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Bubble, Bubble, Toil And Trouble

A new front is opening in the credit wars.  The twist is that the much-maligned ratings agencies are starting to look as much like the heroes of this crisis as they were the bad guys of the last one.

We now live in a supercharged economic reality.  Our financial system has left such stale concepts as the Business Cycle in the dust.  Financial collisions that used to occur with some predictability every few years are now piling on thick and fast as the linkages between crises become more entangled.  Hallucinatory whorls of active, developing, and incipient bubbles in our economy surround us.  Think: Hyman Minsky on a very bad acid trip.

Masterfully overseen by Great Chief He Who Sees No Bubbles (Bernanke), the braves are mustering, sharpening their weapons and daubing themselves liberally with war-paint.  But so far the war drums have yet to sound.  Meanwhile, there’s trouble brewing in the Badlands of Credit.

The National Association of Insurance Commissioners has, as we anticipated, approved the plan to change the classification of certain tax-deferred assets on the books of insurance companies, a move “expected to add more than $11 billion in capital to life insurers’ balance sheets at year-end” (WSJ, 8 December, “Accounting Change Boon For Insurers”).

We note that this measure was initially proposed by the American Council of Life Insurers, an industry group, as a temporary emergency measure designed to tide insurers over as last year’s financial meltdown roiled the markets.  The purpose at the time was to avoid insurers being forced to liquidate portfolio holdings at fire sale prices.  Simply put, they wanted to buy time.  The NAIC didn’t go for the idea at the time.  Now, on consideration, they made it permanent.  Now the insurers have all the time they need.

The simple message is either: we are in a permanent state of crises; or, everyone else is scamming the markets left and right, why shouldn’t you guys?  Either way, this represents a clear step down in the quality of actual financial coverage of insurers’ obligations.  We are trying to figure out how the insurers can use this to best advantage.  Maybe they will do a program like frequent flyer miles.  Did you lose your husband?  Oh, and we see he had a million-dollar policy.  Well, you can either get the payment all in cash, or, if you prefer, we will give you $1.5 million in tax credits that you can use to offset your income, thereby freeing up your other money.

Before you laugh, the Journal reports “consumer groups have complained that these are paper assets that won’t help pay claims if companies hit the skids.”  The obvious solution is to transfer the tax benefit to the beneficiaries, in lieu of cash.  Obviously, at a premium.  Consumer advocates take note.  Lobbyists, start your engines.

We note that, in all the brouhaha about financial markets reform, there has been no recent mention of cracking down on the ratings agencies, no serious discussion of addressing the deeply conflicted model that let – inexorably, many would maintain – to the debacle wherein trillions of dollars’ worth of AAA-rated paper went up in smoke. 

On the other side, we are getting the nasty feeling that Health Care Reform may turn out to be nothing more than a government-sanctioned multi trillion-dollar gift to the insurance industry that will make Secretary Paulson’s bait and switch with the bank rescue dollars look like chump change.  If, in fact, 30-40 million new policy holders are to be added to the rolls, private insurers will need to bolster their capital significantly.  How handy if, instead of socking away cash reserves, they can get regulators to redefine assets.  In the world of money, a tax break is only an “asset” once it is realized, cashed and deposited in the bank.  The insurance commissioners appear to be swapping one moral hazard for another.

The NAIC is not alone.  The Journal also reports (8 December, “What Zions Considers A Loss”) the tribulations of Zions Bancorp, who apparently have avoided recognizing hits to their capital by taking advantage of the new rule for valuing “stressed debt securities.”  You may remember that Congress, which loves tinkering with things they don’t understand, beat the Financial Accounting Standards Board liberally about the head over the subject of “mark to market” accounting which, Congress scolded the FASB, was causing undue hardship to companies that really had their portfolios under control, and were being forced to take unreasonable write-downs.  (Goldman Sachs was not one of them, by the way.  You may remember that they mark everything to market every day.  It’s called managing risk.)

The Journal story reports that Zions held $2.12 billion of preferred securities issued by banks, all in a CDO (collateralized debt obligation) structure.  While the current market value of these CDOs is $1.1 billion, “Zions has taken $712 million of market losses on the CDOs through equity,” which means it does not affect their regulatory capital.  Thus hath Congress wrought.

In the current climate it is exceedingly difficult to see how Washington is supposed to impose restraint in the form of new financial markets oversight and tightened regulation.  No sooner does an industry show itself to be fiscally impossibly irresponsible, than Congress steps in and does its own legislative engineering, every bit as clever as Wall Street’s financial engineering.  It makes sense that Bernanke continues to pander.  He’s up against the brickest of brick walls.  What’s a central banker to do?

There’s more.  Morgan Stanley says that Zions’ risk model predicted a 35% chance of default by United Commercial Bank, one of the issuers whose preferreds are in Zions’ CDO portfolio.  United was seized by regulators last month which, as the Journal observes, “almost certainly means its preferreds are worth zero.”  In their defense, a Zions spokesman said “modeling default was hard, because ‘fraud was involved’ at United Commercial.”   Fair enough, though if we were bank regulators, we would immediately demand to see Zions’ due diligence file on United Commercial. 

Now, it can only be a total coincidence that, right next to the WSJ story about the accounting change benefiting the insurers to the tune of $11 large, is a headline that reads “Moody’s Puts US, UK On Chopping Block.”  The story refers to “an effort, spurred by investor demand, to examine the creditworthiness of the world’s most highly rated countries.”  There are currently 17 AAA-rated countries, and Moody’s said the US and UK ratings largely depend on “the vigor of the economic recovery and the willingness of governments to shrink the deficits.”  Moody’s says the US requires a “credible fiscal consolidation strategy” to curtail both the amount of our debt outstanding, and the associated interest costs.

Deficit shrinking, in our simplistic model – have we reminded you lately that we are not trained economists? – emanates from having cash on hand.  Which is to say, savings in the bank.  People saving money – paying themselves first.  Which is to say the implication of the Moody’s report is that a zero interest rate is not working.  It would also seem to imply that, contrary to President Obama’s exhortation of this week, it may not be feasible for us to “spend our way out of this recession.” 

Rather, by spending borrowed money, we will be beggaring our neighbor all the way to – at least – a credit ratings downgrade.  Oh yes, and then there’s the part about the US no longer being Top Dog.  Chief He Who Sees No Bubbles will need great medicine if he is going to keep this country from going to the Happy Hunting Ground.

A Load Of Bull?

Former Merrill Lynch employees are “delighted” at Bank of America’s decision to restore the old Merrill bull logo.  The Wall Street Journal (8 December, “BofA Yields On Return Of Merrill Bull”) reports that Merrill bankers may now have the bull logo restored to their business cards.

We couldn’t help recalling the famous Business Week cover story “The Death Of Equities” that coincided with the launch of the great bull market of the 1980’s.  That cover, famously, was graced (or should we say “disgraced”?) with a snorting bull.  Is the new-old Merrill thunderer likewise a contrary indicator?  Of course, if the business of managing money is really the business of having money to manage, then it’s all about marketing, don’t you see.  Which means that the bull on the business card is a darned sight more important than what they are actually putting into your portfolio.

Lest you take this as a cheap shot against Merrill’s brokers, let us remind you that financial firms create their own product, then pump it through their distribution pipeline, right into your retirement account.  Merrill, in case you forgot, is the company that sold itself in a desperate last-ditch transaction because they lost… we forget… how many billions was that?  They lost this money by leaping into the various derivatives markets with both feet because defrocked Chairman Stan O’Neal couldn’t see Merrill not participating in what everyone else was doing.  In fact, Merrill’s only really smart market transaction in years was selling itself to BofA at what turned out to be a way above-market price.  Brokers are led by their management.  Beware the next round of packaged product bearing the bull.

In what has to count as one of the daftest statements to emerge from a banking firm this year, the Journal story quotes a Merrill staffer as saying “Merrill without the bull is like Superman without a cape.”  BofA declined to comment.  No kidding.

Light-Saber Rattling

The on-line edition of the German magazine Der Spiegel (10 December) reports a ghostly light bursting in the Norwegian sky on Wednesday night.  Residents of the Arctic Circle town of Tromso beheld what many of them believed was a UFO.  The appearance is captured nicely on a video clip featured in the story, courtesy of Reuters/Scanpix.

Slouching Towards Wall Street… Notes for the Week Ending Friday, December 11, 2009 - norge

The story mercifully did not make a connection between the rising, flaming, bursting and quickly vanishing star in the Norwegian skies, and the appearance the following morning on Norwegian soil of President Barak Obama.  Obama has disappointed his host nation by spending a mere 24 hours on Norwegian soil, rather than staying on for the customary several days of pomp and festivities surrounding the Nobel Prizes.  To be sure, the world hopes the disappointments will end there, and that Obama’s star will gain in intensity, and not flicker out like the apparition.

Tromso is at the northern tip of Norway, almost as far away from Oslo as a Norwegian city can be.  Still, it was Norway.  Not, for example, Finland.

Thoughts of ghosts, meteors and visitors from outer space were  dispelled when it turned out the phenomenon was a failed test firing of an atomic rocket from a Russian submarine.  The rocket, an SS-N-30 Bulava, faltered and exploded in midair, bringing a spectacular show to the residents of the northern Norwegian town, and an ignominious end to the test shot.

The Bulava rocket, with a reach of 8000 kilometers, stands at the forefront of Russia’s modernization of its atomic arsenal.  It is no doubt important for Russia to show renewed atomic might as they head to the table to negotiate a replacement for START, which expired on December 5th.  It is interesting to note that the Bulava rockets have failed in most of their test firings.  The Spiegel quotes sources saying that nine of the 13 test firings have been failures just like this one.

It can only be a coincidence that Russia blows up a rocket in the sky over Norway on the eve of President Obama’s appearance in Oslo.  No one would be so crass as to do such a thing on purpose.

President Obama, for his part, acknowledged that there is such a thing as a Just War, in pursuit of a Just Peace – perhaps an oblique hint to America’s potential adversaries.  We wish to encourage careful attention to grammar.  Sometimes a war is a Just War.  Sometimes a war is Just a War.

Damned If You Don’t

To turn a million dollars into ten million dollars is work.  To turn a hundred million into a hundred and ten million is inevitable.

                                      - Edgar Bronfman


It makes money to take money.

In days of yore, when the likes of Lehman, Bear and Goldman were partnerships, the business model was custodianship.  No more.  The standard model on Wall Street for a generation now has been the Exit Strategy model.  Exiting one’s old model only makes sense once that model no longer has vitality.  As the economic dynamism underlying the partnership model started to erode, partners of old-line Wall Street firms regretfully started moving towards the exits, trying to salvage what was left of the value of the holdings that generations of their predecessors had so lovingly husbanded.

Oh, wait… that wasn’t what happened at all.  As the bull market of the 1980’s spun out of control, price became a primary factor, and the recognition of how great a valuation could be realized in the public market replaced the partnership model.  Under the old model, the partners as a group were rewarded based on the overall performance of the partnership.  What they took out was a function of what they had contributed.  Making money to take money.  No longer.

Ace Greenberg, CEO of Bear Stearns, famously observed during the market ramp-up of the early 80’s that such large concentrations of wealth would necessarily attract society’s most undesirable elements.  Little did he realize that he and his partners in Investment Banking Inc. would come to be seen as the very thing he warned against.

Bear Stearns, early to the party, went public in 1985, Lehman in 1994, and Goldman Sachs – the great ogre, to read the popular press – in 1999.

Now Bear is gone, and Lehman is gone.  We can not tell what the future holds for Goldman Sachs, but the immediate future looks like a long unpleasant slog through the press where they will be ceaselessly vilified – by populists for a token act that means nothing; by capitalists for caving to the populists.

The top thirty Goldman executives will take this year’s compensation in what the firm is calling Shares At Risk.  The Risk is that the shares can be taken back if the management committee deems that an individual executive “engaged in materially improper risk analysis or failed sufficiently to raise concerns about risks.”  In other words, Goldman’s management committee are once again behaving like partners.  Just in time, perhaps, to see their franchise crumble.

Still, it is not clear what the determining factor will be to bring a charge of “materially improper risk analysis.”  Since that is not the Goldman way, we are left with the uncomfortable feeling that it will come down to profitability.  If a partner lose money for the firm, they can take his shares away.

Not only the popular press (think “giant face-sucking squid” in the pages of Rolling Stone), but even the government – replete though it is with Goldman alumni – is squaring off versus Blankfein & Co.  We are not the only ones who think it significant that the Geith-father, interviewed on Bloomberg TV, pooh-poohed the notion that Goldman would have survived without the TARP.  Tim Geithner’s presumed exit strategy from Washington, as a future executive at Goldman Sachs, suddenly looks in doubt, and he appears not to care.  After all he has done for them, Goldman embarrassed him by not showing proper (read “any”) gratitude. 

Meantime, we wonder why it is Goldman that everyone loves to hate, while other financial firms are being waved under the wire.  In what appears to be a race to the bottom, BofA gets to trash their shareholders by raising billions in the public equity marketplace.  Citi is going to be next.  The government is playing this new game of one-on-one with the big failed banks, yanking them this way and that as they scramble to repay the TARP.  In the short term, Geithner and his paymaster President Obama can point to the “profits” the “taxpayer” has reaped (we are waiting to see the line item in our 2010 tax return), meanwhile they are conspiring to wreck the markets.  The difference is they are doing it with toxic equity, not toxic debt, so the only ones to suffer will be the Greater Fools – that is, those who actually buy the stuff.  Wonder how much BofA stock your pension fund manager has bought recently?  They don’t have to disclose that.  You can see their positions at year end, but not the timing of purchases or prices paid.  Conspiracy?  Perish the thought…

If there were a World Series of finance, Goldman would be the winner hands down.  Goldman is the New York Yankees of Wall Street, with a profile and a track record of success that make other banks drool – and, like the Yankees, folks who don’t love ‘em, really, really hate ‘em.  Rather then being patted on the back for making risk management the mainstay of their business, they find themselves in the tumbrel heading for the execution ground.  Meanwhile, untold numbers of financial firms are being loopholed through in the Swiss cheese document that is the Financial Reform Act.

According to the Wall Street Journal (11 December, “Loopholes Lurk In Bank Bill”) there are provisions buried in the House financial regulatory reform bill that, while not specifying individual companies, are clearly designed to exempt specific financial firms from the provisions of the newly beefed-up regulation.  The articles cites GE and USAA as two examples. 

GE we have all heard of.  Its CEO, Jeff Immelt, no doubt has not been advised that apologies are so Last Year.  The Financial Times (10 December, “Immelt Rues ‘Terrible’ Executive Greed That Fuelled Inequality”) quotes Immelt as saying “We are at the end of a difficult generation of business leadership… tough-mindedness, a good trait, was replaced by meanness and greed, both terrible traits.”  Wall Street has the historical memory of a gnat, and no objection was raised to Immelt’s eulogy of Sound Management.  This, even though his predecessor Jack Welch left a conglomerate on the verge of collapse, but which for years had been flogged as the paragon of sound corporate management.

The other company mention in the Journal article – USAA – “caters to members of the military and their families, to so-called fraternal benefit societies.”  The article reports that USAA is “one of the country’s 50 largest federally insured financial companies.”  It is also one of the top dispenser of lobbying dollars, spending $5 million in the first 9 months of 2009 alone, which the WSJ reports is more than Wells Fargo and more than – get this – Bank of America.

As far as risk management at USAA is concerned, one need look no farther than the assurance from none other than Financial Services Chairman Barney Frank: “There’s no remote prospect of them being a problem.”  Feel better?

Goldman Sachs, meanwhile, is probably best served by being most hated.  We encourage them to embrace this status, keep their chin on their chest, and keep swingin’ at the ball.

Goldman traditionally has the best information in the marketplace.  Not inside information, just plain good market information.  They are literally everywhere, and they see everything.  We are mindful of this as we read reports of Goldman bankers buying guns.  Bloomberg columnist Alice Schroeder reported that “very senior” Goldman executives are acquiring guns for “a combination of personal protection and wealth protection.”

Goldman’s efforts at PR are a clear waste of effort.  Their recent half-billion forkover to help out small businesses got not a Thank You.  Maybe, as Schroeder suggests, they should be bailing out underwater homeowners.  Maybe – speaking of underwater homeowners – they should divert a few billion to save the people of the Maldives before their island nation is swallowed by the ocean.  One might think that, given their track record of success, Goldman could single-handedly cure global climate change.

But no one is inviting them to make a contribution.  Where would Geither, Summers, Obama et al be if Goldman actually succeeded?

The barricaded lives of Goldman’s executives are a chilling metaphor for the future of capitalism in America.  In the irrational world of regulatory incompetence, government and press dishonesty, and misdirected public rage, Goldman’s executives buying guns is the best proof of the Efficient Market.  Let us hope it will not be the last.

Moshe Silver

Chief Compliance Officer