEC let Mr. Thain get away with virtual accounting fraud following the firm's second quarter earnings results.  For those who don't recall, Mr. Thain emphatically stressed that the street was grossly undervaluing Merrill's CDO portfolio.  Then, around 10 days after second quarter earnings, he announced another $5 billion loss for the third quarter and that Merill had "sold" the CDOs to an investment fund for 22 cents on the dollar plus 75% financing.  Clearly it was not the Street who was undervaluing Merrill's assets.  Why anyone trusted Merrill's marks on any of its portfolio after that kerfuffle is a mystery.

What happens next?  Will the angry mob force out Ken Lewis?  I, for one, hope not.  Why?  Because I really worry that somehow, Teflon Thain will wind up in charge.            

Administrative Note

I apologize in advance for the lack of posting today.  I had an unexpected personal matter pop up that I must attend to so I will not be blogging today.  Besides, nothing much going on today.  Citi lost another bucket of money ($8.9 billion), is going to split itself up (as if that fools anybody) Bank of America got its government bailout ($130 billionish,) and JPMorgan for some reason is getting pummeled again.  Just your ordinary run-of-the- mill trading day.  Market shrugs its shoulders and just moves on.  It is expiration Friday, of course, so you never know.  Things could get interesting...

Hedge Fund Outflows Pick Up Pace

Outflows from hedge funds were nearly $150 billion for the month of December, bringing total redemptions for 2008 to $200 billion and total assets under management down to $1 trillion from nearly twice the size.  Despite hedge funds' best efforts to put up gates, set up sidebars, drawbridges, electrified fences, (insert your favorite euphemism for "You can't have your money back.  Try again next month.") some investors still managed to pull out cash from their formerly-favorite, high-flying, status-wielding managers.  They were the lucky ones.  The unlucky ones were those investors who placed their funds with GoldenTree Asset Management.  Although GoldenTree claims to only be down 30% for the year, they have received redemption requests totaling 25-30% of the fund, which apparently they cannot meet with cash.  The managers have opted to repay investors "in kind" (i.e. with whatever they have sitting around the office that may or may not be worth something, CDOs, ABS, CDO cubed, and maybe the office stapler if we can get an appropriate valuation.)  Needless to say, investors who will be receiving these "in kind" securities are none too pleased.  Frankly, if these securities are illiquid and can't be sold at the moment, how are investors to know that the amount of securities is actually worth what GoldenTree claims they are worth?  No doubt, the lawyers will be working overtime on this one.  

Perhaps even more embittered than GoldenTree's clients are those invested with Citigroup's Corporate Special Opportunities hedge fund.  Citi is returning 3 cents on the dollar to investors.  Believe it or not, this is actually a huge windfall for investors, as Citi bailed out the fund which would have had negative equity if it weren't for Citi's capital infusion.  CSO, according to the FT, managed almost $4.2 billion at its peak but wound up with a net asset value of about $58 million and debt of around $880 million in November.  December's results, no doubt, didn't offer any improvement and will likely just show up in the negative column in Citi's earnings results to be reported tomorrow morning.  Special Opportunities indeed! 

  

JPMorgan's "Good" Earnings Overshadowed By Bank of America's Need For Bailout

On the surface, JPMorgan's earnings didn't look too bad, relatively speaking (like compared with the run-of-the-mill Citigroup quarter).  The second-largest US bank reported net income of $702 million, or 7 cents a share, compared with $2.97 billion or 86 cents a share in the year-ago quarter.  However, JP's meager profit was boosted by a one-time gain of $1.3 billion from closing a joint venture and "risk-management results" (whatever that means.)  Without the one-time gain the company would've lost 28 cents a share.  This is an earnings "miss" in my book, but investors seem to disagree as the stock is higher on the news.

The scary news out of Bank of America this morning, frankly, overshadows JPMorgan's creative accounting triumph of seven cents of earnings.  According to the Wall Street Journal, Bank of America is close to finalizing a deal for additional aid from the government to help it close the acquisition of Merrill Lynch.  Apparently, Merrill was set to report larger-than-expected losses in the fourth quarter and Bank of America was not likely to complete its purchase.  Bank of America alerted the Treasury Department of the situation in mid-December.  Naturally the Treasury freaked out, fearing another Lehman-like debacle in the market and offered Bank of America help finalizing the deal.  The arrangement more than likely will include new capital in addition to guarantees on further losses.  I suspect this is not the last bailout package we will see for a major US bank.  A friend of the blog asked a very scary but insightful question in recent months.  "What if all bank equity is worth zero?"  I suppose what we'd have left was a bunch of bank stocks trading as if they were call options on some hope for future cash flows that leave something for shareholders, i.e. a bunch of stocks trading in the single digits.  Let review, Citigroup $4, BAC $8.  I'll stop now before it gets any scarier.     

Retail Sales Fall 2.7% and Other Sobering Headlines

Some Economic and Earnings Headlines:

• Retail sales declined by 2.7% in December, the sixth consecutive drop.  
  
• Nortel Networks filed for bankruptcy protection.  To be honest, I'm surprised these guys have hung in there so long.  They seem to lose money every quarter.  Bank of New York Mellon was listed as the largest unsecured creditor in its role as trustee on more than $3.8 billion in notes.
• Deutsche Bank reported a whopping $6.3 billion loss in the fourth quarter.  The bank indicated that significant losses came from sales and trading, although they failed to indicate how much was from prop trading.  Of course, DB's "star" prop trader, Boaz Weinstein, left last week to start a hedge fund (good luck with that), so you had to think the news out of that department wasn't going to be good.  Nevertheless, the losses out of Deutsche Bank should put the fear of God into those hoping for signs of recovery out of the banking sector.
• Tiffany reported a 21% decline in holiday sales.  The company reduced its earnings forecast for the year.  Remarkably, even with the decline, consumers spend $687.4 million on jewelry at Tiffany between November 1 and December 31.  Somebody somewhere still allocates a portion of their money to purchasing jewels, which I suppose is a positive sign.  

Equity markets are in the red, having given back all of their gains since the start of the new year.  So much for that fabled January Effect.  Bad economic and earnings news has overcome any optimism that investors may have faced at the start of the year.

Bernanke Rambles On, Trade Deficit Shrinks

The trade deficit shrank to $40.4 billion in November from $56.7 billion in October.  November exports declined by $8.8 billion from $151.5 billion while November imports fell by $25 billion from $208.2 billion.  Calculated Risk points out that most of the decline was due to the plummeting price of oil which should continue to impact December's numbers as well.  Oil prices aside, a sharp decline in US imports is sobering news for those countries that expect the US to keep buying their products.

Meanwhile, Bernanke is running off at the mouth about the current state of the economy.  To summarize his comments:  Blah blah blah, we need fiscal stimulus, blah blah blah, but stimulus won't be enough, blah blah blah, we need to further stabilize the financial system, blah blah blah, government may need to inject more capital into banks ("Hello Ben?  This is Vikram Pandit calling again.")  blah blah blah, let me explain why what we are doing is different from Japan, blah blah blah, we have many more tools in our arsenal that we have yet to tap and we're certain that these will definitely work, blah blah blah, let me refer you to chapter seven of my book on the Great Depression.  Alphaville has more on "credit easing versus quantitative easing" for those interested in a longer read. 

President Bush is seeking the rest of the $350 billion in TARP funds so that our new President Obama can use them the second after he is sworn in.  Does that make you nervous about the state of the financial system?  Investors who chose to pound shares of Citigroup, Bank of America and various other financial institutions are definitely betting that the government will have to step in and dilute shareholders again.  The new administration has already stated that the terms of the new bailouts will be far more strict and will be monitored closely.

As the crummy economic and earnings news rolls in, the government will attempt to counterbalance it with announcements of bigger and broader stimulus attempts.  I believe that this year will be the year of Bad Economy vs. Big Government Spending.  That is why it is so hard to make predictions about the direction of markets (although really, is it ever easy?) When the rules of the game can change every day based on the whims of our elected leaders, it is difficult to draw a line in the sand and say that the market is going lower because of bad fundamentals.  It is equally as difficult to believe that everything will be fine just because the Government is guaranteeing everything when the fundamentals are so horrible.  Consequently, one grand prediction I have is that of continued volatility, maybe not the kind we witnessed in October, but certainly the markets will be on a roller coaster ride until we figure out which force will win the battle.  The good news is, for those with a strong stomach, roller coasters can be a fun and interesting ride.     

Paltry Debt Recovery Rates Anticipated in Economic Downturn

The Financial Times has a very good article about debt recovery rates taking it on the chin in this economic downturn.  If you thought that Lehman bondholders were disappointed by the paltry 9 cents that resulted in the CDS settlement after the company's bankruptcy, try being a Tribune bondholder.  The settling of credit derivatives linked to the Tribune bankruptcy provided a mere 1.5 cents on the dollar for bonds, with Tribune's loans settling at 23.75 cents.  Historical bond recovery rates have been around 40 cents on the dollar while historical loan recovery rates have hovered around 87 cents.  Moody's head of corporate default research claims those rates might fall as low as 15 cents for bonds and 52 cents for loans in this downturn.  Sadly, even those levels might prove to be optimistic. 

The explanation for the bleak situation facing bond and loan investors who hold debt in companies that go bankrupt is summed up nicely by David Bullock, managing director at Advent Capital: "You have leverage at historically high levels in an economy that is in historically dire straits."  Furthermore, due to loose covenants struck during the go-go days of the credit boom, companies are allowed to operate longer before triggering a default, assets are therefore depleted and liquidations result in lower recoveries once the company finally does go bankrupt.  It would be easy to pity the poor bond investor who is suffering from this unprecedented downturn.  But covenants were invented so that bond investors could protect themselves if conditions at a company deteriorated unexpectedly.  Why bond investors lost their discipline and chose to lend money without asking for any protection in return at record low risk premiums during the credit boom will always be a mystery to me.  Now they must pay the price.  The real pity is that their reckless lending has inflicted so much pain on the rest of the economy.       

Former Peloton Co-Founder Convinces Soc Gen To Fork Over Money

Remember Peloton Partners, the $2 billion hedge fund that spectacularly lost all of its capital in early 2008, before the credit crisis really hit its stride?  One would think that the managers of a hedge fund that punted all of its investors' capital would be shut out of any money management opportunities in this difficult environment where even funds with good performance are battling redemptions.  But no.  The Financial Times reports that Geoff Grant, the co-founder  of Peloton has managed to raise approximately $130 million for a global macro fund, most of it from Soc Gen.  It's funny that a guy who missed one of the largest macro events of the last 50 years and was such a bad risk manager that he lost all of his investors' capital in about a month will now be running a global macro fund.   

Blowing up a hedge fund or a Wall Street trading desk and then quickly moving to another fabulous money making opportunity used to be a common theme.  The twisted thinking goes as follows: "he made a bunch of money before he lost it all, so he can make a bunch of money again."  For some reason, however, I thought that John Meriwether had finally put this ridiculous notion to rest.  After blowing up Long Term Capital and nearly taking down the entire financial system in 1998, Mr. Meriwether went on to found JWM Partners.  Everything was going swimmingly, until we hit another credit crisis, similar to 1998, but more severe.  JWM Partners dropped 43% through November 2008 and has halted redemptions.  The thing is, if you're going to suffer catastrophic losses every time the market has its big credit correction every 4-10 years, you have no business managing money.  You have learned nothing from your previous mistakes, and you're just a one trick pony who only makes money in bull markets.  Even a monkey can make money in a bull market.  The secret to being a good investor is making it though the bad times and being around to take advantage of good opportunities when markets get crazy.

So, Mr. Grant, you get a second chance.  Let's hope you learned your lesson the first time around.  As for Soc Gen, well, at least Mr. Grant's fund will be a better bet than the one they made on Jerome Kerviel.

KB Home Posts Another Loss, Lennar plunges

KB Home posted a $307 million loss on "improved margins and lower write-downs."  While that is a huge improvement over last year, when the homebuilder punted $772.7 million, it's still hard to celebrate those "improving margins" when you're still posting a sizable loss.  Furthermore, the company's revenue declined 56%, new home deliveries slid 52% and the average selling price declined by 6.3%.  CEO Jeff Mezger called the downward pressure on the home-building industry and overall economy "unprecedented."  But why shouldn't an unprecedented boom be followed by an unprecedented bust?  

Meanwhile, as KB Homes stock took a small beating this morning, Lennar's stock was getting hammered by a disproportionate amount.  Could there be some news?  Sort of.  The Fraud Discovery Institute released the Top 10 Red Flags for Fraud at Lennar.  Personally, I've never heard of the Fraud Discovery Institute, but a formidable name like that and a quote claiming that Lennar's joint ventures are a "ponzi" scheme, certainly made my trigger finger itchy.  I'm not sure how many of the red flags were actually new revelations to Lennar's shareholders or those who like to short the stock (yours truly, on occasion), but perhaps the use of the word "ponzi" in a Bloomberg headline woke everyone from their non-farm-payroll induced apathy.  For 2009, "ponzi" is the new "toxic assets."  Prepare yourselves to hear it used prolifically in reference to everything.  Thanks, Bernie Madoff.   

Employment Report: Bad, Really Bad

The US lost 524,000 in December, roughly in line consensus estimates, but the jobless rate rose more than forecast to 7.2%.  The service sector suffered the brunt of the losses (banks, insurance companies, restaurants and retailers) posting a decline of 273,000 workers, after a decline of 402,000 the previous month.  Additionally, the average work week shrank to a record-low 33.3 hours from 33.5 hours.  Average weekly hours worked by production workers dropped to 39.9 hours from 40.3 hours, while overtime decreased to 3 hours from 3.3 hours.  Average weekly earnings declined by $2 to $611.39.

The market is shrugging its shoulders as if to say "ho hum, we knew it would be bad."  But really, this is awful.  A 7.2% unemployment rate is downright miserable.  Furthermore, according to a friend of the blog with a better grasp on economics than myself, the decline in the average work week represents another half a million jobs lost in the economy.  Although the employment report can be written off as "anticipated," often it just takes some time for the bad news to sink in. 

More Gloomy Data

While initial jobless claims declined by 24,000 to 467,000 in the week that ended January 3rd, the total number of people collecting benefits rose to 4.6 million, the highest number since 1982, indicating that those who have been laid off are having trouble finding jobs.  If ever there was a year that the US did not want to revisit economically speaking, 1982 might be a contender after say, 1929.

Meanwhile, retailers all trimmed earnings forecasts after an extremely disappointing holiday season.  Even the great discounter Wal-Mart announced its profit would miss earlier forecasts after sales rose a meager 1.7% last month.  Sales at the Gap, the largest US clothing retailer fell 14%, while revenues at Macy's dropped 4%.  Although a dismal holiday season at most retailers was not necessarily unexpected, the announcement from Wal-Malt was a shock and the stock is getting pummeled this morning.

Speaking of shopping and malls, REITs are having a lousy day, more than likely thanks to the dismal retailing update coupled with a fairly bearish article in the Wall Street Journal that reports on a sharp rise in delinquencies in commercial mortgages in the fourth quarter.  The article makes three important points in my opinion:

• The commercial real estate market is $3.4 trillion dollars, larger than the $2.6 trillion market for consumer credit.  Rising delinquencies in this market is no small matter for the market. 
  
• Many of the loans made in the past three years were based on unrealistic cash flow estimates and may default as cash flows fail to adequately cover debt service.
• Banks and thrifts own nearly 50% of all commercial mortgage outstanding.  In particular some 1,400 commercial banks and savings institutions had more than 300% of their Tier 1 capital in commercial mortgages.  This implies that if and when the delinquencies really hit a fever pitch, there will be many more bank failures.

As usual, there is a nugget of humor in the otherwise beak assessment.  A chief credit officer of a small bank in Illinois that has commercial mortgages outstanding representing 752% of its Tier 1 Capital is quoted with the following: "The economy caused the situation to a great extent.  When the economy rectifies itself, the bank will see a great improvement in its balance sheet."  He speaks of "the economy" as if it were perhaps a person who, as a chief credit officer, maybe had some say over how much risk the banking institution would take with its depositors' money.  But I suppose if Mr. Chief Credit Officer had his head in the sand when he allowed his institution to take so much risk, it makes perfect sense that he'd just wait around for "the economy to rectify itself."  Because hope is always a component of any solid risk management plan.  

Tomorrow will bring the big Kahuna of economic numbers: the employment report.  If you aren't quivering in your boots yet, you should plan on starting right about now.

Another Day, Another Fraud, Another Suicide

If a severe economic downturn is good for anything, it is unveiling fraudulent organizations that have been operating for years in an easy money bull market.  Today brought another shocking revelation of a large-scale financial fraud, when the founder and Chairman of one of India's largest technology companies, Satyam Computer Services, admitted that he had concocted key financial results for several years.  Among other things, B Ramalinga Raju claimed that the company's cash balance of more than $1 billion was a mirage (around $60 million.)  Furthermore, Mr. Raju overstated profits for the past several years, overstated the amount of debt owed to the company and understated its liabilities.  In other words, he was just making that accounting stuff up.  Granted Satyam was an Indian company, and we can all write it off as one of the dangers of investing in emerging markets.  This kind of thing never happens in the US (if you don't count Enron, Worldcom and all those telecoms that were engaged in revenue inflation at the turn of the century.)  The curious part of the story is that PricewaterhouseCoopers was Satyam's auditor and several high-profile independent directors including a Harvard Business School professor served on Satyam's board.  I understand that it is tough to root out fraud when a very motivated person is doing everything in his power to hide the truth.  But is it asking too much for an accounting firm to look at a copy of a bank statement to make sure that the amount of cash sitting in the firm's bank account actually ties out to the firm's balance sheet statement?  If you're billing $250 an hour (or whatever it is these accounting firm's charge) for your services, I think not.  Interestingly, the word Satyam means "truth" in Sanskrit.  But in the language of accounting and auditing, it apparently means "fools!"

Perhaps the saddest byproduct of the severe credit crisis and economic downturn is the increase in the number of suicides.  I am not speaking in the statistical sense, because I don't have any actual statistics to support this claim.  What I can say for certain is that the Wall Street Journal has had a few too many reports of businessmen facing financial problems that have chosen to take their lives.  Today brought the unfortunate story of Steven Good, the CEO of Sheldon Good & Co, one of the nation's largest real-estate auction firms, who took his own life earlier in the week.  Yesterday, the suicide of Adolf Merckle, one of Germany's wealthiest men, was attributed to mounting financial woes at his sprawling conglomerate.  Thierry Magon de La Villehuchet, manager of one of the feeder funds that invested in Madoff's ponzi scheme took his life the last week of December.  Early December brought the suicide of Alex W. Widmer, the head of private banking at Julius Baer.  Although Mr. Widmer's death wasn't linked to problems at the bank, according to a statement from Julius Baer, it's easy to assume that possible financial difficulties may have contributed to his decision to take his own life.  Several other finance executives reported in the press in the past few months have chosen suicide as the preferred method of dealing with what is either the loss of a significant amount of wealth or a complicated business situation that will take years and many lawsuits to resolve.  Prior to his suicide, Mr. Villehuchet was certainly at the center of a significant amount of fury from investors in his fund that were wiped out due to the Madoff fraud.  Suicide may have seemed like the most rational choice when confronted with the alternative: the loss of his own personal fortune coupled with angry phone calls and accusations from investors and regulators for the rest of his life.

I happen to believe that the purging of fraudulent enterprises from our economy is healthy, albeit very painful for those ensnared.  It's hard enough to sustain a healthy and aboveboard business in this economic environment, much less prolong a ponzi scheme or accounting fraud.  So if you're looking for a silver lining, it is the following: any company making it out of 2009 alive is probably worth an investment.  As for the increase in suicides, well, it's just sad.  One can only hope that those who are facing extraordinary stress and depression choose to get help and work through this tough period rather than taking the seemingly easier way out.  For it is most definitely not easier on the the families that they leave behind.            

Economic and Earnings Roundup

First the bad news:

• Intel, in its second pre-announcement related to the miserable fourth-quarter, reported a 23% drop in fourth-quarter sales.  Revenue was $8.2 billion in the period, down from $10.7 billion in the same quarter a year earlier.  Two months ago, the world's largest chipmaker warned that revenue would be around $9 billion, down from an earlier estimate of $10.1 billion.
  
• Time Warner will take a non-cash impairment charge of about $25 billion before taxes in the fourth quarter.  Somehow it only took Time Warner nine years to figure out that it may have overpaid just a tad for AOL.
  
• Alcoa announced it would cut more than 15,000 jobs, halve capital spending and sell four businesses as it reduces aluminum production.
  
• The ADP Employer Services gauge estimated that 693,000 jobs were eliminated in December, the most since records began in 2001.  Also, Challenger reported that job cuts announced by US employers almost quadrupled in December from a year earlier, paced by declines at financial firms, chemical makers and retailers.  Neither of these reports bodes well for the employment report set to be released on Friday.  Economists are expecting a loss of 500,000 jobs.
  

In the good news department:

• Monsanto, the world's largest seed company reported that quarterly profit more than doubled to $1 a share from 46 cents in the year ago period.  The company also raised guidance for the fiscal year 2009.   
  
• Family Dollar Stores' first-quarter net income increased 14% amid sales and margin gains.  The company raised its earnings estimates for the first quarter and guidance for the second-quarter.  
  

Unfortunately, if you're not in the seed or discount retail business, you're probably not having a good quarter.  The economic and earnings news continues to be bleak, indicating that the recent rally in equities can be attributed only to significant improvement in the credit markets.  While it is certainly positive news that credit is moving again, it is extremely difficult to ignore how hard the real economy is crashing.  The Fed, Treasury and the new administration are working around the clock to instigate new measures to blunt the impact of the dreary economy.  But until we have a clearer picture on just how bad things are going to get, it seems hard to justify jumping in to this market with reckless abandon.     

Proposed Tax Cuts To Benefit Banks and Builders

As part of the monster stimulus package currently being cobbled together in Washington, under a new tax break, companies would be allowed to carry back losses for five years instead of only two and get a nice fat rebate check from the government.  Companies that had huge profits during the economic boom had to pay a bunch of taxes on those profits.  Now that they have lost buckets of money in 2008 and stand to lose even more in 2009, they're stuck with all of these pesky losses that they really use, other than to stick them on their balance sheet, call them "deferred tax assets," and hope against hope that someday they will make money again so they can use the losses to offset taxes.  What really irks me the most is that this tax break benefits companies that were the worst risk managers in the corporate universe, those that mismanaged their businesses so poorly that they have wiped out any gains they made when the economy was surging.  Which companies fall under this distinguished umbrella?  Why the homebuilders and banks, of course.  Although clearly cyclical companies who should at a minimum have pulled the reigns in when conditions appeared overheated, the homebuilders can be considered complicit in the housing bubble, as their financing arms were all offering the latest in exotic mortgages.  So, why exactly do these guys deserve a huge tax refund?  Certainly the CEOs who were dumping their stocks in record amounts in 2005 are not being asked to return their gains because the profits the homebuilders posted during those years were an illusion.  Who else would stand to gain from this new tax rebate?  Everyone's favorite bailout candidate Citigroup, who had net deferred tax assets of $13.6 billion at the end of 2007.  After already receiving over $45 billion in capital infusions from the government and another $300 billion in guarantees against future losses, does Citi really need tax rebates from the government?  For the love of God, can we give our tax dollars to someone else?  Please?   

Snippets of Interesting News and Commentary

Welcome to the first full week of trading in 2009.  Equity markets are lower on perhaps a bit too much partying during the holidays.  Very little in terms of hard news released today so I present you with a few interesting highlights:

• Congress is set to review the Madoff fraud and pinpoint exactly why the SEC neglected to discover the scandal despite numerous investigations into the investment firm's operations over the years.  Michael Lewis and David Einhorn wrote a very interesting New York Times editorial explaining, among other things, precisely why the SEC sucks as much as it does.
• The Fed will begin purchasing MBS today.  Details of the purchases will be updated on a weekly basis on the New York Fed's website.
• Obama's stimulus plan will include about $300 billion in tax cuts, presumably to entice embittered Republicans to vote for an ambitious stimulus package.
• The New York Times has a great piece on the the alarming rise in vacancy rates in commercial properties around the country.  You can read a nice summary at Calculated Risk, or just read the entire article in the Times if you really want to be depressed.
• Apple shareholders will be relieved to read that Steve Jobs announced that his drastic weight loss has been caused by a hormone imbalance, rather than a return of the cancer that rumors suggested.
  

SEC Attempts to Look Busy Probing More Ponzi Schemes

Sure it's going to take some time to figure out exactly how one man could misplace $50 billion.  But rest assured that the SEC is not just gonna sit on its laurels while it is unraveling the Madoff mess.  The supposed regulatory agency that has dropped the ball in ways too numerous to count during the financial crisis, has announced that it is pursuing "at least one case" in which investors may have been cheated out of as much as $1 billion.  In fact, just this week, the agency announced that it halted a $23 million scam targeting Haitian-Americans.  Sure it is a travesty that Haitian-Americans were being ripped off to the tune of several million dollars, but I wouldn't parade those numbers around the Jewish community, as they would no doubt be happy about only losing multiple millions instead of multiple billions.  While it's great that the SEC has finally woken up from its slumber and decided to actually do its job of investigating potential scams, it's pretty pathetic that it took a scandal the size of Madoff to light a fire under the agency's hide.  I suppose someone at the SEC has been tasked with finally dusting off the pile of ignored letters from attempted whistle blowers, and might be taking a few of them seriously.  Whether the investigators are capable of unveiling fraud without a preemptive full blown confession from the perpetrators remains to be seen.        

Executives at Citi Follow Other Banks' Lead in Declining Bonuses to Head Off Furor

Pity the poor Citigroup executive who must forego his bonus purely to ward off near-certain flogging by the media and angry taxpayers footing the bill for its bailout.  The Citi chiefs recognized that paying themselves bonuses in a year where they flushed billions of dollars down the toilet and required two bailouts from the government would be political suicide.  The New York Times article quotes Vikram Pandit with: "The harsh realities of 2008, primarily our earnings results, mean that our bonus pool is dramatically lower than last year."    The article goes on to say that bonuses at the top will be down at least 40% for 10 members of its senior leadership team.  Call me crazy, but somehow "at least 40%" doesn't cut the mustard for me.  I would like to recommend "at least 77%" instead, for that is precisely how much Citi's stock was down in 2008.  Or how about "at least 95%?"  For this is the indignity that Wachovia employees were handed for coming in to work in 2008.  Despite Wells Fargo rescuing the Wachovians from their fate as future employees of Citigroup (or more likely just members of the unemployed) after an FDIC seizure, according to the New York Times story, the California bank is refusing to cough up retention packages and bonuses to Wachovia's employees to compensate for Wachovia's stinginess.  A top Wells Fargo executive is quoted with announcing to a group of Wachovia's bankers the following "I know that's very painful to hear, but that's the reality.  It just would have been irresponsible to the company's shareholders to do anything else."  The New York Times managed to find an embittered Wachovia third-year Vice President, who at least had the presence of mind not to identify himself, to make the audacious claim that the bank's decision was putting its employees in "financial extremis" and in some cases, at risk of not making their mortgage payments.  While it is certainly true that if you spent every cent of your bonus money during the biggest boom Wall Street has ever witnessed, and assumed that your bonus was guaranteed ad infinitum, then yes, you are definitely up the creek now that you can't make the mortgage payment on your $(insert a number) million house.  The thing is, that's not really your employer's problem, nor should it be.  

For years, private equity and hedge funds fed the finance compensation boom by poaching already highly paid Wall Street employees and offering them a bigger piece of their profits.  While alternative asset managers rewarded very richly to the upside, they can't pay when they lose money, as 20% of 0% (and more likely negative returns) is still a big fat donut.  After a brutal year for hedge fund and private equity returns, coupled with record redemptions, the competition that was willing to pay up for "talent" is gone.  It seems that several boom years on Wall Street corrupted some executives and employees into thinking that they should get a bonus every year no matter what, even if their employer lost, for example, $22 billion in a quarter (i.e. Wachovia,) was seized by the FDIC, and more than likely would not have been saved by another bank if it weren't for the government's largesse.  

While my thoughts go out to the naive third-year Vice President quoted anonymously in the New York Times article who now finds himself in "financial extremis," I'd like to offer some unsolicited words of wisdom:  First of all, congratulations, you still have a job.  Second, suck it up, downsize, kiss some ass, and keep your thoughts to yourself at work as well as dinner parties, particularly if you happen to go to dinner parties with people who don't have six-figure salaries or are unemployed during a major economic downturn.  And last, never forget that third-year Vice President = Very Expendable.