The cut runs deep

So the US congress have agreed upon an economic stimulus plan. Now comes the real rocker - how to value bonds that have no takers?

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Getting this right will not be easy.

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The wild variations on the value of many bad bank assets can be seen by looking at one mortgage-backed bond recently analyzed by a division of S&P, the credit rating agency.

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The financial institution that owns the bond calculates the value at 97 cents on the dollar but S.& P. puts it at 87 cents, based on the current loan-default rate. It could be worth 53 cents under a bleaker situation if say, the defaults double. But even that might be optimistic, because the bond traded recently for just 38 cents on the dollar, reflecting the even gloomier outlook of investors.

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Both Washington and Wall Street ecognize that there are no current market prices for these toxic securities. But bond dealers say most kinds of securities can be valued and are being traded, but trading has slowed as sellers and buyers disagree about what that the price should be.

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The value of these securities is based on the future cash flow they provide to investors. To determine that, traders have to make assumptions about the housing market and the economy: How high will the unemployment rate go in the coming years? How many borrowers will default? What will homes be worth?"

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To them normally one would suggest go by the realizable value of underlying assets. But even that is a problem if the bond is backed by 9,000 second mortgages used by borrowers who put down little or no money to buy homes. Nearly a quarter of the loans are delinquent, and losses on defaulted mortgages are averaging 40 percent. The security once had a top rating, triple-A.

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Holy Fuck !!!

Docking Big Four yet again!

It is often noticed in business circles that no large scale fraud is possible without the connivance of auditors. But they are the first one to shirk when the ugly underbelly is exposed. We had seen it in Enron, WorldCom scandals and I seem to have had an eerie sense of timing while I posed this question on Auditors.

Then I read this NYT article based on an investigation report commissioned by the DoJ into the collapse of New Century Financial, one of the largest subprime lenders that directly accuses its auditors – KPMG. Some of its accusations echo charges that surfaced about the accounting firm Arthur Andersen after the collapse of Enron in 2001. E-mail messages showed that some KPMG auditors raised red flags about the accounting practices at New Century, but that the KPMG partners overseeing the audits rejected those concerns because they feared losing a client. It also deals with fraudulent accounting practices that masked its likely losses.

The investigator Mr. Michael J Missal, who also worked on an investigation of WorldCom’s accounting misstatements, concluded that KPMG and some former New Century executives could be legally liable for millions of dollars in damages because of their conduct.

I often argue with clients why they insist on a Big Four auditor in every JV deal. They do have a reputation as a firm, but as individual partners they have their own pet prejudices. There are auditors with great track record and reputation that will do a far better job for far lesser fee. But somehow it doesn’t register. Meanwhile Big Four carries on the Arthur Andersen legacy, winking and nodding!
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Rogue trader or a Rogue Bank ?

Société Générale, the French Bank is quick to blame Jérôme Kerviel, the trader allegedly responsible for a €4.9 billion ($7.2 billion) loss it declared earlier this month.

Remember Nick Leeson and the Bearings bank episode? This comes pretty close. Jérôme Kerviel's unauthorized trades may have cost Société Générale €4.9 billion, but they also helped to turn the French bank's $3 billion of subprime losses into something of a sideshow.

Attempt to mask inherent inefficiencies in internal risk management by pinning it on individual traders show bank managements in poor light. May be, they expect to get less sullied by raising this smokescreen to deflect public attention away from subprime induced losses for which they own more direct responsibility. Daniel Bouton, the bank’s chairman, and Jean-Pierre Mustier, Head of SocGen’s investment-banking arm may have hoped to escape with just a smear instead of a much maligning, indefensible subprime bruised image by bringing it up now. Coming at this worst hour for bank CEOs, trading losses emerge as preferred excuses for their plight than subprime losses that nail them straightaway.

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We will never know. But it is hard to digest how Mr Kerviel got away with building up such a big position unnoticed. Do banks only look at net exposure and not a trader’s outsized gross positions? Why didn’t the margin calls on Mr Kerviel’s real trades (likely to have been in the order of €2.5 billion on a €50 billion position) trigger alarms?

I am tempted to call them rogue banks. The trader just played fast and loose – when allowed.

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The Aftershocks

So what are your takeaways from the US mortgage crisis? When things go awry, you can’t do much more than endless finger pointing. If you are a banker, make sure you multi-layer your debt instrument so much and make it as complex as possible so that you always will have someone else to blame.

Lehman Brothers is suing at least six mortgage lenders and brokers, claiming they sold Lehman dubious loans. It claims that borrowers’ incomes were overstated, appraisals were inflated and the homes were in poor condition. In most cases, the lenders are fighting the allegations and Lehman’s demand that they buy back defaulted or otherwise problematic loans.

Meanwhile members of a New Jersey family have sued Lehman for $4.14 billion, saying the firm steered them into complex securities that have become difficult to sell. Lehman denied the accusations.

Bringing securities fraud cases has been made harder by recent Supreme Court decisions that favored Wall Street, companies and professionals like accountants. The court ruled earlier this month that two technology vendors could not be held liable for taking part in a scheme designed by a cable company to inflate its revenue. Last summer, in a ruling favoring the company, Tellabs Inc., the court said that securities cases could be dismissed if investors did not show “cogent and compelling” evidence of intent to defraud. Period.

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Figuring out subprime for you

This is friggin’ cool. Watch this short, hilarious video that describes subprime mess in layman terms. I loved it. Especially the part where they explain the thought process that goes into naming hedge funds....

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Anchor to George Parr (playing investment banker) : Ok. Let’s talk about moral hazards.
GP : Sorry, I understand hazard. What’s the other part?
Anchor : Ok. Never mind. I don’t want to sound insulting. But I think you haven’t learnt anything from this crisis.
GP : On the contrary, we’ve learnt a lot.
Anchor : And what’s that…?
GP : When you know you’re going to make a cock-up, make an enormous cock-up so that the Governments will come and bail you out.

Watch it live... It's a laugh riot.


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Blatant cover-up

Earlier this year, for example, Merrill Lynch, Citigroup and Bank of America gave almost no indication that one particularly toxic debt product -- CDOs, or collateralized debt obligations -- could be the source of billions of dollars in losses. The major banks have already reported billions in unexpected losses from complex investment vehicles known as CDOs. Now they face big risks from other corners of the debt markets -- but don't expect them to warn investors anytime soon.

One likely new trouble spot: Conduits, the opaque structures banks set up to provide debt funding to borrowers. Often, the debt issued by the conduits is collateralized with assets, like mortgages. If the borrower fails to pay up, it’s the bank’s obligation to pay the bondholder.

Conduits typically aren't consolidated on a bank's balance sheet. But banks are often on the hook to fund them if investors stop buying the debt they've issued. When that happens, a lot of risk can get moved onto the balance sheet.

How well do you know your bank, as an investor? Learn about some blatant cover-up here.

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That sinking feeling

If there is one math that nobody seems to get right, it’s the quantum of losses from sub-prime mortgage fiasco. Not just that nobody knows how much, they don’t really know who should bear it. The estimates vary between $100 -$400 billion.

“What were they smoking?” asks the cover of the current issue of Fortune magazine. Underneath the headline are photos of recently deposed Wall Street titans, captioned with the staggering sums they managed to lose.

The answer, of course, is that they were high on the usual drug — greed. And they were encouraged to make socially destructive decisions by a system of executive compensation that should have been reformed after the Enron and WorldCom scandals, but wasn’t. Should the ongoing election campaign make corporate governance a central issue? It had better.

In fact, according to Fortune, Merrill Lynch made its biggest purchases of bad debt in the first half of this year — after the subprime crisis had already become public knowledge.

Now the bill is coming due, and almost everyone — that is, almost everyone except the people responsible — is having to pay.

The losses suffered by shareholders in Merrill, Citigroup, Bear Stearns and so on are the least of it. Far more important in human terms are the hundreds of thousands if not millions of American families lured into mortgage deals they didn’t understand, who now face sharp increases in their payments — and, in many cases, the loss of their houses — as their interest rates reset.

“And then there’s the collateral damage to the economy”, says Paul Krugman in NYT.

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Wall Street sausage flattens the world

Some of my friends that are not conversant with financial world, have often poked me for cluing them in on this subprime situation. They all know it’s got to do with home loans turning bad in the US and wonder how the hell it matters to them living here in India. I had explained how financial markets operate, what happens after loans are made, the process of securitization of loans and marketing of high yield junk bonds that put liquidity back into the system. Few of them got the message, many just nodded. It bodes well to liken it to a sausage making business as this Bloomberg article suggests and would leave me with less and less to explain. Excerpts -

“In the case of subprime loans, which were packaged into mortgage bonds and sliced and diced into collateralized mortgage obligations, there was just enough real meat for the securities to be certified as kosher (AAA) by the rating companies. Eventually the knockwurst and bratwurst started to make people sick. Upon testing, the sausage was found to contain too little meat and too much by-product. It wasn't kosher after all. [In fact], the entire sausage production and distribution chain -- from homebuyers to mortgage lenders, from mortgage brokers to securitizers -- was found to be operating under unsanitary conditions and pretty much shut down until further notice.

And it wasn't just the wurst that was declared unfit for human consumption. Anything suspected of containing meat by- products was shunned by investors in favor of food with a federal government guarantee.”

That sums it up nicely, I guess…

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