Monday, March 17, 2008

Institutional Risk Analytics Interview with Robert Feinberg

Bear Stearns has agreed to sell itself to JPMorgan Chase for $2 a share. The firm's shares closed at $30 on Friday, giving it a market value of $4.1 billion.

The New York Times

It is time to step back and recognize that the current situation isn't a liquidity issue and hasn't been for some time now. Rather there is uncertainty about the underlying quality of assets which is a solvency issue driven by a breakdown in highly leveraged positions. Many of the special purpose entities and vehicles are comprised of pyramids of paper assets supported by leverage whose values are now unknown. If it were a simple liquidity problem the actions that the Federal Reserve has taken would have dealt with the problems by now.

Bob Eisenbeis
Cumberland Advisors

Last week began with the Federal Reserve System opening its doors to the Street, swapping Treasury collateral for illiquid mortgage assets. The week ended with the Fed and JPMorgan Chase (NYSE:JPM) rescuing Bear, Stearns & Co (NYSE:BSC) from a run as clients and counterparties fled what is perceived to be a sinking ship. BSC has since then agreed to be sold for a price that can only be called absurd.

If the Fed thinks that allowing BSC to be purchased at $2 per share will calm global financial markets, then they are not learning as fast as we had hoped.

On Friday, after we returned from a trip to FL to talk subprime with a room full on insurance CIOs, we told Bloomberg one of the root causes of the run on BSC and mounting investor unease is fair value accounting. One CIO describes spending 10x as much time and internal resources on the investment section of his firm's audit vs. 2006, in large part because auditors are forcing a "fair value" review of all illiquid assets.

Another CIO describes how investment decisions increasingly are being driven by accounting rather than economic concerns. "We have assets that are not impaired, that are still paying, but our auditor made us write off the full value," notes the CIO, who adds that his auditor has been attempting - unsuccessfully - to get brokers to attest in writing as to the pricing of illiquid assets.

An advisor in the audience observed: "We are not being paid to render written fairness opinions on illiquid assets and are thus not responding to requests for same." Another opines that the rising cost of responding to endless valuation queries from clients and/or their auditors must eventually push fixed income asset management fees higher.

With concerns about the solvency of and reporting by financial institutions growing each day, on Friday we spoke with the dean of the Washington financial services policy community, Robert Feinberg, from his office in Washington. Bob worked for the House Financial Services Committee for more than a decade and has covered financial services issues for his clients for several more.

You can almost always find Bob at congressional hearings on financial issues, sitting in the corner and quietly typing verbatim notes of the proceedings on his tiny Compaq laptop. Whenever there is a press conference after a hearing, Bob is usually standing next to the chair person, reporting on what passes for serious work in our nation's capital.

The IRA: Bob, when did you start working in Washington?

Feinberg: I came down here right out of law school and the Army. I enlisted in the Reagan Revolution, which was then canceled. We did not have email in those days, so I never got the word about that. Years later, when I was leaving the Banking Committee, a bank lobbyist suggest to me that it would a good idea to cover what was going on the Hill because people like him would pay a modest amount for the product. So that's how I got sucked into doing this.

The IRA: When did you work on Capitol Hill?

Feinberg: What happened was that by just being here and networking, I got to be an legislative assistant for Congressman John Rousselot (R-CA) in the early 1970s and then a few year later in 1975 they expanded the Banking Committee staff so that's how I got into banking law. I should add a disclaimer at this point that I am practicing neither law nor accounting.

The IRA: Noted.

Feinberg: But I still remember the principles that some have forgotten or would rather forget. So I spent 10 years on the Banking Committee, then did another ten years of boutique lobbying for an industry that no longer exists. The song is over, but the melody lingers on.

The IRA: You are referring to the US banking industry?

Feinberg: Yes, look at it right now. Look at the situation with Bear, Stearns.

The IRA: As we mentioned in our last comment, you have always been a proponent of the view that the government-sponsored entity or "GSE" is now the preferred business model in the US. By implication, are you saying that America is no longer a free-market system any longer?

Feinberg: Yes. We have lapsed into a kind of mercantilist/feudal model. It is similar to the Dutch East India Company that was government sponsored and traded with the backing of the government. The only entity that can compete with a GSE is another GSE. We have tended to multiply them because the GSE has become the answer to every problem that crops up. Problems crop up because that is the way it is supposed to work. Now, though, we need 'fail safe' solutions because the regime has told our people that they should all own houses and all have mutual funds. The regime would never allow people to find their ATMs inoperative on their way to the gas line.

The IRA: Correct. It is pretty frightening to see how little our citizens understand the way in which our political system has desensitized them to economic and financial risks. How do you evaluate the role played by Washington promoting "affordable housing" in creating this mess?

Feinberg: You and authors like Joe Mason have described the details of the affordable housing scam better than I can. When I first started working on the Hill, there was a conservative Democrat on the Education & Labor Committee named Edith Green who coined the term "Education & Labor Industrial Complex" to describe what she was up against regarding education policy. Starting about that same time there developed what I call the Homebuilder-Realtor-Mortgage Banker Industrial Complex. They created a mythology that said you could not have enough housing and it was up to the government to make sure that happened. The home builders had a quota of 2 million units that had to be constructed every year. They really didn't care what happened to those homes once they were built.

The IRA: As long as they were built.

Feinberg: Yes. So the blame goes to Congress and of course the Congress has taken the money over the years. I refer to it as purchased public policy or "P-cubed."

The IRA: If you look back at the real estate crisis of the late 1980s, did the Congress push the affordable housing effort through legislation or by other means? Was the structured finance vehicle used to create the subprime bubble enabled by specific legislation?

Feinberg: It was not done via legislation. There were regulatory attempts to curb structured finance, some related to Enron. Enron really put the spotlight on the "special purpose entity." If you could convince someone to buy 4% of an SPE that transaction created an objective valuation for the whole thing. I don't know why anyone would accept such a proposition, but when that fiction blew up with Enron's failure you'd think that that would cause a chilling effect on the use of the SPE, but no, instead the threshold was raised to 10%.

The IRA: More purchased policy?

Feinberg: Yes. And somehow the SEC and the banking regulators also decided that SPEs were a good thing for banks to use, ignoring the funding risk now illustrated by the BSC situation. The enablement for the subprime fiasco was provided at the regulatory level rather than through legislation. No one in Washington did anything to stop the growth of SPEs and the regulators provided enablement, so that's really how the subprime fiasco came into being. When regulations were circulated a few years ago to caution the banks about complex structured finance, I said to you and a mutual friend at the time that this was a way for the banks to get these assets off balance sheet with the full blessing of the regulators. Regulators should have asked more questions because the off-balance sheet finance was taking on the characteristics of a shell game.

The IRA: How did you react to the comments by Joe Mason in our interview last month regarding his experience at the OCC in the mid-1990s regarding securitization as a safety and soundness issue and the refusal of many of his colleagues at that agency to ask those same questions?

Feinberg: OCC over the years has done pretty much what the banks wanted them to do. The one area where I disagree with Joe Mason, who is doing a great service by highlighting these issues and asking these questions, is the idea that banks are special. To accomplish anything, one has to get beyond the idea that banks are different from other types of companies. That's where the Congress fails miserably. Congress has bolstered this myth that banks are special over the years. No matter how many times that this issue is examined on Capitol Hill, we never seem to get clarity on just what it is within the business model of a bank that deserves "special" treatment under the law.

The IRA: How so?

Martin Mayer, for example, in his book The Bankers raised some of these questions three decades ago. He noted that banks were supposed to originate self-liquidating assets. The farmer was supposed to borrow from the bank in the Spring and repay the loan in the Fall after the harvest.

The IRA: So the firms like Countrywide (NASDAQ:CFC) and Bear Stearns which sold these loans are now failing and being bought for pennies on the dollar.

Feinberg: Mayer was pointing out back in the 1970s that the customers of the banks had better credit than the banks did themselves. During his last testimony before the Senate Banking Committee, then-Fed Chairman Alan Greenspan noted that some would argue that the sole reason for banks to exist is to live off the yield curve. And that brings us to today. Heaven and earth are being moved to steepen the yield curve and optimize the circumstances for one segment of the economy, namely the banks, rather than look at it from the macro level and ask: what is the best policy for the entire economy? Maybe we should manage the collateral damage, but we should not pick winners and losers.

The IRA: So Bear gets saved by the Fed and bought by JPMorgan Chase (NYSE:JPM), but hundreds of smaller dealers, hedge funds and mortgage companies fail in bankruptcy?

Feinstein: Yes, we've turned the world on its head. Our policy makers just say "we're going to do these bailout bailouts for larger players and, if there are moral hazard implications, that's regrettable."

The IRA: But what about the law of unintended consequences? Both BSC and CFC are victims of the impact of sudden changes in investor risk preferences due to policies like fair value accounting. We don't think that the folks at the Financial Accounting Standards Board intended to stampede investors in private label securitizations into a panic, but that is precisely what has occurred and is occurring as we speak.

Feinberg: I am more sanguine than you about fair value accounting. I read something which suggested that all of this was cooked up by SEC Chairman Richard Breeden. All that Breeden did was codify from the SEC's point of view what the industry practice was anyway. I think the idea historically was that things marked as marketable securities were carried at the lower of cost or market value. This assumes, of course, that they are marketable. The principle of conservatism puts the burden on management to justify the value and use an objective indicator. When you hear people like Fed Chairman Ben Bernanke saying that the banks can't write down subprime assets because there is no market, the accounting answer to that is if you can't establish a valuation then they have no value. The burden is on the bank to have sufficient capital to absorb that risk. This is all elementary in terms of accounting, even pre-FAS 157, by the way.

The IRA: But you now have auditors, who rightly fear lawsuits arising from inevitable restatements of the value of structured assets, forcing banks and funds to write-down these illiquid securities to zero even though in many cases the assets are not impaired. Some of the BSC subprime loan production reportedly is up to 15% default rates, but that means that 85% of the collateral is still paying.

Feinberg: But that is the point. If you have the capital, then you may hold onto the asset until such time as a different value can be established. I think the resistance to mark downs reflects a lack of realization that it really was a bubble. The same thing happened with Enron. However, you know that you eventually would write the historical number down based on assumptions you thought were more realistic.

The IRA: But back to the point of whether banks are special, isn't there historical acceptance that banks were to be allowed to carry assets at cost in order to weather swings in the credit cycle? If the Building & Loan in the film It's a Wonderful Life had been subject to FAS 157, it would have failed. As today, there was not market for loans in those times.

Feinberg: Everyone would say now that you can set forth in a footnote what the historic cost was for that asset.

The IRA: Or vice versa. What is the value to investors of increasing the volatility of financial reports by including in earnings opinions about assets that have not actually been sold? Cost is a fact under the rules of evidence, but an opinion as to the "fair value" of an asset might be viewed as hearsay in a court of law.

Feinberg: That is the principle of objectivity. What we have here is an interplay between conservatism and objectivity.

The IRA: But by including opinions in the earnings of financial institutions, we are driving a panic against firms like BSC, Ambac (NYSE:ABK) and MBIA (NYSE:MBI), even though on a cash basis these firms may all be solvent. Thousands of people will eventually lose jobs thanks to the fear created by FAS 157.

Feinberg: But you remember what Kyle Bass said at AEI; that these structured assets trade every day and can be marked to market, and that the people complaining about FAS 157 just don't like the prices. I think that FAS 157 should be fairly ruthless in its application and especially when we've come off a period of record earnings. Remember, six months ago Bernanke and the other regulators were saying that the banks are fine, but now we are bailing out broker dealers using the balance sheet of the Fed of New York. One of the characteristics that make us a banana republic is that we don't really have GAAP to the extent that CEOs think they can put accounting principles into play.

The IRA: Let's move on to the next shoe, Fannie Mae (NYSE:FNM), Freddie Mac (NYSE:FRE) and the other GSEs like the Federal Home Loan Banks. You and IRA were talking about the GSEs years ago and were very unpopular as a result. It turns out that the skeptics were correct.

Feinberg: Well, you must remember that 95% of what you hear in Washington is pure propaganda and is not even believed by the people propagating it, so don't feel bad about hurt feelings. People in Washington say that nobody saw this crisis coming, but one thing that IRA got right was looking at the anomalous behavior of bank loan default activity. You put your finger on the fact that the default numbers from the banks were clearly unsustainable; that the time would come when those numbers would regress to the mean. Indeed, given how extreme they were means that loan defaults must now greatly exceed the mean. There were clear signs of trouble for anyone looking.

The IRA: High praise coming from you, Bob.

Feinberg: What I and many others got right was telling the story that FNM and FRE had no accounting or internal controls, and that this fact would become meaningful in time. These entities were flying totally blind without those basic elements in place, yet FNM CEO Frank Raines was going around telling people that they had the best controls and most transparent accounting and that it should be emulated as the envy of the world and so forth. We subsequently discovered that FNM management was monkeying around with journal entries to get them the biggest bonus. When you have CEOs lobbying against accounting and internal controls, they are not the ones anyone should be listening to.

The IRA: FRE just announced that they are not going to be raising new money. Nobody on Wall Street believes them. What happens when one or more of the GSEs becomes visibly insolvent and looses access to the debt markets. Do they get the BSC treatment?

Feinberg: Unfortunately, we probably passed the point of no return on the GSEs. The trouble is that they won't get the BSC treatment, which is going to be resolved on severe private market terms despite the loan from the Fed. The trouble is that even if the GSEs fail and the private shareholders are wiped out, they will be reconstituted as some sort of development bank. They will be getting infusions on a regular basis sort of like the IFC and World Bank because they have this mission which continually gets expanded by the Congress. For example, when Katrina came along both GSEs immediately said that they were the answer to the crisis, thereby endearing them to members from the affected states. They said they would set up a fund to assist hurricane victims and administer same. Likewise the GSEs now are offering to help ameliorate the subprime crisis, but people forget the role that both GSEs played in making the subprime crisis possible. Now they are being portrayed as saviors of subprime.

The IRA: This is one of the comments made by Joe Mason which really struck us, namely the way that the GSEs dominate the fat, low risk portion of the housing market, leaving the subprime scraps for the private lenders. We may never again see private, entrepreneurial firms like a CFC or BSC arise to challenge the GSEs and the largest banks.

Feinberg: This is a basic point that the banks confront and that Martin Mayer also addressed a number of times, namely that banks are in a commodity business because money is fungible. Banking is about communicating opportunities and is perfectly competitive at a basic level, but uncompetitive at the level of the larger banks which have a cartel.

The IRA: And remember that no private bank can compete with a GSE.

Feinberg: Yes, thus private banks, large and small, are trying to squeeze out an abnormal profit from the riskier parts of a commodity business, a business where the safest assets are monopolized by GSEs, and thus the banks have to take more and more risk. There is a certain inevitability about where we are today. It comes from banks trying to do the impossible. And by recapitalizing the banks via extreme interest rate swings and a steep yield curve, the Fed is going to set up the next round of asset inflation. It is a great formula for destruction of value, for shareholders and the nation as a whole.

The IRA: So you don't see the impending insolvency of the GSEs as a practical opportunity to get rid of them?

Feinberg: Should have been done 20 years ago. Bailing out FNM and FRE is the path of least resistance. All of the GSEs, including the Federal Home Loan Banks, are going to be looked to for help in re-floating the mortgage market, both with portfolio expansion and guarantees.

The IRA: That assumes that the markets will tolerate such action. Our take on this is that the credulity of the global investor may have reached its natural limit. If the markets see the footings of the GSEs increasing, spreads are going to blow out implicit guarantee or no. These organizations cannot survive if their funding spreads trade at junk levels.

Feinberg: The markets may certainly be a constraint. The dollar is another. The EU is going to be implementing some type of reform regarding ratings and securitization, but the US probably will not. The "reform," if you take my meaning, is already in place with respect to the GSEs and it obviously did not work, world class regulator and so forth. The GSEs have grown their portfolios and guarantee books right under the nose of the Congress and the world class regulator.

The IRA: So what happens if the Ugly Girls get into real trouble?

Feinberg: There's an old saying, don't do something, just stand there. I have always maintained that everything done in the last real estate bust would be done again, and then some, so look for an RTC type model to come into play. One thing that was done before with the S&Ls was issuing something called "net worth certificates." Wall Street later took the banks public, they reported record earnings for a couple of years, then they cratered. That might be a bridge too far with the GSEs.

The IRA: Certainly for GSEs without new capital. With the dealers in full retreat and the hedge fund industry imploding because of greatly reduced leverage available, the GSEs would seem to be next in line for a haircut.

Feinberg: This goes back to what we were saying about the business model having unrealistic goals. The expected returns from banks and hedge funds are far too high, thus the leverage and the risks taken ensure an occasional crisis in confidence. There's no magic way to earn unsustainable profits.

The IRA: Well, a hedge fund must make 20% to pay 10% to its clients with the 2 and 20 fee structure. With leverage levels in low single digits, we have to believe that a large portion of the hedge fund community eventually must disappear. There is no reason to invest in a hedge fund that pays 4% pre-tax. This begs the question about performance on all of this credit default swap contracts with hedge funds as counterparties.

Feinberg: FNM and FRE seemed to be doing it too, at least for a while. Another example of supra-normal returns was CFC. Again, CFC could not compete with the GSEs, so they had to take more and more risk, using more and more leverage. It's all the same story, just different names.

The IRA: Exactly. The downward skew in loan default rates was also illustrated by the double digit equity returns of many banks. The "normal" returns for this industry, assuming no boom and bust yield curve management by the Fed, are far less attractive.

Feinberg: Greenspan has been blamed by people like Senator Jim Bunning (R-KY) for allowing financial innovation to run riot. The fact that people like Greenspan or Bunning can pretend to be surprised by financial market events like subprime just goes to the fact that public policy has been replaced by public relations in this country. Our leaders don't get told what they don't want to hear because the spin machine let's them pick up the Wall Street Journal and read what they want to read because it was placed by the PR firm hired by the banks or the GSEs for that purpose.

The IRA: So when it comes to the crunch for the GSEs, does a bailout for FNM or FRE meet any resistance in either house of Congress?

Feinberg: No, FNM and FRE are already bailed out. The implicit guarantee is explicit. Everything that happened before with the S&L bailout, which was passed through the Congress in a single day, will happen again.

The IRA: So is there any hope on Capitol Hill? Give us your view of whether any of the members are competent to deal with this crisis.

Feinberg: There is competence on an individual basis. One example which could be reassuring but isn't is my old Congressman Paul Kanjorski (D-PA). He tends to be overlooked but has a very significant position as chair of the Capital Markets Subcommittee in the House. He put his finger on it when he noted that in the whole chain of activity involved in securitization, nobody had any skin in the game. Everybody took a fee and moving the product to someone else. He said that any reform would have to deal with this fact. This goes back to what I was saying before about capital and banks needing to take responsibility for covering the risk of illiquid assets. These mortgage securitization products have been efforts to have capitalism without capital. At least Kanjorski is focused on some of the motivations behind the scene and he has gone to Wall Street and done his own leg work. So when he comes back and holds hearings and is told by witnesses that they don't know how this happened, Kanjorski knows better. He is underestimated.

The IRA: But Kanjorski is an exception?

Feinberg: Yes, well the other side of this is somebody like Senator Harry Reid (D-NV).

The IRA: You mean the Senate Majority Leader, yes?

Feinberg: That's the one. Reid, who asks sharp questions about valuation and looks like he is on the right track, will come along and say something like the subprime bubble was premised on the idea that housing prices would go up indefinitely. But then he says that we got to find away to restore that promise to the American people.

The IRA: That home prices will go up indefinitely?

Feinberg: Yes, that is the task that the Congress must set for itself. This goes for economic growth as well. When you are talking about housing prices or mutual funds, what you really are relying upon for growth is inflation. If we are subject to market forces, there will be ups and downs. Better to use government policy to eliminate the effects of market forces via artificial means so that home prices and mutual funds grow to the sky. The changes to the 401(k) rules making the default vehicle a mutual fund was just another example of this madness, based on a deal worked out between the industry and the Congress. How will Congress reconcile this deal with the voters, I wonder, in a prolonged bear market in equities?

The IRA: That's encouraging about Kanjorski. What's your view of Barney Frank (D-MA) after a few years as chair of House Financial Services?

Feinberg: Frank gets carried away with his own ability to formulate solutions to problems that are rhetorically satisfying but in practical terms not quite right. He's talking in the American Banker today about reality, but the solutions he proposes will create an artificial reality that, again, picks winners and losers.

The IRA: Any chance that his bailout legislation passes both houses?

Feinberg: No, the Democrats can pass whatever they want in the House, but then it goes into the in-box over in the Senate, where it probably gathers dust. My hope is that the Barney Bailout will not pass the Senate. Did I mention that Senator Bob Bennett (R-UT) has conjured up a justification for building even more houses, this on the ground that the houses in the inventory are too big!

The IRA: Scary. Speaking of scary scenarios, you've been predicting Senator Hillary Clinton (D-NY) as the next President for years now. You still like her chances?

Feinberg: I'm sticking with it.

The IRA: So Barrack Obama (D-IL) will play number two?

Feinberg: No, I just don't like to be whipsawed. I have faith in the ability of the Dems to work this out. Could be messy, but I think the Clintons can make this happen. Once they decide who is on the ticket, the numbers are so much in favor of the Democrats that it should be an easy win. I think there is a cultural lag involved in the Republicans not yet realizing how bad things really are in the country.

The IRA: Agreed. How does Senator John McCain (R-AZ) fashion a winning strategy with the war in Iraq and an economy is deep recession or worse?

Feinberg: People forget how similar this situation is to the 1970s, with a post war inflation and economic stagnation. President Bush thinks that he is Lyndon Johnson. Think of the extension of Medicare to prescription drugs as the equivalent of Johnson implementing Medicare, in both cases when the country was already overextended. The Republicans could wake up one of these days in another 1974 scenario. The Republicans are becoming the third party in American politics, being displaced by the emerging Lieberman-Bloomberg-Schwarzenegger party. Members like Chris Shays (R-CT) are also among this tendency. The remaining Republicans stand a good chance of being picked off by the electoral machine created by Senator Chuck Schumer (D-NY). In this next cycle, Schumer becomes one of the most powerful politicians in America since he controls the campaign finance purse strings and has been picking winners of his own liking for the Senate. He is the senior member of banking, finance and judiciary committees, so Schumer becomes the Democratic kingmaker in the Senate. Schumer, by the way, is no fool when it comes to Wall Street and would probably oppose the Frank bailout bill for many of the same reasons as his Republican colleagues.

The IRA: We'll end on a positive note. Thanks Bob.

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