Friday, December 28, 2007

The New Financial Excesses & The Old

Last Thursday's Wall Street Journal contained a wonderful article entitled "Wall Street Wizardry Amplified Credit Crisis."

I wasn't going to write about it, until I happened to be riding an exercise bicycle Thursday night, viewing a rerun of that old, rather misleading cinematic faux classic, Oliver Stone's "Wall Street."

Like much of his other semi-historical films, such as Platoon and JFK, Wall Street mixes some truth with a lot of untruths and improbabilities, delivering it with a straight face that causes the uneducated to believe it as whole cloth truth.

In the movie, as you may recall, Charlie Sheen plays the protagonist, Bud Fox, a young, struggling, newly-minted retail stock broker. Michael Douglas is cast as an Ivan Boesky-like arbitrage trader, Gordon Gecko.

In real life, people like Boesky didn't have anything to do with retail brokers. Instead, they focused on using information sources, sometimes illegally, including underwriters or printers, plus a network of others to help pump interest in positions Boesky and his ilk already had built, such as business media, institutional investors and institutional brokers.

Thus, the artificial pairing of Fox and Gecko made for a lusty, action-packed financial thriller which, in reality, never occurred. Boesky did ultimately go to jail for using insider information and manipulating securities prices by 'parking' stock with, I believe, Jeffries & Co.

What got me thinking about this post was how unreal and seemingly needlessly phony Stone's move was. In characterizing the go-go, 'me decade' financial scandals of the '80s, he simplified the stock price manipulations of the arbs in order to make it salable as cinema.

My, though, how truth can be stranger than fiction.

When I finished the Journal's superb post mortem of "Norma," a CDO facilitated by Merrill Lynch, I was totally incredulous that this sort of thing had actually transpired.

Mind you, I believe it. But it makes for incredible reading. Must reading, if you will.

For quite some time, I thought that the CDO and credit crises were largely the result of simple, bad credit risk practices, pumped by ballooning manufacture of the synthetic securities and distribution of them directly to institutional investors.

Not so, according to the Journal account of Norma.

Rather, according to the article, here is an illustrative example of 'worst practices' a la the late '00s.

Merrill recruited 'managers,' such as Corey Ribotsky, a former penny stock brokerage, to buy, assemble and distribute CDOs from Merrill-originated mortgages and derivatives. Norma is one such CDO which the article traces through its life to date.

By reading this article, I lost quite a few false beliefs in the process which has brought Merrill low.

Merrill didn't merely manufacture CDOs full of mortgages directly to bona fide institutional investors. Instead, they found and orchestrated the 'management' of CDOs full of their mortgages, and associated credit derivatives, by intermediary firms. These firms, such as Mr. Ribotsky's N.I.R., then held the resulting CDO, assembled with help from Merrill. Merrill then found buyers for NIR's CDO.

While NIR was not an SIV in the classic sense, it functioned like one. That is, while funded by buyers of Norma's debt, i.e., the ultimate investors, and wholly off Merrill's balance sheet, it was, nonetheless, wholly a creation of Merrill Lynch.

Norma, the CDO, didn't just contain mortgages. Instead, for reasons best left to readers of the Journal article to learn, it also contained credit derivatives, a sort of insurance policy/bet on mortgage defaults.

Then, later CDOs would use some of the more risky, or toxic, tranches of earlier CDOs. And so on.

What is particularly informative in the piece, and was news to me, is that, by virtue of the use of credit derivatives, CDOs became abundant due to the inclusion of many 'bets' on mortgage rates and defaults.

In essence, then, this allows us to now realize, clearly, why the financial mess of complex credit instrument valuations is quite distinct from the simple, underlying issue of basic home mortgage defaults. The volume of CDOs is far in excess of the value of underlying mortgage loans.

Way back in the 1980s, when my boss, Chase Manhattan Bank SVP Gerry Weiss, sent me to a CMO conference filled with S&L executives, I gleaned a related insight. Upon my return, I debriefed Gerry on what I had learned. The concept of securitizing mortgages to spread risk made sense, I said, so long as the true risk spreading value exceeded the haircut that Morgan Stanley, Salomon, Kidder and Merrill were taking on the business. I speculated that one could endlessly add layers of paper resecuritization to the process, merely massaging risk around, to not greater systemic benefit, but for additional financial fees.

This is, in essence, precisely what has occurred. By mixing in insurance contracts on mortgages, the credit derivatives, securitizers expanded the supply of CDOs far in excess of the underlying mortgage values. It is very much the same as writing naked call options. Anyone can do it, and the outstanding call options on an equity can, at any one time, far exceed the actual shares outstanding.

Thus, when we discuss the basic issues of mortgage defaults, bailouts, and losses thereof, we need to not count any values beyond the basic, first-tier mortgages.

To include CDOs is to begin to double, triple, and perhaps even quadruple count losses. Further, once these CDOs left the simple mortgage content, and became betting instruments, they ceased to really be related to the home ownership issue, and simply became new ways for institutional investors to make market bets on something.

For purposes of regulatory and political involvement in the recent, and ongoing, credit situation, one must, as a result of this piece, distinguish the basic mortgage origination situation from downstream packaging and distribution of securities which contain, but are not limited to, and exist in greater volumes than, the underlying mortgage loans.

To me, from a careful read of the Journal's fine article, one thing remains eminently clear to me- as it has from the beginning of my writing on SIVs and the credit 'crisis.'

Institutional and, if affected, retail investors received what they deserved. Given the incredible complexity, opaqueness, and suspicious provenance of these CDOs, anyone who bought them either: was too naive and inept to be doing so, and/or; thought they were getting 'free' return without commensurate risk.

No amount of regulation or legislation will ever limit the boundlessly creative types on Wall Street from dreaming up new, unregulated ways of packing and selling financial assets and risk to greedy, naive investors.

Thursday, December 27, 2007

Wither Goldman Sachs?

In this recent post, I noted that Goldman Sachs is currently the 'class of the class' among US publicly-held large financial service firms.

Nearby is one of the charts I used in that post. If you were to strip away the other banks, Goldman's consistently superior performance would be more obvious.

From my records, it appears that Goldman first entered our equity portfolios a year ago, in January of 2006. Generally speaking, companies don't appear in our portfolios for more than a few years.

From a Schumpeterian perspective, firms typically fall from consistently superior performance after a rather definable time period.

That said, I don't believe Goldman will continue its enviable streak of consistently superior total return performance for too much longer. Perhaps another 18 months.

What will eventually bring GS back to earth?

Looking back to other great firms which eventually became simply average, such as Microsoft, Home Depot, Kohls, Compaq, Dell and Pulte Homes, one or more of four forces usually do the job.

First, natural market saturation can simply bring a firm's business model to a halt. To some extent, that became true of Home Depot, Pulte and Microsoft.

Closely related to this is competitive action. When a firm is consistently superior for too long, it becomes an easy target for one or more competitors to take advantage of the former's business model and exploit weaknesses, or evolving consumer preferences. Again, Microsoft partially fell victim to this force, as did Dell.

Third, regulatory attention can end a consistently superior streak, too. Wal-Mart has encountered some of this, as well as the other two forces. So has Microsoft.

And, fourth, the market simply accepts the firm's stellar performance, and expects it. This effectively destroys consistently superior performance, by pricing it into the stock, and depressing gains back to the index, or lower. Even sell-side analysts eventually wake up to a firm's consistently superior performance after about a decade.

My guess is that Goldman will face a sort of market saturation/push-back, coupled with some nuanced competitive reactions. And, then, the rising expectations among sell-side analysts that the firm will power through various problems, and maintain its performance. Once this happens, the stock's price will reflect expected continued good performance, and end the run of outperformance.

As I described Goldman's diverse business activities to a friend the other day, she quickly observed how many conflicts the firm has created with its proprietary trading operations and various underwriting and advisory businesses.

Already, it has drawn fire publicly from economist/actor Ben Stein. He wrote a New York Times editorial excoriating the firm's chief economist for having allowed the firm to underwrite so much mortgage securitization earlier this year, while privately forecasting a bear market for the instruments.

But, really, everyone knows this is Goldman's game. Stein, while perhaps technically correct, appeared naive by writing that piece.

It's no accident that Goldman publishes its equity recommendations. How better to make sure the rest of the market piles in and drives up the prices of its holdings?

I think eventually various customers/counterparties of Goldman Sachs will begin to back away from the firm, sensing they are being used and abused. Calling into question Goldman's commitment to doing the best for the customer will, I think, eventually curb its growth.

They seem pretty well-managed with respect to risk. But growth may be a different story, as the firm's profile continues to remain so high. With their CEO, Blankfein, earning north of $50MM two years running, and the firm's relatively unblemished performance, counterparties realize they are paying for these phenomena.

Perhaps one other investment banking firm will eschew so much proprietary trading, in order to earn more market share in underwriting.

Or, given that underwriting is really a commodity business, perhaps enough competitors will attract Goldman alumni that its trading approaches will be cloned, depressing the margins earned by proprietary trading among all competitors.

With John Thain running Merrill now, it could easily become a viable competitor to Goldman in a few years. I had a spirited debate last night with an ex-Merrill friend. I contend that Thain will get rid of the retail brokerage business, while my friend heatedly disagreed. But in Merrill, Thain has the perfect vehicle on which to build a newer version of Goldman, keeping what he liked about his alma mater, and changing what he thinks could be improved.

Between Blackstone, a new Merrill, and customer caution regarding Goldman's self-interested conflicts with so many of its customers, I think the next two years will see Goldman's business growth attenuate.

Add to that analysts' expectations, and Goldman's run as the single consistently superior total return performer among US large financial entities is likely to end within the next two years.

Finance Parable

With Christmas Day past, and just 2 1/2 slow, thinly traded market days left this year, I'm back at posting in my blog. I hope you enjoyed the Christmas holiday, and are looking forward to the new year.

Wednesday's Wall Street Journal carried a piece by their affiliate,, comparing this year's various financial firm follies to a biblical parable involving 10 virgins.

The gist of the column, by one Hugo Dixon, is that, in contrast to the bible story, in which the foolish virgins paid consequences for their mistakes, in the financial version, Chuck Prince and Stan O'Neal left with their pensions intact. Other firms, Northern Rock and Fannie Mae, were either bailed out or left intact, with the assumption that the latter will, if need be, be rescued by the Federal Government.

Hedge funds which took 20% of many years of lush profits from their customers didn't share in this year's losses.

Dixon's point, in his closing sentence, is

"In this financial version, all 10 virgins are invited. The bridegroom looks around the room and scratches his head. Which are the real fools?"

If you ask me, it wasn't the '5 wise virgins,' who, according to Dixon, managed themselves prudently.

No, it would be the shareholders in the unwise virgins.

Whatever loss of options premium we incurred from one position in Merrill Lynch was more than offset by several profitable Goldman Sachs call options this year.

Our overall returns so dwarf any losses from cheaper money that we really weren't hurt by Fed easing, either.

I can't speak as a shareholder of Citigroup, but, from the outside, I'd be thinking twice about leaving my investment in the hands of that board. Same with Merrill, for that matter.

It's not the CEOs of these firms, as much as their boards, that ultimately have been unwise. Prince and O'Neal were each performing inconsistently, or simply poorly, for some years before 2007, as I've noted in prior posts about each of their erstwhile firms.

It's misleading to blame them, when they just worked the system in which they played. Their boards failed to ask about risk, tolerated mediocrity, and paid too well for failure. Is that Prince's or O'Neal's fault?

You, or I, might not like the fact that the two deposed CEOs walked away with so much money. But that's their board's fault.

The best way to discipline or punish those boards is to not buy, or sell, the shares of those companies. You can't change the boards, per se. But you can certainly find better firms, with better boards, in which to invest.

Meanwhile, both Merrill and Citigroup continue to limp along with ailing stock prices, as depicted in the nearby, one-year price chart comparing the two companies' shares with the S&P500 Index.

You could take a chance on their new CEOs, and hope you are buying at a bottom. Maybe each will claw back some of the 2007 40% loss in the coming year, or later. Maybe not.

It's a pretty big risk to bet enough on just these two damaged firms to make it worth your while if either one recovers. And then there are opportunity costs for those investments.

As I mentioned earlier, I'd skip them, with their inept boards, and look at better-performing companies first.

Monday, December 24, 2007

That's Not Possible

This morning, after playing squash, my business partner and I were discussing recent equity and options markets performances.
My website, linked to this blog, provides weekly performance information on the equity portfolio strategy which I run. A chart of monthly gross returns for this year, to date, appears nearby.
As of last Friday, 21 December, the portfolio has realized a 35% return, versus the S&P500's 4.7%, yielding a performance margin for my portfolio of 30.3 percentage points.
When my partner's son related this to some clients of his in one of Deutsche Bank's trading operations, I am told they simply refused to believe this.
Maybe they viewed the rest of the performance information, including the prior year performances of the portfolio's approach, dating back to 1990. Maybe not.
I'm not totally surprised at their reaction, though. I've heard it so often before.
Those who can't do, evidently, simply deny. Especially when the approach differs so radically from that of the critic.
In contrast to institutional traders, we invest in equities for six-month durations. Our options positions are bought and held up to a six-month duration, with sales occurring at return levels established via proprietary options performance research.
It must be difficult, indeed, for institutional equities and derivatives traders to imagine making our returns on simple, unhedged equity and options positions over such timeframes.
If the equity portfolio performance was unbelievable, imagine how my partner's son's clients would have reacted, had they seen our performance data on our options implementation of the same equity strategy. The nearby table is taken from last Friday's closing performance, covering the six active portfolios.
Prior to these six, our May options portfolio had a 41.5% gross return, and June's was 77.6%.
While there are a variety of methods for weighting and annualizing the various monthly portfolio returns, the overall return for this year, to date, for uniform monthly investments, is in the neighborhood of 70%.
Since call options have downside loss protection, relative to holding equities, and allow for inherent leverage of as much as 20x, they provide much higher returns than the equity approach, while using the same selection process and weightings.
Three of the current options portfolios' daily performance charts are included nearby- December, November and September.
The blue curves represent the performance of the options as purchased, without any management. The red curve depicts the performance of a similarly dated and priced, relative to the money, S&P500 call option. No value exists past November, since Yahoo discontinued free index options tracking near the end of that month. The green curve represents the actual performance of our portfolios resulting from sales of call options at pre-determined points throughout the portfolios' durations.
As good as our equity returns have been this year, our options returns have been even better.
By applying the results of proprietary research into the performance of large-cap equities over time, our portfolios, both equities and options, tend to consistently produce superior returns, relative to the S&P500 and its related options instruments.
Not every month's portfolio achieves the same high returns. But, on balance, already, they've delivered stunningly good performances in one of the most challenging and volatile seven month periods in the equity markets in the last five years.
It's been an above-average year for our equity portfolio in terms of the level of outperformance of the S&P500, though not in the mere occurrence of this outperformance.
Our options portfolios, which have been live since May of this year, have met our expectations, considering market conditions.
Are these levels of performance possible? We believe so, because we have experienced them in live investing, including equity portfolios as far back as 1997.
Originally, I began this blog as a way of expressing opinions and analysis about current business topics from the viewpoint of our equity strategy. My partner felt that having a body of written observations and analysis which reflected my proprietary research findings would make it easier to attract equity investments to our portfolio management efforts.
As such, the success of our equity strategy gives us cause to feel that our perspectives on investing and business management are validated.
Others may not believe our live investment results, because they simply cannot imagine strategies which, while simple, rest on quantitative expressions of powerful insights into equity and options performances. More often than not, I think, criticism stems from envy, lack of comprehension, and lack of creativity on the part of the critics. It's easier to simply dismiss what you can't understand, or didn't think of first, than to accept it.
Fortunately, though, in the institutional investment field, most managers will stick with their own underperforming approaches, rather than accept that another approach yields superior returns. And, since our options approach provides return levels which reduce our need for other customers, we don't need to waste a lot of time convincing people that what we do works.
Instead, we now simply treat it as a proprietary approach for proprietary capital.

The 2007 Financial Debacle- It Could Have Been Much Worse

As bad as the mortgage-related travails of 2997 have been for the financial services sector, particularly the commercial banks, it could have been so much worse.

For instance, as I wrote here, in August, commenting on a Wall Street Journal article tracing one family's mortgage,

"What I saw in this article is an example of people who should have waited until they actually had the money for a reasonable down payment, and then should have been more sanguine about their prospects of affording the mortgage they chose. Additionally, they seem gullible, in that they simply believed a mortgage broker's promise that they could refinance the mortgage. Perhaps they should have planned on affording the one for which they applied?

The broker, of course, hardly did anyone a favor by putting the Monteses into a barely-affordable mortgage. The institution which lent the money for the house didn't seem to have done a very careful job stress testing the Montes' ability to afford the mortgage.Then the loan was likely bundled up into a security. I don't know what the 'seasoning' period is nowadays, but years ago, lenders typically had to hold their mortgage loans for a year, if I'm not mistaken, before other investors would buy them in CMOs.

This story displays a shocking tale of greed and overreaching on everyone's part, including the Monteses. They should never have expected, in their financial position, with other loans to service, to be paying as much as 42% of their income for housing, before taxes and insurance.It's no wonder that this is the last year of the housing expansion. With loans like these, to borrowers like these, it was clearly time for mortgage merry-go-round to stop. I can't honestly express any sympathy for investors who purchased instruments backed by loans like those of the Montes.'

This was a total lending, underwriting and investing system failure. But it's not a banking failure, per se. Those who bought these loans, packaged as whatever, deserve the losses they take, just as if they had made unwise equity or currency investments."

The current structure of the mortgage finance system should have been a signal to institutional investors that times have changed. As I further observed in this October post,

"The passage in Wednesday's Journal article citing the importance of the SIV sector, "at its peak....about 30 funds....$400 billion in assets," causes me to ponder how the three largest commercial banks- Citigroup, Chase, and BofA- and perhaps a few more, would have managed the mortgage assets on their own balance sheets a decade ago.

Back then, the largest banks built or bought large mortgage origination businesses, feeding into the banks' own large lending portfolios. The rise of securitization, with its liquidity and market-based risk pricing, made it economically feasible and sensible for the commercial banks to cede the portfolio lending business to a market of CMOs and, now, CDOs.

If the commercial banks had remained portfolio lenders, would this current SIV sector have reached $400B in assets? Or would the risk management functions of the banks have slowed as the mortgages began to decline in quality, hitting the sub-prime market? For example, one-time high-flying manufactured housing lender Green Tree Financial was rescued by an Indiana-based insurer, not a commercial bank.

As inept and stodgy as commercial banks can be, including their own prior mortgage lending problems which helped lead to the RTC creation to clean up the last housing finance mess, I think they perhaps exercise a bit more focused risk oversight than a widespread free market in CDOs."

My own belief is that we should be thankful that securitization has prevented the largest US commercial banks from taking more losses than they already have. Rather than being in the tens of billions of dollars, I believe we would have seen at least one, and probably two of the largest five US banks collapse.

As it was, the banks' formations of SIVs in which to ostensibly park mortgage-backed securities at arms' length from the commercial banks' own balance sheets should have given pause to the institutional investors who bought the notes backing them.

Portfolio lending, while worse than financial markets at correctly pricing risk, does, on the other hand, tend to exert an attenuating effect on a commercial bank's risk positions. A mortgage lending unit can afford to underwrite riskier loans when it knows they will be securitized and sold to investors.

This is simply common sense. That commercial banks have experienced severe losses from CDO tranches they kept tells you they would have experienced even worse losses, had they kept everything they underwrote.

As I see it, the various players in the financial services sector have all gotten what they deserved from playing a form of 'hot potato' with risky mortgage lending.

Mortgage brokers will probably become heavily regulated. Commercial banks are now exercising the kind of credit judgment that they used to when they held most of their mortgages in portfolio. Investors and traders have sustained losses by failing to recognize the new risks inherent in buying structured mortgage-backed instruments that weren't retained by the firms which underwrote the original loans.

What has become clearer over the past few months, including this Christmas season, is that the losses and effects felt in the US financial sector isn't spreading to the rest of the economy's sectors, as so many pundits have predicted since August. Recent consumer spending data, and continuing job and incomes growth would seem to testify to a healthy economy, outside of the self-inflicted damage of the financial sector.

Yes, I think things could have been much, much worse. If not for securitization, much of the risky mortgage loan volumes, though perhaps less in the aggregate, would have remained on commercial bank balance sheets, causing a few total failures.

Thanks to our sophisticated financial markets, those investors and traders who believed they knew how to assess and price risk have borne most of the losses. As such, the few hundreds of billions of dollars of ultimate losses from these bad mortgage loans will appear as simply more investment losses, rather than economy-crippling contractions in bank credit markets.