B
Boyd
Guest
Swim with the Sharks but Risk Being Eaten Alive
July 28, 2007
Richard Benson is president of Specialty Finance Group, LLC , offering
diversified investment banking services.
Private companies that lend their own money are generally very careful
with their loan underwriting, and they know how to collect the money
they lend. Most reputable finance companies use simple accounting
procedures and have adequate loan reserves, and conservative financial
leverage. These firms generally understand derivatives and don't rely
on them to manufacture profits. They're not sharks.
This article is not about the private companies that use sound lending
practices. It's about the many big financial players, the giant hedge
funds, major money center banks, and Wall Street Investment banks.
These are the "Big Boy Sharks" who created $2 trillion in subprime
mortgages, using hubris and Gordon Gekkostyle greed, and have
recklessly used leverage and risk with other peoples' money to book
corporate profits. A typical example of this is the over-levered Bear
Stearns hedge funds investing in crappy mortgage securities that have
now left many investors scratching their heads while they search for
answers as to why their equity vanished overnight.
Are the codes of conduct being abused by the credit rating agencies
when they effectively "sell their souls" to rate untested mortgage
product in unproven financial structures? Should investors look
askance at the mono-line bond insurance companies that are backing
about $2 trillion dollars in asset-backed, mortgage-backed and other
securities? How else could the Big Boys get away with it?
To fully grasp the risk for the financial sector, it's important to
understand how finance companies make money. For finance, the greatest
profit engine of all time has been the ability to take advantage of a
positively sloped yield curve. Long-term interest rates are usually
significantly higher than short-term. If you borrow short and lend
long, you can make an interest spread of two percent on the 10-year
Treasury, with no credit risk at all. However, over the last year and
a half, the yield curve has been flat or inverted and the Fed Funds
rate of five and a quarter percent is actually above the 10-year
Treasury yield of five percent! This means that the greatest profit
engine for banks and finance is totally out of gas.
Another big profit engine for banks and finance is borrowing at a
highly rated credit rating, and investing at a lower credit rating.
The difference between the high rated cost of funds, and the lower
rated investment yield, is called the "credit spread." For the past
few years, credit spreads have set a new record for being the least
profitable ever recorded! A flat yield curve and narrow credit
spreads are usually a disaster for bank and finance company earnings.
You would think that the right time for finance companies to be
minting money is when the yield curve is steep and the credit spreads
are wide, not now during times like these.
So, why are the Big Boys still reporting record profits? It's actually
easy, with a combination of the following: 1) Taking on unprecedented
risk by exploding up the size of the balance sheet; 2) Adding massive
amounts of leverage, including hidden leverage through derivatives; 3)
Robbing loan loss reserves; and 4) Playing accounting games that allow
earnings to be booked today at the expense of losses tomorrow.
Included in the unprecedented risk category is when these same
financial firms switch to the foreign carry trade. Big carry trade
profits can be achieved by borrowing in a low interest rate foreign
currency (such as the Yen). As long as the Yen declines in value, a
fortune can be made borrowing below one percent interest, and
investing in U.S. financial assets yielding much more. However, this
trade is placed and highly leveraged and if the Yen ever goes up
against the dollar, the carry trade losses will make the subprime
fiasco appear like a minor footnote in history.
On-balance-sheet leverage has also reached new heights. If a financial
institution makes nothing on borrowing short and lending long (and
credit spreads are cut in half just to keep profits the same), the
firm will have to double its leverage, which means twice the risk!
Even so, the Big Boys have exploded the size of their balance sheets
and are funding massive positions in securities with short term
"repurchase agreements" in the money market. (Many of the securities
funded are just like those in the subprime mortgage hedge funds where
the security can't find a buyer who will make a bid in the market.)
These securities have value recorded on the balance sheet because a
trader or portfolio manager, with a fancy financial model, says they
have value, not because the market says they do. These balance sheets
are like sandwiches filled with hundreds of billions of dollars of
"mystery meat". This over-leveraged and frequently rotting meat is
something you really wouldn't want to eat. It smells.
Many lenders who have not adequately deducted loss reserves from
earnings for credit losses have, instead, goosed their earnings by
short-changing the loss reserves. These same lenders also continue to
reward their executives by paying them large bonuses and allowing them
to cash out their stock options. It's really all about booking a
profit today, and telling you about the losses tomorrow. In the
derivatives world, credit derivatives are the new new thing. Very
simply put, a credit derivative - known as a Credit Default Swap or
"CDS" - is when the insured pays a premium (like any insurance policy)
and if the credit goes belly up, the insurance pays off. Today, there
are tens of trillions of dollars in notional credit derivatives, and
all of the big players have become sharks with their use of these
derivatives.
For financial institutions, CDSs are a way of making a credit bet
(just like making a loan) without the inconvenience of putting any
real money up or having to place the loan on the balance sheet, that
would require equity. Indeed, there are now about 10 CDSs written for
each and every corporate bond that actually exists! That means that 90
percent of the business is pure speculation because it is not hedged
by someone who owns a bond or loan. Most of the CDS business is simply
a way for the Big Boys to place big bets with no money down. Remember,
if you own the stocks of big financial institutions, they are gambling
with your money.
Why is all this Big Boy betting going on? Just like the accounting for
subprime mortgages, the financial institution gets to value the
instrument they created. Accounting for derivatives allows both the
seller and buyer of the insurance to pretend that the financial
institution isn't gambling at all, as both get to book a profit!
The seller of the credit default insurance can claim "I know the
credit will never default; I can book the premium I collect as pure
profit and don't need to book a loss reserve." At the same time, the
buyer of the credit default insurance can claim "The credit will
default within a few years so I can amortize my profit, net of the
premium I paid, to my expected date of default."
The best analogy would be to picture watching a poker game and around
the table are the biggest Wall Street Sharks. A lot of chips are on
the table and depending on the accounting treatment used, each player
would claim to have won the entire pot even though the last cards have
yet to be dealt. The problem is, those cards will be dealt eventually
and someone is going to have to book a loss. In this type of poker
game, if you don't know who the patsy is, you're the patsy! A number
of investors in some big subprime mortgage hedge funds just found this
out.
The accounting treatment used in each credit default swap derivative
is, unfortunately, not the same. For each and every derivative, each
player gets to build their own fancy computer model and mark the value
of their credit default swaps, or similar securities, to the model.
Since the bonuses that the traders receive are based on what they show
to be their profit, human nature and a combination of hubris and greed
lead to massively over-optimistic and selfserving modeling, instead of
an honest value "mark to market".
Think sausages. We all know they taste great yet we don't dare ask how
they're made or what's in them. The major rating agencies and
accounting firms have been the helpful and highly paid facilitators in
the making of the sausage. Profits at the Big Boy houses look great,
too, at the end of the quarter but if you saw how these profits were
actually made, you might have reconsidered your investment. Don't
count on the accountants or rating agencies to even take a look, until
the Sharks have eaten and everyone sees the blood in the water.
For the past couple of years, 40 percent of profits in the S&P 500
have come from financing activities, and financial profits have a long
way to fall just to get back to historical averages. Remember, the
U.S. economy has been driven by the financial system which has created
an unprecedented level of debt. For those of you celebrating when the
Dow edged up toward 14,000 and the S&P 500 hit a new record high, you
may find the next celebration a long time coming. The recent stock
market slide is caused primarily by worries over credit quality and
excess leverage. The problems are just beginning.
The high level of risk in the financial sector is one major reason why
I buy gold and silver. Remember, these precious metals have no
accounting games attached to them. That gold coin in your hand won't
go bust and suddenly vanish into thin air!
July 28, 2007
Richard Benson is president of Specialty Finance Group, LLC , offering
diversified investment banking services.
Private companies that lend their own money are generally very careful
with their loan underwriting, and they know how to collect the money
they lend. Most reputable finance companies use simple accounting
procedures and have adequate loan reserves, and conservative financial
leverage. These firms generally understand derivatives and don't rely
on them to manufacture profits. They're not sharks.
This article is not about the private companies that use sound lending
practices. It's about the many big financial players, the giant hedge
funds, major money center banks, and Wall Street Investment banks.
These are the "Big Boy Sharks" who created $2 trillion in subprime
mortgages, using hubris and Gordon Gekkostyle greed, and have
recklessly used leverage and risk with other peoples' money to book
corporate profits. A typical example of this is the over-levered Bear
Stearns hedge funds investing in crappy mortgage securities that have
now left many investors scratching their heads while they search for
answers as to why their equity vanished overnight.
Are the codes of conduct being abused by the credit rating agencies
when they effectively "sell their souls" to rate untested mortgage
product in unproven financial structures? Should investors look
askance at the mono-line bond insurance companies that are backing
about $2 trillion dollars in asset-backed, mortgage-backed and other
securities? How else could the Big Boys get away with it?
To fully grasp the risk for the financial sector, it's important to
understand how finance companies make money. For finance, the greatest
profit engine of all time has been the ability to take advantage of a
positively sloped yield curve. Long-term interest rates are usually
significantly higher than short-term. If you borrow short and lend
long, you can make an interest spread of two percent on the 10-year
Treasury, with no credit risk at all. However, over the last year and
a half, the yield curve has been flat or inverted and the Fed Funds
rate of five and a quarter percent is actually above the 10-year
Treasury yield of five percent! This means that the greatest profit
engine for banks and finance is totally out of gas.
Another big profit engine for banks and finance is borrowing at a
highly rated credit rating, and investing at a lower credit rating.
The difference between the high rated cost of funds, and the lower
rated investment yield, is called the "credit spread." For the past
few years, credit spreads have set a new record for being the least
profitable ever recorded! A flat yield curve and narrow credit
spreads are usually a disaster for bank and finance company earnings.
You would think that the right time for finance companies to be
minting money is when the yield curve is steep and the credit spreads
are wide, not now during times like these.
So, why are the Big Boys still reporting record profits? It's actually
easy, with a combination of the following: 1) Taking on unprecedented
risk by exploding up the size of the balance sheet; 2) Adding massive
amounts of leverage, including hidden leverage through derivatives; 3)
Robbing loan loss reserves; and 4) Playing accounting games that allow
earnings to be booked today at the expense of losses tomorrow.
Included in the unprecedented risk category is when these same
financial firms switch to the foreign carry trade. Big carry trade
profits can be achieved by borrowing in a low interest rate foreign
currency (such as the Yen). As long as the Yen declines in value, a
fortune can be made borrowing below one percent interest, and
investing in U.S. financial assets yielding much more. However, this
trade is placed and highly leveraged and if the Yen ever goes up
against the dollar, the carry trade losses will make the subprime
fiasco appear like a minor footnote in history.
On-balance-sheet leverage has also reached new heights. If a financial
institution makes nothing on borrowing short and lending long (and
credit spreads are cut in half just to keep profits the same), the
firm will have to double its leverage, which means twice the risk!
Even so, the Big Boys have exploded the size of their balance sheets
and are funding massive positions in securities with short term
"repurchase agreements" in the money market. (Many of the securities
funded are just like those in the subprime mortgage hedge funds where
the security can't find a buyer who will make a bid in the market.)
These securities have value recorded on the balance sheet because a
trader or portfolio manager, with a fancy financial model, says they
have value, not because the market says they do. These balance sheets
are like sandwiches filled with hundreds of billions of dollars of
"mystery meat". This over-leveraged and frequently rotting meat is
something you really wouldn't want to eat. It smells.
Many lenders who have not adequately deducted loss reserves from
earnings for credit losses have, instead, goosed their earnings by
short-changing the loss reserves. These same lenders also continue to
reward their executives by paying them large bonuses and allowing them
to cash out their stock options. It's really all about booking a
profit today, and telling you about the losses tomorrow. In the
derivatives world, credit derivatives are the new new thing. Very
simply put, a credit derivative - known as a Credit Default Swap or
"CDS" - is when the insured pays a premium (like any insurance policy)
and if the credit goes belly up, the insurance pays off. Today, there
are tens of trillions of dollars in notional credit derivatives, and
all of the big players have become sharks with their use of these
derivatives.
For financial institutions, CDSs are a way of making a credit bet
(just like making a loan) without the inconvenience of putting any
real money up or having to place the loan on the balance sheet, that
would require equity. Indeed, there are now about 10 CDSs written for
each and every corporate bond that actually exists! That means that 90
percent of the business is pure speculation because it is not hedged
by someone who owns a bond or loan. Most of the CDS business is simply
a way for the Big Boys to place big bets with no money down. Remember,
if you own the stocks of big financial institutions, they are gambling
with your money.
Why is all this Big Boy betting going on? Just like the accounting for
subprime mortgages, the financial institution gets to value the
instrument they created. Accounting for derivatives allows both the
seller and buyer of the insurance to pretend that the financial
institution isn't gambling at all, as both get to book a profit!
The seller of the credit default insurance can claim "I know the
credit will never default; I can book the premium I collect as pure
profit and don't need to book a loss reserve." At the same time, the
buyer of the credit default insurance can claim "The credit will
default within a few years so I can amortize my profit, net of the
premium I paid, to my expected date of default."
The best analogy would be to picture watching a poker game and around
the table are the biggest Wall Street Sharks. A lot of chips are on
the table and depending on the accounting treatment used, each player
would claim to have won the entire pot even though the last cards have
yet to be dealt. The problem is, those cards will be dealt eventually
and someone is going to have to book a loss. In this type of poker
game, if you don't know who the patsy is, you're the patsy! A number
of investors in some big subprime mortgage hedge funds just found this
out.
The accounting treatment used in each credit default swap derivative
is, unfortunately, not the same. For each and every derivative, each
player gets to build their own fancy computer model and mark the value
of their credit default swaps, or similar securities, to the model.
Since the bonuses that the traders receive are based on what they show
to be their profit, human nature and a combination of hubris and greed
lead to massively over-optimistic and selfserving modeling, instead of
an honest value "mark to market".
Think sausages. We all know they taste great yet we don't dare ask how
they're made or what's in them. The major rating agencies and
accounting firms have been the helpful and highly paid facilitators in
the making of the sausage. Profits at the Big Boy houses look great,
too, at the end of the quarter but if you saw how these profits were
actually made, you might have reconsidered your investment. Don't
count on the accountants or rating agencies to even take a look, until
the Sharks have eaten and everyone sees the blood in the water.
For the past couple of years, 40 percent of profits in the S&P 500
have come from financing activities, and financial profits have a long
way to fall just to get back to historical averages. Remember, the
U.S. economy has been driven by the financial system which has created
an unprecedented level of debt. For those of you celebrating when the
Dow edged up toward 14,000 and the S&P 500 hit a new record high, you
may find the next celebration a long time coming. The recent stock
market slide is caused primarily by worries over credit quality and
excess leverage. The problems are just beginning.
The high level of risk in the financial sector is one major reason why
I buy gold and silver. Remember, these precious metals have no
accounting games attached to them. That gold coin in your hand won't
go bust and suddenly vanish into thin air!
