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Shopping Spree

Far be it from us to be so cynical as to attribute crass economic motivation to regulators, who are bound by the notions of transparency and market integrity.

The Wall Street Journal (14-15 November, “A Capital Plan For The Insurance Industry”) reports that the National Association of Insurance Commissioners (NAIC) is taking ratings of asset-backed securities out of the hands of the ratings agencies.  Their stated concern is that, with some 18,000 mortgage-backed issues slashed from A down to CCC, insurance companies will shop for ratings in an effort to mitigate their capital requirements. 

This scenario is, of course, nothing more than a rinse-and-repeat of the way the world got into this mess in the first place – where issuers, not investors, paid for ratings, and where ratings agencies had to award investment-grade ratings merely to stay competitive.

The American Council of Life Insurers, says the article, estimates “the low ratings have boosted capital charges for insurers by about $9 billion.”

The states and the federal government are locked in a winner-take-the-disgusting-leavings bout over who will regulate which aspects of the financial marketplace, and the NAIC’s push to set a standard for ratings hits two nails squarely on the head.  One, is that it challenges the clearly self-serving process of issuers and buyers seeking their best deal from ratings agencies; the other is that it flexes muscles at the state level, where insurance is regulated, and may block anything less than a full frontal assault by Congress.  With enough on their plates, and ample opportunities to repeat past mistakes, Washington may choose not to join this battle.

The NAIC’s action will play well on Main Street, as the Association can claim they are removing the conflict of interest from the rating process.  But their targeted outcome is also to reduce capital requirements at the insurers they regulate, which means it should play quite well on Wall Street. Since the SEC has not managed to keep the ratings business free of conflict, we would not be at all upset if the NAIC will.  Indeed, one could argue it was their job all along, and they failed miserably.  This still begs the question of who it is the regulators are protecting.  We suspect they are trying to strike a balance between regulatory overhaul, and not killing the goose that lays the golden eggs.

From the political side, we agree with the Journal that this action looks “rushed.”  We are all for the regulators regulating the marketplace, but regulators need a thriving marketplace, otherwise they will themselves be out of a job.  Penetrating study will be required to determine where the NAIC finds the balance between assuring the public of a safe market for investing, and assuring market participants that they will stay in business.  Who will regulate the regulators? 

Cuckoo For CoCos?

The latest regulatory trial balloon being floated in the financial press is the CoCo – the contingent convertible bond.  This new-fangled instrument appeared at its coming-out party on the arms of no less a beau than Lloyds Bank.  The debutante was wearing a tattered dress, but smiling nonetheless.

Lloyds Banking Group has offered to exchange some $11 billion of debt into CoCos, a form of subordinated debt that morphs into common equity – generally at the worst possible time, and without the bondholder’s consent. 

What is this odd beast, and how does it work?  As described in the Financial Times (13 November, “A Staple Diet Of CoCos Is Not A Panacea To Bank Failures”) “What differentiates them from a normal convertible bond is that the trigger is a regulatory flashpoint, not an asset price swing.”  This allows banks to “strengthen their capital base in a crisis, without tapping taxpayer funds, or going to the markets.”

Simple English:  when a bank’s capital ratio goes down to the point that it can no longer sustain the total debt it has issued, your chunk of that debt automatically converts to equity.  Voila!  No more nasty debt clogging up the bank’s balance sheet, no fresh injection of capital needed, and no risk of default.

Pardon us, but this looks like a total win for the banks and the leading edge of significant regulatory caving-in.  The CoCo is essentially a bond which, instead of a covenant, is issued together with a put to the bondholders.  In the Lloyds case, the exchange is being offered at a discount of more than 50% of face value to holders of subordinated debt.  One might argue that, in the current climate, subordinated debt holders are lucky to be offered anything at all – the bonds in question are no longer paying.  Still, in the good old days bondholders were protected by covenants, and banks had to maintain capital, or go to court to prove why they should not pay out on their obligations.  The risk of bond defaults, with reputational damage and the looming threat of bankruptcy, were all seen as protections for those pieces of paper whose very name means “obligation”.

Enter the CoCo, which permits the bank to automatically convert its “obligation” into “equity”.  “Equity,” we should point out, means “what is fair,” which can be very good.  It can also be very, very bad.  If there is an obligation of the bank that it pay its bondholders, the shareholders will get what’s left over.  That is fair.  And if there’s nothing left over, well, that’s fair too.

The Basel-centered regulatory regime is considering promoting CoCos across Europe and the US.  New York Fed president William Dudley recently said (Financial Times, 12 November, “Wall Street And Fed In Discussions Over CoCos”) that “the worst aspects of the banking crisis might have been averted” through the use of “contingent capital buffers.” 

This looks to us like a stupendously dreadful idea and all sorts of words come to mind.  Slippery Slope – the looming regulatory change permitting banks to all but dispense with capital requirements.  Moral Hazard – the notion that an obligation will no longer be “really” an obligation, but only an obligation as long as the bank feels like it.

This further feeds the bifurcation of the marketplace, as strong participants, major financial institutions, will insist on, and receive, guaranteed obligations with actual capital reserves underpinning them.  Meanwhile weaker investors will increasingly be cashed out with the corporate equivalent of a Pay In Kind transaction.

All of this means that legislation to promote the use of CoCos will probably be implemented soon, as the world’s regulators are desperate to be seen as doing something.  And it looks set to create a splendid new government loophole that will allow banks to issue bonds without additional capital requirements.

In the case of the Lloyds bonds, they are already in trouble.  Swapping subordinated debt which will not be paid off anyway, with a junior-junior obligation on its way to converting to equity looks like prolonging the agony.  But investors and issuers alike are notoriously reluctant to switch off life support, especially if it means a capital impairment for the bank.  In the world of financial services, where everything comes down to convincing someone else to buy something, it is easier to sell a loser a new piece of paper that, one day, will convert to yet another piece of paper than to say “Ooops.  Guess that didn’t work out.”

Forgive our ignorance, but to us the CoCo looks like a pre-guaranteed default.  It gets the government off the hook for at least that piece of the bank’s capital, and it puts the bondholder well on notice.  “Don’t say we didn’t warn you.”  This looks like a regulatory cop-out of staggering proportion, which guarantees it will be implemented.  If the whole world agrees to undermine bank capital requirements, does that make it OK?

If a bond covenant is like a prenuptial agreement, the CoCo is like asking the bride to waive alimony and child support before ever she walks down the aisle.

Would you buy a used bank balance sheet from this regulator?

The Gang That Couldn’t Prosecute Straight


That was the word last week at the US Attorney’s office in Brooklyn, when a jury acquitted Ralph Cioffi and Matthew Tannin on all counts relating to alleged fraud in the Bear Stearns hedge funds they managed in spectacularly unsuccessful fashion.

We wonder whether the prosecutors really believed that tossing inflammatory emails in front of a jury would sway them all the way to a guilty verdict.  A criminal fraud conviction is serious stuff, and the penalties are awful.  Twelve common citizens commonly rise to uncommon heights when given responsibility for a person’s freedom.  Here it would appear they took this responsibility quite seriously. 

We know enough of the practice of law to recognize that intent is devilishly hard to prove.  We wonder why the prosecutors did not tailor a more subtle case.  Surely the argument could be made that a hedge fund manager’s not sharing his existential concerns about the portfolio with investors can be termed a cover up.  One need look no further for motive than the desire to be allowed to continue to run the hedge fund and continue to draw a management fee.

The only explanation we can come up with is the prosecutors believed they could win on the crest of a wave of public outrage.  That this first case, combining as it did two such hated terms – “Bear Stearns” and “hedge fund” – would bring the jury’s blood to a boil.  If the government had won its case on sheer emotion, they could have established a prosecutorial benchmark that would have Wall Street running scared, and would be juicing defense lawyers’ fees.

Boy, did they get it wrong.  The jurors seem to have felt the US Attorney’s office was trying to dupe them by culling lines from emails.  Jurors who were interviewed after the verdict pointed to the isolation of phrases taken out of context from longer emails.  One juror spoke of Cioffi and Tannin as captains who were willing to go down with the ship.  Another praised their dedication and self sacrifice, pointing to email exchanges at 4:00 AM.  Fraudsters sleep at night, was the implication.  Honest guys don’t.  Perhaps the bluntest of all was the juror who praised Cioffi and Tannin for their tireless devotion to their investors.  If I had money, said this juror, I’d invest with them today.

Even assuming the US Attorney’s office truly believed in this case, it appears poor tactics to bring a case that changes the game, but is hard to win.  One might wonder whether the taxpayer, the investing public and the world’s financial markets have been ill served by prosecutors trying to win a case of such magnitude.

The SEC is in the on-deck circle, preparing to bring their civil case.  In the aftermath of the not guilty finding, we think they may have some difficulty.  And with Judge Rakoff’s lambasting of their process in the Galleon matter as a backdrop, the SEC might find courts and juries increasingly ill disposed towards the multiple-bites-of-the-apple approach.  To the lay person it walks, waddles and quacks like a double-jeopardy duck.

The SEC might do best to use this case to establish parameters for negligent behavior.  This could have some real utility and set the ground rules for what is sure to be an increasing flow of cases.  If the SEC’s case is going to rest on damages – you lost people’s money, you have to pay it back – then it becomes a business decision by Cioffi and Tannin, and by whatever remaining Bear entities might be drawn into the litigation.  This would result in a cash settlement with no admission of wrongdoing.  If Tannin and Cioffi really did bad things, then the government needs to get more.  But if Tannin and Cioffi really just messed up, then panicked, then messed up again, what will it take for the SEC to walk away from this case?  Nobody likes to look like a wuss.  There will be public clamoring for blood.  The question is starting to look like – will it be Bankers’ blood, or Regulators’?

It is a well-established principle in securities litigation that there is no law against being stupid.  Prosecutors and the SEC alike would do well to remember that.  And while it may be uncharitable to point out, there is no law against regulators or prosecutors being stupid either.

Caveat… everybody.

Your Arms Too Short To Box With Blankfein

We are as staggered as the next person at the scope of Goldman’s influence in the world.  Indeed, we have been known to take a cheap shot at them ourselves – though we draw the line way before the “giant face-sucking squid” metaphor.  Still, in the cold light of day it is a toss-up as to whether we would sleep better at night if Goldman were completely in charge of this country, or if it never existed in the first place.

Goldman is easy to hate.  They are big, they are successful, and they are everywhere because they really do most things better than most of their competitors most of the time.

In the context of bombast and outright wrong information swirling through the media, we are disappointed that Goldman CEO Lloyd Blankfein now wishes to retract his “obviously ironic, throwaway response” (Bloomberg, 12 November, “Blankfein invokes God And Man At Goldman Sachs”) when he told the Times of London that he is “doing God’s work.”

We like to think Blankfein was not kidding, and we also wish the Times had been less jovial and gone deeper in their reporting.  Given the level of access they enjoyed – including a one-on-one with Blankfein himself at the firm’s headquarters – and the almost 7,000 words the Sunday Times of London devoted to it, the readership was not well served by the time and effort it took to read the tongue-in-cheek piece.  There is nothing new in the fact that Goldman Sachs has lots of money, nor are we shocked that Mr. Blankfein does not come across as rivetingly fascinating.

Let’s face it, the venom and vitriol directed at Goldman comes from two things: they are supremely successful, and they have fostered a profound culture of graduating into the public sector – where former employees have been no less successful than they were at banking or trading.

Clearly, the authors of the piece had their fun.  We can practically feel the pangs of excitement as they typed out such words as “The biggest swinging dicks in the financial jungle.”  But that is not journalism.

The Times appears to have been granted unprecedented access to Goldman and its executives, a gift they largely squandered.  In the end, the piece is conversational, fun and ultimately lightweight.  It is nowhere near mean enough to make us hate Goldman, nor informative enough to make us see the firm in a new light.

And it perpetuates the notion that federal money somehow “saved” Goldman Sachs. 

We recognize that, in the Total Forget world of Wall Street, one year is a very long time.  Secretary Paulson proposed the TARP at the end of September of last year.  The Emergency Economic Stabilization Act was passed in October of 2008.

We do not make light of the depth or extent of the crisis.  But if the financial markets had been thrown to the wolves, there are certain firms that would have nonetheless survived.  Indeed, we suspect the deeper threat was not to the existence of Goldman Sachs, but that Secretary Paulson truly believed there was an imminent threat of social unrest and that he acted more to prevent the imposition of martial law, than to prevent a capital impairment at his alma mater.

Those who castigate Goldman these days forget that Goldman – as well as JP Morgan and Morgan Stanley – took the TARP monies under duress.  We understand the unanswered questions about why Goldman’s AIG trades got paid in full, about how Blankfein showed up in the room when the government was preparing to administer the coup de grace  to Lehman.  But it is simply not accurate to state that Goldman only survived thanks to taxpayer money.

Reports and analysis coming out of Washington at the time painted Hank Paulson as insisting on total control over the financial system.  Given the inherent conflicts in Washington, and their propensity to dither as they wonder How This Will Play Back Home, Paulson emerged as the likeliest candidate to get anything accomplished.  Indeed, he was the only one not conflicted.  He had already cashed out his Goldman holdings, and with the coming change of administration he was soon to be out of a job at all events.  Congress, the Senate, and Chairman Bernanke all were under political pressure to not make obvious mistakes – to not take actions that might impair their ability to continue in their jobs.  Paulson was the logical choice to take control.

In order to do that, he had to bring the banks to heel.  All the banks.  Jamie Dimon, one of the most capable financial Chief Executives in history, tried to turn down the TARP funds.  Goldman and Morgan too demurred.

But Secretary Paulson insisted on an airtight program.  He was taking direct control of the banking sector and insisted on complete cooperation.  In the end, they all dutifully took their checks.  What this accomplished was not to “bail out” Goldman, Morgan, and JP Morgan, but created a regulatory handcuff that tied them to the program.  It is well and good to carp that Goldman made out “like bandits” in the aftermath of TARP.  But no one should lose sight of the fact that they might not have.

Far from being “saved” by taxpayer largesse, Goldman has a long history of putting substantial sums aside, even as it pays out $20 billion in bonuses this year.  The London Times piece says Goldman has $1 trillion in assets.  Much of that is in what was long ago established as the partnership’s Rainy Day fund.

If AIG had not paid off, if TARP monies had not flowed through, and if the firm had not been permitted to switch charters and become a bank literally overnight, then Goldman would no doubt have to dip into that fund.  They would perhaps not be paying record bonuses.  They would perhaps be restructuring and staring at lean times.  But it is a stretch to claim they would be out of business.

Saving money is radical/  Fiscal conservatism and anti-profligacy in major investment banks is not sexy and gets brushed aside by the press in their hunger for a story.  On examination, the press may have the sizzle, but Goldman’s got the steak.

Here’s another thing Goldman does: they mark their positions to the market for risk purposes.  CEO Blankfein has spoken publicly in defense of mark to market accounting.  And surprise!  His firm considers it the appropriate way to manage risk position by position on a daily basis.

As to “doing God’s work,” we are reluctant to defend a statement when its author seeks to disavow it.  But you can’t deny the critical role played by Goldman in keeping the US marketplace liquid, active and dominant.  Do they pay themselves very, very well for the service they provide the rest of us?  Yes.  And, as neither the rules nor the nation’s morality has changed, they continue to be entitled to it.

We are not sure why Blankfein said that he was doing God’s work, what he thought he meant when he said it, and why he now seeks to make it go away.  Looking at Goldman’s phenomenal history of success, if we were God, we couldn’t wish for a better teammate.

Moshe Silver

Chief Compliance Officer