bizzXceleration: Performance, Value and Profit

General & Special

Weidner wonders who'll clean up Street Today's credit crisis has the feel of kids playing football in the house. Everyone is having a good time until the ball goes through the window. It almost doesn't matter who threw the ball -- Citigroup Inc., subprime borrowers or lenders, big banks, the leveraged-buyout guys, ratings agencies -- everyone was doing something they shouldn't have. Here's one problem with this plan: If you follow the money, it doesn't make much sense. Start with a mortgage. It gets packaged by an investment bank into a collateralized debt obligation. That CDO is then sold to an SIV. The SIV is funded by a bank, investment bank or another industry lender. It could be the same bank through the whole process. At the minimum, it's a limited group of players.Now, our original loan and others have gone bad, which means the CDOs have gone bad, which means the SIVs are in trouble. The industry's answer to this is to create yet another investment company to buy the good assets from the SIVs. That suggests there's a fire. Banks and other financial institutions, including Fidelity Investments, are reluctantly stepping forward in the effort even if they're in the camp that didn't set up SIVs or don't have a load of CDOs on the balance sheet. This mega-fund is not only the plan of the moment; it also appears to also be the best plan out there. Unfortunately, it won't stop the losses. Even if SIVs can fetch top dollar by selling good assets, the junk that was bought on borrowed money is still worthless. "To properly solve the liquidity problem, the sponsors of the SIVs are still going to have to take losses," said Gerard Cassidy, an analyst with RBC Capital Markets. "To try to get out of this by papering over the losses is not going to work." Analysts are becoming more convinced that the recent write-downs on Wall Street are the first in what will be a series of charges that banks will take during the next few quarters. Morgan Stanley's vice chairman suggested Monday that the profits made from the buyout boom will be washed away in the fallout.

Markets & Investing

Plan to Save Banks Depends on Investors The planned bailout of bank-sponsored lending vehicles is an attempt to build confidence in a part of the credit markets that remains largely frozen in the wake of this summer's debt-market turmoil. If investors can be persuaded credit-market problems are under control, it will save the banks from having to take big hits to their reputations and their balance sheets. It also would prevent the recent financial tremors from spreading through the overall economy in the form of a new credit crunch. Ironically, by working with the U.S. Treasury Department to develop the plan, big banks such as Citigroup Inc. are admitting things are bad and that their options aren't pleasant. Investors appear more than willing to focus on the positive. In the past few weeks, they have applauded as banks and investment houses took about $20 billion in losses related to their exposure to troubled mortgages and leveraged loans, bidding up financial stocks and sending U.S. stock markets to record levels. The risk is that the plan ultimately requires the implicit cooperation of investors. If they get more frazzled, rather than calmed by the bailout, debt markets could tumble further, potentially making the plan more expensive and risky.

·         Rescue Readied By Banks Is Bet To Spur Market, Big Banks Announce Plan To Bolster Credit Market, For Paulson, Help on Credit Crunch Carries Risk, A Bailout for Citigroup?

It’s Not a Bailout. It’s ‘Financial Engineering.’  Let’s see if we have this right: funds set up to make money on illiquid securities are causing some problems for large banking institutions, so in response, the banks — including some of those smart enough to avoid such vehicles — are all getting together to make an even larger fund to buy all of this stuff. As the Wall Street Journal has pointed out in a handful of stories, there are these off-balance sheet structured investment vehicles (SIVs, not SUVs), set up to issue short-term debt and invest the proceeds in things like mortgage-backed securities, which have seized up as investors have run away from the risk thanks to the downturn in the housing market. These SIVs are still struggling to issue paper, the FT.com pointed out last week. So in response, the banks have created a single master liquidity enhancement conduit, or M-LEC, a sort of golem-like entity that may or may not resemble the Master Control Program from the film “Tron.” The Entity, as it will be known in MarketBeat, will agree (because as an entity, it has no free will) to buy up this debt to help restore these markets. The Entity should work swimmingly, unless, of course, investors in the debt markets become more nervous as a result of what is a tacit admission by the banks that things aren’t going so well. At the moment, the 10-year Treasury note is down 6/32, to yield 4.71%, so that reaction has been limited.

• Paulson's Commercial-Paper Rescue Is Jeered by Champions of Free Markets
• 'Enron, Subprime and the Derivative Disease', October 16, 2007 That Treasury Secretary Henry Paulson is leading efforts to organize an $80 billion or so pool of private capital to finance four times that much in illiquid subprime assets controlled by some of the largest US banks is not a good sign. Looks to us like a prelude to a federal bailout. Led by names like Citigroup (NYSE:C) and JPMorgan (NYSE:JPM), the supposed "super conduit" seeks to make attractive assets which now seem dead orphans. A number of banks and other dealers are increasingly illiquid and face losses on supposedly off-balance sheet conduits or structured investment vehicles ("SIV"), losses that in extreme cases could damage their solvency. Thus Hank Paulson is back in deal mode, but this last minute window dressing may be too little too late to stop the inevitable market based resolution. Orchestrating the pooling of hundreds of billions worth of illiquid assets into a single conduit strikes us as a bad move. In analytics, we call such proposals a "difference without distinction." Instead of seeking to restore the abnormal and manic market conditions that prevailed in the world of structured finance prior to Q2 2007, we think Secretary Paulson and his Street-wise colleagues should be trying to reach a more stable formulation.

·         Signs the credit crunch is over Careful optimism about the U.S. economy and financial system has given way to a resurgence of unease in the last couple of days, prompted by an announcement Monday of an extraordinary plan to pump liquidity into an important part of the debt markets and less-than-upbeat speeches from Federal Reserve chairman Ben Bernanke and Treasury Secretary Henry Paulson. Suddenly, the credit crunch is being talked about as a serious phenomenon again. But, as is always the case on Wall Street, it won't be long before a gaggle of self-interested players make their way to center stage to tell us that recovery is just around the corner, seizing on any halfway optimistic shred of data to bolster their case. So, in an effort to stay grounded amid the hype, it's worth making a shortlist of things that need to start happening before anyone can talk about the credit crunch coming to an end.

Boeing bends the plane truth Whether it's self-delusion or something worse, Wall Street seems more determined than ever to stretch the truth. Two examples: Boeing's predictions for its new airliner and big banks' self-serving bailout schemes. The plan is somewhat similar to an entity created by the New York branch of the Federal Reserve after the demise of Long Term Capital Management hedge fund back in 1998 -- but with a key difference. Back then, the Fed was dealing with a single broken hedge fund that had foreign government bonds that were largely liquid and easily priced. In this case, the superfund would deal with thousands of illiquid, exotic debt derivatives whose value will be a matter of great debate. Although that $80 billion sounds impressive, it doesn't actually represent any cash; it's just the value of the bad paper that this entity would initially obtain at discounts. The notion that the banks, who are archrivals, will agree with each other or their European counterparts on how to realistically price the securities -- a process known as "marking to market" -- is absurd on its face and countermands everything we think we know about how market participants act independently to determine values. And the idea that the Treasury is proposing to have some kind of unprecedented role in this charade is mind-blowing. Normally the government would prevent companies from conspiring in this fashion due to suspicions they will serve their own interests, not those of the securities' owners. The fact that the Treasury has stepped in at all is a stunner because banking-system matters are usually handled by the Federal Reserve, which presumably wants nothing to do with this anti-capitalist craziness. Das figures that the banks are teaming up for a reason much different than the one stated: to prevent the securities from being sold at a discount on the open market, pushing down prices on other securities to which they are linked and causing significant losses throughout the food chain. He points out that such losses would require prime brokers -- who provide funds to hedge funds -- to revalue collateral held against loans, triggering margin calls on already cash-strapped investors.

U.S. Investors Face Age of Murky Pricing Since the invention of the ticker tape 140 years ago, America has been able to boast of having the world's most transparent financial markets. The tape and its electronic descendants ensured that crystal-clear prices for stocks and many other securities were readily available to everyone, encouraging millions to entrust their money to the markets. These days, after a decade of frantic growth in mortgage-backed securities and other complex investments traded off exchanges, that clarity is gone. Large parts of American financial markets have become a hall of mirrors. Such pricing problems have become common in some of Wall Street's biggest markets. The burgeoning universe of complex securities based on mortgages and other assets has turned the once-simple task of getting a price quote into a confounding undertaking. Today, "way less than half" of all securities trade on exchanges with readily available price information, according to Goldman Sachs Group Inc. analyst Daniel Harris. More and more securities are priced by dealers who don't publish quotes. As a result, money managers can no longer gauge with certainty the value of some assets in mutual funds, hedge funds and other investment vehicles -- a process known as marking to market. An official at the Securities and Exchange Commission said recently that some bond mutual funds might be using outdated or unrealistic prices to value their portfolios. The growing uncertainty over what assets are really worth could wreak havoc on the efforts of both individuals and money managers to invest rationally. During this summer's confusion over bond valuations, for example, it was especially difficult to know whether to buy or sell. Investors forced to fly blind sometimes resort to panic selling, which can produce wild swings in the markets.

·         Goldman's questionable quarter Much of the bank's spectacular third quarter earnings were paper gains from financial instruments that Goldman values largely according to its own estimates

Accountants' Hard Line This time, the auditors don't seem to be backing down. After losing public confidence over their failure to warn investors about scandals such as those at Enron Corp. and WorldCom Inc., accounting firms are taking a hard line when it comes to questions that have arisen from the credit crunch. In recent weeks, the accounting firms, operating through a new industry group, have taken views at odds with at least some of their clients about the use of market prices for hard-to-trade securities and over how banks should deal with their exposure to losses in off-balance-sheet lending vehicles. This has prompted financial firms to recognize losses in securities that they may have otherwise put down to short-term disruptions in markets. It also prompted, at least in part, moves by large banks and the Treasury Department to bail out structured investment vehicles, or SIVs, which are special lending vehicles that banks keep off their books. The firms' unyielding stance has pleasantly surprised some longtime critics such as Mr. Turner, who add that auditors seem to have stood firm on proper -- yet unforgiving -- accounting treatments despite the severity of the problems gripping the markets. The auditors' group, for instance, said companies have to use market prices no matter how depressed they are and can't argue that they should be ignored because they represent a fire-sale valuation.

Bookstaber Asks: Where Were the Risk Managers?

What a mess. With multibillion dollar trading losses, we are starting to see heads roll. Citigroup is losing its longtime fixed-income head Tom Maheras and several of his lieutenants. Merrill is continuing in its approach to managing human capital, bringing in new blood and losing experienced hands in the fixed income business. Oh, and they are putting someone into a Chief Risk Officer role. Talk about closing the barn door….  Other firms have fared very poorly but so far without executing any of the troops. Morgan Stanley layered a heart-stopping $390 million one-day loss in its proprietary trading desk on top of far bigger losses on leveraged loans and the like. This loss in Process Driven Trading was similar in timing to the losses at Goldman’s Global Alpha fund, AQR and other quant hedge funds. Which pretty much tells us that what this secretive group at Morgan Stanley was up to was a not-so-secretive strategy: They had a lot of capital riding on the same sort of momentum and value versus growth quant equity strategies as the rest of the gang. What I don’t understand in all of this is that for all the mention in the press of the risk takers, there is not a single mention I have found of the people who are supposed to be overseeing the risk. If you are the Chief Risk Officer and everything blows up, don’t you bear some responsibility? To get the idea of the CRO job, let me tell you a bit about myself. Although I am older and have a slight build, I am an Olympic athlete. My event is the shot put. I consider myself a top notch athlete in this event. I work out like the other competitors, follow a high protein diet, steer clear of performance enhancing drugs and train at the local track. The only trouble I have is when the Olympics roll around every four years, because it turns out that for an Olympic athlete, I am not very good. But then, that is only an occasional blip in my otherwise Olympic-worthy regimen.

In the CRO job 99% of the days there is nothing going wrong. The only test you get of how well you are doing – short of pouring out risk reports and looking ponderous and prudent in meetings – is what happens to the firm during times of market crisis. Every few years something calamitous happens in the market; if the firm gets blown away, that suggests you did not do a very good job. What about the job of the risk taker? Well, a risk taker does, after all, take risk. He tries to do so intelligently, that is, he tries to put on positions that he hopes have a high return per unit of risk. But how much risk he takes and where he takes it has to be dictated by someone. You can’t just say “take risk, and good luck.”  The job of the risk manager at these firms is to convey the risk parameters to the risk takers, to define the boundaries. And that should involve more than simply running a value at risk calculation on the computer. If that is all you want, you don’t need a guy making a few million a year and employing a staff of hundreds. Before I would be so harsh on Tom Maheras and his compatriots, I would be calling to task the people who allowed that risk level to be taken in the first place.