Saturday, January 31, 2009

'Human error' hits Google search

On BBC.com:

Google's search service has been hit by technical problems, with users unable to access search results.

For a period on Saturday, all search results were flagged as potentially harmful, with users warned that the site "may harm your computer".

Users who clicked on their preferred search result were advised to pick another one.

Google attributed the fault to human error and said most users were affected for about 40 minutes.

"What happened? Very simply, human error," wrote Marissa Mayer, vice president, search products and user experience, on the Official Google Blog.

The internet search engine works with stopbadware.org to ascertain which sites install malicious software on people's computers and merit a warning.

Stopbadware.org investigates consumer complaints to decide which sites are dangerous.

The list of malevolent sites is regularly updated and handed to Google.

When Google updated the list on Saturday, it mistakenly flagged all sites as potentially dangerous.

"We will carefully investigate this incident and put more robust file checks in place to prevent it from happening again," Ms Mayer wrote.

Friday, January 30, 2009

How Caisse's bet on quants went wrong

By Konrad Yakabuski in the Globe & Mail:

For four hours and eight minutes, amid the plush decor and sprawling New France tableau of the Quebec legislature's ornate Salon Rouge, Henri-Paul Rousseau gave much better than he got.

It was late 2007, and Mr. Rousseau, the man entrusted to manage Quebeckers' pension savings, had been called before an all-party parliamentary committee to explain why he had risked $13.2-billion of the provincial nest egg on a financial instrument so opaque and complex that only a coterie of elite mathematicians understood it. A financial instrument, what's more, that had turned out to be a bad investment.

The gathering had been billed as a rare public chiding of the head of the colossal Caisse de dépôt et placement du Québec, an opportunity for camera-loving members of the National Assembly to remind Mr. Rousseau that the Caisse was more than a pension fund manager comme les autres. Its $155-billion asset base, the largest single pool of investment capital in Canada, was Quebeckers' meal ticket and a means for them to achieve financial clout in a world where small-nation sovereign wealth funds, such as Norway's, were becoming big names.

The hearing did not go quite as planned. Mr. Rousseau batted off the legislators, a diverse bunch of nine that included a supermarket franchisee from the Montreal exurbs and a legal aide lawyer from Gaspé, with the all the force and self-assurance that his imposing six-foot-four frame and daunting intellect suggest.

One by one, he took their reprimands and remolded them into illustrations of his own genius. Rather than explain how he came to invest a whopping 8.5 per cent of the Caisse's assets in non-bank asset-backed commercial paper (ABCP) – the investment gone sour – he boasted of his own heroic efforts to rescue the entire $32-billion Canadian ABCP market. If the politicians were looking for Mr. Rousseau to eat humble pie, they could forget it.

“We are in control of the situation,” the Caisse chief executive officer persisted. “This will have been an event that will lower our batting average. But it's still very high, I can tell you that.”

The noxious ABCP would later lead to big writedowns, prompt a provincial election, and set off a chain of events that would leave the Caisse with a crushing cash shortage this past October.

By then, Mr. Rousseau had quit as CEO – for a job next door, at the palatial offices of the Desmarais family's Power Corp. of Canada – and it fell to his right-hand man and successor, Richard Guay, to deal with the fallout from the audacious investment strategies the duo had devised.

Those strategies helped take the Caisse to the top of its industry and nourished a long-held obsession – beating rival Ontario Teachers' Pension Plan. But the true costs of the strategies are only now about to be tallied. The Caisse is poised to release its 2008 results and they are virtually certain to be the worst in its 43-year-history. Investment losses of $25-billion or more will wipe out a huge chunk of the gains made during the Rousseau era. A reappraisal of Mr. Rousseau's batting average has already begun.

Almost no one came through the October market meltdown unscathed. But few endured the debacle that hit the Caisse. Somehow, its vaunted risk management practices had led it into a danger zone no pension fund is ever supposed enter: It ran out of cash.

The Caisse was not alone among pension managers in its quest to win higher returns to cover future pension obligations to an aging work force, not to mention industry bragging rights as top of class. It was not alone, either, in relying on mathematical models to manage risk – models that were supposed to predict the maximum potential losses on any investment and the likelihood of incurring them.

But compared with other Canadian institutions, the Caisse appears to have embraced the models more, or at least failed to implement sufficient checks and balances that would have protected it in case the models proved wrong.

Prove wrong they did, and the Caisse suffered accordingly when the market meltdown steamrolled over the models' assumptions. Now, the same practice is increasingly claiming other victims around the world. The Caisse's missteps provide a sobering window on how the meltdown of 2008 spiralled from a normal cyclical downturn into a much more damaging cataclysm.

The pride of Quebec

Created by the provincial government in 1965 in an act of Quebec nation-building, the Caisse has channelled Quebeckers' long-held desire for economic self-determination. Though it originally handled only the deposits of the Quebec Pension Plan, it has come to manage the assets of 25 provincial, municipal and sectoral pension and insurance funds, making it a global financial force and source of nationalist pride.

Starting in the late 1970s, the Caisse partnered with francophone entrepreneurs to lay the foundation of what would become Quebec Inc., a network of provincial institutions and private business empires whose aggressive tactics changed the Canadian business landscape. In the early 1980s, the Caisse even tried to engineer a creeping takeover of what was then Canada's biggest company, Canadian Pacific, by Paul Desmarais. But Ottawa stopped it in its tracks.

The Caisse's economic nationalism, however, has sometimes led to gargantuan blunders, from a botched leveraged buyout of the Steinberg supermarket chain to ill-fated forays into haute couture and Hollywood.

Mr. Rousseau, the youngest of eight children raised in small-town Quebec by a labour activist mother, vowed not to repeat those errors. With Quebec's population aging faster than almost any other in the developed world, the pressures on its pension fund managers to perform are intense. No one felt it more than Mr. Rousseau.

Though polar opposites in some ways, the testy, strapping Mr. Rousseau and diminutive, mild-mannered Mr. Guay were of like mind in their singular focus on returns. In their six years running the Caisse – Mr. Rousseau as CEO and Mr. Guay as chief investment officer, before succeeding his mentor last September – they played down the institution's nationalist mission, distancing themselves from former Caisse managers' stated bias in favour of local entrepreneurs. As former university professors – Mr. Rousseau in economics, Mr. Guay in finance – they were wonks at heart, and naturally receptive to the ideas of the geeky mathematicians who have increasingly replaced traders as the financial industry's biggest stars.

Complex statistical models devised by the mathematicians – or “quants,” as they're called – guided Mr. Rousseau and Mr. Guay as they sought out higher yields. They found them in ABCP, newfangled derivatives and a cornucopia of investments traditionally scorned by pension funds. It made the Caisse shine for a while, even enabling it to outperform Teachers in 2006, for the first time in nearly a decade, and again in 2007.

No one, however, could imagine Teachers running out of cash. But that is what happened to the Caisse in October of last year. Caught by a wrong-way bet on the Canadian dollar and margin calls on futures contracts, the Caisse – hamstrung by its excessive exposure to its ABCP, which had become completely illiquid – was grappling with a cash shortage. As rumours of the liquidity crisis spread, outsiders watched dumbfounded as the mighty Caisse cowered.

The statistical models, it turned out, had a fatal flaw. Using data series going back only a few years – a period of low volatility in asset prices – they failed to capture the risk of a market meltdown. Portfolio managers who relied on the models had developed a false sense of security as they sought out riskier, unconventional investments – ones without proven track records – in a bid to squeeze out ever higher returns. No one, it seemed, believed the models could be wrong.

The Caisse depended on the mathematical models when it bet so heavily on ABCP. But the models underestimated liquidity risks – the probability the Caisse would be unable to cash in its ABCP when it came due.

That is what happened in the summer of 2007 when investors became concerned about some of the assets behind the paper, such as shaky subprime mortgages and credit default swaps, risky derivatives whose holders bet on the likelihood a debtor will default. Those concerns prevented issuers of non-bank ABCP from selling new paper to pay back existing holders, the biggest of which by far was the Caisse.

Few imagined then just how vulnerable the ABCP exposure could leave the Caisse. But as markets tanked in October, 2008, it became clear that the commercial paper debacle could no longer be considered in isolation. With the toxic paper frozen, the Caisse was forced to liquidate other assets to meet margin calls on its huge position in foreign stock index futures.

In good times, ABCP and index futures produced higher yields than conventional debt instruments and stocks. But as October came around, it became clear that the unconventional investments also produced magnified losses in bad times. Unlike stocks and bonds, futures, for instance, are highly leveraged, so investors can lose much more than their initial investment.

Over the years, the Caisse had been ramping up its position in foreign index futures. By the end of 2007, its holdings tied to the relatively new derivatives had grown to 9.4 per cent of assets, worth $14.6-billion, from 3.4 per cent of assets in 1999.

The futures contracts allowed the Caisse to earn a return that mimicked that of foreign stock indexes, without incurring the transaction costs of buying the underlying stocks, all while putting up cash for only a small percentage of its overall exposure. The margin requirement, or amount it had to pledge, usually represented only about 5 to 10 per cent of the notional, or overall, amount by which it was exposed to the futures. (The amount of margin required is a function of volatility, the degree to which stock prices swing up and down.)

As global equity markets began posting near-double-digit movements almost daily in the fall, the Caisse found itself having to post more and more collateral against the futures with its clearing houses. Basic margin requirements on some index futures soared fourfold between early September and late October. And that sum did not include the increased margin required to reflect the massive declines in the stock prices that underlay the futures contracts, a process known as marking-to-market.

On top of it all, major ABCP holders such as the Caisse had to put up billions in additional margin on the frozen paper to prevent a complex restructuring of the ABCP market from collapsing. All told, the Caisse was forced to raise billions on short notice to meet the margin calls.

“They had a cash issue,” explains one Montreal derivatives expert. “Most funds would normally have twice as much margin deposited in the clearing house as required. But nobody provides for a 40 per cent decline in the market when they're setting up this kind of [futures strategy], nor do they assume that volatility is going to increase fourfold.”

Without enough of the high-quality assets demanded by clearing houses – for the most part, government Treasury bills – the Caisse was forced to sell stocks and other liquid holdings at October's distressed prices to raise cash. Had the ABCP on its books been rolling over normally, it could have readily cashed in the paper and bought T-bills. But the frozen paper was tied up in a complex restructuring.

Once again, the Caisse's risk management models had failed it. It made an already dreadful October even more trying for Mr. Guay and contributed to his departure on medical leave in early November, shortly after his 48th birthday.

In late November, as the rumours about the distress sale of stocks and other assets swirled, the Caisse publicly conceded that it had “adjusted its currency-hedging operations in the context of the Canadian dollar's instability and closed out certain futures contracts that could have created the need for additional capital in a down market.” It said the moves, completed in October, were designed to “protect depositors' assets and reduce the institution's total risk level.”

Caisse spokesman Mark Boutet refused to disclose the size of the October margin calls, though sources familiar with the situation pegged them at as much as $5-billion on the index futures alone. In an e-mail response to written questions, Mr. Boutet said the information would be released with the Caisse's 2008 results “if deemed appropriate.”

On Jan. 5, Mr. Guay resigned as Caisse CEO. He remains a strategic adviser to his temporary replacement, Fernand Perreault.

New financial tools

The entire global financial industry has been transformed in recent years by the intricate models that originated in the 1990s with a group of computer scientists and mathematicians at U.S. investment bank JPMorgan Chase & Co. The models, which fall under a broad category known as Value-at-Risk (VaR), use historical price movements and dozens of other variables to predict the extent and likelihood of potential losses on an investment.

If a typical poll claims accuracy 19 times out of 20, VaR could promise to be right 99 times out of 100. But it was useless in predicting what would happen when that one-in-100 moment arrived, much less a one-in-a-million meltdown.

Most institutions came to employ some form of VaR, but some placed more faith in it than others.

Those who did bank on it may, like the Caisse, be suffering the consequences now. Some experts believe that VaR has caused bigger losses at many financial institutions because it has a built-in bias in favour of highly leveraged investments. And since it assigns such low probabilities to nightmare scenarios, most institutions that relied on it never paused long enough to consider what would happen if the unthinkable arose.

“The failing is not in VaR but in the fact that many people stopped there,” says Leslie Rahl, president of New York-based Capital Market Risk Advisors. “The quantitative approach is about one-third of the puzzle. You would also have to take into account a vast number of qualitative factors.”

Ms. Rahl, a derivatives expert who has advised the Caisse on risk in the past, recommends that institutions regularly conduct a series of “stress tests” to determine how prepared they would be to deal with sudden strains on liquidity.

“One of the stress tests they should do is [to see] what would happen if margin requirements are increased. I don't know if the Caisse was doing that. Clearly, a lot of people were not,” says Ms. Rahl, who joined the board of Canadian Imperial Bank of Commerce in 2007 when the institution, hit hard by the subprime mortgage meltdown, moved to better manage its risk.

VaR's biggest critic is Nassim Nicholas Taleb, a professor of risk engineering at New York University, whose “black swan” theory is one of the hottest ideas in investment circles these days. Prof. Taleb asserts that VaR is nothing short of a fraud. It cannot, he says, predict the unpredictable, events that are as rare as a black swan – such as once-in-a-lifetime market meltdowns. So relying on VaR to manage risk is foolhardy.

That idea seemed almost heretical in investment circles prior to the recent crash, when VaR was almost considered infallible. Not any more.

“The black swan story is really popular these s,” says the Montreal derivatives specialist, who described the series of events hitting the Caisse in recent months as “a flock of black swans.”

Though the Caisse started using VaR before the 2002 arrival of Mr. Rousseau as CEO, it was during his tenure that it emerged as the institution's primary risk management tool.

“The era of Henri-Paul Rousseau was the VaR era at the Caisse,” says a former employee of the pension fund manager. “Everyone swore by it. They were convinced they could control risk with VaR.”

Mr. Rousseau, who declined to be interviewed for this story, also implemented a new VaR-based compensation scheme for portfolio managers. Managers could earn bigger bonuses if they earned returns that exceeded their VaR parameters. That, the former employee says, served as an incentive for managers to stuff their portfolios with ABCP, which had initially yielded higher returns than other short-term instruments. In 2006, the Caisse paid out a record $39.7-million in performance bonuses, a 55 per cent increase from the previous year.

In his e-mail response, Mr. Boutet described VaR as “one of the many tools that is used to manage risk at the Caisse […] Each of these tools has its own inherent strengths and weaknesses and must be used as such in an overall evaluation of risk.”

Mr. Boutet refused to provide a copy of a recent PricewaterhouseCoopers report the Caisse commissioned on its risk management practices “because it contains competitive information.” But he conceded that “certain areas for improvement were obviously identified” in the report.

He added: “Obviously, the current financial conditions of a historical nature have tested many of our practices and understandably we are taking at hard look at everything we do and making the appropriate changes as we identify them.”

That is a notable change in tone from the combative position expressed by Mr. Rousseau before the parliamentary committee, when he referred to an RBC Dexia study to insist the Caisse has a lower risk profile than its peers.

“We've created a lot more value and we've done it taking fewer risks,” Mr. Rousseau told Quebec MNAs. “It is false to say that we emphasized returns and forgot about risk.”

But experts familiar with the RBC Dexia study said it provided an incomplete picture. First, it only covered the years between 2005 and 2007, a period of historically low volatility in asset prices, hence low risk. Instruments such as ABCP had a short track record, so risk models could not accurately forecast how the paper would perform over time. For that reason alone, the experts say, the Caisse's risk profile was not nearly as conservative as Mr. Rousseau suggested it was.

“We know now that [before late 2008] we were in a period of low volatility when the underlying sticks of dynamite were lit but just hadn't gone off yet. So, if you generate for a period of time a return that reflects [ABCP] rising, but use low volatility as your common denominator, then of course you show up well. But it's the wrong measure for risk,” says one leading Canadian pension expert, who asked to remain anonymous.

Don McDougall, director of advisory services at RBC Dexia, agrees that the study should not be considered in isolation.

“There is no one perfect measure of risk and you have to look at a bunch of different risk measures over different periods of time,” Mr. McDougall says. “You can't cherry pick it for a particular period.”

As for the Caisse's decision to invest so massively in the non-bank ABCP, on which it took a $1.9-billion writedown in 2007, and which it recently conceded will require further provisions, the expert added: “It's the difference between understanding these investments in theory and having the visceral, intuitive sense about just what you do and don't do.”

Others are more generous toward the quants at the Caisse.

“If they're guilty of anything, it's that they were too smart,” says the Montreal derivatives specialist. “The guys that are losing now are the smart guys. They were trying to create a better mousetrap. But this is one time when it would have been better to be a follower rather than a leader.”

A proposal to prevent wholesale financial failure

By Lasse Pedersen and Nouriel Roubini in the Financial Times:

The worst financial crisis since the Great Depression has highlighted the risks from the collapse of systemically important financial institutions. Huge bail-outs were undertaken based on a fear that the collapse of such institutions would cause havoc, with collateral damage to the real economy. Examples include Bear Stearns, Fannie, Freddie, AIG, Citi­group, the insurance of money market funds and new US Federal Reserve programmes for banks and broker-dealers. Allowing Lehman Brothers to collapse had such severe systemic effects that the global financial system went into cardiac arrest and is still dealing with the aftermath.

We propose a way to measure and limit this systemic risk and reduce the moral hazard and the cost of bail-outs. Our proposal is to impose a new systemic capital requirement and systemic insurance programme.

The current situation leaves the system vulnerable to financial contagion when big banks (or many small ones) go bust. The root of the problem is that banks have little incentive to take into account the costs they impose on the wider economy if their failure prompts a systemic liquidity spiral. This is akin to when a company pollutes as part of its production without incurring the full costs of this pollution. To prevent this, pollution is regulated and taxed.

Unfortunately bank regulation, such as the Basel accord, ignores systemic risk since it analyses the risk of failure of each bank in isolation. It seeks to limit the probability of failure by each bank, treating isolated failures and systemic ones in the same way (and also ignoring how much a bank loses if it fails). However the move by many large banks to lever their balance sheets with similar mortgage-backed securities is more dangerous than if they had made loans to diverse borrowers.

More broadly, a systemic crisis that feeds on itself is more dangerous than the isolated failure of smaller banks. A small bank will probably be taken over with a smooth transition of operations – it does not bring down the economy.

There are two challenges associated with reducing the risk of a liquidity crisis. Systemic risk must be first measured and then managed. We propose to define a bank’s systemic risk as the extent to which it is likely to contribute to a general financial crisis. This measure can be estimated using standard risk-management techniques already used inside banks – but not across banks, as we propose – to weigh how much each trading desk or division contributes to the overall risk of a bank. We set this out in an NYU Stern project on restoring financial stability.

With this measure of systemic risk in hand, a regulator can manage it. We propose two ways to manage systemic risk. First, the regulator would assess each bank’s systemic risk. The higher it is, the more capital the bank should hold. This would seek to ensure that the banking system as a whole had sufficient capital relative to the system-wide risk. This is just like the headquarters of a bank charging each trading desk or division for use of economic capital measured by its contribution to overall firm risk.

Second, each institution would be required to buy insurance against its systemic risk – that is, against its own losses in a scenario in which the whole financial sector is doing poorly. In the event of a pay-off on the insurance, the payment should not go to the company, but to the regulator in charge of stabilising the financial sector. This would provide incentives for a bank to limit systemic risk (to lower its insurance premium), provide a market-based estimate of the risk (the cost of insurance), and reduce the fiscal costs and the moral hazard of government bail-outs (because the company does not get the insurance pay-off). Since the private sector may not be able to put aside enough capital for all the systemic risk insurance, government could provide part of it. Government already provides such partnership on insurance with the private sector in terrorism insurance.

We believe our proposal offers several advantages by explicitly addressing systemic risk based on tools already in use by private companies to manage internal risks. Our proposal is a better way to deal with the trade-off between letting a large institution go bust (Lehman, for example) and causing a global cardiac arrest of the financial system or being forced to spend trillions of dollars of taxpayers’ money to bail out such systemically critical institutions.

Blackstone's Schwarzman: Too Cheap to Pay for a FT Subscription!

From CityFile New York:

You know we're in a deep recession when even billionaire financiers can't afford to pay for subscriptions to the Financial Times. In what will go down as one of the more bizarre (and unintentionally hilarious) lawsuits we've seen in quite some time, the newspaper filed a lawsuit against Steve Schwarzman's Blackstone Group on Wednesday for sharing an FT username and password instead of setting up separate accounts for its employees. Yes, an unknown "senior employee" at the colossal private equity firm "authorized the initiation and repeated renewal of an individual, personal subscription to FT.com" and then distributed the login details to company employees so they could all join in on the fun. (The court documents list the username as "theblackstonegroup" and the password as "blackstone," although FT says it has since "disabled the credentials to mitigate damages.")

Officials at the FT became a bit suspicious when they realized a very industrious Blackstone employee was accessing thousands of articles a day; a subsequent investigation turned up evidence Blackstone had been engaged in the fraud since as far back as 2002. The FT is now suing Blackstone for copyright infringement and violation of the computer fraud and abuse act. The company didn't disclose how much they're seeking from Schwarzman's firm. It's probably safe to say it would have been cheaper for Blackstone to have coughed up the $179 a year that it costs to buy an online subscription.

Printing The NYT Costs Twice As Much As Sending Every Subscriber A Free Kindle

By Nicholas Carlson at the Silicon Valley Insider:

Not that it's anything we think the New York Times Company should do, but we thought it was worth pointing out that it would cost the Times about half as much money to send every single one of its subscribers a brand new Amazon Kindle instead of a physical newspaper each day.

Here's how we did the math:

According to the Times's Q308 10-Q, the company spends $63 million per quarter on raw materials and $148 million on wages and benefits. We've heard the wages and benefits for just the newsroom are about $200 million per year.

After multiplying the quarterly costs by four and subtracting that $200 million out, a rough estimate for the Times's delivery costs would be $644 million per year.

The Kindle retails for $359. In a recent open letter, Times spokesperson Catherine Mathis wrote: "We have 830,000 loyal readers who have subscribed to The New York Times for more than two years." Multiply those numbers together and you get $297 million -- a little less than half as much as $644 million.

And here's the thing: a source with knowledge tells us we're so low in our estimate of the Times's printing costs that we're not even in the ballpark.

Are we trying to say the the New York Times should force all its print subscribers onto the Kindle or else? No. That would kill ad revenues and also, not everyone loves the Kindle.

What we're trying to say is that as a technology for delivering the news, newsprint isn't just expensive and inefficient; it's laughably so.

Bank of England dresses for success

By Tracy Alloway on the Financial Times Alphaville:

As if working at the BoE isn’t depressing enough, its female employees are now being told how to dress. For success, no less. Really.

The central bank held a “Dress for Success” day earlier this week, sending a memo to its female employees.
Women’s Wear Daily has a copy:
Look professional, not fashionable; be careful with perfume; always wear a
heel of some sort - maximum 2 inches; always wear some sort of makeup - even if
it’s just lipstick.” Shoes and skirt must be the same color. No-no’s include
ankle chains - “professional, but not the one you want to be associated with;”
white high heels; overstuffed handbags; an overload of rings, and double-pierced
ears.

We don’t know whether to worry more that someone is actually wearing ankle chains to the BoE, or that this sort of patronising fashion advice (match your shoes to your skirt? Always wear makeup?) is still being spun.

But — if we’re going down this route can we at least ban Mervyn King’s
hideous ties as well?

The Bad Bank: Mother of All Put Options

By David Gaffen on the Wall Street Journal MarketBeat:

The U.S. has transitioned to a new presidential administration, but it’s still grappling with the issues faced by the previous — how to buy, sell or process those assets that are sitting on the balance sheets of the nation’s largest banks. And the most recent proposal being floated — a combination of outright purchases of bad assets and insuring other bad bets — is sort of the world’s largest credit-default swap, with about as much clarity, too.

The current proposal combines purchases of the assets on the balance sheets of the nation’s largest institutions, along with the guarantee against future losses on other assets, and once again, it leaves investors grappling for specifics as the wheels turn slowly. “The administration is promising decisive action — this is very partial and not very good taxpayer value,” says Simon Johnson, professor at MIT. “It may or may not clear the assets depends on the scale but doesn’t provide capital directly to the banks.”

Mr. Johnson says that more needs to be known about the exact proposal — what assets will be insured, what will be purchased, and at what price. He testified this week before a Senate committee on the issue, and believes that patience in Washington is thinning with regard to a bailout for banks. He says that the government’s $300 billion guarantee of Citigroup in November was a bad deal for taxpayers, particularly in considering the government’s warrants to purchase Citi stock at $10.61 a share (it was lately at $3.70 a share).

Josh Rosner, managing director at Graham Fisher & Co., a financial-services consultancy, says the two-tiered plan has myriad problems, particularly because it allows troubled institutions to designate certain assets as those it will hold for maturity — and have the government insure those assets.

But some of those assets, such as whole loans and certain collateralized debt obligations, are likely to show rising defaults, and this does not allow those losses to be recognized. It’s no coincidence, he says, that the large banks sport stock prices that aren’t all that different from where they were in mid-November.

“Two months after the Citi wrap, we still don’t know what we’re on the hook for,” he says. “Look at at AIG, Citigroup and Bank of America stock since we entered into this arrangement — it hasn’t worked.”

Shares of BAC hit a 52-week low of $5.05 a share on Jan. 20; they were lately at $6.62 a share. An index designed by SNL Financial to track the share performance of participants in the Treasury’s Troubled Asset Relief Program, the SNL TARP Participants Index, is down more than 42% in the past three months, compared with a 9% decline for the Standard & Poor’s 500 stock index.

At this point, much is unknown, but it appears policymakers are still dancing around the issue. One of the repeated mistakes of governments and lending institutions over the past year-and-a-half has been to delay the inevitable — Citigroup and others elected not to mark down positions because of some fundamental belief that the market’s expectations were entirely too pessimistic. But this attempt to take a little from column A and a little from column B might fall into the same category.

“We don’t understand anyone’s reluctance, other than dyed-in-the-wool, scorched-earth ideologues, to have the banks start over with new capital,” writes Dan Alpert, managing director at investment bank Westwood Capital. “At first, the government’s, but in short time private capital, in lieu of taxpayers overpaying for assets at a price sufficient to support existing bank capitalization based on smoke, mirrors and overstated asset values.”

Wall Street Bonuses May Go Way of Dodo Amid Bailouts

By Dawn Kopecki and Christine Harper on Bloomberg:

The Wall Street bonus, considered a sacred ritual, may become the industry’s biggest casualty as governments worldwide bail out financial institutions.

UBS AG was told to reduce bonuses after the Swiss government gave the country’s biggest bank a $59.2 billion lifeline. Bank of America Corp. is under pressure to scale back payouts after New York Attorney General Andrew Cuomo subpoenaed executives earlier this week for information on compensation and President Barack Obama said just yesterday that bonuses handed out by banks represent “the height of irresponsibility.”

The current system of “asymmetric compensation,” in which people are rewarded when they do well and aren’t required to return the rewards when they lose money, is detrimental to society and needs to change, said
Nassim Taleb, a professor at New York University and author of “The Black Swan: The Impact of the Highly Improbable,” in an interview.

The worst economic crisis since the Great Depression, a $700 billion taxpayer bailout in the U.S. and the demise of three of the biggest securities firms -- Bear Stearns Cos.,
Lehman Brothers Holdings Inc. and Merrill Lynch & Co. -- didn’t deter investment banks from offering year-end rewards to employees on top of their salaries.

Financial companies in New York City paid cash bonuses of $18.4 billion last year, the sixth-most in history, even as they posted record losses, according to data compiled by the office of state Comptroller Thomas DiNapoli. The payouts are split among everyone from managing directors to secretaries.

Drain the Pool
“We won’t arrive at a situation where there are no bonuses,”
Stephen Green, chairman of HSBC Holdings Plc, said at a press conference in Davos today. “There are always parts of companies that are profitable, and if somebody’s been working in a profitable business in a market where bonuses are a normal part of compensation, it’s difficult sometimes to say you won’t have any bonuses in that business.”

NYSE Euronext Chief Executive Officer
Duncan Niederauer said today in Davos that “some compensation models need to be completely overhauled.” He added that this would be difficult to legislate and companies will have to take the lead.

“While a number of people clearly do create wealth by brain power, by use of the company’s balance sheet and by other resources, other people have been receiving incentives for basically turning up,”
Barclays Plc Chairman Marcus Agius said at the World Economic Forum. “That I don’t think is very smart. An incentive system properly designed and fairly calibrated is absolutely fundamental.”

Claw Back
Credit Suisse Group AG’s investment bank decided last month to reduce the risk of losses from about $5 billion of its most illiquid loans and bonds by using them to pay employees’ year-end bonuses.

The Zurich-based company’s leveraged loans and commercial mortgage-backed debt will fund executive compensation packages. The new policy applies only to managing directors and directors, the two most senior ranks at
Credit Suisse, according to a Dec. 18 memo sent to employees.

Credit Suisse, along with New York-based
Morgan Stanley and UBS, also have added so-called clawback provisions that set aside portions of workers’ bonuses that can be recouped in later years if an employee leaves or is found to have behaved in ways that are harmful to the company.

Subpoena for Thain
Zurich-based UBS cut its 2008 bonus pool by more than 80 percent to less than 2 billion Swiss francs ($1.75 billion) after the company was forced to accept government funds in October. Chief Executive Officer
Marcel Rohner, his 11 colleagues on the executive board and Chairman Peter Kurer won’t get any variable pay for last year.

Former
Merrill Lynch CEO John Thain was asked this week by the New York attorney general’s office for information about payouts made before the largest brokerage firm was acquired by Charlotte, North Carolina-based Bank of America. The U.S. Treasury agreed earlier this month to provide $20 billion of capital and $118 billion in asset guarantees to Bank of America, the country’s biggest mortgage lender, to help absorb losses at New York-based Merrill.

Wall Street firms need to “show some restraint and show some discipline,” Obama said yesterday, with Treasury Secretary
Timothy Geithner and Vice President Joe Biden at his side.

Obama Plan
Obama’s team is drafting a package of measures to address the credit crunch and details may be announced next week, people familiar with the matter said. Geithner met over the past two days with Federal Reserve Chairman
Ben S. Bernanke, Federal Deposit Insurance Corp. chief Sheila Bair and other regulators to work out the plan.

The initiative may feature a concerted effort to remove toxic assets that clog lenders’ balance sheets. The FDIC probably will run a so-called bad bank to take on some of the securities; others will be insured by the government against losses while remaining on lenders’ books, the people said. Further capital injections for the biggest banks also are under consideration.

Senator Banking Committee Chairman
Christopher Dodd vowed yesterday to use “every possible legal means to get the money back.” The Connecticut Democrat plans to summon executives whose companies received taxpayer aid to testify before his committee and explain their bonuses.

“You’re never going to get any support for the continued tough decisions we have to make if this kind of behavior continues,” Dodd said. “We can’t be underwriting to the tune of billions of dollars, whether it was used directly or indirectly. This infuriates the American people.”

Job Reductions
The Treasury Department has injected about $200 billion into banks across the country through its Troubled Asset Relief Program. Banks and financial companies have eliminated 265,000 jobs in less than two years.

Charles Elson, director of the University of Delaware’s John Weinberg Center for Corporate Governance, said it would be “very difficult” for the Treasury to recoup bonuses.

“Usually these bonuses were contractually made and paid out based on a formula unless you can show bad faith, some intentional misconduct,” Elson said. “These are situations where monies were paid under a contract, and the worst you can accuse these people of is making very bad decisions.”

People such as
Robert Rubin, who received more than $100 million while serving as chairman of New York-based Citigroup Inc.’s executive committee, should be punished for their failure to understand the risks their institutions were taking, said Taleb, author of “The Black Swan.” A spokesman for Rubin declined to comment.

‘Don’t Fly’
“These people make excuses, after the fact, saying that nobody saw it coming and that you couldn’t predict it,” Taleb said in an interview. “That’s no excuse. If you know there are storms, don’t fly. And if you fly, fly with someone who knows about storms.”

Unless Rubin and others are required to return their bonuses or are punished in some way, Taleb said a
regrettable system emerges “where profits are privatized and losses are nationalized.”

Treasury has the authority under legislation that created TARP to issue regulations that claw back excessive executive compensation, and that may give the administration some authority to go after excessive pay, said
Larry Hamermesh, a corporate law professor at Widener University in Wilmington, Delaware.

“It was pretty clear from TARP that the secretary of the Treasury was supposed to establish a provision for executive claw-back,” Hamermesh said in a phone interview. “How the secretary has implemented that isn’t clear.”

The Treasury could require companies that request additional funds to repay excessive bonuses as a condition of the further financing, Hamermesh said.

“If they come around to ask again, they could say, ‘We’re going to deny it unless they cough up the bonuses,’” he said.

Canadian plan to guarantee bank debt slow getting off ground

By Tara Perkins in the Globe & Mail:

One of the two main programs Ottawa has created to help the banks - a guarantee of their debt - isn't actually running yet, three months after it was announced.

The temporary emergency program, unveiled in October and extended in Tuesday's budget, has been widely lauded as an important measure to help Canadian banks stay on a level playing field with foreign competitors that have been receiving similar government support.

When it was announced, Finance Minister Jim Flaherty said it was "an important part of Canada's implementation of the recent G7 plan of action to stabilize financial markets, restore the flow of credit and support global economic growth."

The program was designed as a backstop, and a number of bank analysts and other market observers have been unsure whether banks were tapping into it. As it turns out, however, banks aren't actually able to gain access to the program yet.

A Department of Finance official confirmed that yesterday, and added that the program, called the Canadian Lenders Assurance Facility (CLAF), is expected to be operating shortly.

The legal agreements are being finalized in consultation with internal and external counsel, the official said. At the same time, credit rating agencies are being consulted to ensure the program is assigned a triple-A rating, which is important to ensure that Canada's banks are not put at a competitive disadvantage in accessing global capital markets, the official said.

"I think the market looks forward with anticipation to this thing getting off the ground," said Andrew Fleming, a senior partner at Ogilvy Renault LLP. "There is a lot of work being done amongst the market participants, and we're all anxious that this thing get put on the front burner and get done."

When Mr. Flaherty announced the program on Oct. 23, he said it would expire six months after its start date, which was expected to be the beginning of November.

The program was designed to offer insurance for some debt of banks and other federally regulated deposit-taking institutions. It is intended to help banks secure access to longer-term funds to continue lending to consumers, home buyers and businesses, the government said.

"The government of Canada is acting today to ensure that financial institutions in this country are not put at a competitive disadvantage when raising funds in wholesale markets to lend to consumers and businesses," Mr. Flaherty said in October.

In this week's federal budget, he extended the expiration date of the program from April 30 to Dec. 31. The Finance Minister also announced that a similar program, "modelled on the CLAF," would be created for life insurers, to ensure that they "are not put at a competitive disadvantage relative to foreign insurers that benefit from guarantee programs provided by their home governments."

The government released a number of details on how the CLAF would work back in November. For instance, it said it would use reasonable efforts to pay up under the insurance as soon as possible in the event it was called upon to do so, but would have up to 30 days if necessary. The government is believed to be considering changes to some of those provisions, largely in an effort to bring the major credit rating agencies on board
.

Commercial paper volumes, Fed's holdings tumble

By Laura Mandaro in MarketWatch:

Outstanding commercial paper fell the most ever this week, while the size of a program started by the Federal Reserve to help companies hang onto a key source of short-term funding also showed a marked decline, according to new data released Thursday.

Outstanding commercial paper fell $98.8 billion in the week ended Jan. 28, to $1.59 trillion. That was the largest weekly decrease since the Fed started tracking volumes of this short-term corporate debt in 2001. Levels haven't been this low since the last week of October.

In a separate statement released late Thursday, the Fed said its holdings of commercial paper through its Commercial Paper Funding Facility, or CPFF, fell in the same week. They declined $33.7 billion to $316 billion.

Analysts trying to piece together the jigsaw of data sets said the decline in outstanding volumes likely reflected companies' ability to issue other types of debt, as the three-month commercial paper they had sold to the Fed matured.

Rather than sell new commercial paper to the Fed above-market rates, they likely funded some of their short-term capital needs by issuing other forms of debt, such as bank bonds backed by the Federal Deposit Insurance Co.

Foreign banks, meanwhile, may have tapped Yankee certificates of deposits, analysts said.
"The past week's decrease is arguably the result of improved conditions in the money market," said Tony Crescenzi, chief bond market strategist at Miller Tabak & Co.

Analysts and economists will be closely watching levels of commercial paper over the next week to see whether private investors are willing to return to this market. It faces a key hurdle when an estimated $230 billion to $245 billion, issued at the time the Fed started the program, comes due.
See earlier story on commercial paper market.

The Fed has been acting as a lender of last resort to the commercial paper market since it started buying high-quality, three-month commercial paper, for a fee, on Oct. 27. It started this program after the collapse of Lehman Brothers Holdings Inc. in September sent investors fleeing corporate debt, making it tough for companies such as General Electric Co. to access short-term funding for daily operations such as payroll.

The program enjoyed heavy demand from issuers, with the Fed's holdings rising to $350 billion last week. Thanks to the Fed's hand in this market, commercial paper volumes rebounded and, earlier this month, topped levels last seen before the Lehman Bros. failure.

"My impression is that the market has improved, and the Commercial Paper Funding Facility is really a crutch for the market," said Joseph Abate, money market analyst at Barclays Capital.
The Fed's rates are now higher than market rates for top-rated financial commercial paper, encouraging companies that need to refinance their maturing debt to try to sell their debt to private buyers.

But no one knows whether institutional investors will play along.

"Weaning the CP market off of life support ... is a scenario that will need to play out over and over again over the next several years, as the Fed seeks to exit from the various extraordinary programs put into place," said Stephen Stanley, chief economist at RBS Greenwich Capital, earlier this week.

If issuance sinks but the Fed's holdings of commercial paper stay high, that could indicate this market still needs the support of the Fed. Some investors anticipate the Fed will have to extend the commercial paper program past the April 30 deadline.

Analysts said that banks, historically the biggest users of the commercial paper market, have been tapping other corners of the credit market that are also supported by the government.
Citibank last week issued $12 billion of securities under the FDIC's guarantee program.
"Banks that raise capital through the FDIC's program can cut their short-term borrowing, a desirable goal in the current environment where excessive reliance upon short-term funding is extremely risky," Crescenzi said.

Anurag Bhardwaj, an analyst with Bank of America Merrill Lynch, said that banks' issuance of commercial paper had fallen two-thirds from when the Fed's commercial paper program started.

At the same time, the analyst estimates banks and other financial companies issued about $167 billion of bonds backed with guarantees from the FDIC.

But at this point, determining whether erstwhile commercial-paper issuers have found a better alternative in other credit markets -- or were simply barred from raising private funding altogether -- amounts to little more than reading the credit-market tea leaves.

"We don't know if the difference between what matured and what didn't go into in the commercial paper market, where it went," said Barclays' Abate.

Desjardins calms a spooked bond market

By Andrew Willis in the Globe & Mail Streetwise:

To the applause of fixed income investors, Desjardins Group showed Thursday that a controversial financing decision by Deutsche Bank last month did not set a nasty precedent for bond markets.

Desjardins Capital, an arm of the Quebec financial services conglomerate, did exactly what companies are supposed to do Thursday with $450-million of bonds that didn't come due until 2014, but featured an call option that kicked in this month.

Why does this matter? Glad you asked. One way banks finance their operations is by issuing what's known as fixed-floating rate debt. The convention in the market – and it's only a tradition – is that the debt is retired, or called, when the fixed-rate period expires. That's typically half way through the life of a 10-year bond. Investors then turn around and buy new fixed-rate debt.

The credit crunch sent interest rates soaring and made it attractive for companies to break with tradition, and opt to flip into floating rate debt for the next five years.

And that's just what Deutsche Bank did last month with a 1-billion Euro bond issue. Investors freaked when this happened. The spread between fixed-floating bonds and comparable government bonds rocketed upwards, as investors priced in risks that they previously had not taken seriously. All of this put a spotlight on the Canadian banks, which have been active players in this corner of the debt market, and are creeping up on the deadlines for calling bonds.

Desjardins was the first to hit such a deadline, and it demonstrated Thursday that other issuers will follow unwritten market rules. As a result, the premium paid to issue this debt dropped across the board. (In bond market terms, the spread tightened on all fixed-floating offerings.) In plain english, Deutsche bank made it more expensive to run a bank, Desjardins just made it cheaper.

“Most investors believe that Canadian banks will not extend the maturity on their issues due to significant reputational risk and to higher future costs if they want to maintain access to this funding market,” said a note Friday from TD Waterhouse. The next Canadian instutition to hit a deadline on calling bonds will be Royal Bank of Canada.

The IMF runs out of cash

Guillermo Ortiz, the governor of the Mexican central bank said at Davos the other day,

The IMF does not have enough money for what is coming.
Turns out he’s right.

Whereas two years ago the viability of the IMF was coming into question because it simply wasn’t making any money (no one wanted a loan), now the situation has been somewhat precariously reversed. Reports the WSJ this morning:

The International Monetary Fund is finalizing a $100 billion loan from Japan and is considering issuing bonds for the first time in its history, as part of an effort to double the financial resources it has to fight the deepening global recession.

The IMF currently has a lending ability of about $250bn. As the Journal notes, it’s wanted to double that for quite a while now. The problem though, is that the normal revenue for IMF financing - being lent money by member states - isn’t very practicable at the moment for obvious reasons.

Notwithstanding Japan’s putative $100bn commitment, the IMF certainly seems to be considering issuing its own bonds.

This though, is a bit of a political minefield. The US and the UK have blocked plans for IMF bond issues before, and may yet do again. If the IMF began issuing bonds, it would gain significant fiscal independence from its erstwhile masters in Washington.

Goldman: Bank Rescue May Reach $4 Trillion (and "Bad Bank" Issues)

By Yves on Naked Capitalism:

Goldman, in a research note discussed at CNBC, says the total tab for the US bank rescue operation could run as high as $4 trillion:
The cost of restoring confidence in U.S. financial firms may reach $4 trillion if President Barack Obama moves ahead with a "bad bank" that buys up souring assets.

The figure far exceeds even the most pessimistic estimates of how great the loan losses might be because there is so much uncertainty about default rates, which means the government may need to take on a bigger chunk of bank debt to ease concerns.

Goldman Sachs economists said ideally the public sector would step in to remove the hardest-to-value assets, which would alleviate nagging worries about future losses and hopefully help get lending going again.

"Unfortunately, with an unprecedented meltdown in mortgage credit and a deep recession in the broader economy, there is a great deal of uncertainty about the value of almost every asset,"...

Goldman Sachs estimated that it would take on the order of $4 trillion to buy troubled mortgage and consumer debt. That number could shrink if the program were limited to only certain loans or banks, but it could also grow if other asset classes such as commercial real estate loans were included.

New York Sen. Charles Schumer has said that a number of experts thought that up to $4 trillion may be needed to buy the bad assets, an estimate that a Senate aide said was based on informal conversations with people in the industry.

Given the acute need the perps have for more dough, "informal conversations with people in the industry" are the functional equivalent of lobbying.

Now admittedly, Nouriel Roubini, who is both bearish and so far, quite accurate in calling the trajectory of the crisis, pegs total securities and loan losses at $3.6 trillion. But he has only $1.9 trillion of that with US firms, and his totals include unsecuritized loans, and appear to include commercial real estate loans, which the Goldman note excluded.

I'd love to know how anyone can defend a number more than twice as grim as Roubini's.

And even if one were to believe the Goldman figure, there is a practical problem: no way, no how is that much money going to be spent. We will limp along with a Japan style partial remedies. The US public will not stomach that level of spending on banksters in the absence of substantial spending for individuals hurt by the crisis. So you'd need to add a few extra trillion to come up with a remedy that looked fair, or at least not grossly skewed.

And we have a second set of possible issues with the Obama plans in the making, at least if the reports swirling around are remotely accurate.

A sketch of a plan has been circulating (I have seen this in print, and for the life of me, cannot track down a link) with $100 billion of TARP funds used to provide the equity for a "bad bank" that would buy dodgy paper, with another, say, $900 billion in loans from the Fed to give the new entity a $1 trillion+ balance sheet. Bloomberg tells us that the FDIC is likely to be put in charge. Reader Steve, who worked at the FDIC, isn't keen about the idea:
Anyway, the notion that FDIC should manage the thing is more than a little questionable, because FDIC has no experience managing sophisticated instruments (let alone derivatives), and the experienced credit hands have been gone from FDIC for years. I was told about a year ago that FDIC's bank liquidation group, which had numbered about 7,000 in 1992, was all of 200 people. So I expect that FDIC `management' will simply mean more business for Blackrock, GS, and Pimco, who will be `supervised' by a collection of sleepy FDIC functionaries. No doubt they will do `Sheila mods' while trading more complex government-owned assets as test cases for their own portfolios. To be blunt, FDIC and other regulators do not have the expertise to examine banks with sophisticated portfolios, let alone manage those portfolios themselves.

Of the billions in assets acquired by FDIC over the last year -- and most of those are simple credits -- how much has FDIC managed to sell? Seems to be zero; the only thing FDIC understands about liquidation these days is selling to private equity while retaining the quasi-totality of the risk.

Another element of the plan that has been mentioned sans much elaboration is that the bad bank would do loan mods.One theory we have heard is:
The bad bank hires laid-off mortgage brokers to refinance each homeowner with a mortgage that's been sliced and diced into exotic securities now sitting on the bad bank balance sheet. This is not feasible without owning a huge chunk of toxic assets, because claims on sliced-and-diced mortgages are spread all around the global banking system. Appraisals will be waived in situations of negative equity, and principal will be written down. This may include the homeowner granting the lender some sort of future ‘property appreciation right’ in exchange for a principal write-down.

Readers are welcome to correct me, but if I understand mortgage securitizations, this will not work (legally) in a significant portion of cases, one where the offering documents restricted loan mods. Note that there are three general types: no restrictions on mods, mods permitted up to a certain % of the pool, and no restrictions. Servicers do not appear to have done much in the way of bona fide mods (a payment catchup plan would not be what most readers would define as a mod, yet services include them in their reported level of mods), and it remains an open question as to whether the real issue is lack of incentives, given that some pools have no restrictions on mods (they get paid for the work involved in foreclosures, they do not get paid to mod).

So why won't this ducky plan work? Wellie, my understanding is that for those deals that have mod restrictions, to lift them requires the consent of at least a majority (in some cases 2/3 or 3/4) of the holders of EVERY TRANCHE in the deal.

US banks hold mainly what was once AAA paper due to its favorable risk weighting under bank capital regulations. The equity tranche usually stayed with packager, which in many cases was an investment bank. So the aggregator bank might wind up able to get a high enough percentage of those tranches.

But the intermediate tranches went to a whole host of players, and for subprime securitization, a lot went into CDOs. And from 2006 onward, most CDOs were sold overseas, often to not very sophisticated players (think German Landesbanken).

Now we'll see if this sort of "we can mod the loans because we'll own the securities" is part of the official plan. And if it is, one has to question either the competence or the intentions of the plan's architects.

Fed Explains Central Bank Liquidity Swaps

By jck on Alea:

Long overdue, but it works as I explained somewhere in comments on the same principle as xccy basis swaps.

Each swap arrangement involves two transactions. When a foreign central bank draws on (obtains funding under) the swap line, it sells a certain amount of its currency to the Federal Reserve at the prevailing market exchange rate in exchange for dollars. This market rate becomes the swap exchange rate. At the same time, the Federal Reserve and the foreign central bank enter into a binding agreement for a second transaction in which the foreign central bank is obligated to repurchase the foreign currency at a specified future date. The second transaction is done at the swap exchange rate—that is, the same exchange rate as in the first transaction.

In addition, the Fed H.4.1 now clearly shows on a separate line the total outstanding dollar value of c.b. liquidity swaps valued at their respective swap exchange rates, as well as the maturity distribution of these swaps.

Previously, foreign currency acquired under c.b. liquidity swaps, revalued daily at current market exchange rates, was included in “Other Federal Reserve assets”. In addition, each day, an exchange translation account recognized that the foreign currency would be repurchased by the foreign central bank at the swap exchange rate, which generally would differ from that day’s market exchange rate. If that day’s foreign exchange value of the dollar were above the swap exchange rate, then the dollar value of the foreign currency holdings would understate the value of the dollars that would be booked at the maturity of the swap drawing. In this case, the exchange translation amount would be booked as an asset in “Other Federal Reserve assets”. Alternatively, if that day’s foreign exchange value of the dollar were below the swap exchange rate, then that day’s value of the foreign currency holdings would overstate the value of the dollars that would be received at the maturity of the swap drawing. In this case, the exchange translation amount would be booked as a liability in “Other liabilities and capital” and as a liability in “Other liabilities and accrued dividends”. The dollar value of c.b. liquidity swaps valued at the swap exchange rates combines the exchange translation account and the value of the swaps at current market exchange rates so exchange translation amounts are no longer included in the asset and liability categories referenced above.

Picture: historical c.b. swaps outstanding in millions of dollars, since start of program to date

Wednesday, January 28, 2009

Investcorp Bank Goes Rating Shopping

Standard & Poor's Ratings Services said today that it lowered its long- and short-term counterparty credit ratings on Bahrain-based Investcorp Bank B.S.C. and related entity Investcorp S.A. to 'BB+/B' from 'BBB/A-2'. At the same time, the long-term counterparty credit ratings remain on CreditWatch with negative implications, where they were originally placed on Nov. 21, 2008. Furthermore, the short-term counterparty credit ratings were removed from CreditWatch where they had been placed with negative implications on Nov. 21, 2008. Additionally, the long- and short-term counterparty credit ratings on Investcorp Bank B.S.C. and Investcorp S.A. were subsequently withdrawn at the company's request.

"The two-notch downgrade reflects our view of the increasingly difficult operating environment for Investcorp's principal business lines of hedge fund investing, private equity, and real estate. We understand that InvestcorpInvestcorp is in the process of significant deleveraging, and we view this and the relatively conservative approach to originating deals in 2008 as positive for creditworthiness," said Standard & Poor's credit analyst Nick Hill.

"However, in our view, global deleveraging, falling equity and real estate prices, and tight credit are combining to lower the value of Investcorp's proprietary investments, strain funding and liquidity, and reduce capitalization," added Mr. Hill. "Moreover, the prospects for higher quality fee income from the core asset management businesses are likely to be constrained by broader weaknesses in economies and financial markets alike, and we expect this to reduce InvestcorpInvestcorp's interest service metrics," continued Mr. Hill.

InvestcorpInvestcorp has five main business lines covering the management of alternative investments, namely private equity, hedge funds, real estate, technology investments, and growth capital in the Gulf. Assets under management were $17.7 billion at June 30, 2008 (of which $3.9 billion represented Investcorp's own investments), but are expected to fall significantly, reflecting weak performance, a reduction in Investcorp's own hedge fund investments, and client redemptions. The management and investment teams are generally longstanding and we view Investcorp's investment and review processes as sound.

Investcorp's business model appears characterized by significant proprietary investments, which it makes in private equity, hedge funds, and real estate in tandem with its clients. This strategy appears designed to align InvestcorpInvestcorp's interests with outside investors. In our opinion, however, the strategy may expose InvestcorpInvestcorp to significant risks as real estate and private equity investments in particular are relatively illiquid. Like all Investcorp's investments, these are marked to market through the income statement. Earnings are therefore volatile and are likely to be especially weak in the near term, reflecting poor performance in hedge funds and declining valuations in real estate and private equity--all of which, in our view, previously benefited from cheap credit. Furthermore, the lack of investor appetite for riskier assets means that fee income could also come under pressure for some time. We understand that Investcorp has no direct or indirect exposure to Madoff funds. In our view, however, the Madoff scandal and weak performance generally could lead to increased hedge fund redemptions across the industry. These factors appear to have necessitated some restructuring to reduce the cost base.

Furthermore, we believe the unfavorable environment for realizing investments and placing more recent deals is likely to reduce cash flow, at the same time as losses on proprietary investments are likely to reduce capital. The concentrated nature of the large exposures within the private equity portfolio may, in our view, pose additional risks.

Prior to withdrawal, the long-term ratings were on CreditWatch with negative implications, where they were originally placed on Nov. 21, 2008. "We believe that earnings, capital, and liquidity are likely to have been adversely affected by market conditions, as indeed has the alternative asset management business model. We expect these factors to be mitigated in part by capital raising and a shift into more liquid assets," added Mr. Hill.

If we continued rating Investcorp, we would see further downside to the ratings arising from a potential failure to improve capitalization and liquidity. In this scenario, we believe that this downside might be more than one notch.

FDIC May Run ‘Bad Bank’ in Obama Plan to Remove Toxic Assets

By Robert Schmidt and Alison Vekshin at Bloomberg:

The Federal Deposit Insurance Corp. may manage the so-called bad bank that the Obama administration is likely to set up as it tries to break the back of the credit crisis, two people familiar with the matter said.

FDIC Chairman Sheila Bair is pushing to run the operation, which would buy the toxic assets clogging banks’ balance sheets, one of the people said. Bair is arguing that her agency has expertise and could help finance the effort by issuing bonds guaranteed by the FDIC, a second person said. President Barack Obama’s team may announce the outlines of its financial-rescue plan as early as next week, an administration official said.

“It doesn’t make sense to give the authority to anybody else but the FDIC,” said John Douglas, a former general counsel at the agency who now is a partner at Paul, Hastings, Janofsky & Walker, a law firm in Atlanta. “That’s what the FDIC does, it takes bad assets out of banks and manages and sells them.”

The bad-bank initiative may allow the government to rewrite some of the mortgages that underpin banks’ bad debt, in the hopes of stemming a crisis that has stripped more than 1.3 million Americans of their homes. Some lenders may be taken over by regulators as the government seeks to provide a shield to taxpayers.

Bank seizures are “going to happen,” Senator Bob Corker, a Tennessee Republican, said in an interview after a meeting between Obama and Republican lawmakers in Washington yesterday. “I know it. They know it. The banks know it.”

Nationalization Question

Still, nationalization of a swath of the banking industry is unlikely. House Financial Services Chairman Barney Frank said yesterday “the government should not take over all the banks.” Bair said earlier this month she would be “very surprised if that happened.”

Obama is under increasing pressure to drastically revamp the $700 billion Troubled Asset Relief Program for the ailing industry. While setting up a bank to buy underwater assets is emerging as a favored approach, it could drive up the cost of the rescue in excess of $1 trillion.

Frank told reporters that he would be open to expanding the size of the bailout if the Obama administration “can demonstrate the need for it.”

Senate Banking Committee Chairman Christopher Dodd said yesterday he wants to hear more about the bad-bank idea when he meets in coming days with newly installed Treasury Secretary Timothy Geithner.

‘Comprehensive Plan’

Geithner, who was sworn in earlier this week, has pledged to unveil a “comprehensive plan” for responding to the crisis that will aid financial companies as well as small businesses, cities unable to borrow money and families facing home foreclosure.

The new administration is also pressing Congress to pass an $825 billion economic stimulus, which could complicate any effort to get additional bailout funds from lawmakers. Obama will today meet with chief executive officers at the White House on the stimulus. The White House declined to release the names of the CEOs.

A key question for the bad bank would be how to value the toxic assets it would buy. Geithner, in a Jan. 21 hearing before the Senate Finance Committee, outlined three possible alternatives: look at how the market is pricing similar assets; use computer model-based estimates from independent firms; and seek the judgment of bank supervisors.

Pricing Assets

“They all have limitations,” he said. “I think you need to look at a mix of those types of measures.”

Federal Reserve Chairman Ben S. Bernanke suggested on Sept. 23, when then Treasury Secretary Henry Paulson was initially considering buying bad assets, that the government should purchase them at values above the near fire-sale prices prevailing in the market.

Bair has said that cash from the TARP may help capitalize the bad bank and that commercial lenders may kick in some money of their own. One possibility that’s been discussed is issuing firms some kind of stock in the new organization as partial payment for their impaired assets.

FDIC spokesman Andrew Gray declined to comment.

In any new rescue efforts, the Treasury is likely to continue to require banks to hand over ownership stakes to the government as a condition of receiving aid. Programs so far have sought preferred shares and warrants, which can be converted into common stock and cashed out on the government’s request.

Fed Meeting

Bernanke, who has endorsed the idea of a bad bank, is discussing fresh strategies for combating the financial crisis with his central bank colleagues this week. The Fed’s Open Market Committee today will release a statement about 2:15 p.m. in Washington.

The Fed has participated in Treasury-led initiatives that insured toxic assets remaining on the balance sheets of Citigroup Inc. and Bank of America Corp., and analysts said such measures could be used to complement the bad bank.

The government will likely use its ownership of toxic assets to rework soured mortgages and prevent foreclosures.

The FDIC is already modifying troubled mortgages held by IndyMac Federal Bank FSB, the successor to the failed lender managed by the agency since July. Bair, a longtime advocate of foreclosure relief, said the initiative was meant to serve as a model for the mortgage industry.

The Fed also said in a policy paper released yesterday by the House Financial Services Committee that it will ease terms on residential mortgages acquired in the rescues of Bear Stearns Cos. and insurer American International Group Inc.

Tuesday, January 27, 2009

Cuomo subpoenas Thain in Merrill bonus investigation

Today, as part of our ongoing inquiry into executive compensation issues at institutions who have received TARP funds, my Office issued subpoenas seeking the testimony of former Merrill Lynch CEO John Thain, as well as the testimony of Bank of America Chief Administrative Officer J. Steele Alphin. These subpoenas are part of an ongoing inquiry into billions of dollars in bonuses paid by Merrill Lynch late last year just days before Merrill was taken over by Bank of America. The fact that Merrill Lynch appears to have moved up the timetable to pay bonuses before its merger with Bank of America is troubling to say the least and warrants further investigation.

With that in mind, I am also pleased to announce that our ongoing inquiry into executive compensation practices at TARP funded institutions, including this matter, will be conducted cooperatively and in coordination with the TARP Special Inspector General Neil Barofsky. Our offices have already begun working together and I look forward to a continuing and productive working relationship with the Special Inspector General. Our cooperative efforts set a perfect example for how federal and state authorities should be working together on behalf of taxpayers.

Wall Street Employees Unhappy About 2008 Bonuses (Naked Capitalism)

A major caveat: the survey cited below comes from a "financial jobs website." Presumably, users of that sort of site either have no job or are looking to change jobs and therefore are not particularly happy. Nevertheless, the last few years were particularly fat, and the young 'uns appeared to have gotten conditioned to the idea of big money.

From Bloomberg:

About 79 percent of Wall Street employees responding to an online poll this month said they received a bonus for 2008, more than the 66 percent who expected to get a reward in October, according to eFinancialCareers.Com.

Of the people who said they received a bonus, 46 percent said it was higher than last year, eFinancialCareers, a unit of Dice Holdings Inc.....46 percent of people responding to the poll said they were dissatisfied with their bonus
Yves here. Presumably, those two 46% groups don't overlap too much. Back to the artilce:
“What it shows is the bonus culture is very deep-set in the securities industry,” said John Benson, founder and chief executive officer of the Web site. “There’s an entitlement culture amongst a number of people in the industry, which I think in the current environment is very misplaced.”...

“I have been a defender of the bonus system in the past because it provides banks with a degree of flexibility on their cost structure,” Benson said. “I think most people on Main Street would say their organization incurred losses of this size that very few people in the organization if anybody would receive bonuses at all.”

Most of the people who reported a drop in their bonus said it fell between 11 percent and 50 percent, while the biggest portion of increases were 10 percent or less, the survey found.
In the stone ages on Wall Street, most everyone understood it was better to lodge a C performance in an A year than an A performance in a C year. Clearly, the clock is being rolled back.

To save the banks we must stand up to the bankers

By Peter Boone and Simon Johnson in the Financial Times:

If you hid the name of the country and just showed them the numbers, there is no doubt what old International Monetary Fund hands would say when confronted by the current situation of the US: nationalise the banking system. The government has already essentially guaranteed the system's liabilities, bank assets at market value must be massively lower than liabilities and a severe global recession may yet turn into the Greatest Depression.

Nationalisation would simplify the job of cleaning up bank balance sheets, without which no amount of recapitalisation can make sense. An asset management company would be constructed for each nationalised bank, and loans and securities could be clearly divided into "definitely good" and "everything else".

Good loans would go into a recapitalised bank, where the taxpayer would not only hold all the risk (as now) but also get all the upside. Careful disposal of bad assets would yield lower losses than feared, although the final net addition to government debt would no doubt be in the standard range for banking fiascos: between 10 and 20 per cent of gross domestic product.

As soon as you reveal that the country in question is the US, the advice has to change. First, nationalisation is an anathema in the US. Second, the government has no record of running successful business enterprises. Third, think about what would happen if the American political system got the bit of state-directed credit between its teeth, with all the lobbying that would entail. If you want to end up with the economy of Pakistan, the politics of Ukraine and the inflation rate of Zimbabwe, bank nationalisation is the way to go.

Yet no one other than the government is available to recapitalise the banking system. Without sufficient capital, lending cannot be stabilised and any incipient recovery will be strangled at birth. The problem is the scale of the recapitalisation needed to cover the real losses faced by banks. Additional capital is al- so needed to support the banks' (and everyone else's) desire for higher capitalisation in the future. With the world economy still deteriorating, we need even more capital as a cushion against the worst-case recession scenario. These are just the direct recapitalisation components. Asset management companies would have to pay cash for the distressed assets. Buying at current market prices should protect most of the taxpayer investment and is the only ap- proach that will find political support.

The total of these figures suggests the government will need to come up with working capital in the region of $3,000bn-$4,000bn. If things go well, the losses to the taxpayer should be quite limited, with the final cost closer to $1,000bn (€766bn, £723bn). But this requires that the taxpayer gets enough upside participation. How is this possible without receiving common equity which, at today's prices, would imply controlling stakes in the banks - that is, nationalisation? We could receive a large amount of non-voting stock, but a silent majority shareholder is an oxymoron who distorts the incentives of managers towards further bad behaviour.

The most politically robust solution is for the government to acquire not voting stock but warrants - the option to buy such stock. These warrants would convert to common stock when sold, and a Resolution Trust Corporation-type structure could manage the disposal of these controlling stakes into the hands of private equity investors. New owners would restructure bank operations, fire executives and break up the banks (particularly if some anti-trust provisions were added).

The sticking point will be banks refusing to sell assets at market value. The regulators need to apply without forbearance their existing rules and principles for the marking to market of all illiquid assets.

The law must be used against accountants and bank executives who deviate from the rules on capital requirements. This will concentrate the minds of our financial elite. Either they will raise capital privately or the government will provide, but this time on terms favourable to the taxpayer. The bankers' lobby, of course, will protest loudly. Good thing we now have a US president who can stand up to it.