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Saturday, March 28, 2009

Toxic Assets

Investors really need to start taking the term "toxic assets" literally in terms of properties affected by the mortgage implosion. The first case in point publicized earlier this week involves -- literally -- the toxic drywall found to be destroying many homes built between 2004 and 2007 from the inside out. Due to back-to-back-to-back hurricanes earlier in the 2000s, tremendous shortages in the supply of drywall led many builders and wholesalers to buy drywall from China. It seems the manufacturing process or just any lack of concern about the raw materials used resulted in extremely high levels of sulphur to be baked into the drywall. As it ages, the sulphur seeps out of the drywall as a gas. If the house is closed up for any period of time, you get the classic "rotten eggs" smell. That's not the real problem, bad as that may seem.

The real problem is the sulphur being emitted attacks ANYTHING in the home made of copper -- like PLUMBING and WIRING. There isn't really a fix -- you can't "seal" the drywall with paint to avoid the problem cuz it's still seeping on the cavity side of the wall where the real damage is being done. Of course, the vast majority of insurance companies are refusing any claims for this problem. The only solution is to completely gut ALL drywall, copper plumbing and copper wiring in the house and start over, at which point you might as well tear the house down and start over from a cost standpoint. Where is this problem most prevalent? Florida -- one of the leaders in foreclosed properties.

The other problem with toxic home assets is the problem with vagrancy and "squatting". A story earlier this week on the NewsHour illustrated the problem in one relatively nice looking neighborhood in California. A real estate agent working for a credit agency visited several properties on the agency's foreclosed list and tried to shoo away squatters attempting to live in the homes or quiz neighbors about anyone that might be currently away from the house but squatting at night. The story described how poor people and illegal immigrants are getting scammed by people running ads in the paper advertising below-market rents who meet them at the property to collect the first month's rent, let them in (presumably replacing the locks so they can give them keys that match) then disappear. The "renter" thinks they're living in the home legally but find out otherwise when the sherrif shows up to evict them. In other cases, people are just breaking in themselves and living there.

Of course, since most of the houses have the utilities shut off, people just stack trash up in the rooms, no dishes get washed, it isn't clear sinks and toilets work so....

You can imagine what these houses look (and smell) like. In the piece aired on television, many look like crack houses or meth labs on the inside with major appliances and fixtures stripped, gang tags spraypainted on the walls, *#)@ on the walls and floors, you name it.

These are the "assets" being unloaded by banks on well-meaning but unsuspecting regulators and government agencies.

Wednesday, March 18, 2009

The AIG Bailout and Bonus Imbroglio

Given the incredibly low bar of insight and analytical thinking set for itself by members of Congress, it's hard to be surprised by Congressional hearings anymore. The March 18, 2009 appearance of AIG CEO Edward Liddy in front of a House subcommittee was no exception. If you just heard pieces of Liddy's statements and the indignant questions that prompted them, the transcript of the entire session could be succinctly condensed down to a single word.


The entire spectacle not only failed to enlighten Congress or America about the real nature of the problems at AIG and the larger financial system, but moved the spotlight from the areas that remain unaddressed by the government for any true stabilization effort, much less long term recovery.

Bailouts to Protect WHAT and WHOM?

Nearly an entire day was spent by the House Subcommittee on Finance on the topic of a mere $165 million in bonuses paid to over 73 employees at one firm that has already pulled in two bailouts of $85 billion and a second bailout for another $65 billion as part of a larger $700 billion bailout. Had Congress considered the original $700 billion TARP legislation with equal diligence, we'd be only 150 days into the 4242 days of debate on the bailout plan.

Is this an argument to have done nothing to try to stabilize the market in 2008? Of course not. It's yet another example of the substitution of talking points for progress -- the same substitution that produced the half-baked TARP program in the first place by focusing on "coming together" and "doing something" instead of addressing even ONE fundamental regulatory issue that contributed to the meltdown before flooding failed banks with taxpayer money or one material issue of the mechanics of the TARP plan itself.

Until the past week, AIG had refused to disclose the names of major counter-parties who stood to lose from a collapse of AIG and, consequently, stood to gain by its rescue. (#1) Two areas of concern arose when names were finally released. First, many of the parties are foreign banks. Of course, the immediate reaction from that involved the disgust that US taxpayer dollars were indirectly helping to bail out foreign banks. Of course, that emphasis would totally miss the more important point that such findings indicate all of the major banks in Europe are as close to the brink as US banks, meaning the resistance of the worldwide system to any shock is far less than anyone understood or at least publicly stated until now.

The second point about the disclosure of AIG counterparties is that by any accounting, Goldman Sachs was a major beneficiary of the TARP plan. Given the timing and magnitude of the overall crisis, that's not necessarily surprising. However, after considering the decision made by former Treasury Secretary Hank Paulson to #1) FORCE a rescue of Bear Stearns, #2) ALLOW Lehman Brothers to twist in the wind and die, then 3) LAVISH funds from TARP into AIG to help Goldman Sachs -- his former firm -- behind the scenes, one must conclude that is worthy of serious investigation.

Bonuses to Retain WHAT?

The Liddy appearance focused on bonus payments made to top executives in the division of AIG that concocted most of the highly leveraged schemes that tanked the company. Of course, there are two types of bonus payments offered in Corporate America. Performance based bonuses are intended to encourage employees to make business decisions that increase real profits and increase the real value of the company so stockholders make money. (PLEASE!!! Try to hold your snickering until the end of the point…) "Stay bonuses" are intended to stabilize the employee base during periods where the company's ongoing operations are vital to the survival of the company by encouraging key contributors to stay and avoid a disruption in the company's operation. Think of them as "combat pay" for staying in the foxhole and continuing to fire one's weapon as commanded during a corporate firefight for survival.

In the case of AIG, it really doesn't matter what terms were involved for the bonuses paid out -- they are unwarranted under any circumstance. Payment of any "performance bonus", even if routinely structured in financial firms as an end-of-year lump sum equaling even 50 to 100 percent of "base salary", are still supposedly based on actual profits and proper execution of the employee's fiduciary duties to the firm and its clients. These executives and their underlings failed both tests miserably. The firm's strategies failed to provide the financial protection claimed by the sophisticated products sold and produced catastrophic losses for its customers and the firm itself.

If the payments constitute "stay bonuses", exactly what talent is being kept? Few are actually arguing these key players need to be kept because they are geniuses who can return the company to profitability at some point. The argument is that the individuals who originated thousands of derivative contracts are needed to stick around to reverse engineer their own deals, figure out who all the counter-parties are, and help figure out how to dismantle the house of cards without triggering a collapse, thus "preserving" the American taxpayers' investment in AIG.

Uh huh.

Quite simply, there is NO WAY this will happen. The fact that the only person who can makes heads or tails of any particular contract struck by the company is the single employee who cut the deal is ipso facto evidence the employee did not meet his or her fiduciary duty to his client or to AIG and is not only NOT entitled to performance bonuses, they aren't even entitled to their base pay and are likely criminally culpable under racketeering charges. If you hired a lawyer to help you take your company public and after all the paperwork was signed and shares sold, you didn’t' know where your money was, your shareholders didn't get their shares, and only the one lawyer knows the dollar amounts and location of the paperwork, is that lawyer discharging their fiduciary duty properly?

Again, what's interesting about this situation is that NONE OF THE ABOVE is important in the larger scheme of things. What is important is the recognition of the fact that these derivative contracts of AIG very likely CANNOT be "unwound" AT ALL, much less in an orderly fashion with a predictable timeline in a manner that holds up to court scrutiny. If only ONE PERSON on the planet can reverse engineer a deal gone bad, courts would have to rely on ONE PERSON'S testimony who has overarching conflicts of interest that would render any verdict null and void. That literally means AIG -- and many other firms like it -- are in large part worthless mounds of indecipherable paperwork. What THAT really means is that Congress, the Federal Reserve and the larger financial system have not yet come to grips with the inevitable reality that a different approach is required to mitigate additional damage that WILL come forth as pieces of the system hit a stress point and collapse -- not just within AIG but within the entire system.

Implications for Geithner and Obama

Barack Obama's popularity remains quite high despite the turmoil over the bailout plans for AIG and other banks. The same cannot be said for Treasury Secretary Timothy Geithner. There are going to be many critical moments in the Obama Administration but one has already been reached this week and it really isn't clear if Obama "gets it" yet.

Geithner is in completely over his head. He may have been a competent, even brilliant central banking tactician for the New York Federal Reserve Bank. Unfortunately, we already have a Federal Reserve Chairman and don't need a second. The Treasury's outsized role as executor of huge financial institutions places it in a position where expertise beyond normal monetary policy and fiscal operations like Treasury Bill auctions is required. Expertise in contract law, personnel management and compensation, and criminal / civil law is required for the Treasury to more effectively work with the Justice Department and state Attorneys General to properly prioritize stabilization efforts, investigations and criminal / civil prosecutions. Geithner has failed to demonstrate ANY expertise in any of these areas either as Treasury Secretary or in his prior role at the New York Fed. Believe it or not, the current situation is NOT as bad as it can get. If this is Geithner's best game, he's completely unable to handle anything worse.

While these forces are at work and Congress gets distracted by one admittedly fascinating day of testimony, the press is covering green dye in the White House fountain for St. Patrick's Day and the President's Final Four basketball picks.

Psssssst. Barack!

Seriously. Get your head in the game. THE REAL GAME.



#1) http://money.cnn.com/2009/03/07/news/companies/aig.fortune/index.htm?postversion=2009030910

Tuesday, March 10, 2009

Still MIA: A Real Recovery Plan

The financial meltdown still in progress has led most debate within government and the chattering classes to focus on the balance between any short term stimulus benefit and the weight of the long term debt added to pay for it. When the numbers involve "Ts" as in trillions, it seems logical to pay attention to that debate. It's also possible that the size and timing of the stimulus are NOT the most critical issues to resolve first. Until measures are taken to correct the broken financial, legal and regulatory processes that allowed the meltdown to occur, it's HIGHLY likely vast amounts of money will remain on the sidelines and out of the hands of banks, corporations and money managers who enjoy virtually ZERO public trust.

Here's a laundry list of changes that might improve investor confidence in the market to help dissipate the current sense of panic in and anger at the market and replace it with more constructive caution that allows money to flow back into the market for legitimate investment and growth.

Regulatory Reform for Credit Default Swaps

Anyone who has been following the financial news over the past two years know credit default swaps (CDSs) are a key part of the larger meltdown in the financial system. Some may also know that the total nominal value of all of the existing CDS transactions is in the $55 trillion dollar range. Upon hearing that figure, most people would probably assume that SURELY, after events on the ground have proven these instruments to be such a colossal disaster, sophisticated investment firms and hedge funds would have learned their lesson and would avoid entering in new CDS contracts LIKE THE PLAGUE.

They would be wrong.

As stock prices of megabanks head to the penny range, speculators who have already lost their shirt are attempting to make up past losses by betting on the next "sure thing" -- collapsing stock prices of megabanks. There's no certainty any legal change or central bank strategy can gracefully unwind $55 trillion in existing CDS contracts. However, it seems a child of five could understand that it makes NO SENSE WHATSOVER to allow additional CDS contracts to magnify the instability that's already leading to the current remake of The Grapes of Wrath.

The Securities and Exchange Commission and its equivalents in the European Union and Asia need to explicitly restrict new CDS contracts in cases where one or both of the parties are not direct owners of publicly traded stocks or bonds involved with the contract. If the various power brokers can't agree on an outright ban on new CDS instruments, surely a compromise can be reached banning them on securities related to banks and insurance companies.

Regulatory Staffing and Qualifications

The testimony provided by Harry Markopolos to the House Financial Services Committee on February 4, 2009 not only provided a cogent explanation of the Madoff ponzi scheme fraud but also served as an indictment of the entire federal regulatory framework. His testimony made it perfectly clear staffing levels at regulatory bodies were wholly inadequate to keep up with the explosion of complexity of financial arrangements and strategies adopted by banks, hedge funds and insurance firms. He also confirmed the limited staff on hand was completely unqualified to analyze and critique the information they reviewed, even when twenty nine areas of suspicion were handed to them on a silver platter. (#3)

Perhaps the most damning part of his testimony was the revelation that for eight years after he first filed concerns with the SEC about Madoff's firm, not a single staffer had the presence of mind to confirm Madoff was even making the trades claimed in his public explanation of his investment strategy. Had anyone checked, they would have realized the number of trades required to produce the profits claimed would have exceeded all available options on the Chicago Board Options Exchange where those options were traded. (#4) In simple terms, this is like claiming you earned $50 billion dollars making two cents per share in a market that only moved 50 billion shares total. Basic math.

This isn't the first failure of this magnitude due to filings that all added up but failed basic business tests involving simple math. Worldcom inflated profits for years by capitalizing the costs of trunks accepting / terminating call traffic from local telephone companies instead of expensing them. For a telephone company, the relationship between minutes of use that produce revenue and the cost of trunk circuits to carry those minutes of use can be easily calculated. The fact that one carrier in an entire industry had trunking costs one seventh of their competitors should have been a red flag to its own auditors. Even with the failure of Arthur Anderson to flag the fraud, it should have been obvious to SEC staffers reviewing the Worldcom filings.

All enforcement personnel at the SEC should be required to pass a detailed test in "forensic accounting" to retain their jobs. Compensation for enforcement positions should be adjusted to attract more competent, analytical talent and provide incentives for actually pursuing cases for legitimate fraud. Equivalent measures should be taken within the Justice Department as well.

Real Anti-Trust Enforcement in Financial Services

The megabanks we have today are not "too big to fail" -- they're too big to succeed. I made this point months ago (#1). In the panic of 2008 around Bear Sterns and Merrill Lynch, the idea that the shotgun marriages hastily arranged by the Federal Reserve and Treasury were actually compounding the larger problem by further concentrating assets into institutions that had already proven themselves unable to stay away form the dynamite didn't get much coverage. The idea is still out there, however. In so many words, Sheila Bair, head of the FDIC, said the same on the 60 Minutes program aired March 8, 2009. (#2)

I think taxpayers rightfully should ask, that if an institution has become so large that there is no alternative except for the taxpayers to provide support, should we allow so many institutions to exceed that kind of threshold?"

For a better picture of the degree of consolidation in the banking industry, check out the market share of banks in your area using this handy web form on the FDIC web site:


For virtually any geographic area selected, you'll find two or three banks each controlling between 8 to 29 percent of the market with roughly 30 other banks sharing what's left. A market share of even 29 percent share doesn't sound like much compared to other industries. However, when you consider that banking is pretty much a commodity function, that level of market share concentration produces opportunities to use leverage to boost short term profits which are -- by all facts in evidence -- irresistible.

Every bailout should be used as an opportunity to "right-size" the mega-banks back to manageable size. If taxpayer money is going to be used to provide an expanded margin of error to avoid panic in the system, that margin of error should be provided in the form of deals that allow assets to be offloaded to smaller regional banks. A new market share limit of maybe fifteen percent should be imposed going forward. Banks currently over the limit are free to continue to operate BUT:

1) absolutely no purchases of other banks will be permitted
2) any request for bailout assistance will force an auction of assets equal to the bailout to competitors to whittle down assets until the losing bank comes in below the cap

Legitimate Analysis of Automaker Bankruptcy Impacts

We are four months after the first round of dollars was thrown at GM and the other automakers yet not one day closer to any realistic plan for handling the impact of a bankruptcy of GM or Chrysler. The question everyone is asking isn't really "if" but "when." However, the real questions should be "how much" and "to whom?". Without a clear technical plan about the brands and specific product lines to survive, no practical analysis can be completed about plants likely to close or suppliers and dealers likely to be affected. Those plans cannot be made overnight but become more cataclysmic in scope as the firms continue burning through cash and poisoning customer confidence in their long term viability.

What all that really means is that any "rescue money" tossed at the automakers needs to be described for what it really is --- unemployment compensation to workers, healthcare subsidies for retired workers and stabilization money for communities with high concentrations of auto related jobs. From an economic standpoint, which alternative is preferable?

1) spend $30 billion to "rescue" GM to protect 70,000 assembly jobs and retirees
2) spend $30 billion on direct assistance to affected workers and retirees

Either way, it's $30 billion we don't actually have. However, option #1 funnels the $30 billion through a layer of incompetent, unimaginative executive management, thereby diluting the final impact and rewarding thousands of players who already pulled down more than their fare share in the glory years of $50,000 SUVs and $1.40 gasoline.

If the federal and state governments are bent on "helping" workers tossed out of work from auto makers, then pass legislation providing cash to bolster state unemployment funds, retraining programs and tuition assistance plans. Don't attempt to accomplish those same goals by passing the dollars first through the rotting management carcass of firms which are fundamentally unable to move transportation and manufacturing to the next level.

The auto industry debacle also poses a more theoretical question.

Tens of thousands of workers have been unceremoniously cashiered out of well paying jobs over the past twenty years, in some cases tempted by "guarantees" of healthcare coverage for life, only to find their employer later went bankrupt leaving them not only without a pension but without healthcare as well. A disastrous, retirement planning "oh-fer". No national effort was made to replace these workers' pensions or make up for promised but lost healthcare coverage. In the go-go, bubble driven economy, I'm not even sure any thought was even given to the topic.

If GM and Chrysler are truly headed to the bottom because of legacy pension and healthcare costs, exactly what qualifies auto workers and retirees for EXTRA pension and healthcare protections that have not been provided to former employees in other industries that hit hard times? This is a very hard nosed question and is not easy to ask knowing the situation facing these workers. Nonetheless, current auto workers and auto retirees are not the first to face this situation. Arguing for special financial treatment for these workers, by either trying to bail out a failed business model or providing direct benefits to these workers not provided to others makes no more sense than bailing out megabanks and their workers.


#1) http://watchingtheherd.blogspot.com/2008/09/too-big-to-succeed.html

#2) http://www.reuters.com/article/gc06/idUSTRE5256SB20090306

#3) http://www.msnbc.msn.com/id/29009555/

#4) http://money.cnn.com/2009/01/22/news/companies/madoff_tradingfiction/index.htm