Category Archives: Finance Capital

Who Will Really Own Chrysler? (Hint: Initials are “U.A.W.”)

Despite widespread reports that the United Auto Workers union will emerge as the controlling shareholder of a restructured Chrysler, that is not formally true. But a closer look suggests that UAW President Ron Gettelfinger’s recent comments that the UAW will not own a majority stake in Chrysler are not exactly right either.

The 55% stake that current Chrysler owners propose to issue will go to the Voluntary Employee Beneficiary Association, or VEBA, set up as a result of collective bargaining negotiations between the UAW and the Big Three in late 2007 and early 2008. To secure ratification of those dramatically concessionary deals, the UAW and Big Three promised auto workers their health care plans would be secure for “80 years” under the new off balance sheet VEBA.

It turns out that may not be the case. Originally, the Big Three promised to put sufficient assets into the VEBA to pay health care obligations and to secure those assets from any risk of bankruptcy. But over the last year the companies got into further trouble and have now sought agreement with the union and its retired members to substitute equity for cash payments. Of course, that means the VEBA is directly linked to the financial health, or rather lack thereof, of the Big Three.

(By the way, to be clear, there is only one VEBA, for all three auto companies but it manages three separate health care plans with separate asset contributions owed in different amounts and structures from each of the auto companies.)

So who will be calling the shots at Chrysler with that huge 55% share – assuming a federal bankruptcy judge confirms the proposed deal (and that is far from certain)?

In theory it will be the board of trustees of the VEBA, also known as “the Committee” in public filings of the agreements behind the new structure. It is supposed to consist of 5 UAW representatives and 6 independent members.

But very little has been heard from this group. Despite their fiduciary obligation to protect retirees they do not seem to have objected to the very risky exchange of cash payments for equity in Chrysler. And the terms of the new Chrysler deal do not bode well either: despite owning more than half the company, apparently the VEBA will only get the right to appoint one board member out of nine.

In fact, it is a little unclear who really is on the VEBA board but one reliable source (Pension and Investments online magazine) lists the following individuals (since there are 6 listed here and none are UAW members this is likely the list of the so-called “independent” members):

Robert Naftaly, a former Blue Cross Blue Shield of Michigan executive, who will serve as the VEBA’s chairman.

Olena Berg-Lacey, a former assistant secretary of labor;

Marianne Udow-Phillips, director of the Center for Healthcare Quality and Transformation, Ann Arbor, Mich.;

Teresa Ghilarducci, a retirement policy guru at the New School for Social Research, New York;

David Baker Lewis, founder of Detroit-based law firm Lewis & Munday; and

Ed Welch, director of the Workers’ Compensation Center at Michigan State University’s School of Labor and Industrial Relations in East Lansing, Mich.

Of course, “independent” is a relative term. All six were presumably appointed with UAW President Ron Gettelfinger’s approval. They know that, he knows that. And the UAW controls the remaining five seats. In other words, the UAW only needs one vote from this group of six to completely control the VEBA itself and, in turn, Chrysler!

Now, how the supposedly independent Committee of 11 is supposed to defend the fiduciary interests of now and future auto worker retirees under such pressure is anybody’s guess.

Auto workers – meet the new boss, same as the old boss? We’ll see.

(You can read more here and here about the VEBA structure and the risks the UAW took with their retiree benefits.)

Fictitious Capital Update: Super Seniors and the Credit Crisis

A very nicely written excerpt from FT writer Gillian Tett’s new book Fool’s Gold on the origins of the credit crisis appears in the weekend edition of the FT. You can access it online here.

This excerpt shines a light on the original synthetic CDO structure, the so-called BISTRO, set up by JP Morgan in the late 90s. Morgan originally ran 9.7 billion dollars worth of loans through their first BISTRO. This became the model for hundreds of billions of loans in the new synthetic market.

The key to understanding the power of the synthetic CDO is the so-called “Super Senior” tranche. How do these work?

As a simple model, consider Shady Bank A that has made a billion dollars worth of loans to sub prime borrowers. The Federal Reserve Bank requires the Bank to keep a certain amount of capital as a cushion against losses on that portfolio of loans. Ten percent is the usual standard. So if Bank A has 100 mn in equity (it’s more complicated but let’s just assume a simple balance sheet with equity and debt) it must raise more equity if it wants to make new loans.

Or it can use a synthetic CDO to make people believe it has moved the risk associated with those loans off its balance sheet. To do that it sets up a separate entity known as a Special Purpose Vehicle or SPV. The SPV raises money from third party investors like hedge funds and pension funds. The secret, though, of a synthetic CDO with a Super Senior tranche is that it does not have to raise a billion dollars in order to transfer a billion dollars of risk off its balance sheet.

Instead it might raise $150 million. That $150 million is used by the SPV to buy, for example, U.S. Treasury bonds which then sit in a trust fund to be used only if there is an impairment to the value of the first $150 million of the $1 billion of loans. The SPV sells equity, mezzanine, and senior pieces of the SPV to raise that $150 million. The equity tranche has the highest risk because it will be wiped out first if the original loans run into trouble. Thus, equity investors in the SPV will get the highest interest rate.

To make sure that Shady Bank A no longer has the risk associated with the billion dollars of loans, the SPV sells the Bank protection in the form of a Credit Default Swap (or CDS: a swap (the “S” in CDS) of the risk of default (“D”) on the loans (“C” for credit).

But it turns out that the SPV investors only have $150 million in collateral raised to actually pay off on the risk of default. So that 150 million slice is considered “funded.” The CDS protection on the other $850 is “unfunded” and CDS protection on that larger piece is provided by a separate group, often AIG’s Financial Products unit, as in the case of the original BISTRO.

And therein lies the magic. Because AIG’s FP unit was not regulated by insurance regulators it had NO obligation to set aside any cash reserves to back up its promise to pay off if any of the $850 million went bad. Back in 1998 default rates rarely would eat through the first 15% so the risk on these pieces of the SPV/CDO were considered “super seniors” – safer than even the AAA rated senior tranches of the funded (i.e. collateralized) $150 million piece.

On the other hand, if default rates did hit the 850 mn piece then AIG would be in real trouble and sure enough they are and had to come running to us, the US taxpayers to be bailed out to pay off on their super senior obligations!

Meanwhile, of course, Shady Bank A has allegedly “moved” a billion dollars of risk off its balance sheet by raising only $150 million! That frees it up to make new loans without raising any more capital for its own balance sheet (well, not quite, the Fed just reduced the reserve requirement for the super senior tranche to a fraction of its older requirements). And it is free to repeat this exercise dozens of times and many banks did. To the point when, in essence, our carefully crafted reserve requirements were essentially obliterated by financial and regulatory arbitrage.

As Tett writes: “The implications were huge. Banks had typically been forced to hold $800m reserves for every $10bn of corporate loans on their books. Now that sum could fall to just $160m. The Bistro concept had pulled off a dance around the international banking rules.”

Fictitious capital and mark to market accounting

FASB, the accounting entity responsible for setting basic rules of the road for financial statements, bowed to political pressure today and in a 3-2 vote gave breathing room to the same bankers who caused the mess we are in.

Let me explain.

Currently, banks must “mark to market” their assets including now toxic loans they made to subprime borrowers. Thus, if the bank made 100 in loans and then found those borrowers defaulting or late in their payments the value of those loans would fall, as it has in some cases to, let’s say, 30.

Now if a sample Bank A had borrowed 60 and secured equity financing of 40 to make the original loans of 100 then if those same loans are valued according to their market price – the price a willing buyer would pay for them – that is, 30, then Bank A is insolvent, would have to file for bankruptcy (slightly different for banks than, let’s say, GM) or be taken over by the FDIC.

Then the bank would get new management and be resold over time to another bank or broken up and sold off in pieces. It happens every week in the US and has been going smoothly as in cases involving WaMu and IndyMac.

But with the new FASB rules, Bank A can do its own internal analysis and tell investors that voila the loans made at 100 are worth 70 because their own analysis suggests some time in the future those loans will get paid off with interest.

According to The New York Times: “One of the dissenters, Thomas J. Linsmeier, argued that accounting rules already allowed the ‘fiction all banks are well capitalized,’ adding that the changes would ‘make them seem better capitalized.'”

Now apparently the FASB rule which allows this form of fictitious capital to be created (from 30 to 70 despite what the market says) is balanced by better disclosure to the market of the content of the bank’s analysis. That means that outside lenders and shareholders of the bank can have greater transparency into the bank’s real financial condition.

In theory then the market could do its own mark to market accounting of the overall value of Bank A if it thought the internal analysis were overly optimistic.

But notice what happens here: whereas under the current mark to market rules Bank A would be insolvent and the managers of that Bank would likely lose their jobs, under the new rules the managers get to stay in place!

FASB has just rewarded the very people responsible for getting us into this mess in the first place! And along the way the banks now lose their incentive to sell off the now inflated toxic assets to private firms as proposed by Secretary Geithner.

Does the right hand know what the left hand is doing here?

Geithner plan is a wasteful delaying action – nationalization inevitable

I made an attempt to explain to my international finance students today why the Geithner plan won’t work, relying heavily and gratefully on the wonderful analysis of Salman Khan of the YouTube based KhanAcademy.

Turns out Khan is thinking along the same wave length as Nobel prize winning economist Joe Stiglitz who wrote a devastating critique in the New York Times today indicating that the Geithner plan is nothing more than a “Rube Goldberg” machine that “has allowed the administration to avoid going back to Congress to ask for the money needed to fix our banks, and it provided a way to avoid nationalization.”

What is at the heart of the Khan/Stiglitz argument? That the banks are sitting on assets that have a market price that is far less than the money those banks owe to their lenders and shareholders. If they can’t sell those assets at a much higher price they are effectively insolvent.

So the Government is proposing to buy those assets for more than they are worth with the US taxpayer putting up 93 percent of the purchase price and the so-called private “partners” putting up only 7%. That amounts to a huge subsidy to current creditors and equity holders of the banks that caused the problem in the first place. Oh, and probably allows their top managers to keep their jobs.

But wait there’s more. If the assets turn out to be worth more than that juiced up price paid by the new Public-Private Partnerships in the Geithner reworking of the old Paulson TARP plan then the US Government gets only 50% of the upside, since most of the money put in by the Government is in the form of a loan not equity. The other 50% goes to the private partner, including big financial groups like PIMCO and BlackRock.

And the loan to the partnership from the Government is a non-recourse loan which means if the entity loses money the Government has no ability to go after the assets of the private partner, even though they will have managed the business into a loss!

No wonder groups like PIMCO and BlackRock said they would participate and no wonder Wall Street rallied on the announcement of the plan. It’s a win-win for the banks and for the private partners. The real risk is taken by the US taxpayer.

Global slowdown hits China hard

For awhile some advocates of globalization contended that China and other developing countries were immune from the banking crisis hitting the US and other advanced economies. They argued a so-called “de-coupling” thesis which said that an independent growth dynamic was at work in what were once called “underdeveloped nations” and that they could ride out the storm.

Not.

Here is just a snippet of headlines from China in the past week or so, courtesy of Doug Noland at Prudent Bear:

February 2 – Bloomberg (Robert Hutton): “Chinese Premier Wen Jiabao said the worldwide economic crisis shows ‘how dangerous a totally unregulated market can be.’ ‘It brings disastrous consequences,’ Wen said… ‘The main causes are for some economies, they have imbalances in their economic structure. For a long period of time they’ve had dual deficits, trade deficits and fiscal deficits.’”

February 4 – Bloomberg (Luo Jun): “Chinese banks may have offered a record 1.2 trillion yuan ($175 billion) of new loans in January, the China Securities Journal reported… The four biggest state-owned banks completed 20% of their full-year target, with majority of the loans lent for railways, highways, electricity grids and the infrastructure, report said.”

February 3 – Bloomberg (Wang Ying): “China’s oil refineries posted a loss of 149.3 billion yuan ($22 billion) in the first 11 months of last year because of higher raw material costs… China faced an energy shortage in the first half though supplies became ample in the second half as the economy slowed, the Ministry of Industry and Information Technology said…”

February 1 – Bloomberg (Dune Lawrence): “China’s retail sales during the week- long Lunar New Year holiday climbed to 290 billion yuan ($42.4 billion), 14% higher than last year’s holiday period, the Ministry of Commerce reported yesterday.”

February 3 – Bloomberg (Chia-Peck Wong): “Hong Kong’s home sales fell for a seventh month in January… The number of residential units changing hands last month slumped 67% from January 2008…”

Our Ponzi Economy

Every spring I teach securities law to law students and until this year it has always felt somewhat odd to lecture about Ponzi schemes. After all, didn’t this kind of fraud disappear with childhood polio in America?

We thought we had in the SEC and federal and state regulations the toughest legal regime in the world, worth its weight in a lower cost of capital to thousands of companies that sell their shares here and to millions of investors worldwide who park their cash in our financial markets.

As it turns out the concept of the Ponzi scheme is far from dated and, according to Pimco’s Bill Gross, it lies at the heart of understanding the current mess we are in. Gross is one of those commentators about whom it can credibly be said, when he speaks, you owe it to yourself to stop what you are doing and listen.

His argument is that the basics of a Ponzi scheme are what explain the explosion of fictitious capital that is now crashing down around us. The core operating principle of a Ponzi scheme is that the operators of the scheme 1) lure investors into an investment with promises of above market returns; and 2) because the funds they receive are not, in fact, invested in anything that can in fact generate those above average returns must lure in new investors to pay off the old investors.

About the nature of our credit driven economy today Gross writes:

Under the policy-endorsed cover of technology and somewhat faux increases in financial productivity, we became a nation that specialized in the making of paper instead of things, and it fell to Wall Street to invent ever more clever ways to securitize assets, and the job of Main Street to “equitize” or, in reality, to borrow more and more money off of them. What was not well recognized was that these policies were hollowing, self-destructive, and ultimately destined to be exposed for what they always were: Ponzi schemes, whose ultimate payoffs were dependent on the inclusion of more and more players and the production of more and more paper. Bernie Madoff? As with every financial and economic crisis, he will probably go down as this generation’s fall guy – the Samuel Insull, the Jeffrey Skilling, of 2008.

But Madoff’s scheme has a host of culpable look-alikes and one has only to begin with the mortgage market to understand the similarities. Option ARMs or Pick-A-Pay home loans allowed homeowners to make monthly payments that were so small they did not even cover their interest charges. Two million mortgagees either chose or were sold this Ponzi/Madoff form of skullduggery, believing that home prices never go down and that shoppers never drop. One can add to this the trillions in home equity/second mortgage loans that extracted “savings” in order to promote current instead of future consumption, and one begins to realize that Bernie Madoff and our cartoon’s Wimpy had company all these years.

While no one but his closest family members will cry when Madoff is led off to federal prison in an orange jumpsuit, as he surely will the dilatory behavior of our failing SEC notwithstanding, it is Gross’ point that he is only a slightly misshapen example of the entire period in which we have been living.

This argument is not a complete explanation of the crisis. That would require an understanding of the underlying changes in productivity that have helped make very large swathes of our economy socially worthless thus feeding the need to keep fictitious credit afloat lest entire chunks of the economy collapse. Such is the nature of late capitalism. But Gross puts his finger on the dynamic within that machinery that finds a way to keep paper claims to wealth floating like a massive hot potato from investor to investor, from country to country, from year to year.

And now it is the state itself, Gross believes, that must enter the picture to reflate the collapsing world of credit. That is Gross’ blindspot – he is looking, desperately, for a way out. Like all great traders, when he speaks you should listen but you should also understand that he is “talking his book” – his only fiduciary obligation is to his clients, who invest in the credit instruments he finds for them. Thus, he hopes the Government can spend its way through this crisis. He may be right, but it is a big bet.