Monday, August 31, 2009

JP Morgan abandons CDO underwriting

Posted on Asset-Backed Alert:

J.P. Morgan is no longer interested in underwriting collateralized debt obligations.

The bank pulled the plug on its once-active CDO-underwriting division at the end of June, culminating a gradual withdrawal that began in 2007. Employees of the unit were given the option of looking for other positions within the bank or accepting severance packages.

Those who chose to leave include vice president David Goldfinger, who had been originating and structuring CDOs since joining J.P. Morgan in 2002. Also rumored to be gone is Vivek Mathew, another vice president with a CDO-structuring focus.

Meanwhile, Sean Griffin appears to be staying behind temporarily as the sole member of J.P. Morgan's CDO group - with the mission of unwinding the unit. He has worked at the bank for about eight years.

Goldfinger, Mathew and Griffin were among just a handful of personnel left in J.P. Morgan's CDO operation following numerous staff exits amid the credit-market collapse. In October 2007, for example, the bank severed a team brought in just a year earlier to boost its presence as an underwriter of deals backed by structured-product portfolios.

Industry players say the broader CDO division's fate began to look especially dim with the October 2008 resignations of Brian Zeitlin and Jim Kane. Zeitlin presided over CDO underwriting as global structured credit product chief, while Kane led North American structured-product distribution. The two now run a New York advisory shop called GreensLedge Group.

They had joined J.P. Morgan in 2004 from Deutsche Bank - along with ex-Deutsche colleagues Yale Baron, James Millard and Steven Weinreich - as part of an aggressive build-up of the institution's CDO-underwriting capabilities. At its peak, Zeitlin's unit encompassed about 50 staffers.

Then the credit crisis struck. Under Zeitlin's guidance, J.P. Morgan ran the books on $20.6 billion of CDOs worldwide in 2006, according to Asset-Backed Alert's ABS Database. That figure held at $19.4 billion in 2007, only to plunge to $4.7 billion in 2008 as market-wide deal production stalled. So far this year, J.P. Morgan has completed just $2 billion of CDO-underwriting assignments.

Friday, August 28, 2009

Party Time! Leverage Rising on Wall Street at Fastest Pace Since ‘07 Freeze

Posted on Bloomberg by Kristen Haunss and Jody Shenn:

Banks are increasing lending to buyers of high-yield company loans and mortgage bonds at what may be the fastest pace since the credit-market debacle began in 2007.

Credit Suisse Group AG and Scotia Capital, a unit of Canada’s third-largest bank, said they’re offering credit to investors who want to purchase loans. SunTrust Banks Inc., which left the business last year, is “reaching out to clients” to provide financing, said Michael McCoy, a spokesman for the Atlanta-based bank. JPMorgan Chase & Co. and Citigroup Inc. are doing the same for loans and mortgage-backed securities, said people familiar with the situation.

“I am surprised by how quickly the market has become receptive to leverage again,” said Bob Franz, the co-head of syndicated loans in New York at Credit Suisse. The Swiss bank has seen increasing investor demand for financing to buy loans in the past two months, he said.

Federal Reserve data show the 18 primary dealers required to bid at Treasury auctions held $27.6 billion of securities as collateral for financings lasting more than one day as of Aug. 12, up 75 percent from May 6.

The increase suggests money is being used for riskier home- loan, corporate and asset-backed securities because it excludes Treasuries, agency debt and mortgage bonds guaranteed by Washington-based Fannie Mae and Freddie Mac of McLean, Virginia or Ginnie Mae in Washington. Broader data on loans for investments isn’t available.

Before Bear

The increase over that 14-week stretch is the biggest since the period that ended April 2007, three months before two Bear Stearns Cos. hedge funds failed because of leveraged investments. The world’s largest financial institutions have taken $1.6 trillion in writedowns and losses since the start of 2007, helping to trigger the worst financial calamity since the 1930s, according to data compiled by Bloomberg.

Lending to purchase loans rated below investment grade and mortgage bonds is part of this year’s recovery in credit markets. Companies sold $889 billion of corporate bonds in the U.S. this year, a record pace, Bloomberg data show. The Standard & Poor’s 500 Index rose 52 percent since March 9, the best rally since the Great Depression.

Some areas of the credit market haven’t returned to the levels from before the collapse in real estate. Lenders are also requiring more collateral for loans.

Drop in Loans

Banks arranged $61.8 billion of leveraged, or high-yield, loans this year, a 74 percent decline from the same period in 2008, and 91 percent lower than two years ago, Bloomberg data show. Leveraged loans are rated below Baa3 by Moody’s Investors Service and BBB- by S&P of New York. No bonds containing new mortgages have been sold this year, except those with government backing, according to industry newsletter Inside MBS & ABS of Bethesda, Maryland.

The Fed data on loans by primary dealers is down from $113.8 billion in 2007. The data reflects so-called reverse- repurchase financing, securities-lending agreements and other arrangements.

Financing purchases of assets is filling cracks left by the government, whose lending programs to end the recession didn’t address some of the riskiest parts of the consumer and corporate debt markets.

The Fed’s $1 trillion Term Asset-Backed-Securities Loan Facility can’t be used to buy residential mortgage bonds and leveraged loans. The Treasury Department’s $40 billion Public- Private Investment Program excludes the loans and mortgage bonds that are repackaged into new securities.

‘Political Pressure’

“There is a lot of political pressure on banks to lend and this is one form,” said Ratul Roy, head of structured credit strategy at Citigroup in New York.

The Fed and government programs prompted sales of securities backed by auto loans, credit cards, equipment leases and auto-dealership debt.

Yields on top-ranked debt backed by auto loans and credit cards have fallen by as much as 2 percentage points relative to benchmark rates. The yield premium has shrunk to less than 1 percentage point since TALF began in March, according to Charlotte, North Carolina-based Bank of America Corp. data. The average interest rate on loans for new cars declined to 3.88 percent in June, from 8.23 percent in January, Fed data show.

The Fed is also buying as much as $1.25 trillion of so- called agency mortgage bonds. Fixed-rate, 30-year mortgages to borrowers with good credit who put money down are 5.29 percent, according to North Palm Beach, Florida-based Bankrate.com, or 1.85 percentage points more than 10-year Treasuries. The gap was 3.05 percentage points at the end of 2008.

Leveraged-Loan Prices

The increase in bank financing tracks a rebound in demand for securities and assets.

Prices for leveraged loans tumbled to a record low 59.2 cents on the dollar on average Dec. 17, before rebounding to 83.5 cents on Aug. 27, according to the S&P/LSTA U.S. Leveraged Loan 100 Index.

As much as 5 cents of the gains are partly attributable to “leverage coming back into the system,” according to Franz at Zurich-based Credit Suisse.

The senior-most bonds backed by adjustable-rate Alt-A home loans, or those with little to no documentation of a borrower’s finances, have jumped to 52 cents, from a low of 35 cents in March, according to Barclays Plc in London. Top-rated commercial-mortgage securities soared to 90 cents on average, from 72 cents in February, Merrill Lynch & Co. index data show. Merrill is a unit of Bank of America.

Credit Losses

The risk now is that new credit leads to more losses at a time when consumer and corporate default rates are rising. Company defaults may increase to 12.2 percent worldwide in the fourth quarter, from 10.7 percent in July, according to new York-based Moody’s.

U.S. financial institutions probably will report more credit losses as commercial real estate falters through next year, James Wells III, the chief executive officer at SunTrust, Georgia’s biggest lender, said in an Aug. 24 speech to the Rotary Club of Atlanta.

“If you lever up an asset at these already elevated prices, and the underlying fundamentals, like termites, start to chew through the performance of the security, at some point it becomes unsustainable,” said Julian Mann, who helps oversee $5 billion in bonds as a vice president at First Pacific Advisors LLC in Los Angeles.

No Thanks

Chimera Investment Corp., the New York-based mortgage-debt investor that raised $1.5 billion by selling stock last quarter to buy devalued assets, hasn’t taken banks up on their loan offers in part because the company isn’t sure it would be able to continue “rolling” the financing when it matures, said Matthew Lambiase, the company’s CEO.

The lack of a “robust” market means lenders may have too much power to change terms, Lambiase said on a July 30 earnings conference call with investors and analysts.

Investments held with borrowed money by funds including Santa Fe, New Mexico-based Thornburg Mortgage Inc. and Peloton Partners LLP of London slammed the markets as retreating prices made banks wary about getting repaid.

That triggered margin calls, collateral seizures and obligations to unwind, fueling the downward spiral in credit markets. Thornburg, a 16-year-old home lender, filed for Chapter 11 bankruptcy protection in May. Peloton, a hedge-fund firm run by former Goldman Sachs Group Inc. partners, shut its $18 billion ABS Fund.

Money Down

Financing terms are more stringent than before credit markets seized up.

Investors seeking loans to buy non-agency home-loan bonds typically must put down 35 percent to 50 percent, according to four investors and bankers whose firms are using or providing the leverage and didn’t want to be named because the negotiations are private.

That compares to as little as 3 percent for top-rated mortgage bonds before the markets collapsed, according to Laurie Goodman, an analyst at Amherst Securities Group LP in New York. She was among Institutional Investor’s top-rated fixed-income analysts while at Zurich-based UBS AG from 2000 to 2008.

Banks are typically offering as much as $3 in financing for every $1 of equity investors in leveraged loans contribute, down from $6 to $7 before mid-2007, Barry Delman, a New York-based managing director of structured credit products at Scotia Capital, said in reference to so-called total return swaps. Scotia Capital is a unit of Bank of Nova Scotia in Toronto.

The swaps are a type of derivative where a bank passes on returns or losses from a pool of loans to an investor.

Citigroup, JPMorgan

The interest rate that investors are now being charged is usually between 2 percentage points and 2.75 percentage points more than the London interbank offered rate, according to Delman. Three-month Libor, or what banks charge each other for loans in dollars, was set at 0.36 percent yesterday, according to the British Bankers’ Association.

Derivatives are contracts whose values are tied to assets including stocks, bonds, commodities and currencies, or events such as changes in interest rates or the weather.

JPMorgan and Citigroup, the second- and third-largest U.S. banks by assets, are offering similar terms, according to investors. Tasha Pelio, a spokeswoman at JPMorgan, and Jeanette Volpi, a Citigroup spokeswoman, declined to comment. Both banks are based in New York.

“To the degree leverage coming back represents a normalization of the markets, it’s a good thing,” said Michael Youngblood, a former mortgage-bond analyst who last year co- founded hedge fund Five Bridges Advisors LLC in Bethesda, Maryland. “But the idea it should be part of any permanent residential-mortgage-securities portfolio strategy is unwise.”

Why Have Canadian Banks Been More Resilient?

Posted on PrefBlog:

A VoxEU piece by Rocco Huang of the Philadelphia Fed and Lev Ratnovski of the IMF is based on an IMF working paper, Why are Canadian Banks More Resilient? that is of great interest:
Reviewing the data, we note that the pre-crisis capital and liquidity ratios of Canadian banks were not exceptionally strong relative to their peers in other OECD countries. However, Canadian banks clearly stood out in terms of funding structure: they relied much less on wholesale funding, and much more on depository funding, much of which came from retail sources such as households. We posit that the funding structure of Canadian banks was the key determinant of their resilience during the turmoil.

Although bank capital ratio taken by itself was not a robust predictor of resilience, a more specific dummy variable capturing critically low (under 4 percent) capital was a significant predictor of sharp equity declines and probability of government assistance. Low balance sheet liquidity did well in predicting extreme stress.

The second part of this paper (Section 3) reviews regulatory and structural factors that may have reduced Canadian banks’ incentives to take risks and contributed to their relative resilience during the turmoil. We identify a number of them: stringent capital regulation with higher-than-Basel minimal requirements, limited involvement of Canadian banks in foreign and wholesale activities, valuable franchises, and a conservative mortgage product market.

We measure capitalization as a ratio of total equity over total assets. This leverage-based measure has a number of shortcomings stemming from its simplicity: it is not risk-weighted and does not consider off-balance sheet exposures. However, it is well comparable across countries. We find that this simple measure of capitalization turns out to be a good predictor of bank performance during the turmoil, particularly by identifying vulnerabilities stemming from critically low bank capital (Table 2).

This last point is not particularly earth-shattering: see the first chart (reproduced from an IMF report) in the post Bank Regulation: The Assets to Capital Multiple.

We assess the impact of these ex-ante fundamentals on bank performance during the crisis. We use three objective and subjective measures of performance.

The first is the equity price decline from January 2007 to January 2009, which is an all-in summary measure of value destruction during the turmoil, resulting from credit losses, writedown on securities, and dilution from new equity issuances including government capital injections.

The second (pair) of measures are two dummy variables identifying whether that decline was greater than the median (70 percent) or extraordinarily large (85 to 100 percent), respectively.

The third measure of performance is a dummy capturing the degree of government intervention that a bank required during the turmoil: whether it was used to avoid extreme stress or to address a less dire weakness.

I have a problem with the use of equity prices as a measure of performance. It doesn’t really measure the stability of the bank, it measures the market’s perception of the stability of the bank. On the other hand, we have to live in the real world and perceptions can become reality very quickly.

We now turn to bank liquidity. We measure balance sheet liquidity as the ratio of liquid assets over total debt liabilities. We use the BankScope measure of liquid assets, which includes cash, government bonds, short-term claims on other banks (including certificates of deposit), and where appropriate the trading portfolio. BankScope harmonizes data from different jurisdictions to arrive at a globally comparable indicator. Data for bank liquidity is shown in Table 3.

Note that a large number of U.S. banks have very scarce balance sheet liquidity. The key reason is that those banks, in their risk-management, treated mortgage-backed securities and municipal bond as liquid, and reduced holdings of other more reliably liquid assets such as government securities. Our liquidity measure does not incorporate holdings of such private and quasi-private securities. With hindsight, it is fair to say that this narrow definition is a more accurate measure of liquidity during crisis.

I have a real problem with the incorporation of claims on other banks in a narrow definition of liquid assets - the same problem I have with the preferential treatment accorded bank paper in the rules for risk-weighting assets. Encouraging banks to hold each other’s paper seems to me to be a recipe for ensuring that bank crises become systemic with great rapidity.

Yet overall, balance sheet liquidity was a weaker predictor of resilience to the turmoil than the capital ratio. Although low liquidity was a clear handicap (of twelve least liquid banks, eight had equity price declines of more than 70 percent, and four required a significant government intervention), a large number of banks from different countries (U.S., UK, Switzerland) experienced significant distress despite being relatively liquid. Another way to think about the resilience effects of balance sheet liquidity is to recognize that it can provide only temporary relief from funding pressures. During a protracted turmoil, more fundamental determinants of resilience—such as capital or funding structure—should play a bigger role.

We now turn to bank funding structure (depository vs. wholesale market funding). The financial turmoil has originally propagated through wholesale financial markets, some of which effectively froze on occasions. Our measure of funding structure, a ratio of depository funding over total assets, seeks to reflect banks’ exposure to rollover risks — the wholesale market’s refusal to roll over short-term funding, often based only on very mild negative information or rumors (Huang and Ratnovski, 2008).

And it seems to me that this last paragraph supports my argument.

Canadian banks are clearly the “positive outliers” among OECD banks in the ratio of depository funding to total assets. On this ratio, almost all large Canadian banks are in the top quartile of our sample. Anecdotal evidence also suggests that a higher fraction (than in the U.S.) of Canadian bank deposits are “core deposits,” i.e., transaction accounts and small deposits, which are “stickier” than large deposits.

One likely reason for Canadian banks’ firm grip of deposit supply is their ability to provide one-stop service in mutual funds and asset management. Unlike in the U.S. Canadian banks have been historically universal banks, and there is relatively less competition for household savings from other alternative investment vehicles.

This might be used as an argument to reduce the choices available to Canadians even further. You can bet the banks’ lobbyists will have copies of this paper tucked into their briefcases during the next revision of the Bank Act.

Regression results are shown in Table 5.

The main specification (columns 1, 4, 7, 10) shows that depository funding significantly and robustly explains bank performance during the credit turmoil, consistent with initial casual observations of the data. Balance sheet illiquidity is a good predictor of particularly rapid deteriorations in bank conditions (government intervention under extreme stress or equity decline above 85 percent). However, interestingly, the capital ratio appears as an insignificant explanatory variable.

Assets-to-capital multiple. In addition to risk-based capital, Canada uses an assets-to-capital multiple (inverse leverage ratio) calculated by dividing the institution’s total assets by total (tiers 1 and 2) capital.

This is not quite correct; the ACM includes off-balance-sheet elements in the numerator.

Finally, the Canadian mortgage market is relatively conservative, with a number of factors contributing to the prudence of mortgage lending (see Kiff, 2009). Less than 3 percent of mortgages are subprime and less than 30 percent of mortgages are securitized (compared with about 15 percent and 60 percent respectively in the United States prior to the crisis). Mortgages with a loan-to-value ratio of more than 80 percent need to be insured for the whole amount (rather than the portion above 80 percent as in the United States). Mortgages with a loan-to-value ratio of more than 95 percent cannot be underwritten by federally-regulated depository institutions. To qualify for mortgage insurance, mortgage debt service-to-income ratio should usually not exceed 32 percent and total debt service 40 percent of gross household income. Few fixed-rate mortgages have a contract term longer than five years.

I suggest the last point is the most critical one here. If the CMHC had not stepped up to buy securitized mortgages at the height of the crisis, how many of these mortgages have been rolled over? That would have been catastrophic. The liquidity advantage of Canadian banks is heightened by the fact that so much of their lending has a maximum term of five years.

This research is clearly still in its early stages, but the paper is vastly superior to the OSFI puff-piece published in May.

The Rich Have Feelings, Too

Posted in Vanity Fair by Tom Wolfe:

Up until the tarantulas arrived late last year waving their billions in “bailout” money before our faces, there were ten of us, including the two Harvard algorithm swamis, who could use the Gulfstream V, the Falcon, and the three Learjets pretty much anytime we needed them.

The vast majority of the flights—let’s get this straight before anyone starts clucking and fuming—were strictly business, but we also used the planes to “maintain an even strain,” as our C.E.O., Robert J. (Corky) McCorkle, liked to put it.

At the risk of sounding condescending, we should point out that ordinary people haven’t the faintest conception of the strain we had to endure daily. How many ordinary people have ever done anything remotely like betting $7.4 billion—bango!—just so!—that the price of energy will rise sharply 14 months from a certain date? How many of them ever had the animal spirits to go for it on the say-so of a young never-been-wrong-yet meteorology swami from M.I.T. who was convinced that, after a five-year lull in the cycle, a series of Category 4 and 5 hurricanes would pulverize the Gulf of Mexico, obliterating all offshore drilling operations, possibly shutting them down for years? How many ordinary people have woken up in the middle of the night, eyes popped open—swock!—like a pair of umbrellas, stark raving terrified by the possibility that they have just blown $7.4 billion on … a weather forecast? How many of them have ever sat for three days, 72 hours straight, in front of a gigantic plasma TV watching the Weather Channel as if it were the Super Bowl as Hurricane Enrique dithers, dawdles, malingers, messes around off the coast of Fort Lauderdale? How many ordinary people have been reduced finally, by sheer fear, to yelling at the screen, “Come on, Enrique, you pathetic wuss! Move your fat eye, you lazy worthless bitch! Be a man! Move inland! Cut straight across the Everglades, tear ‘em up by the roots and just let the greenies wail! Set your eye on the freaking Gulf! Take your goddamn steroids! Show some rage, you pussy! Barrel into those goddamn oil rigs! Destroy ‘em! Obliterate ‘em!”? How many ordinary people have finally sunk to their knees, hands clasped in prayer before a plasma-TV screen, imploring it, begging it, beseeching it … to save them?

God knows we deserved every chance we could get to even out the strain.

One of the sweetest sounds in the world was Corky making the rounds up here on the executive floor, saying in his laid-back voice, “I feel like boffing some bimbos in the Caribbean. Anybody like to come along?”

We never had to deal with airports like O’Hare or J.F.K. and their intestines of roadways looping over and under one another on the way to terminals teeming with the aforementioned ordinary people. No, we always left from small general-aviation airports.

In the U.S. the term “general aviation” means its exact opposite, the way “public school” does in England. An English public school is private and, on top of that, exclusive. Likewise, general-aviation airports in the U.S. are for everyone but the general public. They exist exclusively for people or businesses with the money to buy and maintain private planes. The fields are usually so small our driver can take us out onto the tarmac and stop right beside our jet. Now, here comes the part a man has to love.

Who is it who puts our luggage into the plane’s baggage compartment, including golf bags weighed down by the steel shanks of every club that a bunch of rich golfers with handicaps of 19 or more have ever heard of? Who hoists all this unbelievable stuff and stows it?

The captain and the co-captain!

Yeah! And they don’t talk like any flight commanders, either! They have the polite, deferential, as-instructed cheeriness of bellboys. They weren’t working for United Airlines or Delta or JetBlue or the F.A.A. or the air force. They were ours. They were our servants, our chauffeurs, and they were expected to act that way.

If there was no stewardess aboard, the captain or the co-captain would come back into the passenger cabin and ask us what we’d like to drink. We would be lounging lushly in what was designed as a living room, not an airplane cabin. There were mahogany, walnut, and amboyna inlays all over the place … You never had to sit next to anybody. You had your own virtual easy chair and all the legroom in the world … and cantilevered tabletops made of the same rich, spectacularly grained woods.

Ahhhh … here comes the captain, returning with your drink upon a little tray, primly placing it on your tabletop, along with a little linen cocktail napkin. Bent over in a half-bow, like any good butler, he asks you if you’d like anything else … and please don’t hesitate to use the call button …

The captain we’re talking about! The co-captain! We could already feel the strain evening out, and we hadn’t even reached Boffingland yet!

Whenever the captain informed us we were descending for landing, Corky always cupped his hands about his mouth megaphone-style and announced in a loud voice, as if over the intercom: “Please return all seats, tray tables, and stewardesses to their original upright and locked positions.”

That always cracked us up. On the Gulfstream V he’d pull that one right in the face of the two stewardesses. Of course, by now the politically correct nomenclature was “flight attendants.” So sometimes Corky would have his fun by referring to them as “flight attendesses.” The girls? They had no choice but to giggle, as if heartily amused. After all, they worked for us. They were our geisha girls in the sky.

But there was a subtler side to it. Corky’s gag mimicked the landing instructions a captain or a flight attendant gives on a commercial airliner—except that on a commercial airliner they aren’t instructions. They’re orders, as one quickly discovers if he ignores them.

On our boffing flights, instructions by a captain or a flight attendess were no more than well-intended advice … or suggestions. They didn’t dare utter them with so much as a faint hum of authority. We owned the very livelihood, if not the hides, of these, our servants …

… and then …

All right, so we did blow the $7.4 billion when oil dropped from $145 a barrel last July to less than half that—$70—in October and less than half of that—$34.60—four months later. And we did have a total of almost a trillion dollars’ worth of bets out on the board when the market crashed. And we were foolish enough to feel it was a miracle when the Treasury Department dangled its billions before us.

Had we but known … Had we but known … we wouldn’t have touched a dime of it. It would have been more honorable just to crash and burn and take bankruptcy like a man. For the tarantulas had arrived—only, we didn’t know that yet. The “bailout” was their Trojan horse. Fools that we were, we welcomed them!

We should have read the writing on the crime-scene tape as early as November 18 of last year, when Rick Wagoner of General Motors, Robert Nardelli of Chrysler, and Alan Mulally of Ford flew from Detroit to Washington in their corporate jets to ask Congress for $25 billion in bailout money. They appeared before the House Financial Services Committee, and that was all the congressmen would talk about, the airplanes. Such resentment! Such scorn! They asked the three men to raise their hands to show their willingness to give up their jets as a precondition before asking for the money. The beggars at least had enough pride and testosterone left to refrain from raising their hands in unison and saying, “Yassuh, massuh.”

A congressman from New York, Gary Ackerman, upon hearing that this impudent trio had treated themselves to private planes to come to ask for the American taxpayer’s money, said his constituents would be appalled, shocked to the point of disbelief: “It’s almost like seeing a guy show up at the soup kitchen in a high hat and a tuxedo. Couldn’t you all have downgraded to first class or jet-pooled or something to get here?”

We couldn’t believe it! It strained the brain! We failed to realize that congressmen themselves had become the first inflamers, provocateurs, mob leaders of every tarantula in the country!

When the three men returned to Washington on December 3, they traveled by car. It took them almost half a day. The congressmen scoffed at it as a cynical stunt or else a phony act of contrition. Why hadn’t they come by commercial airline? That would have atoned for the sin of private-plane pride perfectly well … and they could have made the trip in one hour rather than half a day.

Why No Regulation Of Credit-Default Swaps Or Securitization Could Have Stopped The Bubble

Posted on the Business Insider by Joe Weisenthal:

If you're interested in the debate over financial

innovation (is it good or bad!?) then you ought to check out Felix Salmon's discussion of an article by Simon Johnson and James Kwak, the authors of the popular blog Baseline Scenario.

They're all on the same side, so the debate is advanced. But not surprisingly it comes back to two acronyms we've heard over and over and over again: CDSs and CDOs.

In different manners, these novel ways of insuring debt and repackaging debt had a hand in greatly expanding the supply of available credit, which helped inflate the housing bubble. And you know what happened from there.

If it hadn't been so easy to repackage crap mortgages into securities rated AAA, via the magic of the CDO, then there probably would have been much less subprime lending. At least in theory. And the same goes for the CDS market. If it hadn't been so easy (or cheap) to buy insurance against shaky assets, then that too would have constrained lending.

So it only stands to reason that if we'd regulated these products more tightly -- if we hadn't let AIG (AIG) sell CDS so cheaply merely because it had an AAA-rating as a company -- then we might not have gotten the bubble. Strictly speaking, this sounds true.

But at best, tighter regulation would have merely delayed the housing bubble, perhaps giving us a few more years of bubbly bliss. The real problem was, in the days before the bust, homeownership was universally considered to be A Good Thing. President Bush loved it. The Democrats loved it. Nothing could get in its way. By the time we discovered the extent of subprime lending, Ben Bernanke was calling it a great advance of technology.

The process of owning a home was thought to be an almost mystical experience, connoting economic and spiritual health upon any who went through it. So imagine if we had regulated CDS more closely, and AIG wasn't providing cover for the rest of the world to write bad loans? So what? Do you think that would have stopped anything? Heck no.

Eventually, we'd have reached the point where banks couldn't lend any more money, while at the same time millions of Americans would have been scandalously "un-homed" and politicians and regulators would have set forth to see what the roadblocks were to more lending. And they would have settled on the CDS market, or maybe they would have expanded Fannie and Freddie. They would have taken any number of options to deregulate and expand credit to fix this problem.

Now some might say it's ridiculous to object to regulation on the grounds that it would have been overturned. But in this case there is no doubt, and politicians/regulators actions to expand homeownership at all costs proves it.

Sadly, we had to have the housing collapse to demonstrate that homeownership isn't always an unalloyed good. But wait! Politicians still believe that it is.

Even post-bubble, expanding homeownership and keeping people in their owned homes (even if they remain underwater) is promoted. There's almost nothing we can do to disabuse people of the homeownership ideal, and pre-bust, no piddly regulation would've been allowed to stand in the way of The American Dream.

Thursday, August 27, 2009

Finance: Before the Next Meltdown

Posted on Democracy by Simon Johnson and James Kwak:

If innovation must be good, then financial innovation should be good, too. If finance is the lifeblood of our economy, then figuring out new ways to pump blood through the economy should foster investment, entrepreneurialism, and progress. Right? This, in any case, has been the mantra throughout three decades of deregulation and expansion of the financial sector.

And yet today, financial innovation stands accused of being complicit in the financial crisis that has created the first global recession in decades. The very innovations that were celebrated by former Federal Reserve Chairman Alan Greenspan—negative-amortization mortgages, collateralized debt obligations (CDOs) and synthetic CDOs, and credit default swaps, among countless others—either amplified or caused the crisis, depending on your viewpoint. The journalist Michael Lewis recently argued that the credit default swaps sold by A.I.G. brought down the entire global financial system—and found that the A.I.G. traders he talked to completely agreed.

Recent financial innovation is not without its defenders, of course. As current Fed Chairman Ben Bernanke said in a speech in May:

We should also always keep in view the enormous economic benefits that flow from a healthy and innovative financial sector. The increasing sophistication and depth of financial markets promote economic growth by allocating capital where it can be most productive. And the dispersion of risk more broadly across the financial system has, thus far, increased the resilience of the system and the economy to shocks.

Intellectual conservatives and bankers have mounted an even more fervent defense of financial innovation. Niall Ferguson has claimed, “We need to remember that much financial innovation over the past 30 years was economically beneficial, and not just to the fat cats of Wall Street.” Bernanke and Ferguson are being too generous. For the past 30 years, financial innovation has increased costs and risks for both individual consumers and the global economy. To take the most obvious example, consumers bought houses they could not otherwise have bought using new mortgages they had no hope of repaying, creating a housing bubble, while new derivatives helped hide the risk of those mortgages, creating a securities bubble. The collapse of those bubbles has shaken the world for the last year. Today’s challenge is to rethink financial innovation and learn how to separate the good from the bad.

Financial innovation is different from what we traditionally think of as innovation, which, in recent years, has occurred most visibly in the field of information technology. Certainly, the financial services industry has taken advantage of technological innovation; you can now access your financial statements and pay your bills online, for example. However, these innovations do not affect the core function of the financial sector, which is financial intermediation—moving money from one place where it is not needed to another place where it is worth more.

The classic example of financial intermediation is the community savings bank. Ordinary people put their excess cash into savings accounts; the bank accumulates that money by paying interest and loans it out at a slightly higher rate as mortgages or commercial loans. Savers earn interest, households can buy homes without having to save for decades, and entrepreneurs can start or expand businesses.

The main purpose of financial innovation is to make financial intermediation happen where it would not have happened before. And that is what we have gotten over the last 30 years. As Ferguson said, “New vehicles like hedge funds gave investors like pension funds and endowments vastly more to choose from than the time-honored choice among cash, bonds, and stocks. Likewise, innovations like securitization lowered borrowing costs for most consumers.” But financial innovation is good only if it enables an economically productive use of money that would not otherwise occur. If a family is willing to pay $300,000 for a new house that costs $250,000 to build (including land), and they could pay off a loan comfortably over 30 years, then that is an economically productive use of money that would not occur if mortgages did not exist. But the mortgage does not make the world better in and of itself; that depends on someone else having found a useful way to employ money.

In addition, financial innovation can go too far much more easily than innovation in other sectors. Financial intermediation creates value by making credit more available to people who can use it effectively. But it is possible for the economy to be in a state where people have too much access to credit. With the benefit of hindsight, it is easy to see how the U.S. housing sector passed this point earlier this decade. With negative-amortization mortgages (where the monthly payment was less than the interest, causing the principal to go up) and stated-income loans (where the loan originator did not verify the borrower’s income), virtually anyone could buy a new house, leading developers to build tens of thousands of houses that are now rotting empty, their current value far less than their cost of construction. In short, excess financial intermediation, the result of hyperactive financial innovation, destroys value by causing people to make investments with negative returns. Put another way, we cannot say that innovation is necessarily good simply because there is a market for it. The fact that there was a market for new houses does not change the fact that building those houses was a spectacularly destructive waste of money. Therefore, when it comes to financial innovation, we must distinguish beneficial financial intermediation from excessive, destructive financial intermediation.

In the early 1970s, Mohammed Yunus lent $27 to 42 female basket weavers in a village in Bangladesh; they repaid the loan, with interest, from the proceeds of their sales. In 1976, he founded Grameen Bank to make small loans to poor villagers, often to fund startup costs for small ventures. Grameen Bank was the first modern provider of microcredit. Yunus’s innovation was to recognize that poor people could be good borrowers but had been ignored by a traditional banking sector that refused to or was unable to serve them. In other words, he found an economically productive use of money that was not otherwise occurring. How does recent financial innovation in the developed world compare?

Defenders of unfettered financial innovation depict the alternative as a stale, constricted market. As Bernanke said in April, “I don’t think anyone wants to go back to the 1970s. Financial innovation has improved access to credit, reduced costs, and increased choice. We should not attempt to impose restrictions on credit providers so onerous that they prevent the development of new products and services in the future.” However, as finance blogger Ryan Avent pointed out on Portfolio.com, Bernanke’s examples of beneficial innovation–credit cards, the Community Reinvestment Act, and securitization—all date back to the 1970s or earlier. True, securitization—the transformation of large, chunky loans into small pieces that can be easily distributed among many investors—was a beneficial innovation, because it expanded the pool of money available for lending. And securitization on its own, before the new products of the late 1990s and 2000s, did not produce the colossal boom and bust we have just lived through.

But more recent innovations in securitization led to a new generation of increasingly arcane, increasingly risky products that Bernanke, Ferguson, and others like to overlook. One of the paradigmatic products of the last ten years was the collateralized debt obligation (CDO), in which a structurer combined a pool of assets and sold off the cash flows from those assets to investors. CDOs did promote financial intermediation; those initial assets represent loans to real people and companies, and without the CDO market to absorb them, those loans might never have been made in the first place. But, as with negative-amortization mortgages, the key question is whether those loans should have been made at all.

The magic of a CDO, as explained in the research paper “The Economics of Structured Finance” by Joshua Coval, Jakub Jurek, and Erik Stafford, lies in how CDOs can be used to manufacture “safe” bonds (according to credit rating agencies) out of risky ones. Investors as a group were willing to buy CDOs when they would not have been willing to buy all the assets that went into those CDOs. We don’t have to decide who is to blame for this situation—structurers, credit rating agencies, or investors. The fact remains that at least some CDOs boosted financial intermediation by tricking investors into making investments they would not otherwise have made–because they destroyed value. Another paradigmatic product was the credit default swap, which insured a security (like a CDO) against the risk of default. But by underpricing that risk, it essentially tricked investors into buying securities that they would not otherwise have bought. The losses were borne by the companies that underpriced the credit default swaps, such as A.I.G., and by the government, which had to bail out A.I.G.—leading to the misallocation of capital to value-destroying investments. In other words, while securitization on its own provided real economic benefits, it is harder to defend the very popular, very destructive specific innovations it engendered. Contrary to Bernanke, maybe the regulatory world of the 1970s doesn’t look so bad after all.

The role of financial regulation should be to discourage innovation that produces excessive intermediation and promote innovation that delivers financial services that people need. The key to any successful regulatory regime is therefore discerning the difference between good and bad financial innovation. Right now, ours doesn’t. Unfortunately, the Obama Administration’s financial regulatory reform proposal, despite its improvements over the status quo, follows the old conventional wisdom—that innovation is inherently good, and regulators need only watch out for abnormal excesses or “bad apples.” Instead, the presumption should be that innovation in financial products is costly—it increases transaction costs, the cost of effective oversight, and the risk of unanticipated consequences—and should have to justify itself against those costs.

Instead of a regime where any product is allowed so long as it is sufficiently disclosed, we should consider a regime where only certain types of products are allowed to exist, and they are allowed to vary only along specific dimensions. Georgetown law professor Adam Levitin has argued that all of the “innovation” in the credit card industry has simply been the invention of new, more complicated, and less transparent fee structures, while the underlying product has remained the same for decades. He proposes that regulation should standardize the terms of credit cards, so that charges cannot be hidden in fine print, and issuers should be allowed to compete on the interest rate, the annual fee, and the transaction fee. This would ensure price competition while making it harder for consumers to end up with dangerous products that encourage excessive borrowing.

This model could be applied to a wider range of financial products, even to commercial products such as interest rate swaps and credit default swaps, which baffled a fair number of supposedly sophisticated players during the boom. For example, credit default swaps could be limited to a set of standardized terms—the security being insured, the premium, the length of time, the definition of a default event, the settlement date and mechanism—eliminating the complexity that makes customized CDS difficult to price, difficult to trade, and difficult for regulators to assess. While this could reduce the ability of firms to “perfectly” hedge their risks, it would also reduce transaction costs and, most importantly, reduce the systemic risk created by large, unknown derivatives positions. Customized credit default swaps could still be allowed but should be deterred (through taxation or other means) to ensure that they are only used when “vanilla” swaps are truly inappropriate.

At the same time, regulators should look to promote those forms of financial innovation that the economy sorely needs. One is better ways of providing financial services to the “unbanked” poor and minorities. Today, many inner-city neighborhoods are forced to rely on payday lenders and other high-cost intermediaries for basic banking services. Manuel Pastor of University of Southern California’s Program for Environmental and Regional Equity has shown that traditional banks can succeed in opening ordinary branches and offering ordinary services—savings accounts and accounts, mortgages, among others—in these neighborhoods. In addition to benefiting these communities, this would increase net savings and promote economic development.

Though it is not often thought about in these terms, reforming health insurance—to make it universally accessible and stable in its premiums—would be another financial innovation that would accrue both social and economic benefits. Because individual households’ economic fortunes are volatile, insurance is one of their core financial needs. It is generally possible to buy adequate auto, home, and life insurance, but for most people true long-term health insurance is simply not available. While a majority of Americans get health insurance through their jobs, many would be unable to remain insured should they become unemployed. What they have is subsidized health care during their term of employment; they don’t have true insurance. While there are several ways to do it, making individual health care policies available to everyone (and not subject to an accident of fate like a layoff or divorce) would allow consumers to better plan their economic lives. There could be no better embodiment of positive financial innovation.

Just as importantly, we need innovation in financial education. A large part of our regulatory system relies on consumers being able to make intelligent choices when faced by an ever increasing and ever more complex set of financial choices. The recent crisis has shown that even large and supposedly sophisticated investors, such as municipalities and pension funds, did not fully understand the products they were buying. Economist Robert Shiller has proposed government-subsidized financial advice; this may not be a sufficient solution, but it is a start. Obama’s proposed Consumer Financial Protection Agency (first proposed by Elizabeth Warren in Democracy, Issue #5, “Unsafe At Any Rate”) could also go far in improving consumers’ understanding of their financial options.

Simplifying the landscape of financial products, particularly those sold to consumers, will reduce the opportunities for service providers to generate non-interest fees from customers and will reduce the risk that households will make catastrophic financial decisions. Slowing the tendency toward excess financial intermediation will make it harder for the next credit bubble to form and reduce the severity of the next crisis. In these ways, a more critical eye toward financial innovation will help restore the balance that the American economy needs to produce long-term, sustainable growth.

The Rage Over Goldman Sachs

Posted in TIME by William D. Cohan:

Lloyd Blankfein, the 54-year-old chairman and CEO of Goldman Sachs, is powerfully perplexed. In the past six months, his investment-banking and securities-trading firm has roared ahead in profitability by taking risks — that other firms would not — for itself and its clients in an edgy market. It has paid back the billions of dollars, and then some, of taxpayer money the government forced it to take last October; raised billions of dollars in capital from private investors, including $5 billion from Warren Buffett; and urged its cadre of well-paid and high-performing executives to show some restraint on the conspicuous-consumption front.

For this, the level of resentment and ire directed at Goldman — from Congress, from competitors, from the media, from the public — has never been higher. Blankfein, only the 11th leader of the 140-year-old firm, is having a tough time understanding why.

A recent story in Rolling Stone, of all places, in which the author described Goldman as a "great vampire squid wrapped around the face of humanity," has been particularly troubling to him. "Oddly enough, the Rolling Stone article tapped into something," he says in an interview. "I saw it as gonzo, over-the-top writing that some people might find fun to read. I was shocked that others saw it as being supporting evidence that Goldman Sachs had burned down the Reichstag, shot the Archduke Ferdinand and fired on Fort Sumter." Suddenly a firm that few Americans know or understand has become part of the zeitgeist, the symbol of irresponsible Wall Street excess, the recovery from which has pushed the nation's treasury to the brink. (See 25 people to blame for the financial crisis.)

It's an odd contradiction: an excelling company being reviled in a country that embraces the profit motive. And without question, Goldman Sachs under Blankfein has recalibrated, in very large numbers, its place as Wall Street's most astute, most opaque and most influential firm. In the first and second quarters of 2009, the company earned $5.3 billion in net income, the most profitable six-month stretch in Goldman's history. Goldman's stock has more than tripled since its low last November, to more than $160 per share.

The U.S. unemployment rate has risen too, nearing 10%. In stark contrast, Goldman Sachs has set aside some $11.36 billion so far in 2009 in total compensation and benefits for its 29,400 employees. That's about on pace with the record payout the firm made in 2007, at the height of the bubble. Thanks to Andrew Cuomo, the New York State attorney general, we know that in 2008, while Goldman earned $2.3 billion for the year, it paid out $4.82 billion in bonuses, giving 953 employees at least $1 million each and 78 executives $5 million or more (although Goldman's top five officers, including Blankfein, declined a bonus).

Goldman's riches have deflected the spotlight from what should be great story fodder: Blankfein's personal journey from one of New York City's poorest neighborhoods to its most élite investment bank — and his astounding rise within Goldman. Instead, he has to explain Goldman's performance — and connections — in the face of the nation's epic financial calamity. (See pictures of TIME's Wall Street covers.)

Friends in High Places
Not least of those explanations has to do with Blankfein's appearance in the call logs of Henry Paulson, his predecessor as Goldman CEO, who was Treasury Secretary while the financial crisis started to unfold in early 2007 up until January 2009. For instance, in the week after Paulson allowed Lehman Brothers to collapse into bankruptcy last Sept. 15 — and while the Secretary was playing a major role in deciding whether to pump $85 billion into the rescue of insurance behemoth AIG — Paulson and Blankfein spoke 24 times. On one level it makes sense: a Treasury official discussing a financial crisis with a trusted expert and industry leader. A mention in a call log is not the same as an actual conversation, Blankfein correctly points out. He recalls only a handful of actual conversations with Paulson or Timothy Geithner, then the president of the New York Fed. "Now, that was AIG week," he says, "but it was also breaking the buck on [money-market firm] First Reserve week, and it was the week when Lehman's bankruptcy caused huge problems in the prime brokerage system in London. There were a million things that I would have been talking to Geithner or [Paulson] about."

See pictures of the global financial crisis.

Read "Too Much Profit at Goldman and Morgan?"

The confounding thing, of course, is that after the bailout of AIG, Goldman got $12.9 billion from AIG in the form of collateral that Goldman already had in its possession and a cash settlement of ongoing margin disputes. "The fact of the matter is, we already had the collateral," Blankfein says. "If AIG had defaulted, guess what — we would have kept the collateral from AIG and from the banks we'd bought protection from. The government's decision to bail out AIG was about the risks to the system. It wasn't about Goldman Sachs."

Still, an AIG default could have been catastrophic for Goldman, although Goldman claims to have been perfectly hedged against an AIG bankruptcy. "If AIG would have gone bankrupt, it would have affected every institution in the world, because it would have had a big effect on the entire financial system," explains David Viniar, Goldman's CFO. He countered, though, that Goldman would have most likely figured out how to make money trading in such a volatile environment. (See TIME's AIG cover.)

Nevertheless, critics have feasted on the Paulson connection as just another example of how Goldman Sachs benefits from "Government Sachs" — the propensity of Goldman alums to turn up in top federal financial posts after they leave the firm.

To Blankfein, the criticism seems distorted. "Something that was a virtue now looks like a vice," he says. "I don't think we're going to go far in this country if we make it a bad thing for people to migrate from business into other activities like writing or philanthropy or public service." Goldman, he notes, has already paid back the $10 billion — plus $318 million in dividends and an additional $1.1 billion to buy back warrants (at above-market value, he adds) — that Paulson forced it to take last October from the $700 billion Troubled Asset Relief Program. Taxpayers' annualized return on their nine-month investment in Goldman Sachs? A cool 23%.

If anyone shoulders the "blame" for Goldman's golden performance, it is Blankfein. Self-deprecating and seemingly unassuming, the former gold salesman has been ruthlessly ambitious for his firm and its continued success. "He takes it very personally when people act against the firm or show disloyalty," says a former Goldman executive. (See the worst business deals of 2008.)

After taking the reins of the company when Paulson went to Treasury in July 2006, he accelerated Goldman's transformation from a firm that depended on its clients for investment-banking revenue — fees generated from advising on deals to underwriting debt and equity securities — to one whose clients are driving a resurgent trading and risk-taking business. Goldman has a tradition of taking trading risks. In the postwar era, the firm's DNA has always combined the interlocking strands represented by two of the world's foremost risk arbitrageurs — first Gus Levy and later Robert Rubin — with the investment-banker pedigree of former senior partners, including Sidney Weinberg, John Weinberg, John Whitehead, Stephen Friedman and Paulson. "We would never let our reputation as the key M&A adviser ebb in favor of being a principal," Blankfein says. "We're very self-conscious that our franchise hinges on our client relationships and the business that those relationships generate."

In an era of derivative-driven innovations and massive leverage, Blankfein is the firm's chief advocate for taking risks but also its chief risk watchdog. He has a far different perspective from that of most of the previous Goldman bosses. In December 2006, Viniar led a meeting of senior Goldman executives to examine ongoing daily losses in the firm's mortgage portfolio. Goldman had already underwritten and sold billions of dollars' worth of mortgage-backed securities, much of it labeled investment grade by ratings agencies. It was, in fact, junk. But Goldman realized earlier than most that rot was setting in and famously decided to pull back from the mortgage market. The firm then shorted various mortgage-securities indexes — betting that prices would fall — at the very moment that other firms were still making big long bets on the securities. Goldman avoided losses while other firms infected themselves with the cancerous securities.

Blankfein's deftness under pressure impressed his partners. "He is a totally independent-minded guy," says another senior Goldman official. "Ten years ago, I think most people would have said that it is highly unlikely that Lloyd would be CEO and highly unlikely that he would succeed. But he has done both, and it seems like a dream in this environment ... It's a bit of a miracle. It was unpredicted."

See the top 10 financial-crisis buzzwords.

Read "Goldman's Profits: Gambling with Taxpayer Money?"

A Man and His 'Hood
Then again, Blankfein is different. Born into modest circumstances in the South Bronx, he moved with his family to the East New York section of Brooklyn "in search of a better life," Blankfein says, when he was 3. The family lived in the Linden Houses, a complex of 19 buildings completed in 1957 that contained 1,590 apartments. After losing his job driving a truck, Blankfein's father took a night job sorting mail at the post office — "which in our neck of the woods was considered to be a very good job, because you couldn't lose it," Blankfein says. His mother worked as a receptionist at a burglar-alarm company — "one of the few growth industries in my neighborhood."

Young Blankfein thrived. He stayed out of trouble by not getting off the school bus when he saw things happening that made him uncomfortable. He studied hard. He was the valedictorian of his 1971 graduating class at the predominantly black Thomas Jefferson High School. At 16, he applied to Harvard, solely because Harvard had gone to the school to recruit. Using a combination of financial aid and scholarships, he graduated in 1975. Ben Bernanke was in his class. In the class-of-'75 yearbook, Bernanke was pictured near Blankfein, who was wearing a fashionable houndstooth blazer with groovy wide lapels. Blankfein then enrolled at Harvard Law School, from which he graduated in 1978. "At some point, I can't say that I had a disadvantaged background," he says. "After a while, I kind of evolved into having an advantaged background." Following law school, he was hired at Donovan, Leisure as a corporate tax lawyer. (See the top 10 financial collapses of 2008.)

These early triumphs in the face of adversity understandably shaped his ambition and his worldview. "You can never forget that Lloyd came from a pretty significantly challenging environment," explains Robert Steel, Blankfein's former partner at Goldman and an Under Secretary for Paulson at Treasury. "That's at the root of Lloyd." Steel recalls that Blankfein shared stories about life at Thomas Jefferson High School. "You survive by either one of two things," Steel says Blankfein told him. "You were either a great athlete or funny and entertaining, and I decided to go with funny and entertaining."

Blankfein also developed some pretty bad habits. Once upon a time, he smoked two to three packs of cigarettes a day. He was overweight. He often dressed inappropriately or ostentatiously. And he had a love of gambling in Las Vegas. (See hard times hitting Las Vegas.)

By 1981, Blankfein was on partner track at Donovan, but then he had what he calls a pre-midlife crisis and decided to make the switch, if he could, to investment banking. He applied for banking jobs at Dean Witter, Morgan Stanley and Goldman. He did not make the cut in Goldman's famously exhaustive recruitment process (or at the other two firms either). "It wasn't a nutty decision. I was a lawyer," he says. "I didn't have a finance background." Instead, in 1982 he landed a job as a gold salesman for J. Aron & Co., an obscure commodities firm that Goldman had purchased in November 1981 for about $100 million. According to the Wall Street Journal, when Blankfein told his then fiancée Laura — now his wife and the mother of their three children, one of whom is at Harvard — that he was leaving law for J. Aron, she cried, thinking that he was burning a high-paying career. (Ironically, Donovan, Leisure closed its doors a decade ago.)

Over time, Blankfein became a major part of J. Aron's success. But at first, he says, he was not very good at the job. "I had trouble with the language, with the speed and the pacing." Soon enough, though, he designed a lucrative $100 million trade — then the largest of its kind Goldman had ever handled — for a Muslim client to comply with the religion's rules against receiving interest payments. In 1984, Goldman partner and J. Aron chief Mark Winkelman put Blankfein in charge of a group of foreign-exchange salesmen and later in charge of all foreign-exchange business. Rubin, then on the firm's management committee and responsible for both risk arbitrage and J. Aron, had advised Winkelman against it. According to Charles Ellis' 2008 book about Goldman, The Partnership, Rubin told him, "We've never seen it work to put salespeople in charge of trading in other areas of the firm. Are you pretty sure of your analysis?"

Blankfein's career took off. He seemed to have a sixth sense about when to push traders to take more risk and when to take their collective feet off the accelerator. "It's not about hanging on to a predisposition," Blankfein told FORTUNE in March 2008. "The best traders are not right more than they are wrong. They are quick adjusters. They are better at getting right when they are wrong." Blankfein too was becoming a quick adjuster.

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In 1994, in the wake of Winkelman's departure from the firm after he'd been passed over for the top job at Goldman in favor of Jon Corzine (now governor of New Jersey), Blankfein was selected to run J. Aron. His appetite for risk quickly surfaced. In 1995 he chided his fellow partners for being too risk-averse and promptly left a conference room where they were meeting to place a multimillion-dollar bet with the firm's money that the dollar would rise against the yen. Blankfein's bet — one of his favorites — paid off, and he impressed his partners as a prudent risk taker. He would do the same thing — exhort them to take greater risks — 10 years later and then persuade them to reverse course after December 2006.

In December 2003 he was named Goldman's chief operating officer and co-president after the departure of John Thain — Blankfein's rival to lead the firm — who left to become CEO of the New York Stock Exchange. By then, Blankfein had impressed Goldman's board of directors and especially Paulson, then the CEO, with his tenacity, ambition and hands-on management style. "Hank became increasingly concerned about whether [John] Thornton or Thain" — the co-presidents of Goldman before Blankfein — "would assume responsibility for the business units and show they could run things," says a former Goldman partner. "Lloyd showed a willingness to assume responsibility." Paulson and Blankfein became an effective team, with Paulson globetrotting and hobnobbing with clients and Blankfein assuming more and more operational control of the firm. Year after year, the company was earning billions. "Lloyd made everything run," says the former partner.

Defending Goldman's Crown
When, in July 2006, president Bush tapped Paulson to be Secretary of the Treasury — in the great Goldman tradition — Blankfein's journey from a Brooklyn housing complex to the pinnacle of American capitalism was complete. By then, all of Blankfein's quirky bad habits had been eliminated too. Blankfein has since become a snappier dresser, has lost weight and has given up smoking and gambling. He shaved his once unsightly beard. "I wasn't going to make myself taller," he once quipped when asked about his transformation. He in effect reduced the risks in his personal life as he ratcheted up the risks — prudent, to be sure — that Goldman was taking under his leadership. (See George W. Bush's biggest economic mistakes.)

He is now exceedingly wealthy. In 2007, the year of Goldman's record profit, the board paid him $68.5 million, a record payout for a Wall Street CEO. His 3.4 million shares of Goldman are worth about $540 million. He bought a tony $27 million Manhattan apartment at "Wall Street's new power address," as the New York Times called it, 15 Central Park West. He also owns a 6,500-sq.-ft. (600 sq m) home in Sagaponack, N.Y., near the ocean. (See pictures of expensive things that money can buy.)

Goldman's CEO and other top execs are set for another huge payday this year, although some of his former partners wonder about the backlash against him and the firm as a result. Blankfein is worried too. How is he to juggle the firm's great success — and the attendant increasing bonus expectations of the high achievers working at the firm — with the inevitable public outcry that will result from paying out multiple millions of dollars in bonuses at a time when people all over the country are still reeling from a financial calamity largely of Wall Street's making?

Figuring out how to balance the proper ongoing motivation of some of the nation's best and brightest people with the still simmering public anger toward Wall Street — and, at the moment, toward Goldman Sachs in particular — may be Blankfein's biggest management challenge yet. And he knows it. "Everybody's goal in life is to get 105% credit for all the good things they do and much less recognition for all the bad things they do," he says. "But with us, bizarrely, the view seems to be, What's good is bad and what's bad is good. There's clearly some resentment. There are people who are disposed to think that because we were careful and successfully avoided many of the pitfalls, it should be thought of as some kind of conspiracy."

Blankfein is convinced that Goldman Sachs is good for its clients, for the world's capital markets — and yes, for America as well. "I would like for us to be thought of as always doing the right thing and for people at the firm to be confident that they are doing the right thing," he says. Now if only he could get the public to see things this way too, he'd be all set.

Federal Reserve Says Disclosing Emergency Loans Will Hurt Banks

Posted on Bloomberg by Mark Pittman:

The Federal Reserve argued yesterday that identifying the financial institutions that benefited from its emergency loans would harm the companies and render the central bank’s planned appeal of a court ruling moot.

The Fed’s board of governors asked Manhattan Chief U.S. District Judge Loretta Preska to delay enforcement of her Aug. 24 decision that the identities of borrowers in 11 lending programs must be made public by Aug. 31. The central bank wants Preska to stay her order until the U.S. Court of Appeals in New York can hear the case.

“The immediate release of these documents will destroy the board’s claims of exemption and right of appellate review,” the motion said. “The institutions whose names and information would be disclosed will also suffer irreparable harm.”

The Fed’s “ability to effectively manage the current, and any future, financial crisis” would be impaired, according to the motion. It said “significant harms” could befall the U.S. economy as well.

The central bank didn’t say when it would file its appeal.

The Fed has refused to name the financial firms it lent to or disclose the amounts or the assets put up as collateral under the emergency programs, saying disclosure might set off a run by depositors and unsettle shareholders.

Bloomberg LP, the New York-based company majority-owned by Mayor Michael Bloomberg, sued on Nov. 7 under the Freedom of Information Act on behalf of its Bloomberg News unit.

Public Interest

“Our argument is that the public interest in disclosure outweighs the banks’ interest in secrecy,” said Thomas Golden, a lawyer with New York-based Willkie Farr & Gallagher LLP who represents Bloomberg.

Preska’s Aug. 24 ruling rejected the Fed’s argument that the records should remain private because they are trade secrets and would scare customers into pulling their deposits.

“What has the Fed got to hide?” said Senator Bernie Sanders, a Vermont independent who sponsored a bill to require the Fed to submit to an audit by the Government Accountability Office. “The time has come for the Fed to stop stonewalling and hand this information over to the public,” he said in an e-mail.

The Clearing House Association LLC, an industry-owned group in New York that processes payments between banks, filed a declaration that accompanied the request for a stay.

Negative Consequences

“Experience in the banking industry has shown that when customers and market participants hear negative rumors about a bank, negative consequences inevitably flow,” Norman Nelson, vice president and general counsel for the group, said in the document. “Our members have accessed the discount window with the understanding that the Fed will not disclose information about their borrowing, especially their identity.”

Members of the Clearing House are ABN Amro Holding NV, Bank of America Corp., Bank of New York Mellon Corp., Citigroup Inc.Deutsche Bank AG, HSBC Holdings Plc, JPMorgan Chase Inc., UBS AG, U.S. Bancorp and Wells Fargo & Co.

The case is Bloomberg LP v. Board of Governors of the Federal Reserve System, 08-CV-9595, U.S. District Court, Southern District of New York (Manhattan).

Monday, August 24, 2009

Women With High Testosterone Take More Money Risks

Posted on the Business Insider by John Carney:

Last week, we explained how testosterone in men may affect the markets. Today the Associated Press brings us a story about how women with high testosterone are less risk averse.

From the AP:

Women with more testosterone tend to behave more like men when taking financial risks

, according to a new study.

''Women with higher levels of testosterone turn out to be less risk averse, more willing to take risks,'' Luigi Zingales of the University of Chicago said in a telephone interview.

Known as the male sex hormone, testosterone occurs in both men and women, but at higher levels in men. It has long been associated with competitiveness and dominance, reduction of fear, and with risky behaviors like gambling and alcohol use.

Co-author Paola Sapienza of Northwestern University noted that women in general are less likely than men to take financial risks.

''For example, in our sample set, 36 percent of female MBA students chose high-risk financial careers such as investment banking or trading, compared to 57 percent of male students. We wanted to explore whether these gender differences are related to testosterone, which men have, on average, in higher concentrations than women.''

Previous research in England showed that higher levels of testosterone seem to boost short term success at finance. Researchers there tested male traders morning and evening, and found that those with higher levels of testosterone in the morning were more likely to make an unusually big profit that day.

Zingales and his team tested the testosterone levels of more than 500 MBA students -- males and females -- and asked them to choose between a guaranteed monetary award or a risky lottery with a higher potential payout. Students had to choose repeatedly between the lottery and a fixed payment at increasing values.

In general, men had higher levels of testosterone and were more likely to choose the risky lottery than women.

But it also turned out that women with higher levels of testosterone were almost seven times more likely to take risks that women with lower hormone levels.

On the other hand, there was no difference in risk-tasking between those with relatively low levels of testosterone -- 90 percent of women and 31 percent of men.

In addition, the researchers found that married men and women had lower levels of testosterone than single individuals.

''Married people are also known to be more risk-averse than unmarried people,'' they noted.

The research was funded by the Templeton Foundation, the Zell Center for Risk Research and the Center for Research in Security Prices and the Initiative on Global Markets at the University of Chicago Booth School of Business.

Friday, August 21, 2009

Are Spanish banks hiding their losses?

Here’s a somewhat scary view on Spain that came this week from alternative economic research house Variant Perception.

The top line: that Spain is now the hole in Europe’s balance sheet, and that misunderstanding the severity of the crisis will prove costly to investors as it could have profound implications for the European banking system. As it explains:

Spain had the mother of all housing bubbles. To put things in perspective, Spain now has as many unsold homes as the US, even though the US is about six times bigger. Spain is roughly 10% of the EU GDP, yet it accounted for 30% of all new homes built since 2000 in the EU. Most of the new homes were financed with capital from abroad, so Spain’s housing crisis is closely tied in with a financing crisis.

The impact on the banking sector will be severe. Consider this: the value of outstanding loans to Spanish developers has gone from just €33.5 billion in 2000 to €318 billion in 2008, a rise of 850% in 8 years. If you add in construction sector debts, the overall value of outstanding loans to developers and construction companies rises to €470 billion. That’s almost 50% of Spanish GDP. Most of these loans will go bad.

Spanish banks, in our view, are now facing a very bleak outlook. Spain’s unemployment rate reached over 17%; there are now four million unemployed Spaniards and over one million families with not a single person employed in the family.

We argue and will document anecdotally in this report that:
The real estate crash in Spain is worse than is widely believed, much as the subprime problem was much worse than people believed
Spanish banks are hiding their losses and rolling over debt to zombie companies, much as Japan did in the last decade
• Investors are deluding themselves if they believe that Spanish banks are among the strongest in the world. (This is a new theme. See Forbes’s latest “Spanish Banks In Top Form” for an example of the new fawning articles on Spanish banks.)

If we are right, Spain will soon have zombie banks like Japan and it will face a prolonged period of deflation. However, Spain will be much worse.

According to Variant, Spain’s situation is now pretty reminiscent of the early days of subprime when all the banking results still looked good, until suddenly they didn’t.

But before you can understand the weakness in the system, you have to understand the counter argument — ie, the idea that Spanish banks are among the strongest in Europe. This is based on the idea of “dynamic provisioning” according to Variant, legislation that forced banks to build up reserves against future losses, and prudent lending practice by the large private Spanish banks but which left lending to developers and buyers of second homes to the smaller regional Cajas banks.

The problem, though, is one of magnitude, which is bound to overwhelm even the benefits of dynamic provisioning in the end. As Variant notes:

Spain’s building stocks bubble looks very much like the US bubble and other classic bubbles. It went up 10x and then went down 90%. The math is very simple.

S&P/Citi Spain Proeprty Stock Index - Variant Perception

Yet the picture above is not echoed by Spanish house prices, which are down little more than 10 per cent from their peaks:

Spanish House Prices - Variant Perception

So how can you explain the mismatch? Well, according to Variant, a lot of it comes down to plain old smoke-and-mirrors. As it says:

We believe that Spanish banks are hiding their problems. We explore how they are doing this through:
1) Getting a boost from accounting changes
2) Not marking loans to market
3) Continued lending to zombie companies
4) Making 40 year and 100% loan-to-value loans

All these are good points.

On the first issue, it is absolutely true that the Bank of Spain has now moved to relax its provisioning rules. So whereas previously banks made provision for the full value of loans above 80 per cent LTVs after two years of payment arrears, they now only need to reserve for the difference between the value of the loan and 70 per cent of the property’s market value. Variant says that for many Spanish banks, this has allowed them not to lose money this year.

In April, meanwhile, Spain’s Expansion reported that Spanish banks control 25 per cent of appraisals directly and another 25 per cent indirectly through their shareholdings. Which means they are mostly in charge of valuing the assets themselves. As Expansion reported:

This situation has placed the focus once again on the links between banks and the real estate appraisers that goes beyond in many cases a mere commercial relationship.

Which means official housing statistics are not often corroborated by anecdotal evidence, which suggest prices have already dropped between 30-50 per cent in some coastal regions.

And even if the Spanish banks came into the crisis with prudent practices, these, notes Variant, may now be changing quickly:

Spanish banks are now the largest real estate holders in Spain. They have come to own properties through many different avenues. In order to hide from the effects of the real estate crash, Spanish banks have been buying properties before the loans on them go bad and trying to dispose of them through their own real estate companies. They have also come to own dozens of thousands of homes through debt for equity swaps. Estimates put the value of property repossessed or swapped for debt by Spanish banks at about €16 billion. Consider the following: Spanish banks are now running their own real estate companies and have websites set up to move their stock. Among selling points are: pricing discounts of 25-50%, financial terms of Euribor plus 0% over 40 years, and guarantees to re-purchase the property in the future.

You can view Variant Perception’s rather impressive evidence for the above as well as the full report here.