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%?