Traders Moving to Smaller Firms

The WSJ highlights one of the changes rippling through Wall Street's trading community due to the government's attempts to crack down on compensation. The article begins with the tale of Steven Schonfeld, the 50-year old owner of the trading firm Schonfeld Group Holdings. Mr. Schonfeld took home $200 million in pay last year and bought himself a $90 million house near the Long Island Sound. Since Mr. Schonfeld's firm is private and didn't need any help from the government to stay afloat, you won't see him testifying to Congress to explain his compensation package or apologizing for his grandiose lifestyle. Furthermore, last year's volatile markets gave his traders unprecedented opportunities to make money, allowing Mr. Schonfeld to expand and hire traders from A-list firms.

Fed up with compensation restraints, proprietary traders from big name broker dealers, who don't dependent on order flow for profits, are flocking to smaller securities firms. Smaller firms give larger payouts based on profits generated by the individual trader. Meanwhile, many larger firms, burdened by losses from the credit crisis, not to mention regulatory pressure, are scaling back on proprietary trading operations. This is a positive trend that should continue until no systemically important financial institution is in the business of making huge proprietary trading bets. Profitable traders should get paid as a percentage of profits generated. I just hate the idea of government-subsidized risk taking. If Schonfeld Group does a poor job of risk management and happens to lose its capital due to poor trading decisions, Ben Bernanke is not going to get a phone call in the middle of the night. The company will file for bankruptcy and all the other traders who were up on the year and hadn't been paid out yet will be pissed off. No systemic risk. Nobody else will care. This is where the real trading "talent" should go. Mr. Schonfeld claims that his best traders make $5 to $10 million a year. Very few good proprietary traders operating under compensation constraints at big firms would argue that that kind of take home pay is too paltry to trade for the prestige of working for, say, Citigroup. The catch is, you have to be really good. Smaller firms typically don't pay large salaries, some only in the form of a draw, and if you aren't making money trading, you get zip.

For less talented traders who aren't as confident of their trading skills and don't mind government intervention in their pay checks, there's always the New York Fed. According to the FT, the NY Fed is on a hiring spree in order to get a handle on its exploding balance sheet. Don't like working for a small entrepreneurial firm? Surely the $2 trillion in assets that the NY Fed has acquired over the course of the last two years should keep you busy. No word on what your comp might be, but I'm guessing it won't be $5-$10 million.

Maguire Prepares to Mail Keys to Lenders, Reports Loss

Maguire, one of the largest Southern California office-building owners, has warned it plans to hand over ownership of seven buildings with $1.06 billion in debt to its lenders. Like many commercial property investors, Maguire borrowed heavily in recent years to purchase properties based on hockey stick-shaped assumptions for future rent increases. The reality of a 20% office vacancy rate in Orange County, up from 6% just three years ago, is not really helping Maguire meet debt service payments. Who are the lucky new owners of the buildings? LBA Realty, who purchased the debt on one property at a discount in the spring, already has a deal in place to take over Park Place One, in Irvine, California. The other six properties were packaged into CMBS and are coming to a default rate near you in CMBS Land. The seven buildings make up about 20% of Maguire's portfolio.

It should come as no surprise then that Macguire posted a $375.7 million loss this morning due mostly to the $384.7 million in write-downs related to the aforementioned properties. Funds from operations were a negative $7.10 a share, but it you exclude the write-down, they were a nifty eight cents a share. From a company that only reported revenue of $134.78 million, results like these are disastrous.

For other, depressing commercial real estate news, please turn to page A5 in the WSJ where an article discusses how difficult it will be for commercial real estate in Southern California to rebound from current depressed levels. During the peak four years ago, construction was the fourth-largest employer in the Inland Empire counties of San Bernardino and Riverside. Housing contributed more than $24 billion in revenue to the Southern California economy in 2008, more than double the revenue from Hollywood movies. Fast forward to today where construction has ground to a complete halt and new office buildings sit empty or with few tenants. A few stark statistics: the greater Los Angeles area has lost approximately 15% of the total construction jobs, while the Inland Empire has lost 49% since 2006. The number of housing permits in the five county greater Los Angeles area has dropped by 85% from 2005. San Bernardino has seen housing permits plunge 96% since the 2005 high. Office vacancy rates have grown to 24% in Riverside counties while the retail vacancy rate in the Inland Empire hit 10.6% in the second quarter. With stats like these, it is hard to imagine that construction will help lead the area out of its current slump.

Unemployment, AIG, FNMA

• Nonfarm payrolls fell by 247,000 and the jobless rate dropped to 9.4% from 9.5%. This report was slightly better than expected, yet the economy is still shedding jobs. This month's jobs losses bring the total number of jobs lost since the recession began to 6.7 million.
• Egads! AIG reported a profit, the first one in seven quarters as investment losses narrowed. The insurance company, now 80% owned by the US government, posted net income of $1.82 billion, or $2.30 a share. So if you were looking for an explanation as to why the stock ripped this week, here it is: Somebody leaked the crop report.
• To help offset AIG's tidy profit, Fannie Mae, also 80% owned by the government, reported a $15 billion loss and put in its request for another $10.6 billion from Uncle Sam to cover the resulting net worth deficit. The mortgage giant had a few sobering comments in its press release: "We are experiencing increases in delinquency and default rates for our entire guaranty book of business, including on loans with fewer risk layers...Total nonperforming loans in our guaranty book of business were $171.0 billion on June 30,2009 compared with $144.9 billion on March 31.2009."

On Economic Numbers and AIG's Rally

Retail sales were sluggish last month with discounters posting largely lower results. Wal-Mart no longer reports monthly sales figures but other discounters had sales declines for the month. Costco reported a 2% drop and Target posted a 6.5% decline. One of the worst performers was Abercrombie and Fitch with a 28% decline in same-store sales. I guess everyone is too busy trading in their clunkers for shiny new cars to load up on teen clothing. It will be interesting to see whether the resounding success of the cash for clunkers program cannibalizes sales from other retailers or if it is a boost as everyone decides it's time to max out their credit cards again and start spending.

In slightly more uplifting economic headlines, jobless claims dropped by 38,000 to 550,000 in the week ended August 1st. The four-week moving average also decline slightly to 55,250. Continuing claims, however, rose by 69,000 to 6.31 million in the weekend ended July 25th. While a number over 500,000 is still considered a very weak labor market, the trend of lower claims in the past few weeks is positive for the economy. Unfortunately unemployment benefits will begin to run out soon for those who were axed at the beginning of the recession and have failed to find work. The big daddy of employment reports released tomorrow should shed some light on whether the jobs pictures is really improving.

Meanwhile, what is going on with AIG's stock? The stock popped $8 yesterday and was up $6 at the open this morning, although it has given back some gains. Surely it can't be ripping on the news reported this morning that investment banks are set to reap a $1 billion bonanza on the breakup of the formerly formidable insurance conglomerate. But isn't it nice to hear that the NY Fed and US Treasury are set to throw even more money into the hands of investment banks that contributed mightily to the crisis that threw our economy into the lurch? Perhaps the stock is playing catch-up to all the other financials that have ripped in the past few months. Or maybe analysts believe that once the company is broken up and its various pieces are spun off, the government will reap gains and investors will stand to collect more than what the current market cap reflects. Or perhaps K10 is just turning into a perfect negative indicator, as I vowed to short the stock into the dust after it completed its reverse split. Fortunately, I was too lazy to actually execute a trade, thus saving myself a bunch of money. Being a perfect negative indicator can be just as useful as being right, so I'm not too upset about it. Nevertheless, AIG's earnings report will add to the drama of tomorrow's trading day. Let's hope its more exciting than today.

Regulators At Work: SEC Fines BAC and GE

In an effort to appear relevant and tough, the SEC extracted fines out of two government-backed financial firms for prior transgressions. First, Bank of America settled its "I know we said we didn't know about Merrill's end-of-year bonus payouts, but we knew" dispute with the agency and forked over $33 million. The fine is for misleading investors when it issued a proxy statement for the acquisition stating that Merrill had agreed not to pay year-end performance bonuses to executives without Bank of America's consent. However, Bank of America had already agreed to allow the firm to pay up to $5.8 billion in compensation. B of A paid the fine. Problem solved. Right? If you can ignore the pesky fact that the government wrote a check for $3.3 billion to Merrill's employees after sinking the firm with a $27 billion loss, then we really can put the matter behind us. Besides, B of A hasn't paid back the TARP yet, so technically the Treasury is just giving the SEC $33 million. This is effective and efficient retroactive regulation.

Next up GE shelled out $50 million to settle civil accounting fraud charges that it used improper accounting methods on four occasions to boost earnings in 2002 and 2003. Once again, the company paid the fine, put the matter to rest. GE seems to have a long history of accounting shenanigans going all the way back to Jack Welch's days, when the company used to mysteriously beat earnings every single quarter and post smooth results quarter after quarter even if it meant under-reserving insurance reserves every once in awhile. What is interesting about this particular fine that was levied, oh approximately seven years after the accounting fraud was committed is that accounting problems occurred during the last recession. So when are we going to get the fines for 2008-2009 shenanigans? Is anyone combing through GE's notoriously complex and opaque financials TODAY? Dennis Koslowski and Bernie Ebber's ears must be steaming from their jail cells.

Meanwhile, in real time accounting fraud action, Huron Consulting, an accounting firm that sprung from the ashes of those Enron-document-shredding accountants at Arthur Andersen had to withdraw its 2009 earnings guidance, lower its outlook, and restate three years worth of financial results. The folks at Huron were experts in forensic accounting, a practice that looks to root out the type of accounting fraud that they have apparently just committed. Maybe they can hire themselves and pay themselves big fees to boost their earnings for 2010? But, how would one account for that? The Chairman and CEO resigned, along with the finance chief and chief accounting officer. While this is somewhat troubling news, rest assured the company stated that "no severance expenses were incurred by the company as a result of these management changes." No word yet on when the SEC plans to get involved in this accounting debacle. Probably 2015.

REIT Earnings Disappointing

Two of the largest REITs, Simon Property Group and Vornado Realty Trust, reported earnings results this morning. Contrary to the recent surge in their shares, which would imply that REITs were having a bang-up quarter, both posted losses, sharp declines in FFO, and lower vacancy rates amid deteriorating fundamentals in the commercial real estate market. Simon Property Group posted a $14.1 million loss on a $140. 5 million write-down, compared with a year ago profit of $114.4 million. Funds from operations fell to 96 cents from $1.49 last year. Revenue decreased 11% to $903.6 million. Occupancy rates were down to 90.9% while average rents rose 3.8%. Vornado Realty reported a loss of $37.6 million on a $122.7 million loan loss, compared with a year-earlier profit of $131.1 million. Funds from operations declined to 54 cents a share from $1.19. Revenue was slightly higher by 0.6% to $678.4 million. Occupancy rates fell to 96.1% from 97.5% in New York offices, but rose to 95.4% from 93.9% in DC. The loan loss was related to the company's 33% interest in Toys "R" Us which the REIT helped take private in 2005.

What is with all the recent bullishness in REIT stocks? The WSJ had a front page story yesterday questioning the rally in the sector. According to the article, REITs face $152 billion in debt maturities through 2013 while commercial property values have plummeted and seem likely to continue to do so. The most compelling reason to buy REITs in an environment where asset values are declining has been the yield, which during the lows hit roughly 10%. But at current prices, yields are roughly 4.7%, lower than some corporate bonds. Certainly the bulls will throw out the argument of 4.7% yield plus all that upside appreciation potential. But with the way the commercial real estate market looks today, the days of appreciation in commercial real estate properties are very far away. So if you think a 4.7% yield is "juicy", go buy some long bonds.

High End Homes Miss Out on Housing Rebound

The WSJ has a front page article exposing the dichotomy between the high and low-end of the housing market. Due to significant amounts of government stimulus aimed at fixing the housing market, the low end seems to have clunked to a bottom. Investors and first-time homebuyers are snapping up foreclosed properties at huge discounts and lower priced homes are selling nicely due to the $8,000 first time homebuyer tax credit and super-cheap financing offered by the FHA (3.5% down-payment anyone?), Fannie, and Freddie. The government stimulus stops short of helping those with higher incomes. The $75,000 income cap for singles and $150,000 for marrieds exclude higher income folks from the $8,000 tax credit. Furthermore, jumbo mortgages require 20-30% down-payments and have interest rates roughly 1% higher than conforming mortgages. The inventory statistics provided in the WSJ's article are quite telling. Current inventory for all housing is 9.4 months, down from the 11 month peak a year ago. Meanwhile, at the high-end (defined as homes priced above $750,000) inventory is at 17 months, up from 14.5 months a year ago.

Last week I wrote a post entitled "Has Housing Turned the Corner?," where I discussed the growing gulf between the high and low-end. It does not appear to be a political priority (and shouldn't be in my opinion) to help those looking to purchase a high-priced home. Consequently, those who wish to buy an expensive home have to cough up a sizable down-payment to qualify for a jumbo mortgage under much tighter lending standards. Forget the job losses and the economic downturn, the pool of buyers of high-end homes has shrunk significantly just because of the disappearance of cheap financing. Another interesting phenomenon noted in the WSJ is a change in overall perception about how much to sink into a new house. For many years, the industry (agents, mortgage brokers, and the like), which benefitted dramatically from rising home prices, preached the gospel of leveraging to the hilt to purchase the most expensive house you could barely afford. Homeowners believed in it and many built significant wealth from the growing equity in their houses. The idea of leveraging to the hilt is currently being turned on its head as homeowners discover the "benefits" of too much leverage in a down market. Leslie Appleton-Young, the Chief Economist of the California Association of Realtors declared with brio at a 2007 conference of real estate agents: "This is God's country. When is the 30% decline in Marin County's [a suburb of San Francisco] market going to happen? Not in my lifetime." Rest assured, Ms. Appleton-Young is still alive. I know this because the WSJ got another quote from her stating: "no doubt that the high-end housing prices have adjusted and will continue to adjust." She is clearly still an optimist as she continues to use the word "adjust" instead of coming right out and stating the painful truth that prices are lower, and will likely continue to go lower. Current buyers are more cautious and less inclined to put all their eggs into the housing basket. This shrinks the pool of high-end buyers even further.

The article is littered with stories of homeowners running into financial trouble who cannot unload their homes. The statistics support the anecdotal evidence; the divide between jumbo prime delinquency rates, currently over 7%, and conforming prime delinquency rates, which have yet to hit 5%, is growing. Remarkably, the jumbo prime delinquency rate shown in the article excludes option arms which would pull the delinquency rate even higher.

Given growing inventories, higher delinquency rates, tight financing, and changing attitudes among buyers, it seems inevitable that the higher end is due for more price "adjustments" (and not higher.) To quote a frustrated seller in Winnetka, Ill, an attorney who has commuted to DC for the past year while he waits to sell his home: " You're not sure if it's a price issue or if there aren't any buyers." Interesting that he fails to see the correlation between the two.