Friday, March 28, 2008

Secretary Paulson Speaks To The Chamber of Commerce

Wednesday morning's speech by Treasury Secretary Henry Paulson to the US Chamber of Commerce contained several important points. But of all of the things he mentioned in his address, three stand out in my mind as crucial.

First, he explicitly spoke of the need to begin work on replacing today's crazy-quilt US financial regulatory scheme with a more simplified, streamlined, single-entity model.

Predictably, he began hinting that the Fed should assume this mantle. My own feeling is that it's unwise to overload the Fed with three missions. It should, ideally, still only have one, anyway- price stability/inflation.

Humphrey-Hawkins was a bad idea that has already brought the Fed under Congress' intimidation.

Assigning the Fed more regulatory duties in excess of what it has now is probably a bad idea. Should it be aware of a single regulator's findings and actions? Yes.

Second, he explicitly stated that he thought investment bank access to the Fed window was not meant to be permanent.

Nice try, Hank, but that's probably now irrelevant. Who among us, or, more importantly, investment bank CEOs, doesn't believe the Fed will do it again, when 'necessary?'

So much for enforcing moral hazard.

However, putting the first and second comments together, you can see the investment banks which want continued access to Fed funding being told they must look and act like a commercial bank, i.e., conform to the Basle accords on capital adequacy.

Oh dear. You mean de-lever an investment bank from 30x to a mere 12x capital? How will they ever make money that way? Underwriting commodity instruments, trading run-of-the-mill markets and doing some M&A advisory alone aren't going to make investors sit up and take notice of profits and growth.

As I contended in this recent post, I think you are looking at profound sector consolidation if the Fed window remains open to investment banks.

But to me, the most interesting and heartening message Paulson enunciated was on over-the-counter instruments, i.e., credit derivatives swaps. He called for an 'association' to be established with counterparty safeguards for clearing and settling.

That is, he means an exchange! He wants more transparency, counterparty capital adequacy, and fewer surprises among the participants in such markets.

As I suggested in two prior posts, including the one already linked, and this one, this month's action by the Fed concerning funding investment banks is an historic moment in our financial markets.

Every bit as significant and structure-altering as FDR's bank holiday and the 1914 establishment of our Federal Reserve System.

Thursday, March 27, 2008

Ethan Penner's Misunderstanding of Mortgage Lending

Yesterday's Wall Street Journal featured an editorial by Ethan Penner, one-time head of Nomura's mortgage business, entitled "Of Markets and Mortgages."

Penner begins his defense of securitization, which is what his editorial really stresses, with this passage,

"Yet today we see the search for quick fixes and for villains, with securitization being identified as the chief culprit. Securitization is not the cause of the massive problems in our credit markets. The problems are due to basic mistakes that even the most unsophisticated among us can grasp. Lenders loaned too much money on too easy terms to borrowers who did not have the capacity to make their payments. No alchemy by even the brightest minds on Wall Street could turn bad loans into good assets. Sound simple? It really is."

What Penner writes is true. Unsound lending was and is at the core of the mortgage-related finance troubles. But he fails to note that much of the worst of the lending, the 'no money down' mortgages, were not intended to be held in portfolio, but securitized ASAP.

Penner continues in this vein a few paragraphs on, stating,

"The underwriting of risk in the past few years has, of course, not been so good, and securities backed by poorly underwritten loans are losing value daily. Yet the cry for systemic fixes from various constituencies has been dangerously off the mark. One common fix advocated is to abandon or de-emphasize mark-to-market accounting in favor of allowing companies to estimate an asset's "true" long-term intrinsic value. Another is to move away from securitization and return to a portfolio lending model -- where, for example, the bank originating a mortgage keeps it (in its own portfolio of assets), rather than selling it to a third party (as in securitization). Both fixes are tempting. Both are mistaken."

So Penner is about to disabuse us of the two major notions for repairing the current damage from bad lending and exotic structured finance instruments.

First, he deals with mark-to-market, opining,

"The desire to abandon or deemphasize the mark-to-market model is based upon the logic that, if the public didn't know how bad things were, then the all-important confidence in the system would not be at risk and we would be safer. The price to be paid -- the complete obfuscation of the truth -- is simply way too large."

That's it! Penner simply states, without any supporting statistical or other quantitative, descriptive evidence, that the reason we can't modify or adapt 'mark-to-market' is because it would result in 'complete obfuscation of the truth.'

But is that really true? What about the commercial bank investment account? We've lived with that for decades, and still do. Has that brought down our financial system? No.

Sometimes, when an instrument is truly held for income, to perpetuity, or for a long time, the current market value does not represent the value of the instrument to the holder. This could well be true for many institutional investors, especially pension funds, who hold structured finance instruments.

There are provisions for accounting for the value of such instruments by banks when the no longer perform, i.e., become delinquent or in default. But performing instruments thus benefit from a lack of pressure by markets to affect valuation decisions on performing instruments.

Penner then moves to defend his special co-contribution to our current finance system, the securitized mortgage,

"The argument in favor of portfolio lending is based upon the notion that, unlike securitization, portfolio lending incorporates the discipline of "skin in the game." Since, in the portfolio lending model, the loan's risk is not being transferred from the originator/lender, underwriters will therefore be more careful. But the anecdotal evidence just does not support this thesis. In the last major credit correction, it was portfolio lenders who violated prudent credit standards. And in this correction, many of the world's portfolio lenders are suffering the largest writedowns because of their bad credit decisions. Simply put, human nature exploits both models -- securitization and portfolio lending."

I believe Penner's 'analysis,' again, woefully devoid of any quantitative descriptions or statistics to support his weighty contentions, falls short on two counts.

First, I take issue with the 'fact' that 'many of the world's portfolio lenders are suffering the largest writedowns because of their bad credit decisions.' That rings false to me.

Merrill Lynch, Bear Stearns and Morgan Stanley took most of their write-offs from securities, not home loans. I don't recall specifically if Merrill's housing finance unit actually originated subprimes or not, but it clearly bought the unit to securitize the loans, not hold them. After all, Merrill could never use a commercial bank's 'investment account' approach to valuation, so it's unlikely they ever expected to hold any mortgage loans, as such. Even Citigroup's large SIV losses involved securitized mortgages, not the raw material.

Penner is simply deficient on this point. Without numbers to support his positions, I find them unbelievable.

His second error is less visible, but equally important. Penner glosses over why securitization is so much worse than experiencing the same dollar losses in portfolio lending.

The obvious first reason is that, with a bad bank portfolio, you know where the damage is. It's contained to a set amount within a known institution. Usually, FDIC-insured and Fed-supervised. Thus, arrangements to handle the losses and insulate the financial system, and depositors, from the fallout, are relatively easy and conventional.

When the mortgage losses bleed through countless tranches of countless CDOs scattered among investors worldwide, it's literally impossible to know the extent of the loss for each instrument and each (counter)party.

Thus, the uncertainty of the extent of loss for each participant becomes more important than the dollar value of the losses, because, with losses presumed to be resident somewhere, counterparty risk uncertainty skyrockets.

A useful, if unappetizing analogy, involves sewage systems. Which, sadly, appropriately represent much of the material 'pumped through' our financial system for the past few years.

Portfolio lenders essentially have individual septic systems. If they toss in the wrong material and or exceed the capacity of their own system, they suffer. But relevant regulatory and municipal officials can handle the damage and supervise remedies. Nobody else suffers very much, or for long.

Securitizing mortgages, especially suspect ones like subprimes, more closely resembles a situation in which each securitizer reaps a fee for pumping effluent into a common cesspool.

However, once the effluent leaves the securitizer's effluent outflow into the cesspool, the identity of its 'product' is masked. In fact, nobody knows exactly what, in total, is in the cesspool.

And since no one securitizer 'owns' the cesspool, none of them really care about its status. They are paid for pumping the maximum amount of effluent into the cesspool that they can, not for supervising the functioning of the cesspool.

Unless the operator, if there is one, of said cesspool charges an escrow fee by monitoring the effluent feeds into it, there's no negative consequence to the securitizer's if, one day, the cesspool closes, or otherwise becomes inoperable.

Penner ignores the greater motive of humans to misuse and abuse commonly-accessible resources, i.e., the cesspool-cum-financial markets, as opposed to at least trying to risk-manage their own asset portfolios.

Thus, prior mortgage-lending related bubbles and aftermaths have been relatively more easily cleaned up than this one has been.

Because we don't have 'owners' of markets, the cleanup is vastly different. In part, too, because investors may visit a market, buy some CDO, then leave, not being really 'in' the market anymore.

The insidious nature of distributed CDOs containing bad mortgages has had the most deleterious effect on our markets, not simply the size of the delinquencies or defaults.

This lack of knowledge of who might hold bad CDO paper is what has caused the credit market seizures- the implied or suspect counterparty risk.

None of this is evident, nor mentioned, in Penner's defense of the business he says he helped create.

No surprise there, eh?

Wednesday, March 26, 2008

Citibank-Travelers Merger & Rubin's Board Post

A funny thing happened the other day while I was talking with my friend and sometimes business partner, B.

In discussing the current commercial bank troubles, he noted something about Citigroup that I honestly had failed to notice.

As this article confirms, the Citi-Travelers merger, fomented by then-Travelers CEO Sandy Weill, occurred in 1998. At the time, Bob Rubin was Clinton's Treasury Secretary.

Approving the merger required the effective, de facto dismantling of Glass Steagall, the law prohibiting commercial and investment banking from existing in one institution. The post-1929 crash legislation was intended to prevent the practice of commercial banks originating questionable securities, then stuffing them into investor accounts or other vehicles which they would then market off of their balance sheets.

Is it not odd that, having carefully failed to raise any warning flags about this merger, Rubin subsequently became Chairman of Citigroup's board?

And not a notional chairman. Rather, Rubin is among the three most highly-paid executives at Citi.

Talk about conflict of interest!

It's not hard to connect the dots on this one, is it?

Rubin, as Treasury Secretary, remains silent on the most significant change in financial service regulation since the 1930s, allowing the Citi-Travelers merger to sail through Federal government scrutiny without trouble. It's not certain, but one can easily imagine Rubin cajoling various other parties, such as the Fed, DOJ, and anyone else with a voice, to go along with the move.

Upon leaving Treasury, Rubin becomes Chairman of the newly combined universal bank, Citigroup. Rubin is paid far more than this typically figurehead post commands.

Seven years later, Citigroup records record losses after five years of moribund management under Weill's successor, Chuck Prince. Rubin has remained inactive in addressing Prince's failures for the half decade during which the bank languishes.

Isn't it funny how nobody in Congress has pointed a finger at Rubin's involvement in this mess? If anyone could have called a halt to Weill's rush to merge the two firms and destroy a decades-old, effective bar to the practices which, once again, led to our current credit market troubles, Rubin was probably the guy.

With his Goldman Sachs pedigree and influence over the President whom he served at Treasury, Just a few comments from Rubin would have stopped the merger cold.

Instead, Rubin's inaction led directly to the financial excesses we see today in the mortgage and securities markets.

Pandit Settles In At Citigroup With His Colleagues & Big Bonuses

To paraphrase Clint Eastwood's "Dirty" Harry Callahan's character from the 1971 movie Dirty Harry,

'Now in all the financial services excitement of the past few weeks, I can't remember if I covered Citigroup's latest indiscretions. Well, do you feel lucky, Vikram?'

You probably think I forgot all about Pandit's Citigroup. But I haven't. Right now, I'm eyeing a short stack of Wall Street Journal articles going back to early March.

The first article, from the March 5th issue of the Journal, catalogues the reasons why Citi's stock price was under assault in recent months. Without providing all the details of the now nearly month-old piece, suffice to say, Citi looked unusually exposed, going forward, to more loan losses and slowing growth.
The nearby pictures, including the smirking visage of Mr. Pandit, accompanied the article.

I found this article concerning Pandit's recent compensation numbers, since I had not saved the Journal's piece on this stunner. It reads, in part,

"Citigroup Inc.'s new chief executive Vikram Pandit received $3.16 million in total compensation during 2007 - the year that started with him running his own hedge fund and ended with him at the top of the largest U.S. bank by assets.

And to convince Pandit to stay with the troubled bank while he works to extricate it from losing bets on mortgages and the now-frozen credit markets, Citigroup's board in January signed off on awards valued at about $102 million. That includes a $2.5 million retention equity award; nearly $27 million worth of stock, and 3 million options that in January were worth around $73 million.

For his six months at Citigroup last year, Pandit received a salary of $250,000, according to a Thursday regulatory filing. He received no cash bonus and no perks, but got stock and option awards in July worth $2.91 million."
As I wrote here in late December of last year, Pandit already had a "can't lose" proposition from the Citigroup board. About a week earlier, I wrote this spoof of a hypothetical interview with Pandit, upon his elevation to Citi CEO. As I note in the piece, Pandit and his partner, John Havens, have already received some $800MM for their underperforming hedge fund group, Old Lane Partners.
Now, in concert with the special awards to 'retain' Pandit in this already-plum job, they also elevated his erstwhile hedge fund partner, now Citi confidant, John Havens. Havens, as I recall from the Wall Street Journal article, also received a nice bonus to stay in his cushy new job, as well.
Let's be truthful here. Does anyone besides Citi's board think that Pandit and Havens are likely to bolt their new, overpaid positions running Citigroup? These guys were trying to keep an underperforming hedge fund in business less than a year ago, and now Pandit is CEO of one of the country's three largest commercial banks. His former partner is still his right-hand man at the new firm.
If we needed yet another glaring example of pay for non- or yet-to-be performance, besides Jeff Immelt's, on which I commented in this recent post, this would be it.
Then, last friday, the Wall Street Journal reported that Citigroup is to lay off an additional 2,000 staffers. The article stated,
"Mr. Pandit and other senior officials had said previously that multiple rounds of layoffs are one component of a broad cost-cutting strategy that the bank is undertaking as a result of investment losses stemming from the mortgage crisis. Citigroup has been hit particularly hard by the crisis, having written down the value of its assets by more than $20 billion in the last year."
This distinctive drawing of Pandit accompanied the article. Once again, the CEO is caught in a laughing expression.
It's almost as if he's saying,
'Ha ha, the joke is on you guys! I got the CEO job and millions in compensation, but you get the sack!'
Just a friendly aside. If I were Vikram Pandit, I'd contrive, with my public relations staff, to arrange for some better photo ops to let me show some more concerned, business-like facial expressions. Anything to dispel these grinning, smirking countenances amidst the business of firing people and presiding over record losses at Citigroup.
In the final analysis, does Citigroup's board really believe they need to further incent Pandit and Havens to keep these jobs? My earlier post about Pandit's can't lose situation suggests that he isn't going anywhere for a while. He has nothing to gain by leaving. Neither does Havens.
As the nearby, Yahoo-sourced price chart of Citi and the S&P500 Index for the past three months shows, it's a bit early to reward Pandit for any 'success.' One brief bounce does not a recovery make. So we know these awards are not for his performance of the past few months.
Yes, I know the awards are equity-based in large part. But it's the image that counts, and right now, it appears that the board is just throwing potential windfalls at Pandit.
If Citi really wants to reduce expenses, how about starting at the top?

Tuesday, March 25, 2008

Glass-Steagall, The Fed & Investment Bank Access- Part 2

Last week, exactly a week ago, I wrote my initial thoughts on what I consider to be the most important single US financial services event since FDR- Bernanke's Fed opening the discount window to non-commercial, investment banks.

In the week since, if anything, my conviction on how much of a watershed event this was has grown.

Paradoxically, my sense of the importance of the 'rescue' of Bear Stearns has shrunk, if it could. Yesterday, I wrote about the implied capacity in the market of various investment banking functions- underwriting, trading and M&A advice. I omitted asset management, but that is clearly a sector with nearly-unlimited capacity.

Looking beyond simply Bear Stearns, can anyone truly justify the existence of all four of Goldman Sachs, Merrill, Lehman and Morgan Stanley? Especially in the modern world of large private equity firms and hedge funds? The former provide additional underwriting, M&A advisory and asset management, while the latter focus on providing trading capacity and investment management.

Other than emotional reaction of former employees seeing their old firm's name vanish, what would be different if one or more of those names were bought by or merged with a commercial bank?

Contrary to Andy Kessler's view, in the Wall Street Journal this past January, about which I wrote here, it's unlikely now that an investment bank will do the buying. With their high leverage and dependence upon commercial banks for funding, I suspect the investment banks are the more vulnerable. Now having access to the Fed discount window, it's only a matter of time before the regulators get around to levying a new regulatory framework on the investment banks.

I suppose, in light of the new developments, Kessler might now be correct in hypothesizing that a Goldman Sachs might backward integrate, and merge with the commercial bank of its choice. But, absent the recent development with the Fed window's opening to non-commercial banks, I would not have thought that likely.

What puzzles me is how many people, when I comment on last week's watershed event, respond with,

'Oh, yes, the Bear Stearns bailout.'

It seems that the bulk of investors, institutional and retail, don't yet fully grasp the incredibly large step toward socialized finance that the Fed took on Monday of last week. Unless they can actually retract this access at some point, and close the window to investment banks, and make investors and financial service providers believe it won't ever happen again, then the industry's structure has now changed irrevocably.

From such landmark change must logically follow changes in the structure of firms and regulation. Whether a Republican or Democratic Congress and/or President, the next few years pretty much require the follow-up explicit regulatory finish to the implicit structural changes that led to this point, i.e., Sandy Weill's breach of Glass Steagall by merging Travelers with Citibank.

It's unlikely, but still possible, that a Democratic Congress would repair the breach and resurrect some version of Glass Steagall, perhaps even legislatively prohibiting the Fed's jurisdiction over non-commercial banking.

However, I think the more likely avenue, now that the breach has been widened to actually level the wall entirely, is to simplify regulation and, consequently or in tandem, see a streamlining of service providers and their composition.

Specifically, I would expect fewer separate publicly-held, regulated entities such as commercial banks, investment banks, and brokers. Instead, I think you will finally see the integration of these functions into fewer, larger and more diversified European-style universal banks, with larger shares of more financial services businesses.

Of course, with this 'bulking up' will probably come even more anemic, inconsistent total return performances. Again, just like that of European universal banks.

Seen from a more distant vantage point, does this not all make some sense? We had a concentration of financial capacity and risk taking among lightly-regulated firms specializing in peddling ever-more opaque, complex products to investors. When the value of these complex 'structured finance' instruments became difficult to discern, and the concentrated risk came home, capital shrank as losses among commercial and investment banks caught holding these instruments had to account for the newer, dramatically lower values.

It's a sad commentary on the acumen of the CEOs and senior managements running these firms: Citigroup, BofA, Merrill Lynch, Morgan Stanley, and Bear Stearns. The natural, if erratically-timed governmental response, is to save the financial system, and, thereby implicitly restructure the sector.

Risk and capacity are likely to be further concentrated, but, in exchange, more tightly overseen and regulated.

A natural consequence to this will probably be even more smart financial services people migrating back to the privately-financed arena. Just like consumer goods merchandising has the 'wheel of retailing,' whereby new entrants compete at the low-cost end of the market, as existing players migrate upwards in terms of quality, service, selection and price, so, too, it seems, will financial services now have its own version of this 'wheel.'

Only in financial services, the 'wheel' is between publicly- and privately-held concentrations of capital and risk management. Again, viewed from afar over decades, the story of commercial and investment banking for the past forty years has been a gradual selling of transactions, asset and risk management businesses at their 'tops,' as formerly-private banks of both stripes went public, followed by managerial ineptitude, decline in risk management, and excesses in pursuit of growth via more risk.

Now that the public is absorbing the brunt of the losses, via equity ownership of these firms, the logical next step is for the better executives to join the early-adopters in forming new, or joining existing private equity and hedge fund shops.

And the wheels continue to turn......

Monday, March 24, 2008

Mediocrity Triumphant: The (JP Morgan) Chase Story

Over the weekend, I had some time to reflect on the financial services events of the past nine months. From conversations with a couple of industry veterans, my business partner, and two economics students, and various Wall Street Journal articles in the past week, I realized that there are two cross-currents in the industry which have accidentally led to the current, possibly temporary, resurgence of the most mediocre of all of the original US money center banks, Chase.
One current has been Chase's historic and continuing role as a large, mediocre money center bank which has usually been far less risk-taking and aggressive than other US large commercial banks.
The other is the recent credit crisis which has, ironically, left the staid and usually lagging Chase as the commercial bank of last resort for the Fed's rescue of Bear Stearns.
Even in the latter case, Chase hardly excites.

For instance, this morning's news featured Chase's increased bid for the wreck of Bear Stearns. Now, the plodding commercial bank is willing to pay $10/share, quintuple what CEO Jamie Dimon swore was his highest offer only last week.

In the Journal's Marketing section, Carol Hymowitz extolled Jamie Dimon & Co.'s prompt action to buy Bear Stearns two weekends ago. Unfortunately, Ms. Hymowitz neglected to ask whether this is really a smart, long term move for Chase shareholders.
My guess is that it is not.
This morning I had a long conversation with my old friend, sometime mentor and business partner, B. We agreed that Chase's purchase of Bear Stearns is probably an expensive luxury.
There are many reasons for this, some of which will be the subject for another post. As I have written elsewhere in the past few months on this blog, I believe that margins and growth in underwriting and M&A business confirm that these investment banking businesses suffer from excess capacity and have become commoditized.
Trading, another classic core investment banking business, does not have a shortage of capacity, either. However, profit in this business comes from advantaged traders, risk management, and superior strategies. In this regard, few commercial or investment banks have recently demonstrated any of these. Goldman Sachs would be the one exception.
That said, what, specifically, is Chase buying, besides a new building, for its $10/share offer? As a commercial bank in the wake of the end of Glass Steagall, Chase can do any business Bear could do. And Bear engaged in poor risk management, which makes me wonder just how valuable its book of business would be.
The one business that Chase has singled out as desirable, prime brokerage, could, as always, have been less expensively obtained by hiring the ex-Bear staff of this business, not buying the entire firm.
In fact, B and I laughed over how Dimon had probably been lamenting how late Chase was to the original mortgage banking and securitization party.
But what would you expect from a large money center bank which is the result of cobbling together seven large predecessor banks.
Many years ago, my mentor, Chase Manhattan Bank SVP of Corporate Planning, Gerry Weiss, opined, when asked about eventually merging Chemical, Manufacturers Hanover, and Chase,
'Why would you want to do that? All you'd have from merging three mediocre money center banks is one great big mediocre money center bank?'
Just so. The modern Chase is the result of two bloodlines. From New York, just what my old boss feared came to pass. Chemical took over Manufacturers Hanover when neither was dominant, but Chemical was doing better than the latter. Then Chemical took Chase and its name when mutual fund manager Michael Price drove the ailing, slow-moving latter bank to seek a buyer before Price forced its CEO, Tom Labrecque, to break up Chase Manhattan.
Later on, JP Morgan, long having run out of steam from its days in the mid-80s as a dynamic, nimble money center along with Bankers Trust, fell into Chase's lap.
Meanwhile, in the Midwest, BancOne's acquisition model had stalled and the bank had fallen on hard times. In 1998, the product of a merger between Detroit's NBD and First Chicago took over BancOne, but kept the latter's name. This merged Illinois-based bank was what Jamie Dimon went west to manage before selling the mess to Chase a few years ago.
Thus, ironically, Chase is now the product of seven (or more, if you begin to count Manufacturers Bank, as distinct from its old merger partner, the Hanover Trust Company, and Chase as distinct from the now-merged Manhattan Company) mediocre, large US commercial banks. Not one of the predecessors banks was ever seen in the same aggressive light as BofA or Citigroup, not to mention the acquiring regional powerhouses, the old National Bank of North Carolina, now known as BofA, or First Union, now Wachovia.
The banking history is in order, I believe, to help us understand how Chase has become the staid, large, mediocre bank of today. Not having shot itself in the foot with SIVs like Citigroup, or over-expansive mortgage and investment banking, like BofA, Chase got the chance to receive a $30B guarantee gift from the Fed earlier this month, in exchange for taking over the remnants of Bear Stearns.
If you look at the nearby, Yahoo-sourced price chart of Chase and the S&P500 Index for the past two years, you see that the former has now outperformed the latter. But only within the last several months.
The two have closely tracked over the period, with Chase outperforming modestly for a slightly longer time. The sharp rise in Chase's price so recently as to approximate a vertical line suggests this is unsustainable. As recently as late last month, the S&P was ahead.
My guess is that, over the next six months to a year, Chase's margin of outperformance will shrink and, quite likely, disappear.
As the remaining stable money center bank, Chase may be destined to outperform its commercial bank peers, but probably not the S&P.
You can dress it up anyway you like, but Chase's core culture(s) is one of mediocrity, lack of innovation, and risk aversion.
That should allow it to survive, but hardly become a preferred holding to the index over time.