Starr CEO Greenberg Wins Against the Lawless and Discriminating Feds

The Federal Claims Court today ruled in favor of Starr International Company, the largest shareholder of AIG, against the Federal government's treatment of AIG during the "Lehman Weekend" and its unprecedented, claimed illegal extraction of equity in exchange for an $85 billion rescue loan.  No damages were awarded, and though that outcome seems inconceivable, Judge Wheeler's logic had some very weak merit.

 It is a clean, well written opinion, in which the text's many pithy sentences speak for themselves:

• "This sizable loan would keep AIG afloat and avoid bankruptcy, but the punitive terms of the loan were unprecedented and triggered this lawsuit." 
• "Operating as a monopolistic lender of last resort, the Board of Governors imposed a 12 percent interest rate on AIG, much higher than the 3.25 to 3.5 percent interest rates offered to other troubled financial institutions such as Citibank and Morgan Stanley. Moreover, the Board of Governors imposed a draconian requirement to take 79.9 percent equity ownership in AIG as a condition of the loan. Although it is common in corporate lending for a borrower to post its assets as collateral for a loan, here, the 79.9 percent equity taking of AIG ownership was much different. More than just collateral, the Government would retain its ownership interest in AIG even after AIG had repaid the loan. 
• The weight of the evidence demonstrates that the Government treated AIG much more harshly than other institutions in need of financial assistance. In September 2008, AIG’s international insurance subsidiaries were thriving and profitable, but its Financial Products Division experienced a severe liquidity shortage due to the collapse of the housing market. Other major institutions, such as Morgan Stanley, Goldman Sachs, and Bank of America, encountered similar liquidity shortages. Thus, while the Government publicly singled out AIG as the poster child for causing the September 2008 economic crisis (Paulson, Tr. 1254-55), the evidence supports a conclusion that AIG actually was less responsible for the crisis than other major institutions.

Though the opinion doesn't recount the discussion, the mere association of an $85 billion loan facility to fund a relatively small Financial Products Division with an 80% stake in a holding company with extremely profitable insurance businesses defies logic; surely other arrangements for collateral pledges could have been made had the Feds decided not to put the gun to AIG's head.  

• The Government did not demand shareholder equity, high interest rates, or voting control of any entity except AIG. Indeed, with the exception of AIG, the Government has never demanded equity ownership from a borrower in the 75-year history of Section 13(3) of the Federal Reserve Act. 

The government is cited by Judge Wheeler as carefully orchestrating the taking of equity, installation of management, and overrunning of the company by its favored consultants without requiring a shareholder vote, and to maximize the benefit to AIG Financial Products Division counterparties, the taxpaying public and to the U.S. Treasury.  

On the fundamental issue of illegal extraction of value from AIG shareholders, the court found,

• "Having considered the entire record, the Court finds in Starr’s favor on the illegal exaction claim. With the approval of the Board of Governors, the Federal Reserve Bank of New York had the authority to serve as a lender of last resort under Section 13(3) of the Federal Reserve Act in a time of “unusual and exigent circumstances,” 12 U.S.C. § 343 (2006), and to establish an interest rate “fixed with a view of accommodating commerce and business,” 12 U.S.C. § 357. However, Section 13(3) did not authorize the Federal Reserve Bank to acquire a borrower’s equity as consideration for the loan. Although the Bank may exercise “all powers specifically granted by the provisions of this chapter and such incidental powers as shall be necessary to carry on the business of banking within the limitations prescribed by this chapter,” 12 U.S.C. § 341, this language does not authorize the taking of equity."

Oops.  While the smart folks at the Fed and the Treasury were working hard to save us from a thirties style depression (a red herring), they did manage to violate a fundamental statute of the Federal Reserve Act in the process.  However, when an enemy with unlimited time, funds and access to the court of public opinion comes gunning for you, surrender might be the lesser of two bad alternatives, and so the AIG board capitulated based on that logic. 

• In the end, the Achilles’ heel of Starr’s case is that, if not for the Government’s intervention, AIG would have filed for bankruptcy. In a bankruptcy proceeding, AIG’s shareholders would most likely have lost 100 percent of their stock value.

The last sentence threw me because I thought surely that the extremely profitable insurance businesses would have provided some real residual value to shareholders. However, state regulators which are charged with protecting policy holders at all costs, would have brought assets which supported those policies into their ambit through existing state insurance regulations, as well as through other protections.  

In some ways, Starr and Mr. Greenberg are to be congratulated for using their slingshot against our own rapacious, selective prosecuting, and plundering financial regulatory Goliath.  Goliath has almost finished plundering the financial services sector for cash, and as it continues to selectively apply its novel legal theories to its enemies, perhaps other victims may stop and say "Basta!"  Let's see how Met Life does.  

Jamie Dimon's Extraordinary Shareholder Letter

JPMorgan Chase CEO Jamie Dimon has channeled Warren Buffett in his most recent letter to shareholders.  As readers of this blog know, Warren Buffett's letters are on my required reading list, and I have always recommended them to friends, colleagues and students.

Based on his long track record of success in financial services, which I began following during his tenure at Bank One, Jamie Dimon is required listening.  As CEO of one of our nation's Big 4 banks, he was in the eye of the hurricane during the financial crisis, has been pummeled during the political piling on post-crisis, and has now almost completed steering JPMorgan Chase into calmer, post-crisis waters.  There's a lot to learn about his view of finance and the role of JPMorgan Chase in this letter, but there are some real questions that remain for investors, as there should be if there is real content in the piece.

The CEO's Principles for Running A Business

• Especially for a cyclical, highly regulated business which is periodically subject to massive, systemic crises, it's essential to build the company into an "endgame winner." Through the work of his team and those of his predecessors over 30 years, he believes JPMC is in that elite group.
• Compare yourself against your best competitor is each of your businesses, and a convenient chart shows how that comparison looks.  
• A good company doesn't use cycles as an excuse. He is committed to earning competitive margins over the full cycle, whatever its characteristics, while still investing in the businesses and without taking extraordinary risks.  
• A good company, while always investing in its businesses, is always eliminating superfluous waste.  This has been a consistent theme going back to CC and to Bank One. It is also more nuanced and sensible than the somewhat comical and ultimately misguided "reusing paper clips" memos coming out of Bear Stearns.
• Some expenses thought by others to be excessive are in fact essential to achieving the endgame goals: it is something I have lived through myself as a CFO, and I really like seeing this laid out in specifics, i.e. the Retail National Sales Conference for JPM's top 5% producers. CEO Dimon has been to every one going back to Columbus, OH and Bank One.  You can tell I especially like this one, because what matters for a successful company is ultimately what employees think, which informs how they behave. 

As Regulators Sandpaper Away at Big Banks, Who Needs Them?

• Economies of brand name, scale, operation, and technology are important in a global financial services business.  Taking them away, by separating companies, will not be efficient for shareholders and it will leave customers looking for a competitor which can supply exactly what JPMorgan Chase has put together. 
• The CEO uses the example of Commercial Banking which is now 35% of the U.S. Investment Banking business. Out of 20,000 Corporate and Middle Market Banking clients, JPM supplies global banking services--cash management, treasury, currency trading, hedging, and mergers and acquisitions--to some 2,500 of these companies.  With normalized future growth and natural consolidation of customers, these opportunities will grow and become more valuable. 
• The Private Bank, because of the asset base and diverse financial interests will always benefit customers and attract prospects through scale. Right now, through the expanded system there are $190 billion in deposits in the Private Bank system alone. Globally, 2,300 families had assets of $1 billion or more, and as a group they represent over $7 trillion in assets. Having a system that routinely moves $6 trillion in daily funds worldwide gives Morgan bankers credibility with customers.
• In a liquidity or other banking crisis in the future, banks need to keep lending, and especially the Big 4 and beyond. Statistics in the letter talk about how much credit was rolled over to small and medium sized businesses, large customers, state and local governments and to hospitals and nonprofits. As the CEO rightly points out, non-bank entities would not be in this position in the next crisis, the character of which he alludes to in a few, unrelated paragraphs.

What About the Share Price Lagging Peers

• The CEO won't be driven by goosing earnings or short-term performance by pulling easy levers. (see the principles in how to run a business)
• JPM's price-earnings ratio is lower than peers, he says, due to large levels of legal and regulatory settlements, and to uncertainty about future settlements.  This may be true, but it's a bit hard to understand given some of the issues surrounding Bank of America, for example. 
• Stay focused on what you can control.

What Happens in the Next Crisis for Liquidity?

• More high quality capital is on the books than at any time in its history.
• Compensation levels would be adjusted immediately.
• Dividends would be cut or suspended, and share buybacks halted.
• In other words, the customers and businesses come first: a good recipe.

I'm not doing a full summary of the letter, but these are some of my highlights. What about a question or concern?  It goes back to the London Whale report. 

In the letter the CEO talks about learning a lot, and I am sure he is right. He also talks about many of the bad derivative products having gone away.  The culture described in that report seems totally at odds with what would seem to be espoused by this CEO.  How did it get that way?  Are all the bad actors gone?  There is a reference to "fortress controls."  I think that's just a marketing slogan.  They are neither feasible nor necessary: mistakes will happen, bad trades will be made, and earnings will take a hit, but all of these should be ring-fenced, bounded and fixed quickly.  That is not the company described in the London Whale report.

The CEO does make a reference to consistently espousing the principles in the letter during the year and to audiences in different settings. This could be a big deal.  The question is: who's in the audience? The same folks as before, with religion now?  

I go back to Bill Belichick's adage, "Just Do Your Job!"  CEO Dimon needs to be surrounded by leaders who knowledgeably sit over their global operations moving $6 trillion daily and who can truthfully and with confidence say, "No storms on the horizon" if the CEO asks.  A related question is, of course, who can step into Jamie Dimon's shoes if illness or factors require a successor to step in? 

Having a behemoth of a company so dependent on the acumen, drive and leadership of one person isn't the most risk optimal way of looking at the future: just a thought. 

Apple Pay on Your Apple Watch?

I forgot about the biggest head scratcher in thinking about Apple and what it really wants to be: Apple Pay.  There's nothing more profitable than a large payment network: just have a look at Visa, MasterCard, Discover and American Express.

Private label cards using the MasterCard or Visa networks are a wonderful business for their retail issuers, as research shows that they actually engender loyalty to the co-brander and, provided card users don't abuse their main card, the retail private label cards often get paid more consistently in times of financial difficulty for the card holder.

So, back to Apply Pay. Why?  Check out this link to the Apple Pay site. Look in particular at the picture that goes with this text:
"Apple Watch
 Double-click to pay and go. You can pay with Apple Watch — just double‑click the button next to  the Digital Crown and hold the face of your Apple Watch near the contactless reader. A gentle pulse  and beep confirm that your payment information was sent."

So, in order to save yourself the trouble of scanning the magnetic stripe or reading a security chip on a Bank of America card (pictured on the site), you are going to press a button on a screen which most people can barely read in order to save yourself a second or two, so your funds are debited faster? This physical action is exactly what I have to do on my old digital watches in order to change the modes: it's an awful movement, and in the case of the old watches, sometimes you have to press twice to engage the electronics properly.  The Apple consumer with a $500 watch gets her kicks out of this?

So, again, Apple wants a piece of the action from the big payment networks?  A company with a $700 billion capitalization is wasting its time doing this?

Meanwhile, MasterCard and Silicon Valley Bank have launched their own VC type effort to help entrepreneurial companies interested in setting up their own payment networks to profit from MasterCard's expertise on security and scale up strategies. The beauty of this effort is that MasterCard keeps tabs on what's out there, Silicon Valley Bank eventually gets a lending relationship with lots of warrants, and if successful, MasterCard buys new business.  Meanwhile, what will Apple Pay be doing?  Probably floundering around.

Much as I dislike the monopolistic payment networks whose interchange fees are still monstrously expensive given their economies of scale, it is good to deal with them when there are illegal or problem transactions on the card.  Because of bank and credit card industry regulations, it is easy to get problems on the record, with documentation, and eventually resolved, almost always to the consumer's satisfaction.

If Apple Pay were ever to become a significant enterprise, can you imagine contacting their customer support?  Who would they be?  Where would they be?  That organization would probably be as consumer friendly as Comcast.  What business is Apple in?  I think everyone knows.  Going forward, it may not be so clear, probably to the detriment of returns relative to the past decade.

JP Morgan Looks Like It's Positioned Well

Let's think back to the beginning of Bob Paulson's plan to save the global banking sector from itself, when the nine CEOs were invited to sign the famous one page deal injecting $250 billion of taxpayer money into their banks. On top of that, Wells absorbed Wachovia, JP Morgan absorbed WAMU, and Bank of America absorbed Merrill Lynch.  WWE-style chest thumping and outrage was shown by most of the participants, except by JP Morgan CEO Jamie Dimon, according to the newspaper. He apparently did the cost of capital calculation in his head and saw the Feds as a cheap source of funds.

Fast forward and we've concluded with the Feds now raiding the JP Morgan treasury for some $30 billion in fines for originating and selling bad mortgages to the GSEs and for not blowing the whistle on the Madoff Ponzi scheme.

So the fourth quarter of 2013 capped a pretty miserable year compared to 2012, but the fourth quarter showed all the signs of the bank being well positioned for an improving U.S. and global economy and for the concomitant steepening of the yield curve.

On a managed basis, 2013 corporate revenue of $99.8 billion was flat with 2012 revenue.  Reported, diluted EPS of $1.30 was down compared to $1.39 in the prior year, on the same basis.  However, excluding extraordinary items, 2013 diluted EPS was $1.40.  During this long waiting period for the economy to show a lasting rebound, banks like Morgan and Wells have been pulling out all the stops to generate some semblance of earnings stability.  JP Morgan has taken allowances into income in prior quarters, to the consternation of some analysts, but based on some of the underlying trends in credit cards, business loans, mortgages and deposits, the turn may be coming.

JP Morgan's efforts to position the bank for an economic rebound look like they've put the bank in a strong position,

JP Morgan's Consumer and Community Banking business now serves 43% of U.S. households, and its increased penetration has most certainly been helped by the acquisition and build-out of the old Washington Mutual branches.  What seemed like poison at the time may turn out to be honey for the shareholders. The base of 5,600 or so branches will not be expanded in the near-term as much as it will be reshaped and optimized for better productivity.

The CaCB business grew deposits in the fourth quarter of 2013 to $461 billion compared to $426 billion in the prior-year period, a solid 8% increase.  Allowances for loan losses, non-performing assets, and the net charge-off rates are all down year-over-year in the quarter, and its looks like the charge-off rates are near historic lows.

Fourth quarter 2013 provision for credit losses was $72 million, compared to $1.1 billion in the fourth quarter of 2012, a decline of 93%; the full year provision for Consumer and Community Banking declined similarly to $335 million compared to $3.8 billion in 2012.

The Mortgage Banking business, to no one's surprise, fell out of bed.  Full year 2013 net revenue of $10 billion was down 28% from 2012 revenue of $14 billion.  Provisions for credit losses benefited 2013 pre-tax income by $2.7 billion compared to a benefit of $0.5 billion in 2012. Non-interest expense declined 17% for the full year, driven by the large headcount reductions. Net income of $3.1 billion declined only 8% in 2013, year-over-year.

Mortgage production revenue was down 78% in the fourth quarter, and 54% for 2013, yielding $2.7 billion in production revenue.  According to a slide in a recent analyst presentation deck, the current mortgage underwriting standards look pretty strict, with average FICO scores of around 750+.

The credit card, merchant services and auto businesses had good solid quarters, and delinquencies on the card portfolio have been on a ski slope downward and the portfolio has been cleaned up.

A slide talking about earnings sensitivity to a rising rate environment back in June 2013 modeled earnings gains of $2.1 billion and $3.8 billion, respectively, from a 100 basis point and 200 basis point parallel shift in the yield curve.

The investment bank made gains in various underwriting segments, and the compensation levels ended the year so as to give opportunity should the global IPO and acquisitions cycles continue to heat up.

The one truly eye-watering item was the prevalence and magnitude of the legal expenses all over the financial statements.  The "Other Expense" category for 2013 showed expense of $19,761 million compared to $14,032 million in 2012.  Of these amounts, legal expenses comprised $11 billion (56%) in 2013 and $5 billion (36%) in 2012.

Legal expenses are also buried in some of the mortgage production operation results.  I couldn't follow the CFO's rapid fire presentation about reserves for litigation, but it sounded like large amounts. Because she is a British physics major by training, she has real command of numbers and of the Basel and mark-to-market modelling issues.  The speed of her delivery made me think of the classic Fed Ex commercials.

Revenue Growth: A Challenge for Banks

This is a big earnings reporting week for the Big Banks, starting tomorrow. The folks at Credit Suisse are relatively positive on the big banks, although their overriding comment for the sector is that revenue growth will be very challenging.

Even more ironically, their favorite idea based on earnings exposure to emerging markets and relative valuation is Citigroup. Now remember that former CEO Vikram Pandit was drummed out of his position because his strategy was not engendering a turnaround fast enough.  Never mind that possibly apart from Bank of America, no other global mega-bank had been as badly managed for decades.  It appears from reading the CS analysts their bullish case on Citi is based on developments that really had been the core of Mr. Pandit's presentation from the beginning.

It should be an interesting week for financial stocks.

Redrafting Goldman's Business Principle #1

As we noted in a previous post, the first business principle of Goldman Sachs per its own disclosure is.

"Our clients’ interests always come first. 

Our experience shows that if we 

serve our clients well, our own 

success will follow."

I thought I would take a shot at redrafting this platitude into something meaningful: here goes.  

The interests of every client always come first.

Our clients want to acquire or dispose of assets in order to achieve their financial goals.  We stand ready to help them by acting as their agents in the marketplace for real and financial assets.  Where a suitable financial instrument doesn't exist to achieve their goals, we will work with our clients to create a unique financial structure which does achieve their goal, for which we will earn fees and commissions for our expertise and our market relationships. However, we will always be open and transparent about how we earn our money and about how our interests are aligned with those of our clients.  

In a global financial marketplace, conflicts of interest will inevitably arise between those of Goldman Sachs, Inc. and those of our clients.  We will explain and disclose these potential conflicts when we write a client's business. The culture of our firm does not countenance treating bigger clients differently.  It also does not countenance writing a piece of client business and then pro-actively betting against our client's interest for the benefit of our business.  

While this ethical principle may cost us some business in the short run, if our clients achieve their goals and sustain their relationships with us, experience shows us that our firm and its shareholders will be amply rewarded. 

It's longer, but it does go out on a limb and say something. You may have surmised that this kind of required corporate disclosure is probably meaningless for institutions like Goldman Sachs, Deutsche Bank, the old Lehman Brothers and others.  Hence, Goldman's attorneys crafted their initial formulation: it gets the job done by checking the box for disclosure, and it doesn't impact the business. 

Senator Carl Levin's sub-committee produced a 645 page report on "Wall Street and the Financial Crisis."  It's interesting how the Goldman narrative in this doorstop of a report fits the contours of the Tourre prosecution.  A long chapter is entitled, "How Goldman Created and Failed to Manage Conflicts of Interest in its Securitization Activities."

Goldman went out of its way to "assist a favored client (John A. Paulson) make a $1 billion gain, and profit at the direct expense of the clients that invested in the Goldman CDOs." 

As we noted in our earlier post, "Paulson had a very negative view of the mortgage market which was publicly known...." 

Despite this statement, the chapter goes on to say, "Laura Schwartz (of ACA) was "unaware of Paulson's economic interest in the CDO."  So, the entire multi-billion ABACUS CDO subterfuge rests at the feet of Fabrice Tourre.  Don't get a stitch in your side from laughing: I did. Thanks, Senator Levin. 

Tourre, Goldman Sachs and Corporate Ethics: Nothing Has Changed

So, the financial crisis has past, we've prosecuted the first and only face from the crisis in Farbrice Tourre, and lots more ink is wasted on corporate disclosures.

Have financial markets become more fair, efficient and transparent?  No.

Have additional financial disclosures spread the antiseptic of sunshine into dark corners of corporate behavior so that abuses of the past are precluded for the future?  No.

Have the bad guys been made to pay where it hurts, and are they pariahs in their own country clubs? No.

Fabrice Tourre has been successfully prosecuted for "for making materially misleading statements and omissions in connection with a synthetic collateralized debt obligation (“CDO”) GS&Co structured and marketed to investors." No C-suite executives from Goldman, Sachs and Company, which created and sold the product have been prosecuted.  So, who is Fabrice Tourre?

According to the complaint, "Tourre was principally responsible for ABACUS 2007-AC1. Tourre devised the transaction, prepared the marketing materials and communicated directly with investors."

This is absolutely inconceivable in any kind of factual reality.  Were it true, his bonus would have been multiples of the already excessive $1 million or so that he earned.  Goldman had done enough of these deals well before Mr. Tourre's joining so that there was nothing for him to "devise."  When John Paulson approached Goldman to structure the equity tranche of the ABACUS 2007-AC1 CDO for him and offered to pay Goldman $15 million in fees, you can bet that he never spoke to, or heard of, Fabrice Tourre.  So, this part of the accusation is pure prosecutorial fiction, setting up a fall guy.

So, if devising the transaction was a fiction, what did Mr. Tourre actually do?  The closes thing to a tangible accusation is ,"Tourre had primary responsibility for preparing the term sheet and flip book." Note that word, "primary," which is not "sole."  In other words, he constructed a term sheet based on the text and boilerplate provided to him by lawyers and sales traders. Mr. Tourre can read, and he can cut and paste text. Also, he employed the PowerPoint he learned in university to produced a slide presentation in a flip book format.  Since his were the only personal emails from Goldman presented during the trial, all we know is that Mr. Tourre became delusional enough to believe that he was a player rather than a cog in the powerful CDO machine.

Mr. Tourre's legal costs were paid for by his former employer, and his role will soon be forgotten, as were the roles of Howard Rubin, Joe Jett, Jerome Kerviel and other traders in past financial crises. He will rehabilitate himself as a PhD. economist from the University of Chicago; I would guess that his thesis title might be, "Adverse Selection: The Behavioral Economics of Constructing Equity Tranches of Synthetic CDOs."  All will be well.

What was the nature of the misleading statements that Mr. Tourre made about the ABACUS deal? ACA Capital, hired as a "Portfolio Selection Agent," was to select the reference securities for the equity tranche that would produce a security with the appropriate risk-reward profile that Goldman's client John Paulson hired the firm to produce and market. Through a lot of fog and innuendo, Ms. Schwartz thought that Paulson's firm was long the equity tranche and would not have rated the deal had they known that Paulson was short.  In the case of ABACUS, ACA and Laura Schwartz were apparently duped by the earnest neophyte Mr. Tourre who made representations that Paulson's money was long the equity tranche.  This is probably nothing more than Mr. Tourre overreaching, trying to ingratiate himself and revealing his total lack of understanding of the deal's players.

According to the complaint,

"Had ACA been aware that Paulson was taking a short position against the CDO, ACA would have been reluctant to allow Paulson to occupy an influential role in the selection of the reference portfolio because it would present serious reputational risk to ACA, which was in effect endorsing (very much akin to a rating agency) the reference portfolio. In fact, it is unlikely that ACA would have served as portfolio selection agent had it known that Paulson was taking a significant short position instead of a long equity stake in ABACUS 2007-AC1"

This is totally laughable.  Anyone who even scans the business section of a newspaper would know that Mr. Paulson was broadcasting to anyone who would cover his story, his pessimism about the housing market bubble and how it could only end badly.  A person with the experience of Ms. Schwartz and ACA would never accept the contrary thesis on the basis of an email from a minor league player like Mr. Tourre.  With so much money at stake, either Ms. Schwartz or a principal of ACA Capital would surely just have called Mr. Paulson himself.

In the end, the verdict on Mr. Tourre was, in the words of jurors interviewed by the New York Times about "Wall Street greed," which had gone unpunished because no CEOs had gone to jail.  So, Mr. Tourre takes the fall, with an air mattress underneath him.

With all the ballyhooed academic legal writing about improved corporate governance and disclosure, let's read from Goldman's own published principles for running its business.  Here is Principle No. 1,

Our clients’ interests always come first. 

Our experience shows that if we 

serve our clients well, our own 

success will follow.

This isn't a principle, but a platitude.  Let's try and apply this in the case of ABACUS.  John Paulson and his hedge fund must have been such a client, because he came specifically came to Goldman to design an equity CDO tranche in which he could place the kind of bet for he was widely known to anyone with a pulse. Goldman took a $15 million fee and presumably took a fiduciary interest in Paulson's project.

A deal isn't a deal unless it is sold in the market place, and ABACUS couldn't be sold unless it had the "brand equity" of ACA as Selection Agent for the reference securities in the equity tranche.  If ACA Capital took the other side from Paulson, then they shouldn't be bailed out for being stupid.  Being stupid is not a violation of the securities laws, but perhaps it should be.

Goldman itself took some losses from the selling of swaps to Paulson, which is a bit hard to understand, but it appears that the market froze up on them before they could net out their exposure. So, Goldman takes the other side of Paulson's transaction, which is a service and arguably consistent with their principle that the client's interest comes first. Goldman also takes a bath, net of fees paid upfront.

What about the other big suckers in the deal?   German bank IKB Deutsche and Dutch bank ING.  But, they bought into what they thought was a AAA tranche at a time when the housing market fissures were about to explode.  These are sophisticated investors: what additional protections do they need which they themselves cannot demand from the marketplace?

Goldman, which itself came to see the wisdom in the positions of their client John A. Paulson, soon began trading against the very CDO instruments coming out of the other side of the sausage factory. Does this represent putting "clients first?"  Or, is it just legitimate proprietary trading?   But, isn't it based on material non-public information and communications coming from contacts with Mr. Paulson, the client?

The complaint cites this communication from an employee of John Paulson's hedge fund,

“It is true that the market is not pricing the subprime RMBS wipeout scenario.
In my opinion this situation is due to the fact that rating agencies, CDO
managers and underwriters have all the incentives to keep the game going,
while ‘real money’ investors have neither the analytical tools nor the
institutional framework to take action before the losses that one could
anticipate based [on] the ‘news’ available everywhere are actually realized.” 

This about sums things up.  The second sentence reprises Charles Prince's statement that as long as the music is playing, you have to keep dancing.  Rating agencies (like Moody's and ACA in this case), CDO managers and underwriters (like Goldman and Lehman) have all the incentives to keep the music playing.  Investors like IKB Deutsche and ING are too lazy or not smart enough to tease out the market's truth from publicly available information.

So, Fabrice Tourre is guilty of making misleading statements.  His bosses, who are the managers and underwriters and who hire the rating agencies, escape any prosecution and pay fines with shareholders' money.  Disclosures give no guidance about present or future behavior.  Nothing has changed, save for some intra-system transfer of funds, and life goes on.

Government's Abuse of Eminent Domain: Richmond, California Grabs Current Residential Mortgages

When we wrote about this issue over a year ago, most observers dismissed governments using eminent domain to seize residential mortgages as a tempest in a teapot. Instead, the whole issue has come to the fore in the summer doldrums, just before the coming September Congressional confrontations about sequesters, the budget and debt limits which will really color the 2014 election cycles.  Naturally, the first front has been opened in California, home to one of the biggest pots of electoral and popular votes.

On August 7th, Bank of New York Mellon filed a motion for Declaratory and Injunctive Relief against the City of Richmond, California.  Here's a link to the complaint.

BNYM calls this "a case about the misuse of public power for private benefit," which in effect "rents out" the City's powers of eminent domain for the private profit of Mortgage Resolution Partners, a for-profit group masquerading as a community action group and funded by well heeled investment banks like Evercore Partners, which was founded by former Clinton administration staffer Roger Altman, who is also a major fundraiser for President Obama.

The "Seizure Program" will purchase mortgages, including current mortgages, at deep discounts to fair market value, refinance the mortgages for the existing homeowners, while generating fees for the City of Richmond and its financiers.  The financing investment banks will receive the Federal guarantees for the new mortgages, which will then be packaged and sold, the big paydays for the investment banks.

The trusts which now own the seized mortgages will take their hit, as will investors in pension plans and mutual funds which own MBS.  So in part, this is a government sponsored transfer of wealth from one set of investors, public and private, to a selected set of private investors.

As the complaint states, "...the Seizure Program actually targets performing loans and does nothing to help homes in foreclosure."  Yet, slide presentations attached as exhibits trumpet the community action nature of the program to save the City of Richmond money by forestalling expensive foreclosures while keeping people in their homes.  Well, if the homeowners are current, they were staying in their homes anyway.  The propaganda would make a Russian blush.

The document says the the city has offered to initially purchase 624 loans, 85% of which are not in any stage of foreclosure.  81% are current or have not received any notice of default.  90% of BNYM's 105 loans in this initial pool are not in any stage of foreclosure.

The relevant language of the Fifth Amendment reads, "...nor shall private property be taken for public use without just compensation."  As Professor Mary Ann Glendon of Harvard Law School points out, what began as a notion of the just compensation being solely for a public use became "silly putty" in the hands of the courts.  Glendon cites retired Supreme Court Justice Sandra Day O'Connor who wrote, "where the exercise of eminent domain power is rationally related to a conceivable public purpose, the Court has never held a compensated taking to be proscribed by the Public Use Clause."

"Keeping people in their homes," saving municipal funds and preserving jobs in the local community are all part of the propaganda for the Seizure Program, so MRP and its government enablers have thought this out well.  From as early as the 1790's however, jurists recognized that use of the eminent domain clause should never be used to generate "taking" schemes which merely transferred wealth from one group to another. Unfortunately, that is exactly what is coming down now as this scheme begins to be implemented.

Major fixed income investors like PIMCO and BlackRock have awakened out of their slumber, intoxicated and flush from the longest bond bull market in history, to protest the scam.

The stench has returned worse than before.



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Met Life Reports And More Thoughts on SIFI

I had been thinking about the FSOC process for designating non-banks as Systemically Important Financial Institutions (SIFI) for some time, and Met Life's potential designation as a SIFI stood out to me, which led to the post.  Since they just happened to have reported their second quarter results, I thought I should go over them quickly to see how they tie to some of the points at issue.

The CEO noted that Met Life is in stage three of the process for being designated a SIFI.  He pointed out that AIG and GE Capital had spent about seven months in stage 3 before being designated as SIFI. Designation as such requires a two-thirds majority of the FSOC, including an affirmative vote from the Chair, who is the Secretary of the Treasury.  Met Life is in favor of prudential regulation of insurance companies, since they have lived under that kind of regime for their 140 year history; he does, however, want any additional layers of prudential or capital adequacy regulation to be suited to Met Life's insurance business model.

Non-GAAP operating income for the quarter was $1.624 billion, up 11%  over the prior-year period. The reported net income figure of $471 million was down dramatically compared to a reported net income of $2.264 billion in the prior-year period.  This was driven by a net derivatives loss in the current quarter of $1.69 billion ($1.1 billion after tax) compared to a net derivatives gain last year of $2.092 billion.

Met Life's derivatives portfolio exists to hedge the risks in their business lines and not as a profit center, as was the CIO at J.P. Morgan or at AIG.   About sixty percent of the derivative losses were attributable to the Americas portfolio, primarily the U.S.  The company's announced base case forecast, used for their stress tests in their 2012 10-K, showed the 10 yr Treasury rate at 2.58% at the second quarter of 2013, and it ended up at 2.6% compared to 1.69% at the end of 2012.   Average spreads on their product portfolio were projected to be 200-250 bp, and they ended the quarter at 244 bp.  Overall, there's nothing in their near-term performance versus outlook which suggests unanticipated risk in the next year or so.

Book value per share, excluding accumulated other comprehensive income and using actual shares outstanding, was $47.20 and $46.77 using the diluted share count. Overall the stock looks fairly valued on its outlook, and to their credit the management suggested that share buybacks were not a high priority in near-term plans for returning capital to shareholders. Most buyback programs, particularly in the tech sectors are sops to Wall Street and destructive of value.  Kudos to the CEO for stating his position clearly.

Overall, all of the business segments performed well, and as planned sales of variable annuity products dropped 40% over the prior-year period to $2.8 billion in the quarter, since this business is not a productive user of capital.

One small item, from the point of view of materiality, was a reference to a winding down of Met Life's business in Poland, as a result of changes in the previously privatized national pension system.  The CEO of AMEA noted changes coming in 2014, as a result of the government having to make emergency contributions to the plan assets.  Opponents of the 1999 privatization charge that the costs of the investment products and fees were exorbitant, where some of it surely has to do with plan design, benefit changes, and with economic trends.

GDP growth in Poland has been less than 1.1%, and the public deficit as a percent of GDP is at 4% versus the EU required target of 3%, which could trigger mandated EU austerity.  The system will likely be renationalized, according to local observers.  Met Life assets under management total around $7 billion, and all deferred acquisition expenses related to Met Life assets have been written off.

This company has been a quiet, perhaps sleepy performer which is in the midst of trying to unify and globalize its brand.  As such, some of their investor include value-oriented mutual fund operators like Dodge and Cox and Mass Financial Services.  From much of the conversation on the call, this process has a solid foundation, but is just beginning.

The Strange Situation of Met Life

The U.S. Financial Stability Council, yet another bureaucratic creature spawned by Dodd-Frank, recently moved Met Life to the final decision stage of being named a non-bank Systemically Important Financial Institution, or "SIFI."  Part of the booby prize for achieving this designation is a requirement to introduce something fuzzy called "contingent capital" into the firm's capital structure. G.E. Capital and AIG were just designated as non-bank SIFIs.

The Stern School's V-Lab ranks Met Life just behind Goldman Sachs in terms of its contribution to systemic risk from North American financial institutions.

I can't see any fundamental reasons Met Life should be put into the SIFI category.

Going back to the financial crisis that precipitated increased global financial regulation, it's interesting to look back at how the banking and insurance industries performed during the crisis.  According to an analysis of public company annual reports by Oliver Wyman, from 2007 until February 10, 2010, the cumulative global insurance industry credit losses totaled $271 billion, compared to $1,715 billion for the global banking sector.  Banking sector credit losses were over 6x those of the global insurance sector.

AIG alone accounted for 36% of the insurance sector's credit losses.  Yet, it wasn't anything in AIG's insurance businesses that precipitated the losses, but it was AIG's prop trading business and its outsized exposure to CDS.   Most insurance companies were able to absorb their losses on their balance sheets.

As a result of the crisis, the global insurance industry had to raise $170 billion of additional capital to shore up their capital structures, whereas the global banking industry had to raise $1,468 billion over the same period as above, a factor of 9x higher.  AIG accounted for 58% of the insurance sector's new capital raised, according to Oliver Wyman.

So, nothing in the experience of the great crisis suggests that the basic insurance company model would require heightened regulation or higher capital levels beyond Solvency II or Basel II's respective arcane requirements.

Met Life is the largest U.S. life insurer by assets, so it is a force to be reckoned with.  Met Life, according to Morningstar analyst Vincent Lui, chose to forgo TARP assistance, but it did take advantage of other Federal programs to strengthen its balance sheet post-crisis.

It raised $400 million from the Federal government for general corporate purposes, and it recapitalized with $2 billion in stock and more than $1 billion in debt.  The current debt/capital ratio is about 30%.

Under CEO Steve Kandarian, who joined Met Life at its Chief Investment Officer, the company has made a number of risk-reducing and potentially value-enhancing measures.  First, it gave up its bank charter, whose purpose had been to own a small deposit gathering function through which to cross-sell insurance and benefit programs.  Having sold this in 2013, Met Life was also freed from regulation by the Federal Reserve Bank.  Earlier, it had also sold its ownership in Stuyvesant Town, which removed the company from the risky and politically sensitive business of being a major landlord in New York city.

Getting to its core insurance business, the CEO has slowed the growth of Met Life's variable annuity business underwriting, and repriced the new business. In traditional products like universal life, it has also raised prices and reduced policy rates.  The variable annuity business might have been one reason to be concerned about the stability of Met Life, but this risk has been publicly recognized, the balance sheet strengthened, and the business growth tapered.

The company has made significant ventures into overseas markets.  In 2012, Met Life generated one third of its operating earnings from outside the U.S.  After its recent acquisition of ALICO from AIG, it operates in 45 countries, including Chile, India and Japan; before the ALICO acquisition foreign markets accounted for 17% of operating earnings.  Markets like Chile, the company says, are less price sensitive and customers are stickier than in developed markets where irrational pricing during underwriting cycles destroys profitability.  This move gives the company growth opportunities, margin expansion plays, and geographical diversification.

In the U.S. the company provides life insurance and other employee benefits to about 90% of the companies in the Fortune 500, according to Morningstar.  This business is also fairly sticky and not subject to underwriting cycles, as is traditional life sold to individual customers.

Over 80% of the investment portfolio are in fixed interest securities and mortgage loans.  The company operates in a highly regulated business overseen by state commissioners of insurance. Certainly if the Federal government were to decide to add Met Life to the systemically important list, it would add to policyholder costs and possibly restrict the availability of some products in some states.  When one looks at Met Life, the question is why does this company stand out among its peers for being riskier?

Of course, it is possible that the company becomes mismanaged under the current CEO, but given his initial moves as Chief Investment Officer and then as CEO, this would seem less than likely.  There is talk about raising the dividend and of buying back shares, which doesn't seem warranted where the stock is today.  This is a 140 year old company with a reputation for prudence, hopefully it reverts to its heritage.

Looking at this company through the lens of the British "twin peaks" regulatory model, the two questions would be (1) does the company's failure pose a substantial risk to the global financial system, and (2) would policy holders be protected in the event of a failure.  The answer to the first is "No," and the answer to the second is "Yes," because a supervisor in the event of an insurer failing is given much more latitude to protect policy holders from corporate assets or by sale to another solvent insurer.

Where have we lost the plot on financial regulation?  We are overrun with lawyers, both in our legislatures, government departments, and in private practice.  The British, by contrast, are probably overpopulated by people of an economic/philosophical bent.  One thing they have recognized about regulation is the benefit to keeping it simple.  The article by Andy Haldane, "The Dog and the Frisbee" makes the points well.