Slouching Towards Wall Street… Notes for the Week Ending Friday, December 4, 2009

No Regulation, Radio

The New York Times (2 December, “Black Caucus Seeks To Ease Radio’s Woes”) describes what looks like a pathetically transparent example of the conflicted intertwining of business, politics and the media.

Inner City Radio, a New York company co-founded by prominent New York politician Percy Sutton, owns 17 commercial stations nationwide.  According to the Times, it “faces a possible financial collapse because of pressure by Goldman Sachs and GE Capital to repay nearly $230 million in debt.”  The story goes on to describe ways in which the Congressional Black Caucus has tried to use its leverage to score greater visibility for the ways in which minority-owned businesses have been hurt by the financial crisis.  The lobbyist retained by Inner City is Paul A. Braithwaite, former executive director of the Congressional Black Caucus, and a former senior aide to New York Senator Charles Schumer.  Braithwaite “said the financial crisis has had a particular impact on the radio industry,” citing declines in advertising revenues, and changes in the way audience ratings are computed. 

Barney Frank has gotten into the act here as well.  According to the story, he has arranged for Caucus members to meet with Secretary Geithner and White House Chief of Staff Rahm Emanuel.  Frank also has had discussions with companies regarding Inner City.  Frank declined to name any of the companies with whom he has spoken, but he did not deny that one of their initials might be “GS”.

The article also points out that the Obama administration “did not believe it was appropriate to pressure financial institutions to make concessions for specific loans or businesses.”  In other words, the President believes it is inappropriate to introduce politics into the political process.  Go figure.

We do not learn how the “pressure” from Goldman and GE is any different in the case of Inner City than on any other debtor.  Our guess is that Goldman, being in the risk management business, wants the risk cleaned up and are likely treating Inner City no differently than any other debtor with a similar risk profile.

Times Chief Financial Correspondent Floyd Norris, in his blog (3 December, “The Goldman Veto”) wonders how this story might have been reported if, say, during the 1998 Asian financial crisis, “a group of Republican legislators had threatened to block legislation unless a contributor to their campaign received special treatment.”  

We are not sure what the Times’ take on the story is, and why it has chosen to report it in just these terms.  Can it be that a major New York City newspaper is shocked to discover that there is Politics going on in Washington?  Norris is pretty clear in seeing this as a conflict, but neither his commentary nor the underlying story presents any statistics relating to minority-owned businesses, or to the effect of the financial crisis on smaller independent radio broadcast companies.  On the other side of the argument, it makes no attempt to argue the creeping obsolescence of radio in the internet age. 

We find this journalistic approach disappointing.  In the absence of any analysis, readers will fall back on their own prejudices.  For our part, we suspect the Caucus may have a point.  They certainly have an opportunity.  In the world of politics, it would be a crime to waste it. 

As Easy As AAA, BBB, CCC

We have been reading up on the rating agencies’ new-found zeal for assessing risk – something you no doubt thought they were always paid to do.  On the premise that nothing happens in a vacuum, we note that it is only a few short weeks since the National Association of Insurance Commissioners (NAIC), the body representing state insurance commissioners, took the rating of asset backed securities out of the hands of the rating agencies and handed it to Pimco.

In the same time frame, we noted stories such as “Fitch Raises Alarm At Impact Of $98bn Refinancing On European Real Estate” (Financial Times, 24 November).

Cynics – among whom we surely count ourselves – will take a dim view of Fitch now warning that it will be difficult to refinance European securitized real estate debt due to mature in 2014.  The article says there have been declines in the value of the underlying properties of over 40% in the UK and Europe, and that “much of the debt struck at high loan-to-value in the boom years is in breach of covenants.”  Some are wondering where Fitch was when these loans were structured.

A little arm-twisting seems to have been the order of the day at S&P.  The Financial Times reports “S&P To Clarify Rankings On Capital Strength” (Financial Times, 25 November), on the heels of a newly-issued report “ranking 45 of the world’s leading financial institutions by a new risk adjusted capital (RAC) ratio designed to better capture balance sheet strength.”  The report was based on bank balance sheets as of the end of June, and thus does not take into account any housecleaning institutions may have undertaken. 

Investors might be comforted at the introduction of a more robust risk measure for bank capital.  The banks, apparently, were not, and rushed to lobby S&P to issue corrective statements.  Capital adequacy being a highly sensitive topic, banks wanted immediate credit for steps they have taken since the end of June to bolster capital.  The actual effect on the banks might be to raise questions about what kind of scrambling they had to do to boost capital since the second quarter.  UBS, for example, complained that the methodology failed to account for SFr 19 billion proceeds from the mandatory conversion of notes held by the Swiss government.  Six billion Francs worth of these notes were converted in August and are now part of the bank’s capital.  Duly noted, says S&P.  Oh and, says UBS, we are due to get another SFr 13 billion in March 2010.  Please be so kind as to credit that to us now.  We’re sure you’ll find a way.

We will refrain from overly praising the ratings agencies, but it is clear that they are significantly tightening standards in areas where it has often paid for them to remain lax.

And they are calling public attention to problems.  “Mortgage Backed Securities Downgrades Warning,” reports the Financial Times (24 November) citing over $150 billion in loans backed by commercial mortgages due to mature by 2012.  Moody’s does not foresee a strong rebound in the sector, so they are predicting rounds of ratings reductions.  While the article makes no mention of the D-word (“default”) if you are an insurance company, your capital stands to be severely impaired by a ratings downgrade of your portfolio.

Looking for a way out of this morass, the NAIC has come up with a new source of money: income-tax accounting.  The Wall Street Journal reports (28-29 November, “Insurers Nearing Regulatory Victory”) that the state insurance regulators have called for favorable treatment of “deferred tax assets.”  This looks set to add over $11 billion to insurers’ capital with the stroke of a pen.

Time would appear to be running short for the insurers.  The House Financial Services Committee just approved legislation to create a national supervisor for insurers (Financial Times, 4 December, “Systemic Risks Of Insurers In Spotlight”.)  This new office will not regulate insurance, but will coordinate information at a high level to help create policy, respond to crisis, and mitigate risks to the financial system.

This is becoming necessary, not only practically, but politically.  European Central Bank president Jean-Claude Trichet has told the European regulators that he considers large insurance companies to be “systematically important institutions,” and as the capital base of major insurers has been chopped down significantly, their ability to pay claims in large crisis situations may soon be called into question.

The FT article points out that “there have been times when life insurers have been forced to sell certain assets, for example equities during the dotcom stock market crash.”  The new proposed European capital rules will, it is hoped, influence insurers’ behavior and the management of their portfolios. 

The Financial Stability Board, the international central bankers’ group, recently added six insurers to its list of “systemically important cross border institutions”, which means our domestic insurance industry will also come under scrutiny.  In prophylactically confronting the tide of global opinion, US regulators are taking swift steps to beef up domestic insurers’ capital.  We are puzzled as to why the regulators themselves are pushing for this to be done by accounting legerdemain, rather than by requiring the insurance companies to forsake the behavior that got them into capital trouble in the first place.

Speaking of behavior modification, the Financial Times (5-6 December, “Legal Rulings Show Banks Will Pay For Their Follies”) mentions recent legal rulings in which major banks are being called to account for predatory, inappropriate, and just plain dumb lending practices.

In the case of a Florida homebuilder, Tousa, “a bankruptcy judge ruled that Citigroup and other banks made fraudulent transfers when they lent Tousa about $500m in 2007.”  Less than six months after receiving half a billion dollars in bank loans, Tousa filed for bankruptcy.

Pulling no punches, bankruptcy court Judge John Olson found the lenders were “grossly negligent” and “should have known the company was insolvent.”  The judge might have been tipped of by two items relating to the loan.  One is that Tousa’s CEO stood to receive a $4.5 million bonus, largely contingent on closing the financing.  The other is that Tousa had retained global consulting group Alix Partners to provide the solvency opinion that Citigroup had required as a condition of issuing the loan.  The FT reports Tousa “agreed to pay $2m if Alix opined that Tousa would still be solvent after the loan, but would pay only time charges and costs if it did not so opine.”

We are not sure whether to burst into shrieks of outrage, or uncontrollable giggles.  At the present juncture in our financial history, it boggles the imagination that corporate governance at Citigroup is still so lacking that they actually participated in such a transaction.  Indeed, if Citi knew of the contractual arrangement between Tousa and Alix – and they had a right to that information, as a $500 million loan hung in the balance – it would appear they had an obligation to their shareholders to nix the deal.  They may have even had a regulatory obligation to report the Tousa / Alix contract to the SEC.

Having blamed the ratings agencies for their role in creating the meltdown – as touched upon for example in SIGTARP Neil Barofsky’s report on the AIG bailout – the regulators have doubled back and are attacking the rating agencies for trying to raise their own standards.  We bet the next thing will be attacks on “activist judges” such as Judge Olson.  Jed Rakoff, the judge who kicked the SEC / BofA settlement back into the mudpit, should take note.  With the markets strong once again, no one cares much about transparency or responsible corporate governance.

The Rock-Bottom Line

A casual stroll through the lunatic asylum shows that faith does not prove anything.

                        - Friedrich Nietzsche

Speaking of the New York Times, a CEO who has crossed battleaxes with Floyd Norris on more than one occasion is back in the news again – and in Norris’ blog.

Our colleague, retail analyst Eric Levine, recently posted that Overstock.com is offering more holiday discounts and contests than ever before, a strategy that has produced a return to positive growth, according to Overstock CEO Patrick Byrne.

We scratched our head when we read this, because we remembered an item in last week’s Financial Times (24 November, “Overstock”) which mentions that “After a decade in business, Overstock has never turned a profit and its shares have slumped 80 percent over five years…”  Levine goes on to quote CEO Byrne reporting that Black Friday had produced their biggest single sales day ever, only to be eclipsed by Cyber Monday, which trounced their Friday sales by thirteen percent.

Byrne, for those of you whose chief leisure activity is minding your own business, has issued numerous public statements over the years as he sounded off about illegal naked short selling and the ways in which these dastards have ganged up on his stock, among others.  We have read some of these rants, and they are generally well reasoned and, we think, largely on the money.  If Byrne has committed a sin in his public statements, it has been to reveal the seamy underside of how this bit of Wall Street takes your money. 

The political winds have been blowing against Byrne.  At the SEC, Chairman Schapiro has done a masterful job of Doing Nothing to Great Fanfare over the political firestorm about short sellers.  We think this was probably well advised, in light of the immense disservice done to the markets when the crisis burst like a pus bubble and regulators threw on “emergency” bans against shorting.

What the SEC chose not to touch was the variety of mechanisms that make naked short selling possible – and that still exist.  These include lack of controls on Easy To Borrow lists, where the same securities can be shorted multiple times, and by multiple customers, without an actual count of securities available for borrow.  And no one has any notion of how many shares of how many different issues are floating around in “Ex Clearing” contracts where they will never have to be reported as unsettled short sales, and thus never be bought in.

Byrne has attacked Norris before as being part of a press cabal that plays to the SEC’s hand, determined to turn a blind eye to what is going on and – in Byrne’s analysis – promoting exactly the illegitimate activity from which Overstock’s stock has suffered.

Byrne has now come up with a new one.  In a dispute over the recognition of revenues, Overstock has fired not one, but two auditors – first PriceWaterhouse, and now Grant Thornton.  This was after the SEC questioned certain accounting assumptions, and Overstock and Grant Thornton got into an imbroglio over whether the auditor had, in fact, signed off on a formal opinion on the transactions under review.

Byrne and Grant Thornton have exchanged public statements accusing each other of lying.  Overstock has said there are a plenty of audit firms out there that would love their business, but they are not going to retain a new auditor until they get a clear resolution, which will require a definitive statement from the SEC.  In the meantime, in order not to be delinquent in making its required filings, Overstock has taken the unusual – we think unique in regulatory history – step of filing an unaudited 10Q.  In explaining the situation to Overstock shareholders, Byrne issued a letter that opens with a quote from philosopher Friedrich Nietzsche: “All things are subject to interpretation; whichever interpretation prevails at a given time is a function of power and not truth.”

As near as we can tell, the amount of money at issue in the transactions being questioned by the SEC is $785,000.  This does not strike us as even a material amount for a company that reported $195 million in gross revenues for the quarter ended September 30.  Given Byrne’s public image as a CEO who clings tenaciously to principle, we are not surprised to see him going after his auditors.  And who knows?  Maybe he will emerge both victorious and right.

But we admit to being perplexed as to why a CEO of a company that has not turned a profit in a decade would want to call such attention to himself.  We caught Overstock’s holiday season commercials recently.  It features a quartet all dressed in white singing, to the tune of “Jingle Bells”, “Oh-Oh-Oh!  The Big-Big ‘O’”.

Byrne’s statement about the big jump in Black Friday and Cyber Monday sales might hold a clue to the company’s overall performance.  “Promotions have been good for us,” said Byrne, “and we switched to free shipping for the whole season.  We’ve never done this much discounting before.”

For all his entertainment value as a CEO, we wonder whether Overstock’s “Big, Big ‘O’” will be just as big this year as in the past.

Let’s Assume We Had An Economy

It’s been a challenging year for us all.

                        - Ben Bernanke

 

Economists are famous for working from assumptions.  In his recent job interview, Fed Chairman Ben “I Really Need This Job” Bernanke attempted to cajole his interlocutors into sharing his assumption that Fed “expertise” is needed to re-stabilize the nation’s economy.

The nation has been following economists’ assumptions for years.  We followed Chairman Greenspan’s assumptions (the “Maestro”) into an era of irrational exuberance – oddly, the man who identified it appears to have been its single greatest proponent and driving force.

We followed the assumptions of Tim Geithner, among others, when as head of the New York Fed he participated in blowing the lid off bank leverage ratios.  It is fascinating to see Geithner and Blankfein duking it out in the public media – at long distance, to be sure – over whether or not Goldman would have gone out of business but for the government bailout program.  Geithner gave Goldman and their brethren untold miles of rope, with which many – Bear Stearns, Lehman, Merrill Lynch, to name a few – dutifully hanged themselves.  He is now taking credit for cutting down the one firm that never put its own head in the noose and getting into a public urinating competition over it, all the while ignoring the American consumer twisting and convulsing and slowly strangling on the gallows.  In their defense, Goldman Sachs never pretended their job was to do anything other than gulp down as much punch as they could.   Geithner, on the other hand, was one of those charged with controlling access to the booze.

The nation is now not really debating whether to confirm Chairman Bernanke for another term.  There is not much chance of him not being reconfirmed.  The debate comes down more to what assumptions we will buy into, and which ones we will deflect to third parties. 

Astonishingly, Bernanke’s assumption of “expertise” appears to be generally in the ascendant.  The Fed under Greenspan showed considerable expertise in creating the mother of all market bubbles – equities, housing, and risk derivatives.  Bernanke showed considerable expertise in addressing the inflationary / deflationary concerns in the last few months, but the overall lack of Fed expertise to derail the Greenspan bubble express should be more deeply troubling than it is.

Ron Paul’s idea to hold the Fed accountable through an audit mechanism has actually gained traction, but we do not for a moment believe the solution to Fed errors is allowing Congress to tell them how to run their business.  Talk about “expertise”!

Bernanke supporters are doing an odd pat-and-smack as they attempt to head off the political consequences of voting to reconfirm Bernanke.  The Wall Street Journal (4 December, “Greenspan Haunts The Room”) quoted Senator Chris Dodd as praising Berenanke personally, yet saying “the Fed failed terribly in giving us the kind of warnings that we should have.”  It is a bit difficult to separate the man from the institution.  Indeed, the Journal points out that the institution and the man are truly seen as one.

The simple fact that no one wants to face is, it is the people, not the institutions, who make decisions.  People who score tactical victories, and people who make terrible mistakes.  If we could remove that human element from our economic decision-making, we would be golden.  That was the theory behind bringing professional economists to Washington and having them make decisions for us.  Science would rule the day and we would no longer have to worry about human error.

We’re still waiting.

Meanwhile Senator Jim Bunning addressed Bernanke saying, “Now I want to read a quote to you, Mr. Greesnp—“  Can’t shake the ghost, can we?

After the laughter died down, Senator Bunning corrected himself and said, “Mr. Bernanke.  That’s a Freudian slip, believe me.”

We all know what a Freudian Slip is: it’s when you say one thing, when you really mean your mother.

Moshe Silver

Chief Compliance Officer