Category: accounting

Opening Pandora’s box

On Friday Goldman Sachs was charged by the SEC with fraud regarding a real estate structured finance transaction during the height of the credit bubble in 2007. Like any fraud the various players jockey for position and in this case it appears the other players involve John Paulson, ACA and potentially other industry participants. First thought that comes to mind is how this coincides with the upcoming financial reform bill headed by Chris Dodd which goes to a vote in less than two weeks. Second, we really have limited information about the suit although readers of this blog are more than familiar with the underlying fraud that built the greatest credit bubble in history.

Questions we would like to see answered:

1) Was Goldman creating custom products for John Paulson while trading against other clients?

2) Were clients intentionally misled about what was being sold to them in order to reward other clients?

3) Were these and other transactions done at arms length?

4) How did Goldman and other banks emulate Lehman regarding repo transactions via off balance sheet entities at quarter end?

5) Did Paulson get access to other questionable custom Goldman products, specifically Greek CDS? If so, were these products fraudulent?

6) How were these various products assembled and were there known fraudulent activities within raw material? For example, did Goldman know about fraud at the mortgage origination level? Where did these mortgages originate? I mention this because WAMU executives were on Capitol Hill last week admitting to mortgage originations containing fraudulent documentation.

7) Knowing the plethora of global derivative allegations does the blueprint used by JP Morgan on Jefferson County, AL ultimately open Pandora’s box?

8) Since this is a civil suit do we have to rely on the criminal fraud trial beginning next month in Italy to finally receive the juicy details on this sham?

9) The four largest banks in America are also some of the largest mortgage servicing entities so are they privy to mortgage payment information which could or could not be shared with some of the entities creating structured credit?

10) Does Goldman employees’ $1 million contribution to Obama’s campaign coupled with over $344 million in lobbying efforts last year insulate the firm from criminal charges in the USA?

11) Is this material? “Head of allegedly Goldman buyer ACA is married to Goldman deputy general counsel”?

12) How many other derivative dealers have been front running their clients?

My comments: Slowly the details emerge on the greatest fraud perpetrated on the American people. As we discussed on numerous occasions the public wants blood so let’s see if the rule of law still exists in the United States.

Credit contraction has only just begun

A few weeks ago we presented “Unwinding Planet Leverage” at the Spring CMRE dinner ( where I would say many were concerned about the ongoing credit fiasco. On the other hand, after countless capital raises, reassurances from commercial and investment bankers and the Bear Stearns rescue several months ago, sentiment has swung into bullish territory. Time after time I hear the same response from investors, “the Fed will not allow another large bank or investment bank to fail” or “I’m buying stocks since the Fed has things under control”. Oh really?

Today the Financial Times did a piece about potential accounting changes to off balance sheet entities created by our transparent bankers. Evidently, FASB wants to remove all conduits, SIVs, VIEs and any other form of off balance sheet activities consequently returning roughly $5 trillion to bank balance sheets – ouch!

Accounting changes could force US banks to take thousands of billions of dollars back on to their balance sheets in the coming months in a move that is likely to curb further their lending and could push them into new capital raisings, analysts have warned.

Analysts at Citigroup said a planned tightening of the rules regarding off-balance sheet vehicles would force banks to reconsider arrangements and could result in up to $5,000bn of assets coming back on to the books.

The off-balance sheet vehicles have been used by financial institutions to keep some assets off their balance sheets, thereby avoiding the need to hold regulatory capital against them.

Birgit Specht, head of securitisation analysis at Citigroup, said: “We think it is very likely that these vehicles will come back on balance sheet. “This will not affect liquidity because they are funded, but it will affect debt-to-equity ratios [at banks] and so significantly impact banks’ ability to lend.

In the past I’ve discussed leverage at various financial institutions which in some cases actually increased since the credit crisis began last Spring. For example, since the Bear Stearns funeral Citigroup actually increased their leverage from 18-1 to 19-1 while Lehman and Morgan Stanley shifted more of their level 2 assets to level 3. Adding additional pressure to an already strained banking system, the SEC will hear proposals regarding new credit rating systems, specifically asset backed securities.

The U.S. Securities and Exchange Commission may recommend this week that Moody’s Investors Service, Standard & Poor’s and Fitch Ratings include a new designation to the scale created by John Moody in 1909. The changes may force investors to reassess the way they gauge the risk of securities backed by mortgages, student and auto loans and credit cards, said one of the people, who declined to be named before the announcement. The action could force banks to add capital to guard against losses or curb lending.

To be considered “well-capitalized” under U.S. regulations, banks are required to hold five times as much capital against corporate debt than they are for commercial or residential mortgage-backed securities rated AAA and AA by S&P, Fitch
Ratings and Moody’s.

Should the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corp. order banks to hold more capital, investors in asset-backed securities may balk at buying, making mortgages more expensive, said American Bankers association executive director Wayne Abernathy.

Finally, the Bank of International Settlements is out with a warning on the global credit crisis implying a potential depression from the massive credit contraction.

In its latest quarterly report, the body points out that the Great Depression of the 1930s was not foreseen and that commentators on the financial turmoil, instigated by the US sub-prime mortgage crisis, may not have grasped the level of exposure that lies at its heart.

According to the BIS, complex credit instruments, a strong appetite for risk, rising levels of household debt and long-term imbalances in the world currency system, all form part of the loose monetarist policy that could result in another Great Depression.

The report points out that between March and May of this year, interbank lending continued to show signs of extreme stress and that this could be set to continue well into the future. It also raises concerns about the Chinese economy and questions whether China may be repeating mistakes made by Japan, with its so called bubble economy of the late 1980s.

My Comments: As planet leverage continues to unwind expect numerous rounds of toxic financing as regulators pressure banks and investment banks to raise more capital, diluting shareholders away in the process. Concurrently, regulatory pressure from the Fed will require banks and investment banks to meet margin calls as posted collateral via temporary lending facilities decline in value. Finally, our banking system will move closer to Japan circa 1991-1993.

Fed down to their last few bullets

Wall Street began the week with fear in the financial air as rumors circulated Bear Stearns was unable to meet redemptions from hedge fund clients. The Banking Index probed new lows while T-bill rates followed. Adding to credit concerns were significant spikes in credit spreads, primarily MBS as Fannie/Freddie paper spreads blew wide open exceeding the moves witnessed during the 1998 LTCM debacle. A continuation of margin calls beginning last week pressured hedge fund and other credit related speculators who purged MBS of all flavors to stay alive. Within 24 hours Bernanke and the fearless Fed arrived on the scene with yet another attempt to stop the bleeding:

The Federal Reserve announced today an expansion of its securities lending program. Under this new Term Securities Lending Facility (TSLF), the Federal Reserve will lend up to $200 billion of Treasury securities to primary dealers secured for a term of 28 days (rather than overnight, as in the existing program) by a pledge of other securities, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency AAA/Aaa-rated private-label
residential MBS. The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally. As is the case with the current securities lending program, securities will be made available through an auction process.

Understand this experiment is quite different from the Temporary Auction Facility (TAF) which was introduced several months ago and actually offers cash for MBS collateral. Of course the main objective for the Fed’s TAF was lowering the Fed funds target rate.

I find it interesting that JP Morgan and Bank of America decided to make unprecedented margin calls last week when spreads had already widened the prior week or so. Is 25-1 leverage finally impacting credit availability at the largest commercial banks? How about the immeasurable levels of off balance sheet structured finance experiments gone bad?

Today we read about numerous credit related hedge funds who effectively froze redemptions for partners recently. Of course this is attributed to FASB 157 which went into effect in November, 2007, leading to numerous mark-to-market problems for the mark-to-make-believe world. Some of the twilight zone casualties emerged this morning:

Drake Management LLC, the New York- based-firm started by former BlackRock Inc. money managers, may shut its largest hedge fund, while GO Capital Asset management BV blocked clients from withdrawing cash from one of its funds.
Drake told investors today that it would either liquidate its $3 billion Global Opportunities fund, continue to restrict redemptions or allow clients to shift assets to a new fund. Separately, Amsterdam-based GO Capital prevented customers from taking money out of its $880 million Global Opportunities Fund, saying in a March 11 letter that “current market circumstances don’t allow the fund to sell investments at a reasonable price.”

Hedge funds with more than $5.4 billion have been forced to liquidate or sell assets since Feb. 15 as contagion from the U.S. subprime slump spreads. Others include Peloton Partners LLP’s $1.8 billion ABS Fund, Tequesta Capital Advisor’s mortgage fund and Focus Capital Investors LLC, which invested in mid size Swiss companies.

Finally, as we’ve said from day one, the Fed’s balance sheet is a paltry $866 billion which pails in comparison to the outstanding $43+ trillion of debt in the system. One more bullet has been fired leaving the central planners with fewer rounds of ammunition.

Counting the currency swaps with the foreign central banks, the Fed has now committed more than half of its combined securities and loan portfolio of $832 billion, Lou Crandall, chief economist for Wrightson ICAP noted. ‘The Fed won’t have run completely out of ammunition after these operations, but it is reaching deeper into its balance sheet than before.”

My comments: Bailout talk fills the airwaves so we ask the question: Does Bernanke have enough bullets in the chamber to keep the primary dealers alive until Congress approves a massive mortgage bailout plan? Remember the Fed does not want to destroy themselves so collateral must be blessed by the government in order to keep the Ponzi alive.

Paulson to the bat phone

Returning from New York this past weekend I opened the Wall Street Journal on Monday to discover yet one more chapter in the structured finance shell game. Evidently Treasury Secretary Henry Paulson picked up the bat phone to several of the largest US banks, begging them to work together in order to facilitate an orderly unwind of numerous off balance sheet structured investment vehicles (SIVs). The proposed Super SIV will try to float one year capital notes with proceeds earmarked for the purchase of SIV assets originally created by Citigroup. Thus Citi avoids two problems, an increase in reserve requirements from assets returning to their balance sheet and ongoing reputational risk.

At this point, the rational investor is throwing up his hands, and why not?

“I have never seen Treasury play this kind of role,” said John Makin, a visiting scholar with the conservative American Enterprise Institute in Washington and a principal with hedge fund Caxton Associates LLC. The banks made “riskier investments that didn’t work out. They should now put it back on their balance sheet.”

Paulson and Co have their hands full lately as trust and confidence in structured finance have been waning. Apprehension and/or the inability to mark securities to market have sent a shock wave through the credit markets. More recently we witnessed the following acts of desperation:

  • Increased injections of liquidity by the Fed
  • Broadening the collateral accepted (to include asset-backed commercial paper) and terms (from 7 to 30 days) of the repo market
  • 100 basis point cut (two separate actions) in the discount rate and 50 basis points to fed funds
  • Encouraging use of the discount window (formerly stigmatized) because banks no longer trust collateral being posted when lending to each other
  • Proposed Super SIV whereby roughly 20% of the total SIV market is re-tranched

Clearly the credit markets are faced with unprecedented circumstances due to countless players and massive leverage. Unlike LTCM which required a NY Fed bailout, the credit markets today have grown incredibly opaque while derivative exposure has gone parabolic.

It’s obvious the SIV assets won’t be priced at market rates because there’s not much of a market to begin with (and why the super SIV exists in the first place). But where exactly do they get priced? To whose benefit? And by which standard?

Unlike the Bernanke induced rally two months ago, Paulson seems to be striking out in spades. The banking index is probing 52 week lows while Citigroup has dropped over 6% in 3 days.

This latest scheme, to which the ex-Goldman Treasury Secretary gives his blessing, attempts to put off the structured finance day of reckoning even further. Could the Super-duper SIV create the inevitable mark-to-market across most aspects of the securitization world leading to a run on the bank? Note to Hank: Beware the law of unintended consequences.

Fair Value accounting dragnet: Just the facts

Last month the WSJ reported that SEC examiners would be analyzing valuation techniques related to structured finance in order to verify brokerage securities and loan positions.

According to Chris Whalen:

The Fed’s decision to waive Section 23A of the Federal Reserve Act (Reg W) and allow Bank of America (NYSE:BAC), Citigroup (NYSE:C), and JPMorgan Chase NYSE:JPM) to make large loans to their broker dealer units may be a sign of impending trouble. These loans, which are apparently to support collateralized debt obligations (“CDOs”), are an indication of mounting liquidity problem among the larger Sell Side shops.

The table above, courtesy of Richard Bove of Punk Ziegel & Co, displays data on holdings of these firms which are subject to Fair Value accounting (FASB 157 and 159). Fair Value accounting breaks holding into three categories:
  • Level 1 holdings are relatively easy to value since they are traded daily. Holdings include stocks, treasuries, or commodities.
  • Level 2 holdings are more opaque. This group trades intermittently so holdings are determined by computer models. Holdings include anything from loans, derivatives, restricted stock and thinly traded debt securities.
  • Level 3 holdings are valued solely at the discretion of the holder since there are no comparable issues being traded. Holdings include private equity, residuals from securitizations or complex derivatives.
The past 60 days has truly tested mark to model (Level 2&3) and the results are disastrous. How do we know this? Because mark to market or broker has resulted in transactions well below what supposed book or model values were. In some instances investment grade paper sold for 25 cents on the dollar. Thus, the market has implicated the brokers, banks, hedge funds and rating agencies for obvious reasons.

Looking at the table above we see $5.6 trillion in holdings being held by 8 firms. There is $0.3 trillion that cannot be valued objectively. This is 63% of the combined firms’ common equity. There is $4.1 trillion in Level 2 holdings which we would say are overstated by a minimum of 8-10%. This is 7.9x the combined firms’ common equity.

In summary, the banks, brokers, auditors, SEC, rating agencies and hedge funds will have their hands full trying to value $5.6 trillion in securities, 78.9% of which do not trade on a regular basis.

Allowing the free market to force a mark to market will create relentless write downs for this sector over the next few years. On the other hand continued denial results in perpetuating the twilight zone economy.

From off balance sheet to on

Since the ABS commercial paper market locked up several weeks back the guilty have slowly disclosed some of their off balance sheet conduits. Today news from down under as the largest bank in the country, National Australia Bank, moved $4.9 billion of funding back on to their balance sheet.

“The banks are not totally immune and the credit shakeout is bound to have some effect on them,” said Hans Kunnen, who helps manage the equivalent of $117 billion at Colonial First State Global Asset Management in Sydney. “They have to take appropriate action when circumstances become extreme, but have big enough balances sheets to absorb most of the pain.”

My comments: Mr Kunnen makes the statement about large enough balance sheets but it appears the Reserve Bank of Australia has already hit the panic button. Both Australia and Europe have experienced uncontrollable spikes in overnight lending rates since the credit revulsion began. In fact, Libor surged today as apprehension among lending institutions becomes the norm. The confidence game is waning as most players have no idea what the real balance sheets entail.

Banking’s perfect storm

Returning from the long holiday weekend bulls continue to bank on several rate cuts by Mr. Bernanke while George Bush relieves a segment of subprime borrowers. More and more we witness “portfolio managers” recommending banks based on above average earnings or low price to book. Like the housing bulls several years ago we believe the ‘analysis” is flawed on several fronts:

1) Banks hold over $1.27 trillion in asset backed securities on their balance sheet, mostly mortgage related. Recent collateral repricings caused by tighter lending standards and ongoing foreclosures will create mark to market problems intermediate term. For example, due to national house price declines thus far and 2008 projections one could make the case for a 15% haircut to present valuations.

2) LBO debt exposure is roughly $300 billion, most of which has already declined by 10-12% due to the recent credit crunch. As deals get restructured and or cancelled write downs could approach $40-50 billion.

3) Banks are potentially on the hook for several hundred billion in asset backed commercial paper conduits which remain “off balance sheet” until something breaks. Accounting rules don’t require banks to separately record anything related to the risk that they will have to loan the entities money to keep them functioning during a markets crisis. Several bailouts both here and abroad have already been announced over the past few weeks. Today in the WSJ Citigroup reluctantly disclosed some of these off balance sheet conduits known as SIVs:

Conduits and SIVs are entities that banks use to issue commercial paper, which are usually highly rated, short-term notes that offer investors a safe-haven investment with a yield slightly above certificates of deposit or government debt. Banks use the money to purchase longer-term investments such as corporate receivables, auto loans, credit-card debt or mortgages. The two kinds of vehicles are closely related, although SIVs can also issue longer-dated notes, can use leverage and have tended to have greater exposure to mortgage debt.

Banks affiliated with the vehicles typically agree to provide a so-called liquidity backstop — an assurance the vehicles’ IOUs will be repaid when they come due even if they can’t be resold, or rolled over — for all the paper in a conduit. For SIVs, three to five banks typically offer a liquidity backstop, but only for a portion of the vehicles’ assets.

Those liquidity backstops have become important because gun-shy investors are in some cases refusing to buy commercial paper. That could force banks to ride to the rescue if it happened to one of their affiliated conduits or SIVs.

These conduits are substantial in some cases. Take Citigroup, the nation’s largest bank as measured by market value and assets. Its latest financial results showed that it administers off-balance-sheet, conduit vehicles used to issue commercial paper that have assets of about $77 billion.

My comments: In a U.S. banking industry with $857 billion in equity, roughly $1.75 trillion dollars of securitized real estate loans, LBO debt and off (soon to be on) balance sheet ABS commercial paper exist, certainly not an insignificant number. The threat to the banking system might not present itself in the amount of questionable loans it currently holds, rather in the number of good loans that might later prove vulnerable as weak holders of loan obligations in other sectors of the economy liquidate these loans. Even in a highly leveraged society in which the risk is widely dispersed, the unwinding process can quickly escalate. Housing bulls learned a lesson; will the bank buyers take notice?

Wells Fargo embraces mark to myth

An article today on Bloomberg by Jonathan Weil exposes the accounting games being played by one of Warren Buffett’s favorites, Wells Fargo. Several weeks ago the CFO of Wells appeared on CNBC claiming no exposure to subprime while commenting on a normalization of the yield curve as a positive for banks like Wells. He failed to mention rising default rates in non-prime. Specifically, one should question mortgage servicing rights valuations in an environment unlike anything we’ve ever seen. Especially when Buffett’s partner Charles Munger was questioning collateral values on bank balance sheets some 15 months ago.

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