Tag Archives: Credit Crisis

The charge against Goldman Sachs that may really matter

As readers know I am somewhat sceptical of the basis of the claims against Goldman Sachs made by the SEC regarding their role as a market maker in a derivatives transaction with IKB and Paulson & Co. Both Paulson and IKB are big boys, more than capable of “fending for themselves” (as the Supreme Court put it in a leading securities law case).

But now a leading class action law firm claims that when Goldman failed to disclose that it had received a so-called Wells Notice from the SEC last summer it was concealing material information from investors and thus misleading them. A Wells Notice is an indication the SEC intends to charge a party with a securities law violation. It is an indication that the party has a last clear chance to settle or explain the situation to try to avoid charges. It seems clear Goldman was unwilling to settle with the Commission (though there is some indication the SEC did not want to settle) so when the SEC filed a complaint against the bank recently it led to a dramatic $10 billion loss in the firm’s market value.

The complaint charges that the firm misled the public into thinking things were just fine and dandy when it knew that was not the case. That would mean that the bank’s stock was trading at artificially high prices. Had the firm shared the news about the Wells Notice then Goldman shareholders could have made up their own minds whether to stick by Goldman. Instead, the law firm claims, Goldman went on a tear trying to convince everyone that everything was just fine and dandy. Goldman CEO Lloyd Blankfein claimed, absurdly, that Goldman was “doing God’s work.”

The problem here is that whether or not the SEC eventually prevails on the underlying charge there is little doubt the market has decided that Goldman’s reputation has taken a huge hit. And when you are a market maker – bringing buyers and sellers of securities together – reputation is everything.

Or, as they say in politics, it’s not the crime that matters, it’s the cover up.

The Greek Tsunami?

imagesWith a tsunami its not the first wave that counts, it’s when the water recedes and then ever so slowly a second wave approaches that the alarm bell should sound. It looks like it’s a small inconsequential shift in the tides, but then the water rushes towards the beach and all is lost.

That’s one reason to keep a close eye on the Greek events. Portugal, Ireland, Italy and Greece are all thought to have unsustainable debt levels leading to the need to impose austerity that in turn is feared will trigger social unrest.

A flight to safety causes the dollar to increase in value and undercuts the US recovery.

We are not out of this financial crisis by a long shot.

Yves Smith at Naked Capitalism points to the role of the investment bank everyone loves to hate in covering up the mess that was building up.

Goldman Helped Greece Disguise Deficit « naked capitalism.

GM Bankruptcy and Labor: From Sit Down Strikes to Credit Default Swaps

w-1937-overpassThe United Auto Workers gave organized labor a beachhead in the American economy with the great sit down strikes of 1937. Some seven decades later organized capital is looking to expel what remains of the UAW from GM and at the same time complete the isolation of the trade union to low wage immigrant labor based segments of the economy and the public sector. A labor movement that does not have leverage in the most productive center of an economy cannot hope to influence national social policy or progressive politics.

Unlike the bloody Battle of the Overpass pictured above, however, today’s attack on labor is being wielded with complex financial instruments, instruments of fictitious capital.  At GM, bond holders who hold credit default swaps have disrupted the ordinary incentive structure in a corporation entering the so-called “zone of bankruptcy”.

Traditionally, holders of bonds were deserving of protection as the company approached bankruptcy because insiders could be tempted to use their control over corporate resources to loot the firm and leave less for those who had a higher priority for repayment in bankruptcy.  Thus, courts have held recently that as a company like GM looked more likely to need the protection of bankruptcy its board of directors would have a legal obligation to shift its ordinary fiduciary duty to protect shareholders to the bond holders.

But the emergence of derivative instruments like credit default swaps (CDS) has twisted our ordinary understanding of incentives in corporate governance. Credit default swaps are speculative instruments created to offer a way for investors to bet on the value of bonds that ordinarily would not be open for speculation.  The purchaser of credit default swap “protection” pays an annual premium that amounts to several percentage points of the value of the underlying bond (perhaps 2% on a $10 million investment which translates into $200,000 in annual premiums to the “seller” of the protection).  If a “default” event were to occur on the bond – such as the failure by the issuer of the bond to make an interest payment or in extreme circumstances outright default on the bond – then the seller of the CDS protection must pay the buyer of the protection a certain amount (typically the difference between the par value and the current (depressed) market value of the bond). 

Hence, the term CDS: the credit is the original bond, the default is the event that triggers payoff, and the swap refers to the fact that by putting a CDS in place, the risk of owning the bond has shifted from the bondholder to the seller of protection.  One huge seller of protection on bonds was AIG and it sold a huge amount of CDS protection on sub prime mortgage bonds that have now turned out to be worthless. That has obligated AIG to make good on its promises – which they are doing with taxpayer money.

At GM, it turns out that one default event that will trigger repayment to bondholders is the filing of bankruptcy itself. So investors who bought GM bonds at par, e.g., valued at 100 cents on the dollar now hold bonds that are valued at far less, perhaps 20 cents on the dollar. If GM files for bankruptcy then the seller of CDS protection to a GM bondholder would owe the bondholder at least 80 cents on the dollar, if not more as the bond fell in price. So on $10 mn of GM bonds the payoff would be $8 mn plus the $2 mn that the bondholder could get by selling the bonds. If the bonds fell to zero in price, the holders could get the full $10 mn.

That is just a simple example and there are lots of complexities in this situation. In fact, for example, GM bonds are trading at a different price points – somewhere between 6 and 12 cents on the dollar. There is a net exposure for sellers of CDS protection of about 2.4 billion dollars on a total of 34 billion dollars of outstanding CDS positions (sellers of CDS protection sometimes buy CDS protection themselves to hedge against events such as this, but unlike regulated insurers they do not have to have any actual cash reserves to use to pay off in case of such a catastrophic event.) CDS protection also requires an upfront payment that increases as the bond falls in value, so at GM it costs $5 mn a year to protect $10 mn in bonds today (4.5 mn upfront and then a payment of 5% a year or $500,000).  Of course, that makes the bonds illiquid today or at least uninsurable.

But here is the key point: GM under US government pressure has offered current bond holders the “opportunity” to exchange their current bonds for common stock in a restructured GM. The bond holders would end up with 10 percent of the equity with the government owning 50% and the UAW’s VEBA owning 39%. Current shareholders would end up with one percent.  Apparently, though, bond holders with CDS protection believe that their CDS payoff if GM files for bankruptcy is worth more than the eventual value of the 10 percent common stock position. 

Now look at this deal from the viewpoint of current GM managers. If the bond holders turn down the exchange offer, GM files for bankruptcy which leaves the managers in control (they become in bankruptcy parlance a “debtor in possession”) and they get several months to put together a plan of reorganization. That may lead to the wipe out of the bond holders anyway but they won’t care because they will have received their CDS payout!  But here is the magic: the payout to bond holders is not made by GM or GM managers – it will be made by the sellers of the CDS protection, perhaps AIG or JPMorgan, and perhaps with taxpayer dollars! Thus, GM is freed of its bond obligations paid off with “other people’s money” and they remain in control of the company now free to use the power of a federal judge to tear up the UAW contract and their remaining obligations to pay billions into the healthcare VEBA.

And once they have cleared their books of the bonds, the VEBA and the UAW, they are free to ramp up offshore production to India and China, as they have been planning for several years.

By the way, GM bondholders were warned of bankruptcy risk at GM when they bought their bonds. They got the benefits of mandatory disclosure of risk factors affecting GM when the bonds were first issued. But the rank and file members of the UAW who “bought” the proposed multi-billion dollar VEBA to manage their health care plan were told by UAW President Ron Gettelfinger that their health care would be safe from GM bankuptcy “for 80 years.” So no CDS protection was purchased by the UAW to protect its payment obligations from GM.

The Financial Times has more on this issue here.  There is some interesting discussion of the issue on the blog Naked Capitalism here. And here is a video of an investor explaining how CDS protection is wreaking havoc in another bankrupt company.

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.

The AIG Scandal – An Insurance Company that wants to be paid? Surprise, surprise…

I was interviewed on Oakland-based KTVU about the AIG scandal. You can watch it here.

A key point I was not able to work into the discussion: we need to keep in mind the larger picture here.

First, according to a must read profile of the AIG Financial Products unit in Rolling Stone, its 400 employees were paid some 3.5 billion dollars in salary and BONUSES over the last seven years, including $280 million to the group’s founder Joe Cassanno, a veteran of the junk bond fraud run by disgraced financier and now ex-con Michael Milken. And yet the US Treasury – led by Neel Kashkari – thought it essential to hand them $40 billion in new money last fall and only limit the bonuses paid to the top executives of the holding company, AIG parent, not AIG Financial Products!

Second, what value have these financial geniuses brought the US public for our $40 billion (followed by another $100 billion or so since, including a $30 billion line of credit a few weeks ago)? Instead of negotiating with their counter parties to whom they sold the Credit Default Swaps that were at the heart of the AIG-FP business model, they apparently just paid them off at 100 cents on the dollar!

Now, that’s the kind of insurance company I want.

“There Will Be Blood”

images-1I have not been a fan of popularizers like historian Niall Ferguson, but one has to admit that he puts his finger on the depth and complexity of the current crisis in this interview with a Canadian newspaper. He points out that the US is in a relatively privileged position because its currency and economy remain the central pillars of the world economy. But the crisis represents the end of globalization as we have known it since the end of the Cold War.

Ferguson states:

“There will be blood, in the sense that a crisis of this magnitude is bound to increase political as well as economic [conflict]. It is bound to destabilize some countries. It will cause civil wars to break out, that have been dormant. It will topple governments that were moderate and bring in governments that are extreme. These things are pretty predictable. The question is whether the general destabilization, the return of, if you like, political risk, ultimately leads to something really big in the realm of geopolitics. That seems a less certain outcome.”

We’ll see.

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.


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…”