naked capitalism

This post first appeared on August 27, 2007

Recently, we’ve noticed a new theme among economics writers: Extreme Measures.

Commentators have looked toward the end of the road we are on and fear it leads to a precipice. Hence the calls for radical course correction.

Paul Krugman and Bill Gross of Pimco, each of whom proposed large scale rescues of homeowners at risk of default, were the first cases we noticed.

But what really caught our attention was Gillian Tett of the Financial Times proposing drastic measures, albeit to deal with a different, but equally serious problem, namely, that markets are seizing up due to subprime risk.

Normally, risk does not pose an overwhelming problem to financial markets; au contraire, it’s their bread and butter. But in this case, the risks have been sliced and recomposed into other instruments and distributed around the world. No one is certain who has subprime exposure, and because these subprime loans are often components of very complex, illiquid instruments, no one is sure how much (or more to the point, how much less) they are worth.

Let us stress, we cannot say enough good things about Tett. We’ve sung her praises before, and consider her to be the best source on the markets (although her FT colleagues John Authers and John Dizard are also insightful). So to see her offer up an idea that while it may be directionally correct, is badly misguided in its details, is worrisome indeed.

It suggests that someone as knowledgeable and plugged in as she is thinks we really are in a mess but can’t come up with a realistic way out.

Here’s what she said:

One is the fact that nobody quite knows exactly where the subprime losses truly lie…

But the second problem is that nobody knows the real value of these instruments either…

Common sense would suggest the best way to deal with these two problems would be to take two steps: namely inject more transparency into the system, by encouraging institutions to reveal their exposures, and then encourage financial institutions to create a proper market to trade the assets, and thus determine a price…

Right now, it is probably relatively easy to guess at what a simple subprime loan might be worth.

However, working out the values for associated derivatives, or derivatives of derivatives, of these loans, is far harder…. investment banks say it can take entire weekends for their computers to value instruments such as collateralised debt obligations…

So is there any solution to all this? One option would be to simply wait and hope that eventually a new wave of bottom fishers will emerge….

More specifically, some policymakers now suspect that one key to rebuilding confidence would be to find ways of ripping apart some of these fiendishly complex structures, so that the constituent components can be clarified and traded again. Structured products, in other words, may need to be restructured into less . . . er . . . structured formats.

This endeavour will not be simple. Nor will it be painless. After all, if you unwind CDOs, say, it tends to trigger securities sales, further depressing prices. But high finance is a world where innovation is supposed to pay, and presumably it is not beyond the wit of the financial wizards who created these complex products to invent ways of taking them apart.

Uum, there are at least three big problems with this idea.

First, let’s go over, at a very high concept level, what a CDO is. You take a bunch of financial assets that pay income, like mortgages but can and more often does include tranches of mortgage backed securities and God knows what else. You put them a legal entity. You then set up rules for how principal and interest payments are allocated to expenses (oh yeah, investors have to pay to keep the puppy running) and to the various classes of holders (those called “tranches”). You do some voodoo to make sure the tippy top tranche gets an AAA rating (that usually involved overcollateralization, the purchase of insurance from a third party insurer like Ambac, or credit default swaps).

So you have different holders with different economic interests in this entity. To unwind it, you have to pay them out, either in cash or collateral, or perhaps via paper in a new entity.

To do that you have to make a determination as to what those classes are worth relative to each other. That means you have to value them, at least on a relative basis.

But the whole problem that we were trying to solve to begin with was that no one is certain to value this paper. But unwinding it presupposes some sort of valuation.

The second issue is that unwinding these vehicles would be a nightmarish task. If it takes a weekend to value some of them, how long would it take to come up with a restructuring plan? Now because absolutely no one gets to see the documents on these deals (I am not making that up, the regulators can’t demand them) I can’t be certain, but I assume any modification in terms would require a waiver or other approval from the investors (God only knows what the threshold for approval is and what voting rights the various classes have. A buddy sent me a link to the indenture of one REMIC, which is the most plain vanilla version of tranched MBS; the underlying assets are mortgages. It required the consent of 2/3 of the investors in each class to change the terms). Per the relative value question we raised in 1, you get into the ugly question of “class warfare,” that the different classes can have divergent economic interests.

And you have another wrinkle: fooling with the CDOs ripples back to the credit default swaps market. Some complaints and threats of litigation arose during the Bear Stearns subprime-related hedge funds crisis, alleging that Bear was self-dealing by removing or modifying mortgages from certain instruments. It appeared the issue was these moves improved the credit quality of the CDO, which would lead to losses on the part of CDS holders who would benefit if the CDO did worse, not better. (Note that Tanta at Calculated Risk dug deeply into this issue and was frustrated, both at the lack of specificity of the charges by the allegedly wronged parties, and by reporters not having a good enough grasp of the terminology. Bottom line: someone who knows this area pretty well was still largely in the dark). So you might even have CDS holders suing to block unwindings.

So that is a long winded way of saying that getting any unwinding approved is a huge task.

Third is who pays for this? Any restructuring is, per all that has preceded, a very big undertaking. It will take a lot of investment banker and law firm effort, maybe even (quelle horreur) rating agency time. None is a charitable organization.

I don’t see how anyone makes enough dough for this to be worth their while. And if they did, it would be at the expense of the poor investor chumps who are already under water.

But Tett was on to something with her notion of trying to get bottom feeders to start acquiring CDO tranches. But what could be done to facilitate that?

The problem with my notions is that they are likely still too small to make enough of a difference, yet would require clever regulatory footwork, or blackmail, to get the needed cooperation.

As Tett stressed. the barrier to anyone making headway is the lack of knowledge of who holds what and what those deals consist of.

Now if I were a bottom fisher, I’d want to have some decision rules as to what sort of paper might be attractive. Since I’d be doing price discovery, I’d look only at deals that didn’t have too much embedded leverage (that would rule out CDO squared and cubed, and there might be quick screens you could do on regular CDOs). To do that, you need deal documents (you can’t do this bit with a spreadsheet, you’d screen for certain structural elements and then start analyzing the subset that looked promising). “Qualified investors” can obtain them, but it’s a nuisance to ring around to get them (and you may encounter resistance if you don’t have an existing brokerage relationship with the firm that handled deals you’d like to screen. Note that the high barriers to getting these documents make it impossible for third party analysts to play a role).

Thus it seems that a minimum requirement is for the regulators to compel the underwriters, who are all investment banks, to disgorge their offering documents.

Now let’s assume I found a few deals that looked like they might have some tranches that I’d be willing to make offers on. How would I find people to whom to make such offers? Golly gee, that very same underwriter who developed the deal documents (well technically it was the entity who made the offering that is legally responsible, but let’s not kid ourselves as to who was pulling the strings) would know who bought the paper initially. And if someone wanted to trade this paper, the very first place they’d go first is the bank that handled the offering initially.

You see where this is going. Yes, the paper that was retranched (typically the BBB to B layers) are likely to have disappeared into other entities that will make it hard to trace. But most of the value of these deals was in the AAA tranche. That is unlikely to have retraded, and if it did, it is quite probable that the originating investment bank executed the trade. My belief is that equity tranches don’t trade, so the likelihood is that they are with their original holders.

That means that the Street, collectively, probably has a handle on where a fair bit of this paper sits, more than press reports would lead one to believe (mind you, the CDS written on CDOs, and then sometimes bundled into synthetic CDOs, are another matter entirely, but what we are talking about here is starting a price discovery process that hopefully moves up the food chain). So why are they not letting on that they know more than they pretend to know?

Aaah, the Street has a lot to lose with price discovery. Remember, in the first stage of the Bear subprime-related hedge fund collapse, the Wall Street firms first seized the collateral. Then they realized that if they liquidated the funds, the prices realized would not only be lousy but it would force a remarking of similar paper. That means they’d have to mark down the value of similar collateral, much of which is rumored to sit with hedge funds, which would require them to put up more cash or collateral, which in most cases would require them to sell assets, which would lead to downward price pressure on whatever they sold, leading to further markdowns on collateral and more forced sales. Hello meltdown.

So the Wall Street firms decided the better course of action was to gang up on Bear and make it solve the problem.

Now this remedy is probably inadequate. Even though a big chunk of the value of the initial CDO lies in the AAA tranches, enough of that probably trades for dealers and interested buyers to have decent marks on it. It’s the lower rated tranches that show the effects of embedded leverage more (meaning they are harder to value), and were more often resecuritized (which makes the next-gen instruments vastly harder to value and difficult to locate).

But this discussion nevertheless highlights the basic dilemma: the parties who are in the best position to facilitate price discovery have every reason to impede that process. And I doubt that the regulators have enough will to force them to cooperate.

By Yves Smith and Tom Adams, an attorney and former monoline executive

Louise Story has penned what presents itself as an important story at the New York Times, one that charges Merrill Lynch with misrepresenting the size of its subprime, specifically, collateralized debt obligation exposures, in the runup to the global financial crisis. The ruse the article depicts is a CDO called Pyxis., which purportedly served as a dumping ground for exposures Merrill could not unload. Initially, Merrill was able to escape reporting these positions because it claimed to have hedged the risk. In fact, the hedges failed, the bank was ultimately on the hook and was later forced to ‘fess up to the magnitude of its holdings. This revelation sounds juicy in that Citigroup and some of its recent senior executives paid fines to the SEC for similar, albeit less convoluted-sounding, misconduct.

But in fact, the story is astonishingly incomplete, to the point of being misleading. While Merrill’s probable accounting improprieties are noteworthy and merit investigation by the authorities, they are not the most important element of this episode. CDO abuses amounted to accounting fraud to enable employees and executives to loot their companies. Moreover, they were not perpetrated by isolated actors, but were part of what Bill Black calls a criminogenic environment.

To put it more simply, if you think Merrill’s misrepresentations to investors are a big deal, they are only a small aspect of the bigger, and frustratingly largely untold, tale of the role of CDOs in the crisis. CDOs were the epicenter of the upheaval, the device that magnified a what otherwise would have been contained subprime bubble into an economy-wrecking meltdown. When the music stopped, it was the dealers themselves that wound up holding much of the toxic paper they’d created. AAA rated CDOs went from haircuts of 2-4% in early 2006 to 95% in later 2007. The collapse in CDO valuations and the resulting inability to use CDOs as collateral for repo was a major, if not the major, cause of dealer illiquidity and insolvency which resulted in massive bailouts and backdoor subsidies.

Accounts like Ms. Story’s are blind man and the elephant affairs: at best, they do a good enough job of depicting, say, the trunk, but leave the beast undimensioned.

The New York Times account muffs how the deal works, making it sound as if the only important actors were the bank itself and three Merrill traders (and it isn’t even clear whether they acted as employees of Merrill, or were operating through affiliated vehicles).

Ms. Story somehow completely misses that the critical actor in these transactions was the sponsor of the CDOs, the hedge fund Magnetar, whose name appears nowhere in this article. A simple Google search of “Pyxis” and “CDO” turns up not only the Magnetar connection, provides links to deal lists (ours, recapping and adding to our discussion in ECONNED and ProPublica’s), which show that there was not one Pyxis deal, as the story suggests, but two, a Pyxis 2006-1, issued in October, 2006 with Calyon as the underwriter (that deal is not the subject of this article), and the deal in which Merrill provided assets, Pyxis 2007-1, issued in March 2007, with Lehman as the underwriter. She also fails to mention Putnam, the CDO manager for the Pyxis deals, anywhere in the story or indicate that Magnetar’s CDO deals were being put together by an analyst they hired from Putnam.

Why did Ms. Story not contact either of the two groups that own the Magnetar story, or at least review their work? The bizarre failure to mention Magnetar, which is integral to understanding this deal, suggests Ms. Story was going to some lengths to present the story as a new account, at the expense of reader understanding.

A key illustration of the shortcomings of the New York Times reporting: the description of the deal is so muddled as to be incomprehensible, which suggests not onlydid she not understand it, she did not consult anyone with expertise in the CDO market.

Nevertheless, the article does serve to provide some pieces of a mystery of sorts: how and why did Merrill manage to wind up with so much CDO dreck on its balance sheet when the bubble burst? But as you will see, it missed the context and the implications.

The conventional account is that Merrill’s head of its CDO business, Chris Ricciardi, who had a history of trading out to a better paid job at the peak of a market (and his timing was again accurate), quit in early 2006. Merrill, determined to keep its leadership position, set a very aggressive transaction volume target, which resulted in it underwriting three times as many CDOs in 2006 as 2005. The amount Merrill was stuck with looked, superficially, like a pipeline problem: Merrill was making CDOs faster than it could sell them.

While the subprime market had gotten wobbly at the end of 2006, it went serious distress in February 2007. Everyone in the market knew that Merrill was long a ton of subprime paper, at least $10, perhaps as much as $20 billion. Thus the critical parties – investors and bond guarantors – knew that Merrill needed badly to lighten up on its exposures, and the fastest route would be CDOs, but since Merrill was expected to be putting a lot of supply into the market, their deals were certain to be bid wide (meaning at prices unfavorable to Merrill).

To make matters worse, it is likely that Merrill was even more long subprime exposure as of February 2007 that the Street surmised. Merrill had an active relationship with Magnetar, whose massive CDO program (named after constellations like Pyxis) has taken Wall Street by storm (industry sources and our own analysis suggest Magnetar’s CDOs drove the demand for at least 35%, but more likely 50%-60% of subprime demand in 2006). The role dealers like Merrill played for Magnetar, among other things, meant that they served as the long side of the CDOs Magnetar created. So Merrill, as of February 2007, desperately needed to unload a ton of CDOs, both to offload residential mortgage backed securities exposures, and to bundle up tranches of unsold CDOs on its balance sheet (even first gen mezzanine CDOs contained up to 10% of other CDOs; so called “high grade” were as much as 30% CDO by early 2007).

Between March 1 and September 1 of 2007, Merrill issued just under $23 billion of CDOs – a record setting level. But in early March, the market was still wobbly, everyone knew Merrill was long, and there was no assurance it would be able to dump as much dreck as it wanted to (even this $23 billion was short of what Merrill needed to offload). So using another outlet, in this case, pushing some of its exposures out through a Magnetar deal underwritten by another firm, would have been a very appealing idea.

During this timeframe, even more remarkably, MBIA insured $10.8 billion of the Merrill CDOs, a phenomenal amount of new CDO exposures in a short window. This, plus the 2007 Pyxis deal (insured by FGIC), would explain why Merrill thought they had hedges in place which ultimately turned out to be worth less than they thought. Merrill was an investor in ACA. It appears likely that Merrill used ACA as an additional insurer for CDOs it was dumping in 2007 to get out of its massive pipeline. ACA blew up by the 4th quarter of 2007, which would be another reason Merrill’s “hedges” on its exposures had failed.

So what is troubling about this transaction? Two issues stand out.

First is the way some critical parties are unlikely to have operated on an arm’s length basis. One of the critical assumptions of a bond guarantor (and Pyxis 2007-1 was insured) is that the manager who is selecting the bonds, in this case Putnam, in an independent party. During this frenzied stretch of activity, Merrill underwrote one deal in March for Magnetar, the notorious Norma, which a Wall Street Journal makes clear the manager was not even remotely independent. Just like ACA in the Goldman 2007 Abacus trade, the manager of a Magnetar-sponsored trade took its marching orders from the supposed sponsor (in the Abacus case, the famed subprime short John Paulson, although curiously he never stepped up to actually play that role, but participated solely on the short side). It is even more likely that Magnetar had considerable influence over what exposures went into the CDO if the objective of Pyxis 2007-1 was, as it appears, to allow Merrill to dump CDO and RMBS exposures through a hidden channel.

How is it possible that Merrill’s MBS exposure ended up in a Lehman led, Putnam managed Pyxis CDO if not for Merrill’s connection to Magnetar? And if this is so, how plausible is Magnetar’s previous denial that they played any role in influencing the bond selection process in deals on which they were the equity sponsor?

Second is the motivation for Merrill to get itself into this mess, which is bonus fraud. For the most part, the firms that wound up with a lot of CDOs on their balance sheet were Eurobanks (Citibank is a special case, in that it was the biggest player in SIVs and had to take those transactions back). The Eurobanks, thanks to an unfortunate interaction of Basel II rules and internal metrics that rewarded managers and traders who found ways to use less capital in their businesses, incentivized dealers to engage in the so-called “negative basis trade.” If a trader bought or retained an AAA tranche of a CDO and hedged it (at some banks in full, in others, merely in part), the difference between the income on the CDO and the cost of the hedge over the life of the trade was discounted and included in the trader’s P&L. In what other business is it legit to be paid bonuses on yet-to-be received profits?

Ms. Story alludes to bonuses as a driving factor in the alleged disclosure fraud, but this is merely an aside, when it should be a central issue. No one, in particular regulators, seems willing to look at how firms paid particular actors and executives for deals that went bad, particularly ones that were questionable even at their inception.

With this as background, the supposed revelation is framed, per the title, as “How Regulators Unearthed Merrill’s Dodging of Risk Disclosure” (later revised to “Merrill’s Risk Disclosure Dodges Are Unearthed”). This is laughable. The regulators certainly did not unearth this story. But given Ms. Story (and Gretchen Morgenson’s) close connection with the SEC, the agency is probably a significant source for this story. The SEC appears to be eager to show progress on pursuing bad behavior during the crisis and has latched onto the failure of various dealers to make proper disclosure of their subprime exposures.

But the real story is about the widespread corruption in CDOs and about Magnetar. The SEC appears reluctant to pursue this angle and is using Ms. Story to focus on a different, narrow aspect. It is embarrassing that the Times cites the widely derided Citi settlement as a strong precedent. But this is consistent with SEC patterns – extolling their success with Citi (such as it is) to show the advances they are making. The SEC’s strategy is evidently to limit its effort to the narrow issue of adequacy of disclosure, which is the common thread among the Goldman, Citi, and Merrill cases. Appallingly, that blinkered approach means the agency is likely to give Magnetar a free pass, since the SEC apparently regards Magnetar to have made adequate disclosure of conflicts of interest. But presenting CDO managers as working on behalf of all the investors when they were in fact serving the interests of the sponsor, whose true interests were opposed to all the other investors, is a separate basis for investigation and action, but one the SEC has evidently decided not to pursue.

Thus what the SEC tries to publicize as progress is grossly inadequate and misses the drivers of crisis- of widespread fraud throughout the CDO market, which involves price manipulation, inadequate disclosure of parties and intentions, and tying among transactions, in addition to corporate level misleading statements regarding mortgage exposure.

The SEC, via Ms. Story, appears to display a desire to get credit for investigating financial crisis issues without addressing the problem with the CDO market head on and almost seems afraid to capitalize on the progress they made with Goldman on the Abacus deal. Are they afraid what they will uncover (might it implicate Deutsche Bank, which would undermine the credibility of SEC enforcement chief Ray Khuzami, who was General Counsel for Deutsche Bank in the US, which along with Goldman, was a leader in synthetic CDOs)? Or is it simply that they felt these CDO cases are too much work and they’d rather go back to the usual SEC low hanging fruit of insider traders? Given how central abuses in the CDO market were to the crisis, neither of these is good enough reason for the SEC to punt.

Update and correction 4:45 PM:

We owe a bit of an apology to readers and to Louise Story of the New York Times, for an apparent error in our analysis. We have been informed that, remarkably, there were two separate Pyxis vehicles which were issued in the 2007 time frame one of which was a CDO and the second a structure which some sources classify as a CDO and others describe differently. The Pyxis 2007-1 transaction which we discussed in the post was a CDO but did not have any Merrill involvement. The Pyxis deal referenced in the NY Times article that was issued by Merrill, Pyxis Master Trust, Class 2007, was an entirely different vehicle and was underwritten by Merrill

The brief description of the Merrill-devised transaction in the NY Times article, which was frustratingly vague, included references to “notes” being issued, which we took as an indication that it was an external transaction with investors and corresponded to the Magnetar-sponsored CDO, since there was no evidence of any other deal named “Pyxis” being marketed during this time period. It appears that the Merrill transaction was actually an internal transaction.

Is it any surprise that Wall Street went a bit off the deep end with the (admittedly barmy, but that’s a separate issue) Blanche Lincoln proposal to spin off derivatives desks? Derivatives, which are now deeply integrated in how dealer banks devise customer transactions and how they manage their own risks, are a large proportion of total transaction activity. And to illustrate how important they are in total, Liz Rappaport of the Wall Street Journal (hat tip Rolfe Winkler) reports that Goldman just told the Financial Crisis Inquiry Commission that derivatives transactions provided 25% to 35% of its revenues in the last two years.

If you excluded the retail businesses of other major financial firms, I doubt the percent of total business attributable to derivatives would differ much from Goldman’s level. Derivatives (ranging from not-terribly-lucrative “plain vanilla” interest rate and foreign exchange swaps to highly profitable customized trades of various sorts) are now a bread and butter business of all the major firms.

But the fact that this revelation rises to the level of a news story points up another issue: the opaque, impenetrable accounting of the major dealers. At best, investors understand only aspects of their operations, putting them in the position of blind men trying to sus out an elephant (which might instead be a camel…..).

From the Wall Street Journal:

Goldman Sachs Group Inc. told the Financial Crisis Inquiry Commission that 25% to 35% of its revenue comes from derivatives-based businesses, according to a person familiar with the situation…

A memo sent to the panel Thursday night by the New York company included an analysis of derivatives-based revenue at Goldman from 2006 through 2009, said the person familiar with the matter. Based on the percentages provided by Goldman, such businesses generated $11.3 billion to $15.9 billion of the company’s $45.17 billion in net revenue for 2009….

Goldman’s analysis reflects all derivatives products, ranging from credit to equity to interest rates, traded on and off exchanges, said the person familiar with the situation.

Goldman said it doesn’t conduct its businesses in a way that delineates revenue from derivatives transactions or other types of trading….

For example, Goldman cited credit-trading desks that are separated by industry group, adding that traders are indifferent to whether they are selling clients a bond or a credit derivative. As a result, separating the revenue among the two product lines is useless, Goldman told the FCIC. The firm also said its technology systems firm-wide don’t single out derivatives transactions.

The analysis was based on a “best guess” of the main type of trading on each Goldman trading desk at the firm, said the person familiar with the matter. The numbers vary widely, with the company’s fixed-income unit getting much more of its revenue from derivatives than investment banking, where no revenue is tied to derivatives.

Yves here. Goldman’s inability to produce a tidy derivatives number is not “not credible.” I’ve always marveled at how a perennial aspect of McKinsey’s business is that financial firms are set up (typically because it reflects organizational structures) to do a good job of reporting revenues and profits by customer or by product, and be pretty incapable of providing the other view. McKinsey therefore inevitably finds good cause for believing that the understanding the missing perspective would add value, and gets to throw bodies at rejiggering the numbers.

Even in this TARP and Fed supported, “heads I win, tails you lose” of the banking industry, the “you live by the sword, you die by the sword” element has not been entirely removed.

Witness the schadenfreude-gratifying distress at JP Morgan’s commodities unit, headed by Blythe Masters (a supersaleswoman who has already gotten a fair bit of profile as one of the moving forces behind the credit default swaps business). Less than stellar results of an internal unit seldom make for Bloomberg coverage, but evidently layoffs (which appear in part the result of an ill timed and perhaps also badly-executed acquisition, the acquisition of $1.7 billion purchase of RBS Sempra) and revenue shortfalls have led to juicy, unflattering rumors.

The business also appears to contradict the usual notion that low interest rates help raise all boats. Low interest rates reduce the cost of speculation, and aside from wrong-footing some market bets, a second cause of distress for the JPM unit appears to be spread compression, the result of too many dealers (and dealer capital) ready to act on behalf of (evidently) a less than commensurate level of end customer business. Indeed, the article indicates specifically that JPM’s coal trading unit, which suffered a big loss, was a disproportionately large player relative to the size of the market.

Of course, this begs the question of why government-backstopped firms are permitted to trade commodities at all….

From Bloomberg (hat tip reader Scott):

Blythe Masters, JPMorgan Chase & Co.’s head of commodities, sought to reassure her team on an internal conference call after “extremely difficult” dismissals, defections and a first half in which some results were as much as 20 percent below expectations….

JPMorgan’s fixed-income revenue, which includes commodities, fell 27.7 percent year-over-year to $3.6 billion in the second quarter, compared with $4.9 billion a year earlier and $5.5 billion in the first quarter. The company attributed the drop to poor results in the credit and commodities markets, and a squeeze in interest rates….

Coal derivatives trader Chan Bhima made an error of judgment, not of character, in “taking a risk on our behalf,” she said. Coal prices plunged 24 percent from January through March and then surged 35 percent through June. Marchiony, the bank spokesman, said Bhima wasn’t available for comment.

The company took an oversized position both relative to their fledgling operation and relative to the market, Masters said. The error cost the company as much as $250 million, the New York Post reported June 8, without saying where it got the information…

JPMorgan “became bigger than the market,” said Robin Bhar, a metals and energy analyst at Credit Agricole CIB in London. “They were the coal market,” Bhar said, adding, “these mistakes could happen again.”

The article indicates JPM lost some key members of the RBS Sempra oil team. It also makes for intriguing reading, the quotes are so exact and lengthy (with a lot of rah rah corporate speak) because a JPM employee recorded and leaked the entire call to Bloomberg, which is particularly amusing given that Masters also chides employees for talking to the media.

Augmenting Ed’s recent links re Tom Adams, regular readers will remember Yves got a magazine cover and write-up in Calcalist.

Now Tom Adams, another contributor to “Naked Capitalism”, (and ECONned helper, Magnetar sleuth, etc etc), has got a writeup by Calcalist. The main article is here, and it’s all in Hebrew, which Google Translate struggles with, though you can make out roughly what’s going on.

There’s a sidebar article too, though, which is short enough to clean up, thus (and with apologies to genuine Hebrew speakers for any unintended liberties with the translation!):

Tom Adams and Yves Smith Change Wall Street

by Uri Psuvsky, Calcalist

A few months after his dismissal, in an attempt to understand what really happened to him and his company, Tom Adams opened an independent investigation. This led him to meet Yves Smith, (Susan Webber), who runs the world’s leading financial blog, Naked Capitalism (an extensive interview with Smith was published two months ago).

“When I met Yves, in early 2009, the level of denial and fear in the market were high, and very few financial or media people wanted to find out what really happened”, says Adams. “I had bad feelings about the role I played by the collapse, I thought I was damaged goods and I was not sure about my future employment prospects. But when I was working with Yves, publishing my findings at “Naked Capitalism”, I began to realize the value of 20 years of experience in providing an insider’s introduction to the crisis. Then I started to receive consultancy requests from organizations who needed counseling, and I realized that I could contribute to changes in the industry. ”

The collaboration between Adams and Smith did indeed led to changes in the industry. Among other things, they broke the conspiracy of Magnetar, the Chicago hedge fund, now under investigation by the Israel Securities Authority, that inflated the real estate bubble in order to bet on its collapse. Another success story: how they managed to bend the central bank’s hand and to publish full details on AIG’s rescue , which the Fed was trying to keep classified for ten years. Adams was able to recover all the information and publish it at Smith’s blog, leading to the leaking of the original documents by a member of Congress, and opening the current demons’ dance against Goldman Sachs.

Cross-posted from New Deal 2.0

By Wallace C. Turbeville, the former CEO of VMAC LLC, and a former Vice President of Goldman, Sachs & Co.

The current system of trader compensation will continue to decay the heart of Wall Street.

Which is a greater threat to the nation — terrorism or the relentless decline of middle income families? Unless we abandon our core values out of unwarranted fear, terror cannot fundamentally change our way of life. The number of people affected by growing income disparity is vast. When I was a student, income disparity was indicative of an underdeveloped and unstable society.

The government appropriately devotes enormous resources to protect our lives and property from terrorism. It is unthinkable that a leader would display any weakness opposing this threat. Politicians have stiff backbones when it comes to terrorism.

In contrast, the government is timid and half-hearted in its approach to the system which perversely rewards a few Wall Street traders with billions of dollars of bonuses, yet allows the foundation to decay.

Kenneth Feinberg issued his report identifying outrageous Wall Street compensation of executives despite their role in the financial disaster and bail out. He proposed that the banks voluntarily adopt “brake provisions” that permit boards of directors to nullify bonuses in the event of a new financial crisis.

He might have more success asking the lions of the Serengeti to give the wildebeests a sporting chance of making an escape.

Over the last fifteen years, the financial sector’s percentage of GDP has increased dramatically. At the same time, the median family income stagnated and then declined. I do not believe that this is a coincidence.

The large banks have changed. They slice and dice the constituent elements of a stagnant economy, squeezing value out in ever more sophisticated ways. Wall Street has turned away from its roll as the financial backer of industry and commerce. In the short term, it is more profitable for them to use their capital for trading. Newfangled software and MIT “quants” allow the traders to “rip the faces off” of corporate counterparties and investors which were once trusted clients.

These young traders are simply doing what America has told them to do. They are allowed to earn obscene amounts of money using the advantageous information, technology and capital of their employers. Making money from less powerful counterparties is like shooting fish in a barrel. The banks make so much money that they have no problem shoveling it out to the traders.

The alternative careers for these talented young people offer upside which is modest by comparison. Besides, the trading world, in which the law of the jungle prevails, appeals to youthful aggressiveness. Michael Lewis expected that college students would be appalled by the amoral environment he described in “Liar’s Poker.” Instead, the overwhelming response he received from students was a desire to get in on the action. The draining of talented and energetic young professionals away from corporate America where they could help create jobs by the millions may be as damaging as the new allocation of wealth.

The government’s flaccid approach to Wall Street compensation, embodied in the Feinberg report, is appalling. Geithner and Bernake appear intimidated by Wall Street, yet intent on its approval. Why do they guilelessly buy into the notion that giant, multi-purpose banks dominated by trading are essential to America’s competitiveness in the world? Smaller, less risky institutions aligned with economic growth would seem to be a better idea for the vast majority of Americans.

Greenspan and his progeny, including Geithner and Bernake, are enthralled by financial innovation. Innovation, by itself, can be good or bad. Innovation does not fall into the “good” category if it corrupts the home mortgage market, siphons off business productivity and the jobs and wages of employees and unfairly enriches the few at the expense of the many. It is good if it creates jobs and enriches the public as a whole.

Trader compensation is at the heart of the problem. It encourages behavior that is inconsistent with Wall Street’s most important function: raising capital for industry and commerce. The banks and the government are afraid that the traders will desert the banks and move to hedge funds if their compensation is reduced. If they do jump ship, it is all the better for America. At least hedge funds can blow themselves up without crippling the US economy in the process.

Former traders now run most of the financial sector. They believe that the traders somehow deserve compensation at the prevailing levels. The system will not change unless it is forced to do so. The restrictions in the financial reform legislation only inhibit specific abuses. The banks will concoct new ways to trade risk. It is the only way to maintain their unconscionable profits (that is, until the next bubble bursts and we are in an even worse predicament). The only way to really change the system is to reduce short term incentives, that is to say limit bonuses. The government needs the kind of resolve it uses when fighting terrorism. After all, the stakes are actually higher.

Felix guessed how this Structured Finance issue pipeline would get sorted out, for the moment.

Three not necessarily inconsistent takes on causes and effects:

A neat way to embarrass the government. The rating agency logjam and the GM deal announced yesterday are closely related: if there’s one thing GM will think it still needs for its IPO, now that it’s got a subprime lender, it’s a freely moving subprime auto loan pipeline. So I would guess that there might be a GM IPO sometime in the next six months, but possibly not right at the end of that time.

Or, this instant fracas just points to the likely result of the tortuous bill-drafting process – “unintended consequences”, a phrase we will see plenty more times in connection with regulatory change. Maybe that turns into organized push back by the business.

Or, perhaps it was an intended consequence, and the agencies’ letters to issuers, requesting that the rating not be registered, actually represent first drafts of  the ratings agencies’ suicide notes. If even they don’t trust their own ratings, why should anyone else? What is the formal point of the agencies now, apart from their niche in the regulations? Who is left to offer guarantees against rating agency risk, if not the agencies? Actually, one can see why they’re a bit windy. Pretty much everyone else who took that risk on has gone bust, or lost their job. But maybe it’s a business opportunity for someone if the price can be got right.

Oh, I see Disequilibria sort of agrees with me, plus a linked video.

Richard covering for Yves here, in case that maritime internet connection, which seems OK for terse emails, is not so great for navigating 100 eurowebsites, to whizz through as much detail as possible.

Just seven failures, making Chris Whalen’s EU stress tests: who knows, who cares? the main takeaway, I suppose. Not enough blood to be convincing.

I am sure the market will be constructing its own stress tests based on the foreign sovereign exposure info, which was of some interest.

First, it appears that a few banks availed themselves of the late-breaking option not to publish their sovereign debt exposures as part of the test results. These were mostly German banks:

Landesbank Berlin, Landesbank Hessen-Thueringen, WGZ Bank (tiddlers)

DZ Bank, HRE, PostBank (medium-sized)

Deutsche Bank (whopper)

Perhaps the tiddler and medium-sized omissions are only there in an attempt to make the whopper omission less obvious. For instance, HRE’s coyness about its sovereign exposures is rather sudden: it blithely confessed its Greek and other exposures to Reuters on May 7th.

The other major non-discloser seems to be ABN-Amro (this is the part-nationalized piece that our dear RBS couldn’t swallow back in 2007, and now merged with Fortis). That omission sticks out like a sore thumb (I did have a rummage round their web site to try to make sure it wasn’t just my navigation). ING has a fair amount of Greek stuff (~EUR 2,5Bn) on its books; a possible hint as to why ABN is being shy?

Update 26-07-10 the ABN exposures are here, h/t Rikkert

The French, on the other hand, are letting it all hang out, with very chunky Greek exposures evident at BNP and SocGen, and merely largish ones at BPCE, Credit Agricole. A big (and expected) clue about who wants Greece to go right, and why there was only a 23% haircut in the Greek default scenario.

Nothing very striking to my inexpert eye about the Spanish banks (caution, slow downloads) . I can’t see why a caja would pile into dubious foreign debt, and they haven’t. If there are any obvious risks connected with Spanish banks it is their RE assets, and the private debt they have issued. They do have larger exposure to Portugal than other Eurobanks would have, but that’s not a massive surprise.

The largest exposures to Italy were at that French quartet, again.

With due apologies to Malta and Cyprus I took a flyer that their banks did not present any kind of systemic risk.

The Slovenians (who did have one reputedly rickety bank, Nova Ljubljanska Banka, which scraped through) seem to have mucked up their link to the results detail. Oops.

A couple of other things caught my eye:

an extra Irish connection: RBS’s GBP4Bn exposure to Irish sovereign debt. That’s apparently on top of our two nationalized sickies’ (RBS and HBOS) existing RE exposure to the Irish mess.

A Hungarian connection – to the Austrians, of course: RAIFFEISEN ZENTRALBANK, ERSTE GROUP BANK AG, UNICREDIT. There’s a hint that the Hungarian IMF row may point to a problem that’s bigger than first thought, so if it blew up, these banks would get some of the fallout.

So that’s it – a tentative and probably spotty map of the sovereign interconnections that might matter.

If only we had the same sort of info about what’s in the Eurobanks’ real estate books, and any legacy toxic debt holdings from the US, and for that matter, from Iceland, where the Landesbanken went quite potty.

Little rumor that the SEC “is giving asset-backed bond issuers a 6-month reprieve on quoting ratings, hoping to stem fears of another market freeze”. Fawn Johnson of Dow Jones, on Twitter, via a kind helper.

Update: Yup, it’s a blink. AP

H/t Mindrayge and others.

This post first appeared on March 14, 2007

One of today’s lessons is to have greater courage in my convictions. In a number of earlier posts (such as “The Rising Tide of Liquidity,” part 2 and part 3 of the same, “Where Has the (Perception of) Risk Gone“) I pointed to how toppy the markets have been, and how much capital has flowed into risky assets, particularly in the credit markets. I’ve also lived through several bad times in the securities markets (1980-81, the 1987 and 1989 crashes, which preceded the nasty 1990-1991 recession, and the unwinding of the bubble in Japan) so I have seen how rapidly sentiment can shift.

I’ve also been struck by the generally grim tone of reporting in the Financial Times for the last few months. The Brits have a higher tolerance for bad news than we do.

Commentary in the US has gone from a Pollyanna market to a Tinkerbell market. If enough people believe in it, the markets, or in this case, market valuations, won’t perish. And in fact, confidence is a heady elixir. Look how long the dot com mania persisted, despite the patent lack of grounding in reality and positive cash flow.

The optimistic commentators here have stressed how the economy is strong, the subprime market is a just a sector of the overall mortgage market, concentrated in lower-priced housing. Any damage, they argue, will be localized. Default rates are a function of employment, and unemployment is low.

One can make a counterargument around particulars, for example, that latest job additions were weak, which doesn’t bode well for unemployment. But the fundamentals aren’t really what is driving this correction. They may appear to be the cause, but are merely triggers. A different mechanism is at work.

As John Authers pointed out in the FT last weekend, credit is overvalued. Lenders have given borrowers way too generous terms, and not just in the subprime market, but in junk bonds, emerging markets, and so on. And even equities are overvauled, just not to the same degree.

So this correction is really about valuations. Investors are realizing that the prices that assets have been trading at are high, systemically high. That knowledge will precipitate a rush for the exits, since investors that can realize these unduly high prices will. That’s why the price drops in equities and riskier fixed income instruments have seemed out of proportion to events.

Let us not forget that more stringent lending will be a damper on growth, and may finally put a crimp in the free-spending ways of US consumers, who have been the engine of growth for the US and an important contributor internationally. So the change in the financial markets doesn’t simply anticipate worsening fundamentals; it will feed them. That’s why the Tinkerbell crowd is so eager to keep belief going any way they can.

The Tinkerbell fans do have a case, that in the long run, investors have to put their funds to work, that most of the time markets go up, because most of the time we have economic growth. So if and when confidence returns, the markets will resume their general march upwards.

The problem, of course, is when confidence is shaken, it can take a while for it to return. And the latest reports aren’t very cheery.

The much decried New York Time story by Gretchen Morgenson, “Crisis Looms in Mortgages” doesn’t appear as overblown as it did two days ago. The front page of this morning’s Financial Times, “Fears of subprime fallout escalate,” had a paragraph that fit the thesis, if not the overwrought style, of her piece:

The rapid decline of New Century, the latest in a wave of problems at US subprime lenders, raised concerns that problems could spread in the $8,000bn (£4,000bn) mortgage industry and other parts of the capital markets.

The FT gave this recap of today’s events, “Markets slide as subprime woes escalate:”

A steep sell-off swept through global stock markets on Tuesday as investor confidence was hit by the escalating woes of the US subprime mortgage market and weak US retail sales data.

Stocks began the day on a bearish note but selling pressure intensified after the Mortgage Bankers Association said that the rate of late payments and defaults on US home loans hit 4.95 per cent in the fourth quarter, up from 4.67 per cent for the prior quarter.

The problems were particularly severe among subprime borrowers – people with patchy credit histories. Delinquencies for subprime adjustable rate mortgages rose to 14.4 per cent, up from the third quarter’s 13.2 per cent…

GMAC, a financial services group 49 per cent owned by General Motors, said subprime lending woes contributed to a $651m fourth-quarter loss at its home lending arm.

Sentiment across markets was driven by fears that subprime problems will slow consumer spending and hamper economic growth, leading investors to sell risky assets and seek the safe haven of government bonds.

The S&P 500 tumbled 1.6 per cent, while the yield on the 10-year Treasury note fell below 4.50 per cent. The Dow Jones Industrial Average was trading more than 1.7 per cent lower in afternoon trading, having fallen 200 points earlier. London’s FTSE 100 and France’s CAC 40 both closed more than 1 per cent lower…..

An odd news item on the Wall Street Journal’s website, and it looks to be the lead item in their news summary for the print edition: “Goldman Goes Hunting in Battered Loan Sector After a Record Quarter.”

Seeing growing turmoil in the market for risky home loans as an opportunity, Goldman Sachs Group Inc. is looking at pushing deeper into the business, ramping up its own subprime-lending operation and pondering the purchase of another.

Although David Rothschild attributed his wealth to buying a little early and selling a little early, this appears to be more than a bit early. There are going to be more subprime failures, and more important, Congress has taken interest in the question of regulating lending practices. Capacity clearly needs to leave the subprime sector; it’s never going to be as big as it was. Failures of originators like New Century are part of this process. But the market, even in its reconstituted form, will be much smaller, and could be less attractive if new rules are imposed. Goldman appears willing to take that chance.

Or could Goldman have a completely different set of motivations? Could this be a cheap way to show confidence the subprime market to help calm investors? After all, this is a mere announcement of an intent to look, nothing more.