Henry Kaufman's Mistaken WSJ Editorial

Henry "Dr. Gloom" Kaufman wrote an editorial in the Wall Street Journal on Wednesday in which he makes some serious errors in his diagnosis and prescription for the current credit market dilemma.

One could write chapters on all the detailed issues involved, but it really boils down to just a very few points.

Kaufman is correct to note that debt instruments- e.g., CDOs, credit derivatives- have become much more complex than those which predominated credit markets in 1987 or 1998. However, he is wrong to suggest that, because so many quants at hedge funds have modeled relationships between the instruments, and ignored the potential for markets for these instruments to vanish, the Fed and other authorities need to add/improve/modify regulatory frameworks and procedures.

In truth, I am, and you should be, thankful that commercial banks no longer bear so much of the rate and default risk, due to portfolio lending, that they did as little as a decade ago. The same securitization of assets, such as home loans, credit card receivables, and corporate loans, that have resulted in the CDOs and credit derivatives which Kaufman views negatively, has largely insulated commercial banks from dramatic losses in value of the underlying loans.

To the extent these banks have lent to private equity or hedge fund firms, whose assets, some of which may be complex, risky assets, then, yes, they are still liable for some risk.

However, in the past decades, we have seen the movement of loans from bank balance sheets, where they used to be the subject of dubious reserve and loss recognition treatment, to the marketplace, where their prices and risks are now determined by buyers and sellers.

As such, in my opinion, the current situation is not that serious in terms of overall financial system solvency. Some borrowers misrepresented their ability to handle loans, and secured mortgages which they probably should not have been given.

Some mortgage brokers and lenders looked the other way, or not at all, while processing these sub-prime loans. Some financial engineers at investment banks packaged up these suspect loans into CDOs, and some unwise investors bought pieces of these CDOs, wrongly believing they were earning above-average returns for average-risk assets.

I don't own any CDOs. I don't know anyone who does.

It's my opinion that some large hedge funds, pension plans, etc., own a lot of CDOs which are backed by some sub-prime loans.

Those investors have lost a lot of value in the past few weeks, as market prices for such instruments have plummeted.

So what? How is this different than if they had bought badly performing corporate equity, foreign equities, foreign currencies, corporate debt of weak firms, etc.

Essentially, some large investors thought they could buy risk cheaply, and were wrong.

Better some hedge funds and pension funds lose value and, in the case of the former, go out of business, than our commercial banking system implode as those institutions hold bad loans in large amounts.

See, the beauty of the last decade's financial instrument innovations is that investors know they are taking risks with their money. Or ought to know. They don't receive deposit insurance, and have no guarantee of the return of their capital.

Commercial banks, on the other hand, do have deposit insurance, and guarantee those deposits.

Far better the suspect loans become property of investors with appetites for risk, than remain as collateral on the balance sheets of our large commercial banks.

In the end, this 'credit crisis,' to the extent there is one, involves large hedge funds, investment banks, and wealthy individuals. All of whom are sophisticated, and were capable of understanding the risks they took in buying assets underpinned by sub-prime mortgages.

The Fed might need to offer some temporary collateralized lending to commercial banks, in order for them to extend the time in which their hedge fund customers can repay short term loans. But overall rate decreases to bail out sophisticated investors is a mistake, and will only result in greater moral hazards going forward.

Other than very limited, temporary loans, at high rates, the Fed should remain on the sidelines during this period in which some large investors are realizing losses in their investment portfolios. Because, regardless of what assets are incurring those losses, the losses are the business of those managers and investors, not that of the general financial system.

How Rating Agencies Abetted The Sub-Prime Mortgage Situation

Yesterday's Wall Street Journal carried a fascinating article concerning how S&P's and Moodys' rating of so-called 'piggybacked' sub-prime mortgages, in 2000, led to today's credit turmoil.

Amazingly, the ratings agencies first allowed the CDOs backed by these mortgages to be investment grade, then changed their minds last year. It evidently took five or six years for S&P and Moodys to sample and test the payment history of such mortgages, leading them to downgrade them to junk status.

Now, as Wilbur Ross said on CNBC yesterday morning, nobody should simply blame a rating agency for their own bad investment decision. And I agree with that.

However, when buyers included institutions which could not buy those CDOs with today's ratings, but could earlier, you have to wonder how much the agencies' appetites for fees led them to inappropriately collaborate with the issuers, and look the other way over an obviously riskier type of home loan.

While issuers observed S&P guidelines for how much, apparently 20%, of a CDO could be sub-prime mortgages, over time, some just incurred the rating penalty and stuffed much more of the sub-prime originations into CDOs.

The result is something which I was not aware was now common- that CDO would contain a mix of types of home loans. Thus, evaluating these would have become a nightmare for any purchaser. And, again, thus why an S&P or Moodys rating became so important.

Unless, of course, the buyers should have perhaps just passed on paper like this at all.

And therein lies the lesson, per Wilbur Ross's comment which I quoted in yesterday's post,

"Rather than microscopically price risk correctly to the nth degree, CDOs have, instead, allowed originators to bury risk in amongst tranches of some portfolios of loans, and, in some cases, further mix them with other types of loans. That's not how the instruments were originally marketed, but that's how they now are used."

Adults who should have known better chose to buy this paper, to earn returns which they thought were not really all that risky.

Honestly, I am not at all sure the Fed should be doing much to bail these non-bank institutions out.

What Hedge Funds Have Not Learned Since 1998

As I have read more accounts of the unfolding turbulence in the credit markets, and its spillover into equity markets, a few cardinal lessons continue to loom large.

First, as I noted last week in this post on risk, there exist arcane, exotic debt instruments which, in many cases, simply have no market. No bids are available, and, so, the effective 'market' price falls to zero.

Second, to paraphrase Wilbur Ross, a self-made tycoon via conventional buying, improving and selling mundane businesses, and CNBC's guest host this morning,

'when someone mentions two words, financial engineering, you know it's really an attempt to underprice risk.'

I could not say it any better. Rather than microscopically price risk correctly to the nth degree, CDOs have, instead, allowed originators to bury risk in amongst tranches of some portfolios of loans, and, in some cases, further mix them with other types of loans. That's not how the instruments were originally marketed, but that's how they now are used.

As we see in the current market turmoil, risk has come to be defined by qualitative factors, such as a security not being a CDO, or having anything remotely to do with housing finance.

Third, despite the post-LTCM crises shift away from leverage usage by hedge funds, such usage has, it turns out, returned with a vengeance. Nothing like an up market to give comfort to even institutional investors, and sustain unwise, lax policies.

By using leverage again, these hedge funds have been caught on margin calls while holding hard-to-price exotic securities. Usually CDOs or other debt instruments.

Fourth, when many smart people pile into an investment style by starting hedge funds, borrow money, and use similar, programmatic trading models to hedge and invest, it is not surprising that, when risk becomes important, and some of the instruments used by these funds to hedge suddenly lack 'markets' into which to sell. The result is for those funds to essentially lose most of their value.

My partner asked,

"But what else should they have done to earn returns? What other options did they have?"

My response is that they were always excess supply in the investment world. Many large, sophisticated institutional and individual investors will now lose a lot of money because they chased a chimera- outsized returns with no perceptible incremental risk.

It's unclear whether, except under purely bull market conditions, these funds, with their similar automatic hedging programs, ever really offered sustainable excess returns over the market, for the risk they incurred.

Put lessons three and four together, and you get the new hedge fund whiz kids borrowing to the hilt to buy and hedge exotic instruments. Then, as the credit concerns began to erode the value of those instruments, all of these funds began to try to unload the same types of instruments, causing a failure of markets for them. It's a sort of perfect storm for hedge fund mismanagement.

A few thoughts on the markets, risk, and fund management during a day in a week of yet more equity and debt market turmoil.

More to follow......

More On Female Business News Network Anchors: Who Really Likes Liz Claman?

Yesterday, I wrote about former CNBC anchor Liz Claman's much-desired departure from that network last month. I wrote, in part,

"I have found Claman to be ill-informed and of no particular added value to any business topic which she covered. Her interviews with people like Warren Buffett are notable for their cloying obsequiousness and adoring, softball questions. Following the Barbara Walters approach, she gets these plum interviews because her subjects know she will paint them in a soft, glowing light and never surprise them with any truly probing, potentially uncomfortable questions.

With Claman, you know she'll never ask the questions you'd ask if you had her subject on camera with you."

As is so typical with blogs, the heavy weight, more important posts rarely draw comments. But the fluffy ones do. For example, "Anonymous" (seems they usually are) wrote, in response to my post,

"Oh god, You're so effing in the minority here that it's not even funny. She had the #1 show on CNBC and judging by todays little tidbit in the NYDN, Looks like she has tons of offers on the table.....Hofefully she'll be on Fox Biz soon"

For clarification, Claman did not "have" a show on CNBC. She appeared with other anchors in the mid-morning slot. So it is difficult to understand how she could have had the "#1show" on the network.

But anonymous' comment about Claman's purported, rumored offers got me to thinking. With whom is Claman so popular? According to the blurb for which 'anonymous' provided a link, it is CEOs.

However, networks sell advertising on the basis of viewers, not CEO viewers, per se. Yes, I know CNBC likes to show ads with CEOs who watch their network. But that is not what pays the bills.

What's the likelihood that a network full of Claman-type interviewers could actually succeed? CNBC has Donnie Deutsch and Michael Eisner doing CEO interview shows. But not all day long.

Then there's the issue of how long such a rich diet of CEO interviews will last, before viewers realize that these have simply become well-orchestrated, safe publicity opportunities for the CEOs and other 'leaders' in question. This is my major bone of contention with Liz Claman as an interviewer. She just gushes over her subject, literally, and then lobs softball questions which smack of adoration and wonderment, rather than scepticism and objectivity.

Interestingly, nobody claims that Claman actually added value at a desk on air. Most of her appearances, as I recall, tended to be either in live interviews, or running taped interviews. For good measure, I followed the NYDN link (it's a daily updated page, so the Claman story is already gone), and the Claman paragraph stressed her popularity with CEOs because of her reputed feminine attractiveness.

Wonderful. Women try to be taken more seriously as business people, and we have people celebrating a plump, middle-aged woman for her physical features, overlooking her lack of intellect.

If loading up on this sort of 'talent' is what Fox is planning as major content for its business news channel, then I don't think they'll do very well. On the other hand, it's just possible that CNBC will become more attractive with the loss of its Wall Street Journal connection.

For example, Joe Kernen routinely cites Journal articles on the CNBC early morning program with Becky Quick. Since I watch the network primarily for breaking business news and market news, that works for me. They have occasional guests and hosts whom I respect, like Mike Holland, Brian Wesbury, or John Rutledge. But these are, frankly, exceptions among a parads of also-ran analysts and fund managers of whom you have never heard, prior to their 2 minutes of fame on CNBC.

Either way, it should be fun to watch the competition between Fox's new business channel, and CNBC. Who knows, maybe competition will result in one, or both, channels focusing on news and intelligent commentary, rather than glamour interviews with primping CEOs.

Belated NewsFlash: Liz Claman Departs CNBC...for Fox's Business Channel?

CNBC did not publicize Claman's departure last month, but I suddenly realized that I have not seen her massive, somewhat dim-witted presence on the network's midday programs for a while. At first, I chalked it up to her being on vacation. Now, after googling her name, I have learned that she left CNBC in July, amid rumors that she is going to be an on-air personality with the new, yet-to-be-unveiled Fox Business Channel.

Heaven help us, and Rupert Murdoch. Let's hope this is not a precursor of the kind of moves that Fox will be making in relation to its new cable business news channel. Murdoch didn't need to buy Dow-Jones for this.

I have found Claman to be ill-informed and of no particular added value to any business topic which she covered. Her interviews with people like Warren Buffett are notable for their cloying obsequiousness and adoring, softball questions. Following the Barbara Walters approach, she gets these plum interviews because her subjects know she will paint them in a soft, glowing light and never surprise them with any truly probing, potentially uncomfortable questions.

With Claman, you know she'll never ask the questions you'd ask if you had her subject on camera with you.

With the considerably more-talented female anchors available on CNBC- Becky Quick, Erin Burnett, Michelle Caruso-Cabrera- it's hard to believe that Fox would bother with Claman.

After my hopes have been raised by the promised arrival of a competitor to CNBC, I would truly be unhappy if watching the new business channel meant I had to tolerate seeing even more of Claman.

More on Risk: Details On The Recent Credit Market Turbulence

I had a chance to catch up on reading a lot of Wall Street Journal articles this weekend. Among the pieces on which I focused was one in this past Friday's edition concerning how a German bank, IKB, has crippled itself through injudicious involvement with sub-prime mortgage CDOs.

What amazes me is that so much of this is a rerun of the 1998 LTCM debacle. For instance, the German bank had been encouraged by its regulators to move out of basic corporate lending, its historical area of business, in order to diversify its revenue base. The result was for IKB to play 'investment manager,' creating two separate entities which issued commercial paper, collateralized by investments in CDOs containing, among other things, American sub-prime mortgages. According to the Journal article, the bank's commercial paper program recently won an award from one of that sector's organizations. Like LTCM's eventual demise, due to hedges involving equities, with which it was not historically experienced, IKB has been brought down by a foray into unfamiliar financial market instruments, as well.

Stepping back, however, there is absolutely no obvious economic value-added which IKB provided, or could have provided, to the buyers of its paper. What it was really doing was making a spread between its commercial paper, which enjoyed low rates typical of such instruments, while collecting higher rates on its riskier investments in CDOs.

Unfortunately, these guys didn't even do anything so esoteric as construct complex hedges between, say, equity and debt instruments. They simply got caught holding the risk of, well, riskier instruments, while having promised commercial paper returns which they suddenly could not pay, in light of the severe losses on their mortgage-underpinned CDO holdings.

In the US, the coverage late last week of various "quant," or quantitative hedge funds running into trouble again reminded, once more, of LTCM's troubles. As I discussed with a friend yesterday, it's almost an exact rerun of the Long Term Capital Management dissolution.

Whiz kids at the helm of trading desks and risk management functions assume that various correlations between instruments will always obtain, and that markets for all instruments always function smoothly.

In neither case is the contention true. Unusual debt instruments can simply become unsaleable at any price. Nobody wants the risk. Thus, losing positions cannot be unwound.

Perhaps the more worrisome part of this recent credit market debacle is how much of it seems to be a function of the compensation and promotion practices among elite financial service firms.

When frontline traders and their management reap tens of millions of dollars annually in compensation, they simply no longer really feel any risk from ruining their company, customers, or the financial system. How much trust can you really place in a person who risks your money, but keeps perhaps 90% of his own millions safely out of harms way. He's no longer managing in your interests, as if they were his.

And don't be fooled by the line that they, too, want their bonuses, etc. Just like overpaid CEOs who underperform, these traders and investment managers lose little, financially, if they become unemployed due to wrecking their firm.

Ego damage, yes. But someone like the recently-departed senior executive of Bear Stearns, Warren Spector, will hardly feel any change in his lifestyle due to current unemployment. No, he'll be more affected by the embarrassment of having lost his powerful job at Bear. But not by the loss of income.

This is critical, because we trust these people to manage other people's money with fiduciary care. But now we see they do not do this. The ultimate cost of failure to themselves, which is loss of customer assets and their own positions, is more than sustainable. The upside of taking so much risk is more money, in the form of bonuses and added compensation in subsequent years.

If it were my money, I would not commit substantial capital to any fund or strategy in which the manager was not required to have the bulk of his net worth also invested. Otherwise, it becomes worthwhile for the manager to take higher risks with my capital, on which he is paid for performing well. Losses only affect my capital. The manager doesn't have to return prior compensation.

Thus, it's my belief that until measures are taken to address this mismatch between trader and investment manager compensation and equity participation in their own activities, we will continue to see the type of problems we are witnessing in the buying, trading and holding of sub-prime mortgage-backed instruments for many decades to come.