Fed MBS Purchase Program Ends Today

Today marks the end of the Fed's $1.25 trillion agency MBS buying spree. The program contributed to reviving the mostly dead housing market by keeping mortgage interest rates low so home buyers could afford their mortgage payments. A zero fed funds target didn't hurt either. It's like the Fed acted as the anesthesiologist, while Drs. Fannie, Freddie and FHA argued over how to correctly perform the quadruple bypass, with the Treasury occasionally running in with a crash cart, shouting "Clear!" and introducing another homeowner tax credit.

The Fed's attempts to boost the housing market had other side affects as well. Today's WSJ has a front page story on the monster rally in bonds since October 2008. Junk bonds, in particular, have outperformed nearly every asset class since the lows in the market. By buying over one trillion in MBS and another $250 billion in Treasuries, the Fed gobbled up a significant amount of supply from bond market investors who had nowhere else to go with the $375 billion in inflows that their funds received in 2009.

So now what? Pundits far and wide are arguing over what will happen to interest rates once the Fed is out of the picture. My two cents is that the long end absolutely has to go higher. It's just simple economics. A huge portion of the demand has been removed and who will replace it? Bulls keep arguing that zero interest rates for an "extended period of time" will continue to stoke demand for higher-yielding assets. But does anyone really know the Fed's exact definition of "extended period"? Sometimes my three-month-old spends nearly 30 minutes in her swing, a time period which she refers to as "an extended period." The Fed can turn on a dime if it needs to. Particularly if the FT's front page stories go from today's "Steel Prices Set To Soar" to "Holy Cow! Steel Prices are Surging" tomorrow.

Financial Headlines 3/26/2010

• The headline reads "Europeans Agree on Bailout For Greece". Although leaders of the euro zone backed a deal where they and the IMF would jointly bail out Greece "should the country's debt troubles intensify," (yeah, because that hasn't already happened) details remain somewhat scant. "The agreement won't immediately trigger a Greek rescue, but it lays the groundwork." Sounds like if things get really bad, everybody's promised to have another meeting.
• More than a dozen banks are accused of conspiring to rip off muni bond issuers in a criminal probe begun by the Justice Department's Antitrust Division. Financial are ripping on the fabulous news.
• The White House has entered the mortgage principal forgiveness fray by extending its foreclosure prevention program. The new efforts will give unemployed borrowers forbearance for a few months as well as require banks to consider writing down loan balances as part of a formula for lowering monthly balances. The FHA is going to be used to put this initiative in place, which aims to help borrowers who are current on their mortgages, but are just unhappy about being upside down on their mortgage. For awhile there, I was leaning towards Fannie and Freddie ultimately costing the government the most in the long run, but now I'm rooting for FHA.
• Meanwhile, at the Fed, Bernanke and Plosser have been running off at the mouth about what to do about all the crap they purchased in the quantitative easy frenzy of the past year. "I anticipate that at some point we will, in fact, have a gradual sales process." quoth Bernanke, in his typical calm and measured way. Because unloading a couple of trillion in securities when the world is watching your every move will be really easy, calm and measured. Right. I'm sure bond traders aren't going to be running around with their hair on fire trying to front run while screaming "Just find me a freakin bid and hit it!!"

Bailouts and More Bailouts

Today's winners in the world-wide bailout ruse are:

• Dubai World, which announced a restructuring plan involving a $9.5 billion lifeline from the government. The plan will take months to implement and will require some discussion with creditors but it will involve recycling the $5.7 billion left over from the $10 billion bail-out from Abu Dhabi last year, and the remainder from "internal government sources." It's always nice to see a government use a bailout from another government to fund a bailout of its ill-timed property bets. Dubai World will receive a $1.5 billion cash injection to cover stuff like working capital and interest payments, with the remaining $8.9 billion of government funding and claims turning into equity in the government-owned businesses. Meanwhile non-government creditors will receive "100 per cent of their claims, through the issuance of two new tranches of debt with five and eight-year maturities." So, extend and pretend is the name of the game here. More details of the package in the FT article.

• Bank of America is offering to reduce principal balances by as much as 30% for troubled borrowers. As it turns out, offering mere interest rate reductions to borrowers who are upside down on their mortgages is not enough to entice them to make their monthly payments. B of A probably has no idea if this is going to work. But they are just tired of all the rejection. According to the President of Bank of America Home Loans "The whole purpose of the program is to get more customers to return phone calls." Who knew that defaulting borrowers could be so rude?

In bailout announcements we're still waiting for:

• German chancellor Angela Merkel said EU leaders were set to "specify" what "combination of IMF and bilateral aid" might be awarded to Greece, should it ask for help. Which it hasn't done. Yet. Even though everyone knows that it will have to. Meanwhile, in completely related news, the ECB has announced that it will relax its collateral requirements so that European banks could continue to shovel Greek debt to the central bank for funding beyond the end of 2010. Originally, the ECB was going to raise collateral requirements by the end of the year, before it realized that banks were in a tizzy over where to park their Greek garbage. Whew! That was easy. Problem solved. Right?

Why Does Main Street Hate Wall Street?

In a shocking development, a Bloomberg National Poll reveals that most Americans say they "don't like Wall Street, banks or insurance companies and favor letting the government punish bankers who helped cause the worst financial crisis since the Great Depression." Everyone knows that polls can be skewed, so maybe this is just some sort of error. Perhaps the questions were phrased like this:

Poller: Do you hate Wall Street?

Pollee Uh, I don't know. Some of my good friends work for banks.

Poller: Do you hate whoever caused the worst financial crisis since the Great Depression?

Pollee: Definitely!

Poller: Do you think that whoever caused the worst financial crisis since the Great Depression should be punished?

Pollee: Hell Yeah!

Poller: Thank you for responding to this poll. Have a nice day!

Paradoxically, despite the fact that Americans hate Wall Street and think those cads should be punished, nearly seven out of ten people surveyed supported using current bank regulators for consumer protection rather than introducing a new federal agency. Because keeping the same regulators who allowed banks to lend millions of dollars to people who couldn't afford a shoebox, then leverage themselves to the hilt, then bankrupt themselves, then allow them to go crying to the Fed for zero percent financing, then plead with the Treasury for capital injections, and then use the capital injections to pay bonuses to employees, is the best choice for sound future regulation. Bloomberg quotes a lawyer specializing in banking supervision with the following: "People are generally satisfied with the way consumer protection has worked with banks." I'm sure the people who bought a house with a zero down negative am mortgage, and have been living in that house in default for the past year, arguing with their lender over their HAMP loan mod are very satisfied. The rest of us, maybe not so much.

The reality is that Main Street is still suffering, while Wall Street thrives. Unemployment is still very high. Home values are stagnant, if not still declining. Credit continues to contract. Meanwhile, the stock market has ripped 73% off the lows, bond spreads are back to pre-crisis levels, and bankers are busy counting their bonuses, albeit in a somewhat more restricted and stock-like form. Furthermore, headlines about JP Morgan, as well as other banks and homebuilders getting huge tax refunds, don't help ease the ire. This is the kind of crap that gets tacked on to $800 billion stimulus bills that should make Americans hate stimulus packages. How does allowing the homebuilders to carry back losses five years instead of two, giving them huge tax refunds help stimulate the economy? It isn't making more people people buy new homes, that's for sure. If you checked this morning's economic headlines, new home sales fell to record lows.

In any event, the growing divide between the two Streets should continue until the economy improves and everyone starts having fun flipping houses again and forgets that they were mad. Or the market collapses and Wall Street crumbles again and politicians no longer have the political or actual capital to bail them out. Then everyone can be miserable together.

Merrill Tattled on Lehman

The FT reports that Merrill officials warned the SEC and the Fed in early 2008 that Lehman was "incorrectly calculating a key measure of its financial health" (or, "cooking the books" as you or I might call it.) The former Merrill officials' intentions were far from humanitarian. They alerted regulators because Lehman was touting its reported liquidity position to investors and counterparties as proof that it was sounder than Merrill. Merrill officials probably said to themselves, "Hey wait a minute. I know we're insolvent, but Lehman is DEFINITELY more insolvent than we are. " We're talking about Wall Street guys here. They're so damn competitive.

The Merrill guys didn't believe Lehman's claims. In fact, they thought that Lehman was including regulatory capital in its liquidity calculations. Big no no. So, they picked up the phone and called the SEC and the New York Fed, both of whom did, well, absolutely nothing about it. But we already knew that because we know how this story ended. The SEC declined to comment beyond saying that the folks who fell asleep at the switch at that particular unit are no longer there. The NY Fed claims it was unable to verify that the conversation with Merrill ever took place.

The Fed's Move: Expected and Unexpected All At the Same Time

Yesterday's Fed statement following the FOMC meeting offered little in the way of surprising news. Sort of. Traders and investors were focused on two things:

1. Would the Fed remove the statement about keeping interest rates low for an extended period of time? (It left it in.)
2. Would the Fed end its purchases of mortgages as scheduled by the end of the month or extend its quantitative easing further? (It chose to end the program.)

It seems somewhat contradictory that the Fed would both end the purchase program AND plan to keep interest rates at zero, yet this is exactly what it did. The Fed justified its moves by stating that "Economic activity has continued to strengthen. The labor market is stabilizing." And "Inflation is likely to be subdued for some time." Now that economic activity has picked up, the Fed thinks it can end its quantitative easing program, yet leave interest rates at zero all without causing inflation. You see, it's a "Goldilocks Economy." Growth is not too high, not too low, it's just right. Besides, if inflation does pick up, the Fed will know exactly what to do to stop it in its tracks without causing another meltdown in the markets. The Fed is really good at this type of thing, right? Remember the last time we had a Goldilocks economy from 2004-2007, and how well the Fed handled "easing" us into a recovery after asset price inflation got a wee bit overheated? It'll probably go something like that.

The Lehman Report

The court-appointed examiner's report on Lehman Brothers is available to peruse and it is a doozy. Coming in at over 2,200 pages, the report provides a more detailed look into how and why the investment bank failed spectacularly in September 2008. I say "more detailed" because it was obvious to many, even before the firm collapsed, that the bank was mismarking assets and engaging in accounting fraud. You don't wind up with 10 cents on the dollar as a secured creditor unless the assets were wildly overinflated to begin with. Still, it's always nice to know the details.

Most of the report focuses in on the so-called "Repo 105" transactions. Repos are collateralized loans used to finance a bank's assets and are reported as liabilities on the balance sheet. However, if the repo met conditions of an accounting rule called SFAS 140, it could be counted as a true sale and the assets could be moved off the balance sheet. Lehman used these specific Repo 105 transactions to move assets off of its balance sheet to reduce the leverage ratios it reported to investors. Lehman's auditors, Ernst & Young, even signed off on the transactions, so they had to be kosher, right? According to FT Alphaville, Lehman could not find a US lawyer to sign off on their treatment of these particular repos as a true sale. So what did the enterprising folks at Lehman do? They just went abroad and found some London lawyers to sign off on the transactions. Presto! $50 billion in assets disappeared off of the balance sheet. So while maybe technically not illegal, the transactions were most definitely used in a calculated way to mislead investors about the investment bank's true financial condition.

The folks over at Zerohedge have unearthed more juicy tidbits from the report about the ordinary tri-party repo transactions with JP Morgan that indicate the firm was definitely mismarking assets and that JP Morgan knew about it. According to the excerpts from the report, Lehman was attempting to pledge more and more worthless collateral at par against the loans as the bank's financial condition deteriorated. Apparently, as Lehman neared bankruptcy in September 2008, it had attempted to pledge $3 billion of a security called "Fenway," that was actually asset backed commercial paper credit enhanced by Lehman itself. That's right, backed by the full faith and credit of...Lehman Brothers. JP Morgan said, "Um, no thanks. Maybe some Treasuries would be better? Or perhaps a sack of potatoes?"

Back in August 2008, "JP Morgan had learned that Lehman had pledged self-priced CDOs as collateral over the course of the summer." Lehman "pledged $9.7 billion of collateral, $5.8 billion of which were CDOs priced by Lehman, mostly at face value." Of course they were self-priced. There was no liquid market for CDOs so Lehman had to price them using its own models. Pricing them at par was the really stupid and possibly criminal part. Furthermore, why did JP Morgan just "learn" about this in August? Didn't JP Morgan know what collateral was in the repo since JP was the clearing firm that is supposed to verify and price the collateral in its own repos with customers? Why on earth did JP Morgan ever accept CDOs as collateral in its repos? My how far the standards of the repo market have fallen since back in the day when I was a lowly repo trader. If you didn't have treasuries, agencies, or agency backed MBS, no financing for you!

The report goes on to state that when JP Morgan "discovered" the CDOs and decided it wanted other collateral, Lehman said it had no other collateral to pledge. Ok, so Lehman was clearly insolvent, even during the time that the firm continued to claim that it was swimming in a pool of liquidity and was just a victim of short sellers. Furthermore, JP Morgan KNEW that Lehman was insolvent. Meanwhile, the SEC and the Fed sort of knew about some of this, but probably didn't understand and mostly just had their collective heads stuck up their collective asses.

"Hard Work" of Selling Build America Bonds Costs $1 Billion

The WSJ has an amusing article about Build America Bonds this morning. The new bonds were introduced in April 2009 under the economic stimulus plan to create jobs building roads, schools and hospitals. Unlike traditional muni-debt, Build America Bonds are taxable and generally carry higher interest rates. The US pays 35% of the interest, which helped the local governments to borrow during the credit crunch while saving money on interest payments.

Naturally, this has been a huge profit center for Wall Street firms, as it has allowed them to collect fees for a new product. Furthermore, the clients have unlimited resources, so why not jack up the fees? Apparently the fees Wall Street is charging are "surprisingly high" according to a Federal Reserve economist and amount to a significant mark-up over traditional muni bonds. The underwriters have netted approximately $1 billion in fees over the past year from $78 billion in sales and will continue raking it in on the more than $150 billion in forthcoming Build America Bond issuance. The banks don't deny charging higher fees, but claim that the fees are justified because they are "wording harder to sell the bonds to investors who wouldn't traditionally buy municipal debt, such as pension funds, insurance companies and foreign investors." Right. Because it's such hard work picking up the phone, calling a bunch of pension funds, insurance companies and foreign investors that are already your clients and saying "hey, I've got some bonds that have high yields, where the interest is subsidized by the federal government."

Yes, selling muni debt is such hard work. The investment banks probably had to pay out a bunch of disability to the sales forces for sprained fingers from dialing too hard. Certainly worth $1 billion in fees. Seriously, does our government ever, even for a second, consider negotiating for better rates from the private sector?

Banks On Edge Not Happy With FDIC Auctions

Bloomberg is out this morning with an uplifting story about the current state of our regional banking system. Apparently, banks that are on the brink are not happy with the FDIC's upcoming auctions of assets seized from failed banks because they may trigger writedowns of their assets and weaken them further. According to Bloomberg, of the $50.4 billion in loans seized from failed banks currently held by the FDIC, 63% involve participations by other lenders. Consequently, if the seized loan is auctioned at a discount, the lenders who participated on the loan will be forced to write down the loan on their own books.

The funny, and therefore highly mockable, portion of the story is the great quotes Bloomberg has managed to extract from the various mouthpieces of the banking industry. Take this gem from the lawyer who is representing 25 lenders that took part in financing the W Hotel (which will be auctioned next month by the FDIC): " These banks can't believe that the regulator they pay to protect them is going to sell these loans to someone who can flip them and cause them serious losses." For clarification purposes, the FDIC's role is not to protect banks; they are required to pay premiums in order to get deposit insurance. The FDIC is tasked with protecting depositors FROM banks, in the event that banks decide to piss away depositors' cash on ridiculous investments such as financing the construction of a W Hotel in Atlanta in the middle of a property glut and a credit bubble. Mr. Lawyer for the Bankers goes on to say "Our banks just cannot believe they are being treated in a way that ultimately hurts the FDIC's insurance fund because some of them are right on the edge." How dare the FDIC treat banks this way after they've done such a fabulous job winding up on the brink of insolvency!

"We have a number of banks teetering on the edge, and we don't need this problem" quoth the president of Community Bankers of Washington. Yeah, so can we just get back to burying our heads in the sand and forgetting about the fact that we're insolvent? That 140 banks failed last year, another 26 this year, and 702 are on the "problem" list? If it weren't for those pesky FDIC auctions, the banking system would be virtually sound. Right? In any event, those interested in purchasing a swank hotel in Atlanta, as well as a myriad of other half-built and partially vacant properties across the US, for a song are in luck.

FDIC Investigates Failed Integrity Bank

The FDIC has been busy for the past couple of years cleaning up the mess left behind in the wake of the credit bubble. Only the big banks were politically powerful enough to get the bailouts, while the smaller banks are getting shuttered on a weekly basis. The WSJ takes a peek inside what went wrong at Integrity Bank, a Georgia bank that opened in 2000 and was closed by the FDIC in August 2008.

What is interesting about Integrity Bank is that it went belly up because it lent out all of its capital to one borrower, a real estate developer that owned a hotel in Sausalito, California. The hotel went bankrupt and was auctioned off by the FDIC last month. Why on earth would a bank lend all of its capital to one borrower? Don't worry, the FDIC plans to find out. Now. After it has already cost the deposit insurance fund $295 million. Nevertheless, the regulator that was tasked with keeping and eye on banks and making sure they don't do things like lend all their capital to one guy in Sausalito, has launched an investigation. The FBI and Federal prosecutors are also hot on Integrity's tail postmortem.

Everybody's looking for the flight recorder because investigators want to know why the plane crashed so that we can keep it from ever happening again. But do we really need an FDIC investigation to conclude that it was a dumb idea for the bank to give 14 loans totaling $83 million, or 127% of the bank's capital, to one guy? Or that it wasn't a great idea for said loans to have interest reserves so that said guy wouldn't have to pay interest on the loans? I mean, don't banks already know that they should expect their borrowers to pay them interest? Or that dipping into a credit line to pay interest on a borrower's other loans doesn't actually lower the risk associated with the borrower? Really, are we going to have any big epiphanies here? Federal prosecutors just need to put a few people in jail. The FDIC needs to focus its resources on the rest of the regionals that are going to fail.

How Dumb Did CMBS Investors Get?

Even on the most boring financial news day, the WSJ Property Report always offers up a few tasty morsels of mock-worthy stories. You can skip over the tale of Istithmar World Capital, the private equity arm of the Dubai government's investment fund, which is handing back yet another building to lenders. As it turns out, buying a former hotel-turned-office building in Times Square, kicking out all the cash-flow producing tenants, in the hopes of turning it back into a high end hotel, maybe wasn't such a great idea. Must've been a bug in that excel spreadsheet that spit out the ridiculous purchase price in 2006. Then there are the continuing problems of former real estate mogul Kent Swig who used to like to do deals in just nine days because he was just so great at ripping apart the numbers and analyzing the deal "very, very quickly." Now Mr. Swig is being sued by lenders and five of his properties are listed by Real Capital Analytics as "troubled." You don't need nine days to analyze that.

No, the real juice this morning is in the article about the Biscayne Landing development (or lack of development) in Miami. Sure we've read a multitude of stories about silly CMBS issued in the 2005-2007 period secured by properties with extremely optimistic and preposterous future cash flow assumption. But this is the first time I've read about CMBS that was used to finance a land acquisition. In Florida. On landfill. That had been on the EPA's Superfund site list. Sure it was taken off the EPA's list in 1999, but still. Are you kidding me???

The developer of the project, Boca Developers, had grand visions to build 6,000 residential units, a hotel, a town center, pools and clubhouses. Oh, and they were going to cleanup the groundwater that had been contaminated by the aforementioned landfill. Credit Suisse gave the developers a $233.5 million loan, of which $163 million was repacked into CMBS secured by the ground lease and sold off to a bunch of investors who were apparently too sophisticated to read offering documents. In any event, the project is now largely unbuilt except for two condo towers that are involved in a separate foreclosure action. Furthermore, the affordable housing and the Olympic training facility that the developers agreed to help build elsewhere in the city has yet to materialize so the Mayor is pissed. "The project currently is a failure" says the angry Mayor. Ya think? Apparently the next step for the failed development is for someone to step up to take on the ground lease. Shockingly, there are few bidders that are willing to sink equity into unimproved property that doesn't throw off any cash flow. Any takers?

Calpers Considers Cutting Rate of Return Target

Calpers is considering taking some drastic action on the heels of the bruising 23% decline its investments posted for its last fiscal year ended June 30th. The mammoth pension fund that manages approximately $200 billion in assets for California's pensioners is contemplating reducing its current projected rate of return from 7.75% to maybe something with a six handle. You see, it was time to take some decisive action. What could be more effective than tweaking an imaginary number and using that as a basis for all future investment decisions?

I totally understand the decision. I did the same thing with my own investments. In fact, I just resolved my looming retirement fund issues by raising my return "target" from 8% to 35%. Now I should have no problem retiring with a cool $100 million in the bank. Problem solved.

A logical person might ask why Calpers chose to lower its imaginary rate of return number instead of raising it to plug the hole in its future obligations? Imaginary (and scary) as it might be, the percentage is an important factor in calculations by Calpers officials of future contributions needed from employees and local governments to cover payouts promised to retirees and other beneficiaries. If return assumptions decline, contributions have to rise. Uh yeah, because California has so much extra money lying around that it's going to be thrilled to increase its contributions to the pension fund that pissed away retiree assets while making private equity and real estate investment fund managers rich. In case the folks at Calpers haven't been keeping up with current events, California is mired is some pretty serious budget poop. This is not exactly the right time to go hat in hand to the state and local governments.

Additionally, the pension fund believes that lowering the rate of return would "reduce the temptation" to seek outsize profits through real-estate, private equity and other alternative investments. This decision would've been brilliant had it been made like three years ago. Now? Maybe not so smart. In any event, the final decision isn't expected until early 2011. So they have another year or so to debate whether the right number is 6%, 6.1%? How about 6.5%?