Tools to Help Business Owners Understand and Survive the Financial Crisis

Secondary Loan Markets On a Tear – Is M&A Rebirth Far Behind?

Posted by John Slater on April 23, 2009

Since the collapse of the syndicated loan markets in August 2007, the private equity M&A market has gone from red hot to stone cold at the high end and luke warm in the middle market. The primary cause of this collapse is not lack of equity; at the beginning of the year PE firms had close to $200 Billion of dry powder. The issue holding back the M&A market worldwide has been the lack of leverage for new deals.

The M&A bubble of 2005-2007 was driven in great part by an explosion of new funding sources that entered the leveraged lending market, leading to an unprecedented narrowing of lending spreads. At the peak, leveraged loans were being written at spreads as much as 300 basis points narrower than historical norms. Funding sources included hedge funds, special purpose entities created by the banks, collateralized loan obligations (CLOs), institutional investors and various international purchasers.

From the market crack in August 2007 through August 2008, this market traded at a discount of up to 10% of principal, reflecting a partial return to normality in terms of risk based loan spreads. During this period it became increasingly difficult for lenders to syndicate new deals. In September 2008, coinciding with the collapse of Lehman Brothers, this market went into freefall with a basket of the largest leveraged loans trading below 65% of principal by late 2008. The market for new syndications, particularly the multibillion dollar deals that had been so prevalent, ground to a virtual halt.

leveraged-loans

Source Churchill Financial - On the Left; S&P LCD Index

At the beginning of this year, the leveraged loan market priced in not only a correction of the previous mispricing of risk, but the assumption that battle horns were blowing in the Valley of Armageddon. After rising from 63.5 to 80.6 in the last four months, the LCD Index now reflects normalization of spreads plus a fifty year flood, a substantial improvement, but far from Nirvana. The market collapse in fall 2008 had far more to do with the deleveraging of the hedge funds and special purpose entities than it did with a considered pricing of risk. A cry of “give me a bid, any bid” could be heard across the land. As the deleveraging has run its course, inventories have declined and prices have recovered.

In a thoughtful piece in Tuesday’s Wall Street Journal, Michael Milken described past manic swings in the leverage levels of America’s corporate balance sheets. He pointed out that every cycle of overleveraging has been followed by a period of recapitalization, through debt for equity exchanges, repurchases of discounted debt and new equity offerings, which restores corporate balance sheets and provides the foundation for a renewal of new investment and growth. The current rebound in leveraged loan pricing may indicate that this process is now underway in the current cycle.

So long as existing senior debt was trading to yield potential returns approaching 20% per annum, those lenders with capital remaining had little incentive to provide new debt at acceptable spreads. With that competition for investment dollars winding down, new loans will become increasingly available, though still at spreads far in excess of those available at the peak of the boom. While we are a long way from a return to the frothy M&A market of mid-decade, it’s reasonable to expect a return of the financial buyers to the marketplace and a far more active M&A market for the balance of the year than we have seen over the past six months.

Allen Stanford Proclaims His Innocence

Posted by John Slater on April 21, 2009

Recently we have been presented with the spectacle of a high flying banker in deep financial trouble proclaiming that he and his organization have been wrongly singled out for reprisal by the Federal government.  The charges are clear.  His bank aggressively sought deposits from around the world to fund a portfolio of outrageously bad investments, leading to the bank’s insolvency.  The bank funded high paid executives’ lavish lifestyles, including Caribbean junkets, sports sponsorships, a fleet of private jets and outsized bonuses unrelated to actual performance.  Insider loans were made to bail out the personal financial problems of those in control.  Yet that banker has the gall to blame overzealous government actions for his problems.

We are speaking, of course, not of Allen Stanford of Stanford Financial, but of the CEO’s of America’s largest banks.  While there is certainly a difference in degree and Mr. Stanford’s personal style is less than savory, the biggest difference between Stanford Financial and several of our nation’s largest banks, is that the U. S. government chose to bail these institutions out of their mistakes rather than prosecute them as has been done with Stanford Financial.  And these bankers are whining daily about their inability to pay “adequate” compensation due to the restraints placed upon them under the TARP legislation.

Don’t get me wrong, Stanford abused the trust of thousands of investors, many of whom are presumably innocent, and he will likely be punished severely for his apparent wrongdoing.  But so did the big banks.  Had the big banks been allowed to fail in September, as they surely would have absent the federal bailouts, the damage to investors would have been far more dramatic and the retribution on their executives would likely have been far bloodier.  The difference is that they hail from the financial and political centers of the U. S. and are far better at gaining support in Washington.  Instead of indictments and fraud charges, they are given audiences with the President and free rein on CNBC and Bloomberg to make their cases for support.  And yes, even after they’ve sold some of their jets, I’m not likely to see any of them on row 21 the next time I fly Airtran.

Time for Transparency on Bailing Out the Banks’ Bondholders

Posted by John Slater on April 20, 2009

This morning the New York Times reported that the Treasury is planning to convert TARP holdings of preferred stock into common equity at a number of banks. As we previously raised, the real issue is whether and why the Treasury is committed to protect the bondholders of the big banks. There is a great deal of capital in the banking system in the form of unsecured debt.  In a normal world, when a company goes broke, some or all of the debtholders’ interests will ultimately be converted to equity capital either in bankruptcy or in an out of court restructure.  The current issue of The Institutional Risk Analyst makes a very interesting proposal for conversion of Citibank debt into equity, which would address the capitalization issue once and for all.  It’s time the Treasury explains in clear English why they are electing to further commit taxpayer funds to bailing out the big banks’ bondholders.

We’re Seven Months into the Great Mess. What’s Going to Happen Next?

Posted by John Slater on April 14, 2009

Seven months ago (Monday September 15, 2008) we learned of the failure of Lehman Brothers and soon thereafter the sale of Merrill Lynch and the bailout of AIG.  These events were the culmination of a series of market shocks that had started with the demise of the sub-prime loan market, had accelerated with the collapse of the leveraged loan market starting in August 2007 and had included the takeover of Bear Stearns in March 2008.  But September 15, 2008 is the current era’s equivalent of 1929’s Black Monday.

Since September we have witnessed dramatic governmental actions designed to prevent the current crisis from descending into a downward spiral reminiscent of the 1930s.  For the moment, the stock market seems to be giving these actions (as well as our charismatic new President) a vote of confidence.  We’re also hearing from some of our clients that their operations improved in March and that they are more optimistic about their businesses looking toward the summer.  Another “green shoot” is the middle market M&A market, where I spend much of my time.  The M&A market has definitely improved since the first of the year and indications are that it will remain reasonably strong for a while, at least for profitable companies in favored industries such as government contracting, IT services and health care.

So what is the economic scorecard to date and what can we expect to see going forward?

1)    The World economy is in the midst of the first major global recession of the postwar era.  Global trade has been collapsed for many of the major exporters, particularly China, Japan and Germany.

china-exports1

While there have been some recent hints that the rate of decline is slowing (the second derivative of negative growth) or even bouncing a little, world trade is still an area of significant concern.  Additionally, there remain a number of weaker economies (the Baltics, Spain, Ireland and Hungary among others) which could precipitate a currency and/or banking crisis at any moment.

2)    U. S. government commitments to the financial system bailout now total around $10 Trillion and perhaps more.  At this point we appear to have a two tiered banking industry, with most smaller banks reasonably well capitalized, though closures of the worst continue on a weekly basis, and a number of larger banks in the intensive care ward.  Both Chairman Bernanke and Secretary Geithner have said that these larger banks will not be allowed to fail, though additional capital may be required at some point.  The Treasury has committed to bet $1 Trillion of the FDIC’s credit on a public private investment plan (PPIP) designed to fix the balance sheets of the large wholesale banks.  Secretary Geithner has indicated that a primary focus of this plan is to restore the function of the securitization markets.  As we indicated last fall, the loss of these markets has had a far greater impact on credit contraction in the U. S. than credit tightening by the banks.  In fact, politics aside, indications are that the banks have been lending more to consumers, not less, since the crisis began.

consumer-loans

The primary unresolved issue with the big banks is whether there has been an impairment of their capital large enough to wipe out shareholders and potentially some of their unsecured creditors as well.  The PPIP is predicated on the belief that mark to market accounting has forced the banks to write down mortgage assets to levels below their ultimate realizable values and that, by stabilizing these values through injection of federal guarantees; the major banks will be able to fix their balance sheets and return to their normal businesses (primarily wholesale lending, trade finance, securitization of consumer loans, mortgages and other assets, and trading of derivative contracts).

A lively debate has developed over this point, with many observers convinced that the PPIP plan (combined with the earlier AIG bailout) is an outright subsidy to the banks, without compensation to the taxpayers.  As a result, a real question exists as to whether Congress will be willing to commit additional budget dollars when the fast dwindling TARP funds run out.  To prepare for this eventuality, Treasury and the Fed have asked for new authority to place major financial holding companies into receivership in the event of insolvency.  Additionally, trial balloons are being floated to test the possibility of a forced debt for equity conversion at some of the big banks similar to that now being push for GM’s bondholders.

Our view is that the wheel is still in spin with regard to the financial solvency of some of the larger banks.  With residential mortgage defaults still working their way through the system, there are at least three major categories of bank loans at risk:

a.    Credit card receivables.  Delinquency rates are at historic highs and expectations are for further deterioration through 2009.

b.    Commercial mortgages.  Leon Black, one of the most successful distressed asset investors, recently projected it will cost the banking industry $2 Trillion to clean up losses from commercial real estate problems.

c.    Leveraged loans.  Leveraged lending peaked in 2006-2007 at the zenith of the buyout boom.  Many of these loans were made on relatively short terms and will be coming due or moving into a period of rapid amortization over the next two years.  While some of the larger loans have most likely already been haircut under mark to market rules, many others are being treated as level three assets held to maturity and have likely not yet sustained any impairment.  Many of these will eventually default, particularly if the recession drags on into 2010 or worsens further.

Countering these negatives is the strongly positive yield curve being maintained by the Fed.  This is the perfect environment for bank profitability, leading some bankers such as Jamie Dimon of J. P. Morgan Chase to argue that they will be able to earn their way out of these issues, given a reasonable amount of time.

3)    The U.S. economy is far from healed.  Consumer confidence may have bounced at the bottom, but remains at historical lows

consumer-confidence

U. S. consumer spending was in free fall at the end of January and, based on today’s surprise report to the downside, has likely not improved much since.

retail-sales

The decline in U. S. manufacturing at the end of February was even more dramatic:

manufacturing

We previously predicted that yearend financial statements would cause significant stress in companies’ relationships with their banks.  This chart below, produced by Randy Schwimmer of Churchill Financial in their On the Left newsletter, shows Q4 results for selected firms financed with leveraged loans, as well as the dramatic impact in terms or renegotiated covenants and likely interest rate increases as well.

leveraged-loans

There is nothing in this picture that supports the cheer seen in the stock market in recent weeks.  As we have written previously, the real issue that must be addressed if the economy is to recover and resume its growth is the dramatic overleveraging that has occurred since the 1990’s.  Far from addressing this issue, the Administration’s bailout plans are calculated to maintain this high level of borrowing, which hit a new record of 3.7 times GDP in Q4 of 2008.

credit-market-debt

Notwithstanding all these negatives, an enormous amount of financial stimulus have been injected into the U. S. economy over the past four to five months.  Additionally the Obama administration’s fiscal stimulus package is just now beginning to flow into the economy.   With normal lags, this is likely to begin to have an impact on the economy in the next few months.  We expect to see some near term improvement in economic activity in some sectors.  This should not be confused with the end of the economic malaise; that will only come with the deleveraging of overstressed consumer balance sheets, which will likely take several years.  In the meantime, a better tone in the financial markets may present a short window of opportunity for companies to clean up their balance sheets through refinancing, loan restructures and asset sales.

It’s Raining; Has Your Banker Asked for the Umbrella Back?

Posted by John Slater on April 13, 2009

The old saw goes “a banker is someone who lends you an umbrella when the sun is shining and asks for it back when it begins to rain.” It’s certainly raining now and we are working with a number of clients who are in danger of losing their umbrellas. My partners Stan Cutter and Mike Zook have recently published a very insightful article which addresses some of the issues companies are facing with their banks. One of their key points: you may be in trouble even if your company is performing well, if your lender is in trouble or has recently been sold. We’ve reproduced the article in its entirety below:

Is Your Company Ready to Face Financial Institutions in a TARP World?

By Stan Cutter and Mike Zook

What is your strategy if your bank calls and invites you to find a new lender? One of our customers recently met with their banker to find that their loan renewal would have substantially different provisions. The Bank requested:

* Higher collateral levels,
* Lower availability,
* An interest rate floor provision,
* Increased fees for changing the agreement.

Another customer was told to raise more equity before the bank would renew the loan!

Risks and Opportunities of Credit Restructuring Issues

Today’s credit environment is characterized by market turbulence, bank consolidation, markets in disarray and increased regulatory scrutiny. Many companies find themselves weathering the storm although business is not as good as they would like. But, even if every interest and principal payment has been made on time and there is no apparent reason for concern, the onset of credit restructuring issues can be sudden.

Companies and managers need to understand the risks and opportunities surrounding the financial markets’ impact on capital availability. While most often the impact is felt through banking relationships, the impact extends to other financing sources and can affect the company’s liquidity.

As the new year begins, your annual financial statements are with your accountant and they will be sent to the bank as usual. You expect no reaction, but perhaps your bank has gone through some changes:

* Have they applied for TARP funds?
* Have they merged or consolidated with another bank?
* Has their credit quality declined?
* Has your banking officer changed?

If any of these are true, you may want to prepare for potential changes in your banking relations.

Credit agreements are legal contracts that have a number of provisions which may affect your business during this turbulence:

* Is your company within stated covenants?
* Are your company’s minimum equity requirements met, or is the value of your collateral still sufficient?

If you do not understand the consequences of not meeting any of these provisions, you may be surprised by your bank’s reaction.

The Era of “Easy” Corporate Banking is Over

Needless to say, the credit environment has changed and it is likely that your bank will ask for substantial changes to the agreement if anything is out of compliance. The era of “easy” corporate banking has come to an end and banks have tightened their credit standards. In addition, the bank may not have full control over the decision as regulators may have caused the bank to re-examine its portfolio and lending practices.

Recent discussions with bankers have revealed several concerns which play in their credit decisions:

* Is the client or prospect strong enough to survive a prolonged downturn?
* Is the company proactively managing the critical factors in its business?
* Is the company’s Balance Sheet reflective of a financially well managed firm?
* Are there multiple ways to repay a loan beyond cash flow from the business?
* Will making a loan be profitable to the bank?

The banker translates these thoughts into a financial analysis, often historical, to seek answers, and to lead discussions with the company. A ratio analysis of the company’s historical income statement and balance sheets will be compared to others in the industry.

This financial analysis will eliminate or greatly reduce any inaccurate perceptions about the company’s performance. It will direct the banker into specific areas for questioning management and will look to formal plans and benchmarks for the company to overcome prior to a loan being made.

If the banker decides to move forward, the covenant, collateral structure, and the loan amount will be driven by the same analysis and designed to prevent the company from going too far astray. Loan pricing also will reflect the economic times and allow the bank a profit, even if prime rates fall to new lows. The banker may use an interest rate floor to protect himself as rates drop.

Proactive Companies Must Move to Understand Their Liquidity Position

This is not good news. Proactive companies move to understand their liquidity position, though liquidity planning is not usually part of the budget process. Budgets predict revenues and related costs to make sure they are in alignment, but liquidity planning centers on the operating cash needs of the company in comparison with its capital plans and budgets. If there is not enough cash, then budgets must be changed. If a faulty assumption is made about a banking relationship, the results may be devastating.

In-Depth Financial Analysis Can Better Position a Firm’s Capital Structure for the Future

A financial review is a proactive, analysis based plan for the company’s liquidity whose foundation is an interactive review of the company’s budgets, plans, operations and sales expectations. In addition to reviewing the company’s liquidity position, it also reviews the financing alternatives available to the company. The in depth analysis can review covenants to insure compliance over the budget period.

The results of the review may suggest that the company prepare for tough banking discussions, or to seek an additional banking relationship. The review also may suggest other financing sources that might bring capital to the company. There are active mezzanine lenders and minority equity investors who might support the company if the plans and opportunities are of sufficient size or materially change the company’s position.

How Much Risk is the Treasury Really Assuming from the Financial Institutions? (Part 2)

Posted by John Slater on April 8, 2009

Our previous post raised the question of just how much risk is being assumed by the U. S. Treasury with its apparent implied guaranty of the unsecured obligations of the major financial institutions.  We asked whether the $188 Trillion (notional amount) of derivatives transactions on the books of four major banks (J. P. Morgan Chase, Bank of America, Citibank and Goldman Sachs) could potentially pose risks not fully understood by the banks or their regulators.

In evaluating the potential risks inherent in the derivatives positions of the banks (and more particularly at the risks of the Credit Default Swaps (CDS), it is necessary to look at the one situation where similar risks have been converted to real losses: i.e. AIG Financial Products (AIG FP).   Chris Whalen of Institutional Risk Analytics has done so in depth in a recent article posted here.

Mr. Whalen paints a picture of financial instruments created for the purpose of enabling financial as well as non-financial companies to falsify their earnings through the issuance of insurance contracts calculated to remove certain assets and liabilities from companies’ books and by doing so to bring them into compliance with regulatory capital requirements or shift earnings and losses between reporting period, with the presumed intent of manipulating the equity prices of the counterparties.  He further asserts that these ostensibly “economic” transactions were converted to blatant fraud through side letters never disclosed to company management, auditors or regulators that absolved the writers of these contracts from responsibility for honoring their commitments.  These activities are further described as the essence of the SEC’s charges against AIG in a Complaint brought against AIG in 2004.

In broad strokes Mr. Whalen then concludes that AIG FP changed its business practices around 2004 to absent itself from issuing insurance products of the type described above.  Instead Mr. Whalen suggests that AIG FP pursued the Credit Default Swap market as an alternative mechanism to accomplish similar goals:

“It appears to us that, seeing the heightened attention from regulators and federal law enforcement agencies such as the FBI on side letters, AIG began to move its shell game to the CDS markets, where it could continue to falsify the balance sheets and income statements of non-insurers all over the world, including banks and other financial institutions.”

Whalen goes on to raise substantial questions as to the enforceability of the AIG CDS contracts:

Are the CDS Contracts of AIG Really Valid?

The key point is that neither the public, the Fed nor the Treasury seem to understand is that the CDS contracts written by AIG with these various non-insurers around the world were shams - with no correlation between “fees” paid and the risk assumed. These were not valid contracts as Fed Chairman Ben Bernanke, Treasury Secretary Geithner and Economic policy guru Larry Summers claim, but rather acts of criminal fraud meant to manipulate the capital positions and earnings of financial companies around the world.

Indeed, our sources as well as press reports suggest that the CDS contracts written by AIG may have included side letters, often in the form of emails rather than formal letters,  that essentially violated the ISDA agreements and show that the true, economic reality of these contracts was fraud plain and simple. Unfortunately, by not moving to seize AIG immediately last year when the scandal broke, the Fed and Treasury may have given the AIG managers time to destroy much of the evidence of criminal wrongdoing.

Only when we understand how AIG came to be involved in CDS and the fact that this seemingly illegal activity was simply an extension of the reinsurance/side letter shell game scam that AIG, Gen Re and others conducted for many years before will we understand what needs to be done with AIG, namely liquidation. Seen in this context, the payments made to AIG by the Fed and Treasury, which were then passed-through to dealers such as Goldman Sachs (NYSE:GS), can only be viewed as an illegal taking that must be reversed once the US Trustee for the Federal Bankruptcy Court for the Southern District of New York is in control of AIG’s operations.

Former AIG Chairman Maurice Greenberg is reported to have testified before Congress that AIG’s counterparty banks should be required to return a portion of the settlements they received from AIG following the Fed/Treasury bailout.  The Government Accountability Office has added to the chorus in its March 2009 report to Congress on the Status of Efforts to Address Transparency and Accountability Issues with regard to TARP, at page 61 of the report, recommending in part that:

Based on our previous work on government assistance to the private sector, as well as the Treasury Secretary’s position, as articulated in the Financial Stability Plan that government support must come with strong conditions, Treasury has an opportunity to take additional steps to strengthen its agreement with AIG by requiring AIG to seek to negotiate concessions from management, employees, and counterparties, as appropriate, before the agreement is finalized. For example, Treasury could require that AIG seek to renegotiate contracts with its employees, such as existing contracts similar to the contract for retention bonuses with AIG Financial Products’ employees, and with existing counterparties that would face substantial losses were AIG to have its credit downgraded or fail. While we understand that Treasury is making an investment in AIG, Treasury’s failure to act in this instance could cause additional harm to its repute and impair its ability to seek additional funding for TARP that might be needed in the future.   (Emphasis added)

It seems apparent that, whether through a forced bankruptcy proceeding in which the Trustee seeks return of the settlement amounts under the Fraudulent Conveyance provisions of the Bankruptcy Code, or through political pressure on AIG’s counterparties similar to that applied to AIG’s executives with regard to their bonuses, a great deal of pressure is building for AIG to unwind the payments made to its counterparties in settlement of the CDS transactions.  It is yet unclear whether AIG took full advantage of the setoff opportunities and other loss minimization techniques outlined by the Comptroller of the Currency-Administrator of National Banks in its quarterly report on Bank Trading and Derivatives Activities-Fourth Quarter 2008 which are discussed in detail in our prior post on the subject.  As of April 7 these issues were reported to be under investigation by Neil Barofsky, the Treasury’s Special Inspector General for the Troubled Asset Relief Program.

Unwinding these payments would have serious implications for a number of financial institutions, both domestic and foreign.  As Tyler Durden reported last month, $49.5 Billion had been paid out to AIG counterparties either directly by AIG or through the Fed’s Maiden Lane III facility.  A required repayment of these funds could be particularly troublesome to Goldman Sachs where credit exposure to swap transactions ballooned in Q4 2008 to more than 1000% of Risk Based Capital.

CDS Risk

For more information on this subject see Tyler Durden’s recent article here.

Finally, in addition to the direct impact of a potential unwinding of the AIG CDS contracts, there remains the larger issue raised by Chris Whalen: i.e. the potential unenforceability of many CDS contracts as a result of secret side letters.  The OCC’s rationale for minimizing the potential credit exposure of derivative transactions to the financial institutions depends in great part on their ability to set off obligations to particular counterparties against balancing transactions.  In the event contracts are held unenforceable as a result of side letters or other defects in their execution, the setoff rationale would no longer hold true and the overall exposure could be far greater than currently assumed.  Presumably the Special Inspector General will be exploring these issues during his investigation.  Should this activity prove to be pervasive and should these letters and emails extend beyond AIG to its counterparties, we could find the $16 Trillion notional amount of CDS contracts issued by the major financial institutions becoming a major Achilles Heel for the Treasury/Fed/FDIC’s efforts to save the wholesale banks.

How Much Risk is the Treasury Really Assuming from the Financial Institutions?

Posted by John Slater on April 7, 2009

What does it really mean to talk about saving “the banks”?  The Treasury would like us to have a mental picture of Jimmy Stewart in It’s a Wonderful Life, protecting the savings and mortgages of the good citizens of Bedford Falls.  In truth, for all material purposes, the current Public Private Investment Plan (PPIP) is about saving four mammoth financial institutions considered too big to fail, BankAmerica, Citicorp, J. P. Morgan Chase, and Wells Fargo.

These financial behemoths, each as large as a significant number of the world’s national economies, bear as much relationship to the Bedford Falls Building and Loan as a rowboat does to the Titanic.  For public consumption, however, it is convenient for the Treasury to continue to describe its efforts as a rescue of “the banks”;   rescuing hydra-headed financial giants just doesn’t have quite the same ring.  Additionally by lumping these institutions under the category of “banks” the Treasury can continue the fiction that the bailout is about “getting the banks lending again.”

Notwithstanding this fiction, as we showed last week, even Secretary Geithner has abandoned the pretense that the PPIP program is about encouraging direct bank lending in the traditional sense of taking deposits and making loans, admitting that the primary purpose of PPIP is to restore the strength of these wholesale institutions so that they can restart the private securitization markets that fueled the credit bubble earlier in the decade.  So here’s the plan.  Just remove the toxic assets from the books of the financial giants and the system will be restored to its former picture of robust health.  Hopefully the PPIP will be sufficient to fund the fix.  If not the Treasury can use its proposed new liquidation authority, invest few hundred billion dollars more to fill the gaps and sell the freshly minted “clean” institutions to the capital markets for a premium.

On its face this appears to many to be a rational bet.  With the survival of the financial system at stake, risking a few hundred billion more to clean up the banks would indeed be far less costly than another liquidity crisis like that surrounding the Lehman collapse.  Unfortunately this calculation omits one major element of risk that has the potential to increase the cost of the bailout beyond even the capacity of the Treasury to fund: i.e. the derivatives portfolios of the major banks.

Last week the Comptroller of the Currency – Administrator of National Banks issued its quarterly report on Bank Trading and Derivatives Activities – Fourth Quarter 2008.  In reviewing the report, several things become quickly apparent.

1.    Derivatives Trading is a really big business; the notional amount of all derivatives positions at all U. S. commercial banks and trust companies that participate in this business was slightly more than $200 Trillion on December 31, 2008.  That’s more than three times Gross World Product which the CIA estimates to have been a little over $62 Trillion in 2008.

2.    Over 93.7% ($188 Trillion) of this gross exposure was held by only four bank s, J. P. Morgan Chase, Bank of America, Citibank and Goldman Sachs.  One institution, J. P. Morgan Chase, accounted for $87 Trillion of the total exposure or approximately 140% of Gross World Product.

3.    While the bulk of the exposure ($181 Trillion) was in the “traditional” derivatives markets, interest rate and FOREX swaps, almost $16 Trillion was in Credit Default Swaps, up from $1 Trillion in such transactions five years earlier.

4.    What had once been a very profitable business for the major banks, turned decidedly sour in 2008, with net reported trading losses of $836 million for the year as compared with profits of $5.5 Billion in 2007 and $18.8 Billion in 2006.  Drilling down to the details, Credit Default Swaps generated losses for the banks in 2008 of $12.6 Billion, more than offsetting gains for the year in Interest Rate and Foreign Exchange trading.

The OCC report provides a lengthy explanation as to why the notional amounts dramatically overstate the risk posed to the system by these contracts.  First, the real credit exposure is not the notional amount of the contract, but the amount that the market has moved from the strike price of the swap: i.e. the net amount the counterparty would be obligated to pay to true up the contract based on current market conditions.  This is referred to as the Gross Positive Value (GPV) of the contracts.  Since this GPV is in effect an unsecured claim against another financial institution, it represents a credit risk to the holder of the claims.  At yearend total GPV held by U. S. commercial banks was $7.1 Trillion.  Actual credit exposure was much lower, however, as the holders have the legal right to set off this exposure against certain of their counter exposures to the obligor institutions (Gross Negative Fair Values).

The netted credit exposure was estimated to be only $800 billion.  Added to this was Potential Future Exposure of $782 Billion based upon the amount by which the contracts could move in favor of the obligee banks to generate a Total Credit Exposure of $1.58 Trillion.  For the top five derivatives trading banks (the four above plus the U. S. operations of HSBC) total credit exposure averaged 489% of the institutions’ Risk Based Capital at the end of the fourth quarter.  At one bank, Goldman Sachs, credit exposure was more than 1000% of Risk Based Capital.  To be fair this calculation does not take into account pledged collateral backing a portion of the credit risks, which the OCC estimates as typical averaging 30-40% of the exposure amounts, so actual credit exposure was presumably somewhat lower.

By now your head may be swimming a little.  Mine certainly was as I worked to puzzle this out.  These are very large numbers.  Notwithstanding the OCC’s implication that all of this exposure is well managed and under control, I am reminded that we heard similar assurances with regard to subprime loans and CDOs, not to mention AIG’s Credit Default Swap portfolio.  The closest analog we can observe (AIG Financial Products) does not provide much comfort.  Apparently AIG FP had Credit Default Swap exposure of $440 Billion out of total derivatives exposure of $1.6 Trillion.  To date the AIG mess has cost the Treasury/Fed approximately $170 Billion to clean up.  With bank Credit Default Swap exposure in the aggregate reported at 36 times AIG’s CDS exposure, how much risk are the Treasury/Fed/FDIC actually assuming if they take on the unsecured debts of the big banks as they seem increasingly committed to do?  While I draw some comfort from the OCC’s explanation of netting and other factors limiting bank exposure on these volatile instruments, I am left with the nagging concern that there may ultimately be more risk here than meets the eye.   Absent more facts to the contrary, I’m reminded of the immortal words of Judy Garland as Dorothy Gale, “Toto, I’ve a feeling we’re not in Kansas anymore.”

Geithner Told it Straight (But you really had to listen)

Posted by John Slater on March 29, 2009

This morning (March 29) Treasury Secretary Geithner appeared on Meet the Press to explain his plan for rescue of the financial system.  He described a series of actions to not only fix the banks, but to get the securitization markets working as well.  For perhaps the first time we heard a (relatively) clear rationale explaining how the Treasury expects the toxic asset rescue plan to lead to the restoration of credit for consumers and entrepreneurial business.

The interview started with an explanation of the difference between bank lending and securitization.  Per Geithner, “Typically somewhat less than half of lending for business and consumers comes from the securitization markets.”  As I have written previously the current financial crisis was created by an explosion of debt to unsustainable levels in great part through the mechanisms of the shadow banking system, which includes the securitization markets.  This created a massive amount of liquidity, much of which was not captured in traditional measures of the Money Supply.  The collapse of these mechanisms beginning in August 2007 created the credit crunch.  Sec. Geithner believes that, until these non-bank markets are restored, the financial system can’t be fixed.

There’s been much loose talk in the media claiming that lending to small business entrepreneurs can’t be restored until the toxic assets come off the balance sheets of the banks.  Here is what Geithner said on the subject of the toxic asset bailout:

“This is a better way to get these markets working again.  Let me just      step back for one second.  What we’re trying to do is get the entire financial system – our complicated financial system - working again so that we get credit where it needs to go in the economy.  And that requires strengthening our banking system.  It requires making sure there is enough capital in the financial system to withstand a wider and deeper recession.  And we’re going to make sure that capital comes with conditions to make sure that banks restructure; that there’s accountability for boards and management; that the firms emerge stronger, not weaker; and that there are tough conditions to protect the taxpayer.  That is a critical part of what we’re going to do.  But our system is much more complex, depends on more than just banks.  So we have to do things to get these markets working again by providing financing directly to those markets that small business, consumers depend on.”  (emphasis added)

So what does this really mean?  The last sentence above clearly states that the toxic asset rescue will do nothing directly to encourage small business and consumer lending.  That’s a job for TALF.  The bottom line is this.  The Treasury believes that a restoration of the securitization markets is critical to restore lending by non-bank lenders.  Securitization is the province of a few big banks in New York.  Two of these, Goldman Sachs and Morgan Stanley, have said they don’t need further help from the government.  So basically the task at hand is to save the other major players (primarily the four biggest banks) on which the securitization markets depend so that they can restart the merry-go-round.

Underlying all of this is a bit of sordid history.  Securitization is essentially an agency function.  Prior to the repeal of Glass-Steagall, securitization was conducted by investment banks, which were limited by their (relatively) small capital bases from taking on significant principal risk.  They bought loans for short holding periods during which the bankers and lawyers packaged the loans and quickly sold them off to investors.  If they got caught short and couldn’t unload the paper, they were soon out of business or merged into a larger player.

By the late 1990’s Wall Street had found these limitations to be too constraining.  As the instruments became more and more complex, it became more and more difficult to market the riskiest portions of the loan packages (the “toxic waste”).  If the toxic waste couldn’t be sold, there would be no deal.  No deal meant no commissions.  And no commissions meant no bonuses.  The repeal of Glass-Steagall enabled an ingenious solution.  Where the investment banks had no choice but to unload the toxic waste because there was no place to hide on their balance sheets, the major money center banks had much larger and deeper balance sheets and complex corporate structures with multiple regulators.  Aided and abetted by the invention of credit default swaps, which enabled the pooling of toxic waste into “investment grade” securities which could be sold to third parties or into off balance sheet conduits created and managed by the banks, the major players in these markets dramatically ramped up the securitization engine between 2003 and 2007, fostering the housing bubble.

While much of this activity was not conducted directly by the banks, the bulk of it was ultimately for the account of bank lenders, which in effect supported proxy institutions in the securitization market through lines of credit and asset purchases.  This appears, for example, to have been the case with Bank of America’s support for Countrywide mortgage.  When the music stopped, the biggest non-bank participants were quickly rolled up into the major banks (Countrywide and Merrill into Bank of America and Bear Stearns into J. P. Morgan).  The toxic assets the Treasury is now proposing to deal with through its bailout plan are the detritus of the securitization collapse that these banks could not unload on third party investors when the music stopped in the fall of 2008.  This was confirmed by Lloyd Blankfein of Goldman Sachs following last week’s meeting between the big bank heads and Pres. Obama, when he was asked whether Goldman would be selling assets into the new program.  His response was that with its business model Goldman didn’t have much exposure to that type of consumer assets and what they did have had already been marked to market.  I. E. Goldman (and likely Morgan Stanley as well) stuck to their knitting as investment bankers, quickly moving the paper they had created off their balance sheets and did not retain the types of principal risk taken on by the big banks.

More than half of U. S. banking assets are held by four banks that are also major players in the securitization markets: Bank of America, Citigroup, J. P. Morgan, and Wells Fargo.  Almost certainly a far larger percentage of the securities and loans that will be purchased from U. S. based banks under the toxic asset plan will be from the balance sheets of these four institutions.  If you believe that these new multibillion dollar conduits created by Treasury are going to be purchasing bad subdivision loans to clean up the balance sheet of Podunk Thrift Bank for Savings to enable it to make loans to local businesses, then I’ve got a bridge in Brooklyn I need to sell you.

So why, you might ask, should we be willing to put the U. S. Treasury on the line for $1 to $2 Trillion to bail out these banking behemoths?  Sec. Geithner’s answer today is that we must save the banks to restart the securitization engine.  What he doesn’t say, but which is likely far closer to the truth, is that the government is deathly afraid not to.  An outsized percentage of outstanding corporate debt was issued by the major bank holding companies.  When the government allowed a comparatively smaller player (Lehman  Brothers) to fail, the world’s financial markets ground to a halt.  Geithner’s unspoken answer:  we’ve got to bail out the bondholders of the big banks because their failure will crater the system.  Since it’s politically impossible to do so directly, we’ll do so by allowing these banks to unload their underwater assets on the Treasury.  We’ll dress it up by getting a few friendly institutions (many of which will likely be big holders of corporate debt) to take a small slice of the risk so we can put the pricing decision on them rather than the Treasury.  Once the big banks are cleaned up, they can again raise money in the capital markets and we can depend on them to again create a vibrant private securitization market so that the merry-go-round can again turn.

All of this makes me profoundly uneasy, but I am not sure that there is a good alternative to bailing out the creditors of the big banks.  There may well be no other way to avoid the chasm of economic collapse than to bail out the debt holders of the big banks.  To not do so could irreparably damage the U. S. standing in the world capital markets.  I do object to selling this plan as being necessary to “get the banks lending again” or to provide liquidity to entrepreneurs.  That’s not what this plan is about.

The powers that be hope to sell this plan without an honest public debate over its real implications for our economy and society.  Inherent in the Geithner plan are a number of assumptions, which are presented as givens not open for discussion.  At a minimum the following questions need airing and extensive public debate:

1.    Is a banking system in which more than 50% of the assets are controlled by four institutions good for the economy, the political system or the social fabric of America?

2.    Should the taxpayers ever be called on to preserve the equity value of the shareholders of insolvent private entities?

3.    Should the Treasury be committed permanently to an implied guaranty of the debt (as opposed to consumer deposits) of “systemic” financial institutions and, if so, is there a regulatory structure that can be created that is adequate to protect the Treasury from the need to conduct similar bailouts in the future?

4.    Is a system in which 50% of credit is created through securitization healthy for the long run stability of the economy?  Do we have regulatory and monetary tools in place that can deal with the impact on the larger economy of the market swings inherent in such financing?

5.    Is our focus on the big banks preventing the allocation of capital to those institutions (community and regional banks) that have traditionally provided most of the financing for entrepreneurial businesses?

Let’s do what it takes to save the economy, but not at the cost of an open democracy.  It’s time to demand a debate over the real issues at stake, rather than blindly accepting the PR smokescreens of those with trillion dollar vested interests in the outcome.

We’re The Marks

Posted by John Slater on March 17, 2009

From Dictionary.com

Def. Mark - noun

15. b.   Slang.  the intended victim of a swindler, hustler, or the like: e.g. “The cardsharps picked their marks from among the tourists on the cruise ship.”

It’s midnight in Vegas.  A somewhat paunchy fiftyish guy from the Midwest has just sauntered over to the poker table.  With a bourbon in his right hand and a party girl on his left arm, he stumbles slightly before announcing “mind if I join you guys?”  The player with the dark glasses looks up briefly, mumbles something unintelligible and looks back at his cards.  The one in the cowboy hat says “howdy partner, glad to have you”.  Our hero throws his chips on the table and takes his seat.  “Boy I’m feeling lucky tonight.”

Guess who’s flying back to river city tomorrow with a lot fewer chips than he came with?

Uncle Sam stumbled into the world’s highest stakes casino last fall.  He didn’t know how to play the game, but he certainly knew how to raise the table stakes.  Nothing that has happened since then increases my confidence that the U. S. of A. will be leaving this game as a winner.

This morning Andrew Ross Sorkin of the New York Times was on Morning Joe making the case for payment of the AIG bonuses.  His core argument in an article in Tuesday’s Times is that we can’t ignore contractual rights just because they’re not politically popular.  To do so would cause untold damage to the American economy.  On Morning Joe Andrew was brave enough to take the even more unpopular position that the partially nationalized financial institutions must pay up to hire good people or the smart guys at Goldman, et. al. will clean their (and our) clocks.

That this has suddenly become a major political issue should come as no surprise to anyone.  As I said in this posting published February 15:

The big banks have tens of trillions of dollars of credit default swaps and other risk positions on their books. It’s not hard to picture recruiting calls going out from hedge funds and other trading firms not subject to the new law offering the best and brightest traders highly incentivized deals to move from the big banks to begin trading for these non-regulated firms. These traders will come armed with extensive knowledge of their former employers’ investment positions and will have every incentive to take advantage of that knowledge at the expense of their former employers and ultimately at the expense of the taxpayers who will likely soon own the big banks. And they’ll be trading against bank employees happy to take a comfortable salary and a 50% stock option bonus.

The stakes in this game aren’t millions, but trillions of dollars of taxpayer money. Odds are we just bet on the wrong champions.

An old saw on Wall Street goes like this.  “What’s the best way to end up with a $1 million account?  Start with a $10 million account.”  The Treasury and the Fed are starting with a $10 Trillion account, which they have placed on the line at the great Wall Street casino.  They clearly don’t have enough talent in house that knows how to play the game.  Even worse a political consensus is building that will block them (and their proxies at AIG, Citigroup, Bank of America, et. al.) from hiring people competent enough to play in the big leagues against the world’s best and brightest.

It is naïve indeed to think that the political and media demagogues will be any more forgiving of a government controlled bank that pays a star derivatives trader a salary of $20 million, than they are to see her earn that as a bonus.  Yet that’s what top traders earn in what is likely the most complex market ever invented by the mind of man.  If we’re not willing to pay these stars what it takes to attract them to the government owned banks, then they will most certainly be working for the competition and the competition will win.

There’s a lot of anger building over AIG handing $7-12 billion to Goldman to settle derivatives contracts.  Imagine how much anger there will be when the public learns in a couple of years that the government’s mismanagement of the major financial institutions has caused not billions, but trillions, of dollars of new losses from naïve and ill timed trades, made, not on the watch of “former management”, but under the noses of their new Treasury overlords.

There’s no way that we the people are going to win this game.  Continuing to use public funds to trade these treacherous markets is a course guaranteed to lead to a disaster on a scale that makes everything we have seen to date pale by comparison.  It’s time for the Treasury and the Fed to run, not walk, for the exit and demand that the institutions under their control cease these dangerous trading activities immediately.

Beware the Ides of March

Posted by John Slater on March 1, 2009

We won’t be seeing bloody togas on the Senate steps, but there will be great pain and destruction in the American business community.  There’s an annual ritual which starts in March and generally goes through sometime in April, in which tens of thousands of private companies, the heart blood of the American economy, deliver their annual audits and reviewed financial statements to their banks.  For many the results will not be pretty.

In the fourth quarter of 2008, firms throughout the manufacturing, retail and distribution economy, and likely in a number of other sectors as well, were hit by a strong downdraft precipitated by the credit crunch of September and October.   Many of these companies sustained a precipitous drop-off in revenues and resulting operating losses for the quarter.  Others may have seen a dramatic decline in the value of their inventories, particularly if they were in industries dependent on volatile commodities or imported raw materials.  The bottom line is that many companies will report a loss for the fourth quarter and a substantial number for the full year 2008 as well.

Contrary to current opinion, banks don’t like to take losses and will do everything in their power to avoid doing so.  Until now banks have been relatively lenient with their commercial borrowers other than in industries related to residential construction, where the reality of losses is too obvious to be ignored.  Unfortunately for their borrowers, however, banks are subject to strict accounting rules and answer to regulatory supervisors that demand that action be taken to head off potential loan losses.  Delivery of the 2008 annual audits and reviewed financial statements will make the potential for problems all too obvious.

Partially in response to the CRA (Community Reinvestment Act), within the last ten years many banks began to apply credit scoring and other “objective” financial modeling to their credit analysis and management.  As the 2008 audits are plugged into these models, it will become quickly apparent that many, if not most, borrowers have not hit the financial projections on which their loans were based.  We are already seeing this with companies that depend on asset based loans and report on a monthly rather than quarterly or annual basis.  Many such companies are now in “negotiation” with their lenders, which are demanding higher interest, more collateral, loan reductions and more.  In such situations the borrower’s first response is layoffs, salary reductions and plant closings, further exacerbating the economic decline.  For many lenders this will not be enough.  Companies that do not act quickly and aggressively to shore up their balance sheets are in great peril.

Adding to the problem is the tremendous loss of wealth among the owners of small and medium businesses.  Frequently their lenders rely on guarantees backed by personal financial statements composed of stock portfolios, investment real estate and other assets, the value of which has declined precipitously in the market collapse.  We are aware of a small business lender that was forced to shut its doors when the owner’s stock portfolio dropped by 50% and the bank pulled its credit line.  The collateral damage impacted scores of small borrowers.

Perversely TARP has increased the likelihood that the scenario described above will result in more, not fewer, declarations of default and resulting business bankruptcies and shutdowns.  Troubled banks cannot afford losses, lest they fall below minimum capital requirements and become the subject of unwanted regulatory attention or even takeover by the FDIC.  However, once a troubled lender is recapitalized or acquired by a stronger bank, it has the breathing room to take strong actions to clean up its portfolio, particularly if those losses are covered by a guaranty from the Treasury.  Rather than working with borrowers, the recapitalized bank may elect to move quickly to cleanse its balance sheet through rapid write-offs, declarations of default and foreclosures.  In the process jobs, productive capacity and wealth are destroyed.

Much discussion is heard about the “other shoes” left to drop for the banks.  Those that have gotten some exposure include leveraged loans ($3 Trillion to be refinanced over three years), consumer credit and commercial real estate ($560 Billion in the U. S. over three years).  Little if any attention has been given to small and medium business loans.  Yet in an economy that depends on small business for 75% of job creation, this “shoe” will feel more like a pair of hobnail jackboots to the thousands of SMBs (and their employees) about to be crushed under foot.