Friday, April 04, 2008

Congress Determines There Were No Buyers of Toxic Structured Finance Instruments- Only Sellers!

This week's appearance by Bernanke in front of a joint Congressional committee provided another pathetic example of Ted Kennedy's failing grasp of reality. To be fair, not only Teddy, but many of his Democratic and Republican fellow Senators and Representatives, too.

Brow beating the Fed Chairman, Ted repeatedly asked Bernanke why the Fed didn't 'remove harmful financial products' from the 'shelves' of America's banks, just like the Congress forced toy retailers to clear their shelves of lead-contaminated painted toys. Judging from Kennedy's assault on Bernanke, it is clear that Ted thinks there were no buyers of structured finance instruments, only sellers.

Here's a little piece of information you evidently missed, Ted.

Wall Street's investment banks, and commercial banks, too, wouldn't have securitized toxic loans if there weren't informed, willing adult institutional buyers.

That's right. Nobody actually put a gun to anybody's head to make them buy CDOs or auction-rate securities.

As I wrote in this post last year, every institutional investor who bought CDOs, shares of an SIV, or other structured finance instruments surely believed they were receiving excess returns for no commensurate additional risk.

Without willing buyers, none of the risky, opaque structured instruments now so roundly criticized and reviled by regulators and Congressional pooh bahs would have ever been created and sold.

Further, very few retail investors seem to have bought CDOs. Those were mostly institutional investors including your typical local county or state pension or sinking funds. Those people are paid to make informed investment decisions. They can't blame the rating agencies or their investment bank advisers for decisions for which they are handsomely paid.

These investment professionals, the ones who willingly bought CDOs, SIV shares, and similar structured finance instruments, are, it seems to me, the real source of the financial market excesses. These people, whoever and wherever they are to be found, failed to exercise due diligence in understanding what they were buying on behalf of their investing organizations.

How does Senator Kennedy propose to stop this consensual buying behavior?

Maybe we should be realistic and stop denying the obvious. We have financial market turmoil because a lot of institutional investors failed to do their jobs, became greedy, and believed excess returns could be had for no added risk.

It turns out that they were, as usual in every financial cycle, wrong on all counts.

Don't blame the sellers of these instruments. Or at least, not them alone.

Blame the buyers who provided the market demand for the toxic financial paper that lies at the root of the credit market mess.

Thursday's Senate Financial Regulator Witchhunt

Yesterday provided some free comedy theatre. The Senate banking committee grilled Chris Cox, Bob Steele, Tim Geithner and Ben Bernanke, respectively, SEC Chairman, Treasury Undersecretary, NY Fed President and Fed Chairman.

As usual, the spectacle was both amusing and frightening. Among other adults who understand financial markets who were at my fitness club in the afternoon, the universal sentiment was something like,

'These clowns barely understand what they are overseeing/regulating, and they've been on this committee for years!'

Of course, between this being an election year, a year with a more slowly-growing economy, and in the wake of the subprime mortgage and fixed income markets debacles, all of the Democratic Senators are attempting to hang all possible blame and responsibility on the administration of the opposing party. The Republican Senators, predictably, ask the respondents helpfully leading questions to elicit explanations that depict and impossible situation which could not be managed ahead of time.

If I were giving awards for this comedy show, without question the award for Most Witless Statements and Questions would go to Jim Bunning of Kentucky. The always-irascible former pitcher thinks he knows much, much more than he does. This time, he castigated the Fed for not knowing all about the brewing subprime lending debacle years in advance.

I'm guessing Jim still doesn't realize that, as Michelle Caruso-Cabrera so ably stated recently, in America, we let innovation work in free markets, until they don't. We don't generally regulate a priori with a heavy hand.

The award for Narrow-minded Agenda and corresponding Witchhunting Questions would go to.... Chuckie Schumer of NY.

This perennially partisan Democratic Senator focused with laser-like precision on a sort of 'what did you know and when did you know it?' line of questioning in an attempt to make all of the regulators present look stupid and slow. Of course, it didn't work because Chuck is actually the slow one, showing no grasp of the rapidity with which modern financial markets can move liquid assets away from a financial institution. As Chris Cox explained- many times, due to the Senate panel's stupidity- Bear Stearns lost $10B of its $12B of liquid assets during the Thursday before the weekend during which it effectively ceased to exist independently.

Bob Menendez, the corruption-tinged Democratic Senator from my own state of New Jersey would be the runner-up for witless questions. He embarked on some will o' the wisp search for 'quantitative' measures of the ultimate value of securities the Fed took as collateral for its $29B loan in the matter of the Bear Stearns collapse.

If Menendez had a real grasp of finance, which shouldn't be too much to ask after his years on this committee, he'd understand that the incredible complexity and fluidity of the financial situation surrounding Bear Stearns prohibits firm dollar amounts to be known for various risks and valuation of securities. Unfortunately, asking Bob to actually learn something about the industry overseen by the committe on which he sits is apparently too much.

"Doddering" Chris Dodd, chairman of the committee and Democratic Senator from Connecticut, also postured and blustered about the situation, with little in the way of any insightful questions. Preening from CNBC's Jim Cramer's fawning adoration earlier in the morning, Dodd behaved with that all-too-familiar Senatorial gravitas, as if he and his fellow committee Democrats were the last protective barrier between Americans and their financial assets.

As I noted earlier, the only real message that came through to me from the morning's, and, for that matter, afternoon's questioning of various financial markets regulators and players, was how little grasp of modern financial markets and the plumbing that allows them to function smoothly these Senators have, after so many years allegedly making acquaintance with the sector.

It's really tempting to believe that no Congressional oversight whatsoever wouldn't be much worse than oversight by a collection of preening, pompous, self-aggrandizing fools and idiots.

Thursday, April 03, 2008

More on Auction Rate Securities

The Wall Street Journal published an article this past Tuesday on auction-rate securities, with another one this morning. Recently, I've been getting a large number of readers coming to my blog for this post from mid-February.

Probably the best that can be said is that nothing has improved about this situation.

In Tuesday's article, the Journal reported that UBS has begun writedowns of retail account holders' auction-rate assets. Today's article noted that, by contrast, Merrill Lynch is still recording them at a higher value to its retail customers, although they note that the firm itself has reduced the values at which it carries comparable auction-rate securities.

To attempt to end the mess involving these notes, some issuers either calling their own notes or simply refunding with conventional long term debt.

But it's noteworthy that nearly two months after the Journal's first mention of this market failure, the only 'solutions' in sight are the same as those originally mentioned- lending to customers on the collateral of a reduced value of the auction-rate securities, and calling/reissuance of the auction-rate securities as conventional longer term securities.

Is this not essentially indicative of an instrument which has no further use in current markets?

Like a hot-house flower, it seems that auction-rate securities could only exist and thrive in a rather narrowly-defined financial market condition. A condition of fairly easy and low-risk credit which has now vanished from current credit markets.

At this point, it is probably fair to say that the word 'fix' doesn't really apply to the auction-rate securities dilemma. A word like 'end' or 'terminate' seems more applicable. In time, one suspects that these securities will simply disappear as they are replaced by less-volatile, truly more cash-equivalent securities.

Hopefully, both issuers and buyers will now be more sanguine and suspect when Wall Street securities salespeople insist that some abstruse, complex instrument is 'as safe and liquid' as cash.

Wednesday, April 02, 2008

The Uptick Rule & Recent Market Volatility

Yesterday's Wall Street Journal piece on the effects of the removal of the 'uptick rule' provided some fascinating information on recent changes in the securities markets.

As background, the article began with the passage,

"With the stock market posting its worst quarter in six years, an obscure change in how stocks are traded is the subject of a nasty debate on Wall Street, with one side blaming the switch for everything from increased volatility to the collapse of Bear Stearns and the other side dismissing those critics as fools and worse.
The subject of this rancor is the "uptick" rule. Until July, investors typically had to wait until a stock was rising before they could wager on its decline. Under this rule, adopted in response to the stock market's crash in 1929 to inhibit bearish traders, there had to be an "uptick" in a stock's price before traders could short the shares. In other words, investors could borrow shares and sell them, hoping for the price to fall, only after a trade that pushed up the stock's price.

After years of academic research suggested that the rule was hindering trading without protecting prices, regulators eliminated the rule last summer, giving a green light to those eager to sell a stock short, even as it was falling."

So last summer, just as the Bear Stearns mortgage-backed mutual funds were experiencing losses, the uptick rule disappeared. Accordingly, the article notes,

"Some argue that the move unleashed a new era of volatility. Consider the drastic drop in Bear Stearns stock, which tumbled to $4.81 a share March 17 from $57 just two days earlier. When groups of traders short a stock they effectively flood the market with shares they are selling -- even though they don't actually own them -- which can drive down prices and sometimes even cause a panic, critics say. Some investors maintain that groups of hedge funds and others conspired to knock down Bear's stock price, hoping to profit by forcing the big brokerage to seek bankruptcy protection.

"Traders are in hog heaven -- they keep banging and banging a stock [down] -- but investors find it hideous," argues Mario Gabelli, chairman of Gamco Investors, who wants the rule re-instated. "The increased volatility causes investors to want higher returns, so there will be a higher cost of capital for companies, putting our markets at a competitive disadvantage."

Adds Martin J. Whitman, founder and co-chief investment officer of Third Avenue Management: "In my 58 years in the market, it's never been easier to conduct bear raids." His funds sustained losses when shares of companies such as CIT Group and bond-insurance companies, such as MBIA and Ambac Financial Group, fell significantly, declines he blames on short-sellers.

And, just over a week ago, CNBC's James Cramer encouraged his viewers to contact the Securities and Exchange Commission and Congress to complain about the change, saying that "tens of billions of dollars" have been lost because of the change, and that SEC officials "are total morons" about the issue.

Thus we have a number of industry pundits complaining that the sky is falling, and all because of this one minor change. But there are other views, as well. For example, as the Journal piece continues,

Hogwash, say others. They argue that a debt crisis and economic weakness are at the root of the market's problem.

"Anyone who thinks the removal of this rule is somehow causing havoc in the financial markets is hopelessly lost in the bark of one tree and may never be able to see the forest," says James Bianco, who runs Bianco Research in Chicago. He notes that there were ways around the uptick rule, such as using options strategies and exchange-traded funds, or simply violating it and paying a small fine. "To suggest that the removal of this rule is causing the markets to go down is to loudly announce 'I don't understand the credit crisis, and I am incapable of ever understanding it.'"

I love Bianco's comment. And the Journal article clearly set up the sequence in order to imply that Bianco thinks anyone who thinks and behaves like Cramer is 'incapable of ever understanding' the credit crisis.

Which I think is pretty much true, in Cramer's case. He railed for lower Fed rates and bailouts for his hedge fund and trading desk friends. But the credit crisis, as I've since written, has always been more about counterparty risk than it has about a need for lower costs of funds.

The article goes on to describe some of the other, confounding changes in the markets which occurred with the disappearance of the uptick rule. To wit,

"But lots of bad things have gone on in the market since July, making it difficult to isolate the impact of the dissolution of the uptick rule. And volatility eased when the market rebounded in October, though it remained somewhat above pre-July levels.

A representative of the SEC, which made the rule change, notes that since 2001, stocks have traded in decimals, rather than fractions. So even before the July change, a bearish-minded investor easily could have pushed a stock even just a penny higher with a little buying and then come back with a big short sale, effectively skirting the intent of the rule. He notes that some foreign markets also have seen a volatility spike, even though there were no similar changes in how stocks can be shorted."

Decimalization alone is very important. So, of course, is the usage of puts to do what shorting does, without any uptick complications.

I think it's pretty hard to view the relevant market changes since last summer and lay all of the damage on one rule involving upticks.

Tuesday, April 01, 2008

Michelle Caruso-Cabrera's Sound Thoughts On Our Financial System

Michelle Caruso-Cabrera, one of the brightest on-air personalities on CNBC, and one of perhaps only two with a business or economics degree, had some choice words yesterday afternoon about the US financial markets.

As Steve Liesman whined about market failure, and Dennis Kneale made some fairly forgettable remarks, She conveyed eloquently in just two minutes several complex but important sentiments.

Among the salient points Caruso-Cabrera made in her brief comment were:

-Our financial system is all about risk and innovation, not control.

-Unless it's prohibited, you can do it.

-By contrast, in other countries, like France, if it's new, you must obtain explicit permission.

-Financial service firms will abuse leverage in every cycle. It is, she said, 'addictive- it's their cocaine.'

-So we have to expect some blow-ups in financial markets every few years.

-Regulation won't ever stop this, because we favor innovation and growth over control.

Could anyone capture the essences of US financial markets any better or more succinctly? I doubt it.

In the process of explaining these points, Ms. Caruso-Cabrera implicitly provided the rationale for why there will always be a tendency toward US financial market excesses. Innovation and risk taking lead to the marginal service provider taking the imprudent, marginal risk, in search of excess returns.

The key is not to smother innovation, but to attempt to provide sufficient safeguards, in the manner of clearing exchanges with collateral, margin and settlement rules, to make any one party's downfall less cataclysmic to the entire financial system.

And that is something Treasury Secretary Paulson clearly understands and is moving to do, per my post on his recently released blueprint for regulatory reform of the US financial service markets.

Monday, March 31, 2008

Secretary Paulson's New Financial Markets Regulatory Blueprint

Hank Paulson's speech last Wednesday to the US Chamber of Commerce on financial markets regulatory redesign, about which I wrote here, was, in retrospect, a warning about today's release of the Secretary's 'blueprint' for a new scheme.

You can read all about it in today's Wall Street Journal. The details would be many, I am sure. The executive summary was reported to be some 22 pages, the full report running to something in excess of 200.

However, to me, three facets of the recommendations stand out.

The first is one on which I picked up during Paulson's speech on Wednesday- forming exchanges for current OTC instruments such as credit default swaps. When he referred to this on Wednesday, I found it telling.

When Paulson mentioned it twice today- once in his speech, and another in an interview on CNBC- it told me that Paulson correctly understands that these unregulated instruments, whose settlement and clearing has become problematic, are going to be reined in hard.

This is a good thing. Leaving them roaming in OTC land has become a dangerously destabilizing feature of today's financial markets. It may end up as one of Paulson's two best legacy achievements.

The other would be Federalizing the insurance markets. Paulson took the politically difficult, but economically- and regulatorialy-necessary step of calling for Federal supervision of insurance to supersede any existing state-level regulations. Citing national and international scale of providers and a need for competitive developments in the industry, Paulson's recommendation may finally force loose a major stumbling block which has helped delay meaningful progress on affordable healthcare insurance plans in this country. It would be his other monumental legacy to accomplish this particular Federalization.

The third noteworthy aspect of Paulson's recommendations is the near-term formation of a Federal mortgage certification board. The intended consequence of this board would ostensibly create a body of Federally licensed mortgage industry professionals.

Are there no bad practitioners of law or medicine? Plumbing, electrical work or carpentry?

Licensing alone will not prevent the shoddy lending practices or improper mortgage broker activity which played their parts in the home lending debacles now being sorted out.

A recent Wall Street Journal editorial noted that requiring licensing for a profession typically raises prices, but offers no guarantees of better products or services. This will, sadly, be true for the mortgage business, as well.

Rather, as my partner suggested over a month ago, the more obvious and simple solution is to require a 20% cash downpayment for any mortgage made in the US. Period.

No exceptions. A borrower's balance sheet must be frozen and clean, and on that balance sheet must he sufficient cash to constitute 20% of the purchase price of the home.

Most of the problems with subprime mortgages or shady brokers would have been mitigated simply by requiring the borrowers to qualify with 20% of the purchase price in cash.

It is very similar to the original installment credit regulations in place in the US in the 1950s, before the growth of installment lending via bank credit cards.

Other than overloading the Fed with excess supervision duties, as I noted in my earlier, linked post, and this bad idea for mortgage banking licensing, Paulson's recommended blueprint for newly-regulated US financial markets holds great promise, and is long overdue.

Carl Icahn & Motorola: Are Big Changes Afoot?

Last May, I wrote this post when the Wall Street Journal's minority-owned '' group castigated Carl Icahn for trying to gain seats on Motorola's board.
The post contains two interviews with Icahn at that time, plus some then-current price charts of Motorola and the S&P500 Index.
This past Thursday, the Journal carried an article discussing Motorola's partial surrender to Icahn, in the form of their announcement to spin off the handset unit, though not necessarily until 2009.
Here's an updated five-year price chart for the company and the S&P500.
Clearly, things have only gotten worse since last spring.
On the face of it, Motorola's decision to simplify its business by ridding itself of the ailing handset business is sensible.
But Carl Icahn wants more assurances that things will change. For example, in the Journal article, he noted that the company's promise to spin off its handset business is not the same as actually getting it done expeditiously.
Further, Icahn reminded investors and the public that he complained last year when management badly missed quarterly performance targets. He still believes the company is poorly-managed, handset business or not. That's why he is still seeking four seats on the company's board.
Will any of this help the troubled communications equipment maker?
Spinning off or selling the handset business will be a good first step, as it seems, as run by Motorola, to be more like a fashion business than a solid equipment business. Having missed with customers after the now years-old, 'must have' Razr line, it is probably better off letting others manage the quixotic unit.
That will leave it with a clearer focus on networking equipment. The good news might be that most of the firm's awful performance since early 2006 has been handsets, and it will now right itself in short order.
Or, the bad news may be that Icahn was right to demand a large cash dividend, because the firm's core communications network business is also now hopelessly behind competitors.
Either way, I know I wouldn't be investing in the firm for some time to come.