Analysis: SEC vs. Goldman

The civil fraud charges filed by the Securities and Exchange Commission Friday accused Goldman Sachs of "defrauding investors by misstating and omitting key facts". These financial charges also mark a new era of government regulatory enforcement of Wall Street. No longer will the SEC simply come to consent decrees with financial firms where they do not admit guilt and in most cases pay a small fine viewed as a cost of doing illegal business.

One immediate question is how do the SEC charges filed against Goldman Sachs change the playing field? Do these charges even mean anything in a broader regulatory context? In my opinion, the actions from the SEC on Friday defines a new playing field by Washington marked with the following game-changing alterations:

a) A broader effort to get the derivatives market properly regulated to minimize the possibility of future meltdowns.
b) The Goldman Sachs charges are expected to be the first of a lengthy string of government actions against multiple firms that contributed to the financial meltdown. The lack of accountability by firms which accepted bailouts is no longer acceptable to main street and their representatives in Washington.
c) A dismantling by regulation of firms that are "too big to fail"; including the scaling back of previous government legislation that allowed the merger of commercial and investment banks.
d) The teeth of the SEC are back in place. For the last twenty years the SEC has been a toothless enforcement entity; forcing state AGs to take a leading prosecution role in financial malfeasance. This is likely to be the start of a change where the federal government will have deep roots in the policing of problems involving large financial firms.

The roll out of these regulatory reforms are expected to take years; however as noted by an AFP news article "We suspect that after Friday, others on Wall Street may have a harder time sleeping."

Another good clip is Ratigan on MSNBC where he compares Goldman Sachs to an automobile manufacturing company that deliberately took critical component from the inside of cars (CDOs) and then sold the cars as being great investments while betting on the side that the cars they created would all blow up spectacularly. An apt analogy - watch it here.

WaMu Execs dragged before Congress today

There will be excitement in Washington today as former WaMu Execs are dragged before Congress kicking and screaming. Now that a Senate panel has had over 18 months to gather information, hopefully some sharp questions will be asked about Washington Mutual's abusive and illegal practices.

Allow me to urge the Congressional panel headed by Senator Carl Levin to refer the entire situation to the Justice Department for criminal prosecution.

'Washington Mutual "was one of the worst," Levin told reporters Monday. "This was a Main Street bank that got taken in by these Wall Street profits that were offered to it."'

Top ex-WaMu executives come before Congress
http://news.yahoo.com/s/ap/20100413/ap_on_bi_ge/us_washington_mutual_investigation

The new price tag: $945 billion

$200 Billion (nope)
$400 Billion (nope)
$550 Billion (nope)
$800 Billion (nope)

According the IMF the new cost of the subprime credit crisis is $945 billion globally. Over $565 billion of losses are expected for U.S. residential loans and securities. The figure has risen to $240 billion for commercial loans.

"The U.S. subprime crisis is not only eroding the U.S. economy -- the world's largest -- but also wreaking havoc on global financial markets, including Japan's stock and currency markets. "

There appears to be one item that the U.S. is very good at exporting – our credit crisis.

In other related news, it appears that the Wall Street investment banks are hooked on emergency funds. As outlined in an earlier HingeFire article, these financial institutions built on risk-taking are borrowing over $38 billion each day from the Federal Reserve.

The program was designed as a temporary measure to alleviate the credit crisis; it appears that the investment banks are using it as a payday scheme to make further bets in the market. Finally the mainstream press is coming to grips with the story, stating that the Federal Reserve will need to wean these banks off of these loans, similar to taking the needles away from a heroin addict.

From across the pond: The Banking Crisis

The mortgage credit crunch has not only impacted banks in the U.S., but has shocked financial institutions overseas. Filmed after the demise of Northern Rock in the U.K., this edition of Dispatches featuring Jon Moulton outlines the financial meltdown. The clip is an excellent educational summary of the greed-driven problems in the credit market that has left the world on the brink of recession.

Quick Takes: Credit Churn, Bear Stearns

The failure of auction rate securities is still causing angst for the closed end bond funds. The leveraged funds that issue auction rate preferred shares are in serious trouble.

BlackRock and others in this business are searching for strategic alternatives. Over $300 billion in securities are at risk, and BlackRock has 66 impacted bond funds with a value of $9.8 billion.

Despite proposals for re-financing and put features for these instruments, the probability of a resolution appears bleak. By the end of the auction rate failure crunch, there is an expectation that one or more of these fund families will flounder. Most likely the backing company will be sold for pennies on the dollar.

The news is not any better in the subprime sector, the delinquencies on the mortgages issued between 2005 and 2007 continue to rise according to Standard & Poors. The delinquency rate is rapidly approaching 40% for many of the notes issued in these years; the rate of delinquency is jumping 4 to 10% per month. Wall Street expected a delinquency rate of 15% worse case when it packaged the notes in CDOs; so much for financial modeling.

In other news, you don’t have to feel bad for all those executives at Bear Stearns; many of the top insiders sold large chunks of stock in December in advance of the implosion. It appears that these folks will not have to move out of their multi-million dollar mansions.

In related news that will cheer up Bear Stearns employees, JP Morgan raised its bid to purchase the bank to $10 from $2. The question being if Bear’s chairman James Cayne who is probably off-site at either a bridge tournament or the golf course has heard this news yet.

The Great Mortgage Industry Heist

Each evening newscast brings the latest fall-out of the mortgage industry bubble; the credit failures on Wall Street, “sub-prime” as the word of the year in 2007, job losses in the financial and construction industry… the coverage is regularly the lead story. As local homes sit on the market for months and neighbors search for jobs, the crisis appears closer but not directly in our wallets.

The credit crisis triggered by the sub-prime lending caused the Fed to quickly reduce rates and inject huge amounts of cash into the banking system in an attempt to alleviate the financial liquidity issues. An increased money supply makes the cash a consumer holds worth less -- a classic definition of inflation. Reminiscent of Germany printing currency after World War I until a loaf of bread cost millions of deuchmarks. Overall the U.S. government action has led to increased inflation, a falling dollar, and spiraling commodity costs; all in support of bailing out an industry that created its own problems due to its insatiability for riches.

Of course, mortgage executives and Wall Street deal makers are not feeling any pain. Lax lending standards allowed everyone to profit at every level of the food chain. The entire mortgage industry was focused on greed rather than proper lending standards. This includes every level within the mortgage industry from the broker who placed homeowners into improper loans for increased fees to the Wall Street bank executives whose firms packaged up junk mortgage paper and painted lipstick on these CDO pigs as triple-A investments. No thought to proper risk control was given; the entire industry was driven by a voracious hunger for money.

Countrywide Financial Corp. chairman and chief executive officer Angelo Mozilo, former Merrill Lynch CEO E. Stanley O’Neal and Charles Prince, former chairman and CEO of Citigroup, have all been in front of Congress attempting to explain why their multi-hundred million compensation packages were justified while their companies went down the flusher. Certainly the Wall Street bonus machine felt little pain.

In the end, who is holding the bag? Many would state that it is the main street consumer. A number of people may not think that these events impact their pockets; however this is no longer true. Every time a consumer fills up their tank or goes to the local grocery store they are paying the price for the greed of the mortgage industry. Welcome to the Great Mortgage Industry Heist – the greed that placed money in the pockets of a few impacting everybody.

The credit crisis, triggered by the sub-prime fiasco, has driven an inflationary economy with prices for most necessities spiraling at nearly unprecedented rates. Not only are the prices increasing but the associated total taxes being paid on necessities is rising – regressively impacting those who can afford it the least.

Consumers dropping by their local grocery don’t only encounter rising prices for milk, bread, and other basics – as prices increase the total collected sales tax on the necessities rises. While from a county level the total sales tax collected may be offset by the drop in consumer spending on non-necessity items such as clothes, electronics and other items as consumers are more stressed --- the staples needed to live are in the increased collections column.

The situation is no different at the pump, as fuel costs increase the associated gas tax in many states rise, making the commute to work more expensive.

Rising inflation due to action by the government and its agencies can in itself be viewed as a tax on the entire population. Certainly there is an option to let these institutions fail instead of extending liquidity by printing money and lowering rates, but for some reason this is viewed as a worse alternative than effectively taxing the entire population for the greed-driven decisions of the financial industry. “Too Big to Fail” can regularly be seen in print as government decision makers defend their actions to bail out larger banks.

Is it simply a choice between a deflationary depression and an inflationary recession? Government policy can drive either alternative. Either allow the market to wash out the excesses without interference or continually bail-out institutions. A good case can be made that the Great Depression would have lasted a much shorter period of time if the government had allowed the financial markets to run their course.

The sub-prime bubble will act as the historical example of a greed-driven institutional credit balloon which overwhelmed banks and governments. The contagion to other credit markets will drive required systemic reforms in risk management while placing many Wall Street quantitative models into the historic dust bin.
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An excellent overview of the bursting of the Mortgage Bubble can be found at:
http://www.blownmortgage.com/files/presentation3-2008.pdf

The 75 page power-point presentation, put together by T2 Partners LCC, includes many graphs and provides first-rate set of fact & figures about the situation, and demonstrates why the implosion is still in the early innings.

Ring, Ring: Hello, This is your Margin Call for $325 Billion

JPMorgan Chase issued a report on Friday that Wall Street banks are facing a "systemic margin call" for $325 Billion due to their weakening subprime mortgage exposure. "A systemic credit crunch is underway, driven primarily by bank writedowns for subprime mortgages," according to the report co-authored by analyst Christopher Flanagan. "We would characterize this situation as a systemic margin call."

This past week, JPM sent a default notice to Thornburg Mortgage after the lender missed a $28 million margin call – sending a ripple through the market. The Thornburg notice is just the start of the cycle according to JPM. There were others this past week missing margin calls, the Carlyle Group's mortgage fund also failed to cough up $37 million it owed. Is there any wonder, why sovereign wealth funds are now taking the position that they can not save Citi.

The worst news is that this is just the start of the cycle, despite the Fed planning to add an unprecedented $50B in liquidity at each of two auctions in March. The current margin calls are only for sub-prime debt; the deteriorating auto loan, credit card, and commercial real estate loan situations have not been addressed yet.

The jumps in unemployment, faltering consumer confidence, and other headwinds make it more likely that the first quarter of 2008 will officially be recorded as a recession for the U.S. economy.

The Subprime Mess Explained

A very funny skit that gets to the heart of the subprime crisis....

http://it.youtube.com/watch?v=SJ_qK4g6ntM

Quick Takes: Another $50B and some theories to test

Banks hit up the Fed for another 50 billion

Hoping to pour some liquidity into the credit squeeze, the Fed loaned banks $50 billion over the past few weeks. The Financial Times reported that the use of the Fed's Term Auction Facility (TAF) program increased greatly by mid-February.

The Swimsuit Indicator

Bespoke has recently discussed a leading indicator which defines the performance of the S&P 500 for the upcoming year – The Swimsuit Issue Indicator. I am not so clear if the correlation between the Sports Illustrated Swimsuit Issue and index is justified quantitatively. It appears that I will have to study the issue in great detail over the upcoming the weeks to see if the theory is valid... carefully researching all of the reference material.

The Subprime Primer

Finally, a subprime explanation that providers a suitable overview of the situation. The Subprime Primer slide show is a humorous look at the subprime lending fiasco and properly hits the key points. [Note: some NSFW written language near the end].

New Poll: Is it Time to Buy Banks

The January survey shows that 43% of the respondents believe that the Tech Sector will be down by over 5% in the first quarter of 2008. So far these folks are right on target, NASDAQ was down over 9.9% in January. The trend in Tech does not appear hopeful looking forward for the next two months.

Banks have recently completed their fourth quarter earnings reports. One immediate question will be if all the bad news is out of the way. The entire sector has been pounded with large write-downs and negative news related to the subprime fallout. There also is an industry consolidation underway, as outlined with the Bank of America acquisition of Countrywide.

Is it time to start bottom feeding and purchase banks? Is this the start of the recovery? Take the new poll !

Bear Stearns CEO Expected to Step Down

The Wall Street Journal states that Bear Stearns CEO James Cayne is expected to resign, but remain as chairman. To many pundits watching the situation at Bear Stearns, it was just a matter of time until this step was taken. Cayne has been under intense scrutiny since a series of articles appeared showing that he was playing golf and bridge while a major crisis sunk two hedge funds at his firm. The subprime credit crisis caused Bear Stearns to write off billions of dollars of bad debt while its stock price dived nearly 50 percent. An earlier summary (Is Your Investment Bank Executive a Doper) provides some more details.

WSJ: Bear CEO Expected to Step Down

Citi: Some quick math

Analysts warned this week that Citi may need to right off another $18.7 billion in the fourth quarter, exceeding earlier estimates of $8 to $11 billion. The actual total may be even greater than this based on some simple math. Citi holds some $43 billion in CDOs with subprime mortgages underlying them. At this point, these derivatives are trading best case for 43 cents on the dollar; many are down near 22 cents on the dollar. A simple calculation of 57% of $43B shows that $24.5 billion of bad CDO investments will still need to be written down. Not all of this will occur in the fourth quarter, but to properly mark the books to market the greater part of it must.

The totals may even be worse, Citi has an additional exposure of $12 billion to subprime that is non-CDO. Additionally the bank will be fortunate to hit a peak salvage value of 43 cents per dollar on these investments; many will go for below 30 cents in the current crunch.

This makes it likely that Citi will need to significantly cut its dividend and seek additional outside investment from sovereign funds to bulk up its capital ratio to regulatory minimums.

The banks are still running red, and the impending credit card meltdown is not included in the tally yet. A number of notable Hedge Fund managers were quoted this week saying that Citi was a buy at $5 per share, a mere 83% tumble from the current share price.

Citi May Write Down $18.7B, Analysts Say

Coming Soon in a Mall near you

Santa for adults

Quick Takes: BW labels mortgage CDOs a pyramid scheme

Business Week provides a detailed look at the Bear Stearns’ Hedge Funds which collapsed and outlines their similarities to a pyramid scheme. A good read…

The Bear Flu: How It Spread
A novel financing scheme used by Bear Stearns' hedge funds became a template for subprime disaster.
http://www.businessweek.com/magazine/content/07_53/b4065000402886.htm

“The global markets are dealing with the consequences: The tab from the mortgage mess could run up to $500 billion, and central bankers are struggling to stave off recession. As investigators sort through the wreckage, the records of Bear Stearns' doomed hedge funds are turning out to be some of the most revealing in an era of financial folly.”

Quick Takes: The biggest crisis of the last half century?

We can thank the mortgage industry and the wizards on Wall Street for brewing the huge subprime credit crisis. Smug in their beliefs that real estate values always rise nationwide, people always pay their mortgages, and that generating new finanical vehicles will eliminate risk, a catastrophe has been created. One that will be with us for years probably causing $6T or more in housing wealth to evaporate.

The Wall Street Journal provides their perspective:

U.S. Mortgage Crisis Rivals S&L Meltdown
http://finance.yahoo.com/loans/article/104050/US-Mortgage-Crisis-Rivals-S&L-Meltdown

Goldman Sachs: A windfall, but at what cost?

To many, Goldman Sachs defines the term “Chutzpah”. While some investors admire the power house bank for avoiding the mortgage fiasco by effectively going short subprime debt; others question the integrity of a firm pimping these structured assets as great investments to customers while simultaneously shorting the entire market with its own capital. A common place duplicity which highlights the misbehavior of Wall Street in the minds of many regulators and industry analysts.

“Goldman's success at wringing profits out of the subprime fiasco, however, raises questions about how the firm balances its responsibilities to its shareholders and to its clients.”

“Why did Goldman continue to peddle CDOs to customers early this year while its own traders were betting that CDO values would fall? A spokesman for Goldman Sachs declined to comment on the issue.”

A recent article gives an excellent overview of the structured products trading group that saved Goldman’s bacon.

How Goldman Won Big On Mortgage Meltdown

The Mortgage Plan

The administration rolled out its mortgage initiative late this week. The plan will help 340,000 mortgage holders whose teaser rates are due to reset. Another 60,000 sub-prime customer are already so far behind on payments that they will not qualify for the plan. The standards for inclusions in the plan require that “the loan must have been originated between January 1, 2005 and July 31, 2007 when underwriting standards were at their worst. They must also have been made for at least 97 percent the value of the home, and the borrower cannot be more than 30 days delinquent.” The rate freeze scheme would lock in the initial teaser rates for a period of five years, avoiding payment increases for homeowners.

With an estimated 1.4 million homeowners expected to enter foreclosure in 2008, any plan that will possibly enable nearly a quarter of the houses to escape the situation is likely to be received positively on Wall Street. Reducing the number of foreclosures by 25% clearly reduces the stress on mortgage-backed derivative debt.

However the immediate upbeat reaction ignores the reality that the bulk of outstanding mortgages are still likely to flounder. A report released today shows that mortgage delinquencies have risen to a 20 year high. One in five adjustable-rate sub-prime loans had late payments in the quarter. The deterioration of the housing situation is accelerating. The U.S. is likely to establish new standards for peaks in foreclosures, crests that even exceed those in the 1930s.

U.S. Mortgage Delinquencies Rise to 20-Year High
http://www.bloomberg.com/apps/news?pid=20601087&sid=aNNNcUnDqS_g&refer=worldwide

Subprime plan seen reaching 340,000
http://www.reuters.com/article/ousiv/idUSN0731666420071207

The Mortgage Bailout: Moral Hazard

The federal government is working with the financial industry to hammer out a proposal to temporarily freeze interest rates on troubled sub-prime and adjustable rate mortgages. Treasury Secretary Henry Paulson is scheduled to reveal the details of the plan at a national housing conference on Monday,

The major thrust of the proposal would be for lenders to extend for a number of years the lower, introductory teaser rates that were offered on subprime mortgages. Initial details suggest an extension of the lock period to seven years.

Over 2 million of those initial "teaser" rates are scheduled to rise to much higher levels by the end of next year. Many homeowners will not be able to meet the higher payments, likely triggering hundreds of thousands of defaults. Naturally this would dump more unsold homes on an already suffering housing market, pushing home prices down further, further jolting consumer confidence and increasing the probability of a full-blown recession.

Most of the hue and cry in the press recently focuses on the moral hazard of saving homeowners who made very bad choices, few articles focus on the absurdity of bailing out irresponsible banks.
Mortgage aid plan sparks hope and resentment
http://news.yahoo.com/s/nm/20071130/us_nm/usa_housing_hazard_dc

"It's not the government's job to bail them out."
"It feeds into the mentality that the next time you screw up, someone will rescue you."

These statements are even more applicable to the banks than to the stressed homeowners. In reality this plans is about saving the bacon of the banks. Since when does the government actually care about individual homeowners, this entire bailout is about salvaging the entire banking system from a crisis. The concept of moral hazard is even more applicable to bailing out these banks.

Some industry specialists such as Peter Schiff, president of Euro Pacific Capital present a more comprehensive perspective. He recently stated, "The rhetoric is 'We've got to help homeowners,' but the reality is it's designed to help the fat cats, Wall Street. It's bailing out the lenders."

Many historians view the Great Depression would have lasted a mere two years rather than ten if the government had allowed the implosion of the excesses of the financial system to run their downhill course. The intervention of the government to prop up banks and interfere with market activity caused the dismal economic conditions to linger for many years. Only the intervention of WWII caused a turn-around.

At this point it appears that the bail-out plan in some form is a sure lock. Major players in the mortgage industry such as Citigroup, Wells Fargo & Co. and Countrywide are on board. The holders of the CDO notes may cry about reduced interest payments. However CDO holders such as pension and hedge funds face a stark reality either getting paid nothing at all as the entire stack of derivative dominoes tumble or losing a portion of the interest. Most will gladly grab the horns at this point and accept the reduced payments. It is likely that only the lower tranches will suffer and the higher tranches get paid first, leaving only the holders of the lower quality segment of the mortgage derivatives out in the cold.

Maybe this time, the U.S. should simply allow the excesses to be washed out of the financial system. The pain, however sharp, will last for a shorter period of time then a continually cycle of bailouts. Wall Street has a long history of ignoring risks in order to make a quick buck; this leads to constant repetitious cycle of poor financial management. The game ends the same each time; with individuals left out in the cold, the financial firms propped up, bankers flashing big bonuses while every taxpayer is zinged, and another cycle of unnecessary government intervention. Is it time to steer a new course?

Reference:
An earlier post discusses the moral hazard of bailing out Citi
Should Citi Pay for its Mistakes
http://hingefire.blogspot.com/2007/10/should-citi-pay-for-its-mistakes.html

Dismal Housing: No End in Sight

Fannie, Freddie, Countrywide, and some builders crowded the front page of the financial press today as their stocks dived to new significant lows.

Freddie Mac (FRE) reported a $2 billion dollar loss as the fair value of its assets dropped by $8.1 billion. Freddie indicated that it must seek outside funding in order to meet regulatory liquidity requirements; meaning an immediate infusion of up to $4 billion is needed to keep the government sponsored mortgage entity afloat. Additionally, the firm was forced to increase its provision for credit losses to $1.2 billion, from $112 million, a year ago. Most investors view Fannie Mae (FNM) as being in a similar situation. The speculation is that the issues will just keep getting worse in upcoming quarters.

Countrywide (CFC) spent most of the day denying bankruptcy rumors as their stock tumbled below $10 for the bulk of the trading day. This is a case of the stronger and more frequent the denials, then the greater the probability of the filing occurring sooner rather then later. Many local investors give them less than six weeks in our bank “death-watch pool”. The situation may possibly end with some sort of merger with another bank in which assets are valued for pennies on the dollar as the last resort

On the homebuilding front, D.R Horton reported (DHI) reported huge quarterly losses today. While there is speculation that many builders will go under due to liquidity issues, Standard Pacific (SPF) sunk over 20% today on this type of concern. Many more will surely follow.

Some traders would look at the huge tumbles of FNM and FRE as short time buying opportunities as the market was over enthusiastic in punishing both stocks for the negative news from Freddie. There is a good likelihood of a short term rebound. However the recent news today that drove the stocks to 10 year lows is just the leading edge of further write-downs that will occur in upcoming quarters. Leaving both government sponsored entities drained of capital and desperately seeking financial assistance. This may amount to further issuing of preferred instruments which smacks the existing common shareholders, to the straight-out begging for a bailout from the federal government (read as “possible bail-out with your tax dollars”).

Housing's Roof Collapsing
http://www.thestreet.com/_yahoo/newsanalysis/realestate/10391123.html?cm_ven=YAHOO&cm_cat=FREE&cm_ite=NA

“The drop in housing prices is causing most of the pain. A report from real estate information firm Zillow.com released Tuesday shows that U.S. home values fell 6% in the third quarter, the largest decline in the last 10 years.”

“On top of that, nearly 16% of homeowners who bought houses in the past year now have negative equity in their homes, meaning they owe more than what their homes are currently worth, the report says.”


The turmoil leaves many of those focused on mortgages or housing with a knot in their stomach. The question for many active investors will be “when will it be time to start bottom feeding and grabbing the survivors at rock bottom prices”. Who wants to catch the falling knife or should we just let it bounce off the floor and grab the handle down the road?

Subprime: The hits keep coming

The stunning magnitude of the subprime losses at investment banks is just beginning to be revealed, and the write-offs are nowhere near complete. The contagion to the troubled $925B credit card market has just begun. Many of these institutions will have to take an additional write-down of $10B each to come clean and properly align their books with the actual market value of troubled sub-prime investments. The infection of the other derivative markets such as credit cards and commercial paper could leave these banks with additional destabilizing losses which comparatively would make subprime appear to be a minor headache.

“Merrill Lynch analysts, for example, calculate that mid-quality ABX debt is on average now trading at 40 cents in the dollar. But these analysts say that Merrill Lynch itself has only written this type of debt down to 63 cents in the dollar - and UBS is still assuming this debt is worth 90 cents. "Simple math would imply that UBS needs an additional $8bn write-down [on its $15.4bn holdings] if the ABX pricing is correct," Merrill says.”

What's the damage? Why banks are only starting to uncover their subprime losses
http://biz.yahoo.com/ft/071104/fto110420071335381700.html?.v=1

An earlier post discussed the unsettled credit card debt derivative market:
Quick Takes: The Next Subprime
http://hingefire.blogspot.com/2007/10/quick-takes-next-subprime.html

In additional news today…
Citigroup CEO Resigns; Interim Named
Citi to take an additional $8 billion to $11 billion in writedowns.
http://biz.yahoo.com/ap/071104/citigroup_ceo.html