Archive for the 'Uncategorized' Category
July 2, 2008 9:41AM
By Elizabeth MacDonald
Before I get to the thunder bolts being thrown at oil speculators from Mount Washington–some of it a needed attempt at more transparency in oil trading–there’s more lazy thinking on the oil supply and demand front that ignores the bigger, macroeconomic factors at play.
Don’t let the facts get in the way of the narrative here, the thinking goes, don’t let the truth ruin a polluted stream of oil consciousness. I find the oil witch hunters a tedious, self-serving, unreflective and rather boring crowd. They are habitually self deceiving, and listening to their orgy of self-righteousness, I can feel my brains running out of my ears.
They tend to lead with their muscle and not with their minds, because it’s oh so much easier to get out the rakes and torches. Especially elected officials who find it easier to pass the blame buck in this political season, with scapegoats now in season, rather than make the tough legislative decisions to make energy affordable for cash-strapped American taxpayers hit with soaring costs for health care, college tuition, you name it.
Thinking about their daily struggle, I find myself constantly grinding my teeth into Tic Tacs on their behalf.
Now you’ll hear an attempt at a reasonable argument from the witch hunt theorists who say oil speculators are solely to blame for oil price spikes–which on closer look is just lazy spitballing that ignores what the pros are saying.
Trust me, I think oil speculators are partly to blame, but they are part of a much larger picture. I’ve said so repeatedly on camera and in prior blogs, based on my reporting–no one can say definitively and with any veracity how much oil prices have risen due to oil speculators. You’ll see estimates that are all over the map.
However, watch what the Paris-based International Energy Agency, the big oil industry think tank, just said about oil speculators, that there is “little evidence” that large investment flows into the oil futures market have sparked an imbalance between supply and demand and led to the surge in oil prices.
Or that the IEA specifically said that “money flows and speculation can have a day-to-day influence on prices, but it is not one that can be sustained for any length of time without a market imbalance being apparent,” adding in its report that ”the economy is impacted by fluctuations in spot oil prices, not futures prices.”
Or that the IEA says demand is to blame as demand for oil is rising, as it is still forecasting global consumption of oil products will increase 1.6% a year on average through 2013, largely due to demand from non-OECD countries, including China and India.
Or that the agency also says because oil production is slowing worldwide, that caused it to cut its outlook on global oil supply levels in production from the Organization of Petroleum Exporting Countries members and non-OPEC nations. The IEA also said that poor supply performance since 2004, combined with strong demand from the developing world, started to push prices higher.
Despite those facts, you’ll hear from the oil speculator witch hunt crowd that oil price spikes are not a supply and demand issue, because US gasoline reserves are at their highest levels since the early 1990s, laudable since the nation’s refineries like Valero (VLO) have been dialing back on their gas production as their margins have declined.
You’ll hear too from the oil speculator witch hunt crowd that there is no supply problem because average gasoline reserves on hand have risen since this past October, and the US oil stockpiles in this country have gone up nearly every week this year.
To wit, the argument is that because there’s more stockpiling going on, there’s no shortage of gasoline or oil in the U.S. today, because we have near-record reserves on hand.
You have just witnessed an advanced case of severe rectal cranial inversion.
What’s missing in this argument? The reason why countries stockpile and set up reserves to begin with: because countries are doing so in the face of rising demand or supply shocks.
Just as a publicly traded company books increasing cookie jar reserves to take care of future losses, (witness the financials now), so, too, do countries stockpile to protect against future rising costs and/or losses in oil supplies. Or in the face of growing demand. As China is now doing with its offline stockpiling so it won’t face embarrassing shortages during the summer Olympics in Beijing.
And as reserves rise, it’s the quality of the oil increasingly coming on-stream that has also helped oil prices go ballistic. There is a glut of sour crude, sulphurous grades that is way more expensive to refine than the sweeter crudes, now becoming increasingly rare, say oil traders and oil statisticians at the IEA.
Oil prices go up after Nigerian oil attacks because Nigeria pumps out light sweet crude that’s cheaper to refine, versus the sour grades swamping the markets, according to sources. The Sauds pumping more sour crude–when it has historically pumped sweet–is not a good sign for the markets. And has been taken as a negative, which is why oil futures have risen.
You can talk all you want about how gas reserves are at their highest levels. But if all the world has to refine is an increasing amount of sour crude, then listen to the oil pros and oil majors who say that going forward, you can expect a squeeze on those reserves. Which is why oil prices are going up.
“Refiners are paying record premiums for the high-quality crude oil they use to produce diesel and petrol, a sign of strong demand in the physical oil market that calls into question claims that soaring oil prices are being driven by speculators,” the Financial Times reports.
It’s a big reason why Valero Energy may sell one-third of its refinery operations due to poor margins in recent months.
You’ll also hear arguments from the Cotton Mathers in the oil-speculators-are-solely-to-blame crowd that this is not a demand issue, because demand in the US is flat-lining or expected to go down due to higher gas prices. The US is the world’s largest oil consumer with 20.7 mn barrels of oil consumed in the country daily (a quarter of the world’s consumption).
Now it’s true that the US government’s energy officials now expect US demand will be lower than had previously forecast due to the recent gas price surge. The IEA has predicted that global oil product demand in 2008 would grow by 0.9% or a teensy 800,000 barrels a day, with predictions that US demand would drop up to 2.5% this year, down to 20.3 mn barrels daily.
But yes and let’s sit on our couches with our remotes and Cheez Doodles (*(I love cheese doodles, the hard kind) and never go outside our own front door to see what else is going on in the world.
It’s expected that 1.8 bn new entrants will join the middle class next 12 years by 2010. The world’s middle class will grow to a staggering 52% of total world population, up from 30% now. That means increasing demand for gasoline.
Explosive middle class growth in formerly poor countries, such as China, Russia and the Middle East means they will consume more crude oil than the U.S., burning 20.67 mn barrels a day this year, an increase of 4.4%, according to the International Energy Agency in Paris.
Economic growth of more than 8% in China and India, coupled with increasing car ownership among the countries’ combined populations of 2.45 bn people, will more than compensate for falling U.S. demand, the IEA says. Oil use worldwide will increase 2% this year because of growth in emerging markets, the Paris-based IEA says.
China has a tiny 15 passenger cars for every 1,000 people–meaning it’s Japan circa 1963, when Japan had 13 cars per 1,000.
China has 1.6 bn people. Which is why the US automakers are saving themselves by piling into the Middle Kingdom. Which means gas consumption will soar in this country for decades to come.
Demand is rising everywhere. Last year Mideast’s six largest petroleum exporters, Saudi Arabia, United Arab Emirates, Iran, Kuwait Iraq and Qatar curbed output by 544,000 barrels a day. At the same time their domestic demand increased by 318,000 a day.
You’ll also hear arguments from the Pierre de Lancres of the oil speculator witch hunt crowd, that oil production is still moving apace, with some suggesting oil production is expected to increase by 3.3% in the second quarter, and by as much as 4.1% by the third quarter.
The game here is this: throw a dart at stats pasted to a barn door, with the game’s rules saying you get 1,546,789 tosses to hit the stat you like to suit your argument.
Officials at OPEC and the IEA say oil production is decreasing in 54 of the world’s top 60 oil producing nations, including the US which produces 5 mn barrels a day, down fm 11 mn in 1970. The overall amount of oil discovered has been falling for 40 years. Sadad al Husseini a former top executive at the state-owned oil company Saudi Aramco, says Saudi production already hit a peak and will begin dropping in 15 years or less.
I’m exhausted, there are more oil production stats I can give you, but I am getting bored.
Ok I’ll go on.
You’ll also see the argument from the witch hunters that all is well, that the U.S. daily buffer for oil production against demand, which was a paltry 1.5 million barrels as recently as 2005, is now up to 3 mn barrels in excess capacity today.
What’s missing here? A worldwide outlook-enough with the US-centric focus here. You need to compare the worldwide spare cushion to overall daily demand, and that comparison is terrifying.
The world’s spare capacity, the oil cushion as it were, has dwindled to just over 2 mn barrels per day with global demand at 86 mn barrels a day. That’s way down, by more than half, from 5 mn nine years ago vs 76 mn barrels consumed daily, says the U.S. Energy Information Administration. And again much of today’s surplus is sour crude, high in sulphur, which refiners loathe.
Don’t forget that the oil price spike story is a weak dollar story too.
David T. King, a former chief of the New York Federal Reserve’s Industrial Economies Division, noted on the editorial page of the Wall Street Journal earlier this year, when oil prices were at around $120, that last August the dollar price of oil was $70. King points out that the current spike in oil and other commodity prices coincides almost exactly with the Fed’s decision to turn on the monetary spigots to save Wall Street.
The day that the barrel price of oil in dollars was exactly the same as in Euros was in 2002, when both were about 25, King notes. Since then oil has risen by 50 Euros in the past five and a half years. It now stands at 75 Euros, triple what it was then.
But check this out: in the US, the price is over $120, about five times what it was then, King says. He says that the collapse of the dollar exchange rate explains at least half of the increase in the pump price of gas over the past five years.
The falling value of the dollar has caused the price of gasoline to soar. Gee that was hard to figure out wasn’t it?
I’ve said at the outset that speculators are adding to the price spikes, we just don’t know by how much. The hope is that more sunlight in their trades will help market watchdogs and regulators stop the torquing that goes on, especially when a hedge fund like Amaranth Advisers or a miscreant firm like Enron want to game the system.
Really?
NEXT UP: The regulatory blow torch aimed at oil speculators.
FOOTNOTE: After this story was published, the IEA released a report stating that supplies may not keep up with demand, noting that the growth in global spare capacity will peak at about 2.5 mn barrels daily in 2010, dropping to–watch out–less than a million a day for the ensuing three years. Crude oil prices hit a record in trading after hours on the report. Already the haymaker of inflation has come a cropper, due to oil price spikes.
July 1, 2008 1:36PM
By Elizabeth MacDonald
Americans now face sticker shock at the gas pump, as the average cost of gasoline veers towards $5 per gallon.
And that has oil speculators in the futures market now in the regulators’ bulls’ eye, as the price of crude has about doubled in a year. The spike has effectively vaporized the $140 bn in fiscal stimulus checks now in the mail.
Ignored here are some basic supply and demand facts. Nigeria is pumping about a third of the amount it was a few years ago. Russia has major oil infrastructure problems, same with the geriatric refineries in Iran, where the oil mullahs as well as Venezuela are delighted to stick it to the US and Europe.
Meanwhile, the Mideast, including Iran, as well as Venezuela, China, India, Malaysia and Indonesia, all shield their citizens from the full rise in oil prices with fuel subsidies. Together the countries that subsidize fuel account for half the world’s population and a quarter of the world’s fuel use, one report says.
And countries that subsidize their fuel account for all of the current demand growth, because demand in developed regions such as the US, Europe and Japan is either flat or contracting, as drivers feel the hit of unsubsidized fuel costs, a report says.
Another factor too: The world’s spare capacity, the oil cushion as it were, has dwindled to just over 2 mn barrels per day with global demand at 86 mn barrels a day.
That’s way down, by more than half, from 5 mn nine years ago, says the U.S. Energy Information Administration. And much of today’s surplus is sour crude, high in sulphur, which refiners loathe.
Shoddy and corrupt oil supply data, detrimental weather and ethanol mandates, all cause oil prices to gyrate too.
And a key driver is the strength of the US dollar. Since oil is traded in dollars, the plunging value of the US dollar likely has traders scrambling, as the amount earned from future oil sales may get slammed as the dollar loses real value.
However, oil speculators are now held solely to blame for price spikes. But they are not even largely to blame.
Think about it. As proof that oil price spikes match speculative investments, hedge fund manager Michael Masters told Congress recently that $240 bn sits in commodity index funds, up from $13 bn five years ago. Some have put that figure at $250 bn.
Paul Horsnell of Barclays Capital, an investment bank, puts the total value of index funds and other similar investments at $225 bn. Horsnell cheekily notes that figure is less than half the market capitalization of Exxon Mobil, but more importantly is a tiny fraction of the $50 trillion-odd of transactions in the oil markets each year.
The Commodity Futures Trading Commission says that some $5 tn worth of futures and options transaction flow through U.S. exchanges and clearing houses daily. Can that $225 bn to $250 bn in investments, a drop in this $5 tn ocean of money, really move prices?
But what happens in an oil futures trade?
No physical barrels of oil are traded. Instead, futures contracts exchange hands, which are essentially bets on the future direction of oil prices, often a year out or as long as eight years out. On the other side of the transaction sits a trader who bets oil is going down.
These trades are matched. If a big investor is buying oil futures contracts, on the other side is somebody willing to unload a lot of oil futures contracts to them. Airlines, trucking companies, any heavy user of oil use these futures contracts to lock in now their oil costs, in other words, by hedging their future oil costs. No barrels exchange hands.
But the fact is that if oil was really a speculative bubble, then the future forward contracts should be a lot higher. But they are not, the December 2016 is marked at $136 as well.
Those who do set the price of physical barrels look to the futures markets for a sense of where prices are headed, but mostly those prices are set by supply and demand.
Take note of the nearly 90% average price mining giant Rio Tinto disclosed in iron ore for its voracious customers in China to get a sense of what demand can do to commodities prices.
However, you may have seen the data from the Commodity Futures Trading Commission that showed speculators have increased their share of oil futures contracts in West Texas Intermediate crude on the NYMEX to 71% in April from 37% in 2000.
But that figure may be inflated due to double counting, as the CFTC says that 70% figure includes both long positions, or bets on a price gain, and short positions, or bets on a fall, held by swap dealers and speculators.
Moreover, swap dealers, because they tend to hedge their bets, have a virtually neutral position in the crude-oil markets, the CFTC has said, as they are almost equally long and short in the marketplace. Acting CFTC Chairman Walter Lukken said a large portion of those swaps deals would be for commercial businesses looking to hedge fuel costs, such as airlines.
Instead, the CFTC has said that speculators only make up about 30% of the market.
Should you blame the shorts and not the speculators? In June 2008, a report from oil analyst Theodore Butler notes that the spike in oil prices began when the credit crunch started in August 2007, primarily due to short sellers buying back futures contracts so as to cut their losses.
A run on contracts caused momentum trades in oil to spike the price higher, the thinking goes. Short sellers borrow a stock or in this case an oil futures contract from a broker and then sells it, in the hope of repurchasing that stock or contract later at a lower price.
Butler says that “index funds are holding the same size, or smaller, long positions in crude oil than they held 10 months ago, when crude oil was $70/barrel.” Butler adds that “the buying back of previously sold short futures contracts, primarily in the commercial category, account for the bulk of the buying over the past eight months or so.” Meaning last fall.
August 2007. Why should that date stick in your mind? What’s the action here? Why did the spike in oil prices begin, as Butler says, in August 2007?
Because it’s when the Federal Reserve opened the monetary taps to save Wall Street. Let’s go to the tape.
The inflation adjusted price of a barrel of crude oil traded on NYMEX generally stayed around under $25 a barrel up until 2003, much as it had the prior 20 years. In 2004 the price spiked above $50, a year later in August 2005 it topped $60, mid 2006 it briefly surpassed $75, dropped back to $60 a barrel in early 2007, then rose inexorably to $99.29 a barrel for December futures in New York on November 21, 2007.
This year alone has seen record oil prices, with oil now marching toward $150 a barrel. “The number of transactions involving oil futures on the New York Mercantile Exchange (NYMEX), the biggest market for oil, has almost tripled since 2004. That neatly mirrors a tripling of the price of oil over the same period” reports The Economist Magazine in May 2008.
Not surprisingly, the steady march upward in oil coincides with the steady plunge in the value of the dollar after the Fed opened the money spigots in August 2007 to rescue Wall Street.
Does the short action signal a potential strengthening of the dollar, has the jawboning lip service paid by Federal Reserve Chairman Ben Bernanke in a recent speech (not official policy yet, mind you, the strong dollar), worked its magic here to cause the futures markets to think oil prices will go down?
Still the regulators want to have their say. And indeed they are. Next: The regulators move in on oil speculators.
July 1, 2008 9:38AM
By Elizabeth MacDonald
More on the oil speculators in later blogs, I need to report the following to you first.
Michael Masters, principal and founder of the hedge fund firm Masters Capital Management LLC, achieved near rock star status after his recent testimony before Congress about the impact of oil speculators on oil prices.
The hedge fund manager said speculators are largely responsible for jacking up crude oil prices to new heights. A supposed Wall Street insider was finally coming clean, making for great sound bites. Masters reportedly said he is not currently involved in trading the commodities futures markets, that he is not representing any corporation or lobby group, but merely came forward as a concerned citizen.
Recently, the U.S. House of Representatives approved a bill directing the Commodity Futures Trading Commission to invoke emergency powers to “curb immediately the role of excessive speculation” in the oil futures market, partly due to his testimony.
Masters introduced in testimony the data point that some $250 bn has been invested in commodity index funds, up from $13 bn in 2003, a stat that’s used to argue oil speculators are causing prices to soar. How a hedge fund manager arrived at that $250 bn figure, and what data sources he used and how it was calculated, hasn’t been appropriately challenged. It may be right-it may be wrong.
And Masters, more than regular citizens, apparently has a lot of skin in the game when it comes to getting oil prices lower. Credit Greg Newton at Naked Shorts for diving into filings with the Securities and Exchange Commission to figure out what Masters’ hedge fund invests in.
Newton testified that he has been managing a long-short equity hedge fund for over 12 years and that he has extensive contacts on Wall Street and within the hedge fund community.
But Newton dug into the most recent Securities and Exchange Commission 13F-HR filings for Masters Capital and found that the hedge fund portfolio “is at least knee-deep levered long in US airline stocks and General Motors,” which is “doubtless contributing to Masters’ distress at crude oil prices.” Didn’t see that in testimony, did you?
As of March 30, Masters’ fund had call positions in AMR Corp (AMR), the parent of American Airlines, Delta Air Lines (DAL), General Motors (GM), UAL Corp., parent of United Airlines (UAUA) and US Airways (LCC). About 30% of his fund’s portfolio was in companies that feel the heat from oil price spikes. In the first three months of this year, says the total value of the portfolio declined 35 %, from $1.38 billion to $905 million. BusinessWeek has been on this story too.
Masters has since said that this math “way off,” in part because it did not account for offsetting positions, and other options and derivatives not reported on the SEC forms.
But more to Masters’ argument, that futures contracts cause oil price spikes. These are paper barrels, they are not physical barrels of oil. No oil supply is removed from the market in an oil futures trade. Instead, in commodities trading, when oil positions are being hedged, each contract has a buyer and a seller, so for every contract that says that prices are going up, the other side of the trade is essentially betting they are going down, offsetting the trade.
The question is, do the price setters in the markets look to futures prices to set the cost of oil per barrel? Of course they do-it’s likely why Saudi Arabia has threatened to keep their oil in the ground for the future generations.
But supply and demand matter more in setting oil futures prices, which in turn are used to set oil prices. More to the point, it is the shoddy information on forward supply and demand that is hurting the market. More on this in a future blog.
And recently, the country’s top energy analyst, Daniel Yergin, head of Cambridge Energy Research Associates, said in testimony before the Joint Economic Committee that when it comes to oil price spikes, history “demonstrates that changes of this scale and significance result not from a single cause, but rather from a confluence of factors.”
Yergin acknowledged that speculators have played a role in fueling oil price spikes, however, he said they largely add to the mania behind price scares and noted the credit crisis and a weaker dollar are largely to blame.
July 1, 2008 8:48AM
By Elizabeth MacDonald
You’ve heard the argument that the last time the US saw an oil rig spill was in 1969, when residents of Santa Barbara, California saw a massive spill that coated their beaches with goo.
And you’ve likely heard the argument, too, that no oil spills occurred offshore due to hurricanes Katrina and Rita in 2005.
The argument is used to shut down the environmentalists now upset that the US may drill offshore on the outer continental shelf to go after the estimated 86 bn barrels and 420 tn cubic feet of natural gas technically recoverable. Some 54% supposedly sits in the Gulf of Mexico, 31% is thought to be off of Alaska, and Florida supposedly has 3.9 bn barrels of oil off its coast, as well as 22 tn cubic feet of natural gas.
But it’s wrong to say that Katrina and Rita did not create oil spills.
Just as it’s wrong to say that oil speculators are largely to blame for high oil prices.
Just as it’s wrong to take as gospel facts and statistics in recent testimony from dubious experts about oil speculation.
Just as it’s wrong to sit tight when someone tosses down a lightening bolt of a data point about oil spikes at you from on high, especially when there are bigger, macroeconomic factors involved, so conveniently left out of these arguments, don’t let the truth ruin a good narrative.
Because it’s hard to coalesce into this polluted stream of oil consciousness the weakening dollar, strong demand from emerging world economies, shoddy and corrupt oil supply data, Mideast political unrest, Nigerian conflicts, detrimental weather and ethanol mandates.
It’s easier in this irksome political season, one that likely has you feeling like you are chewing aluminum foil, to scapegoat and deflect the blame, especially when you are responsible for crafting legislation that could help American consumers.
On May 1, 2006, the US Government’s Minerals Management Service issued a release saying Hurricanes Katrina and Rita destroyed 113 oil platforms and 457 oil pipelines in the Gulf of Mexico. It also said these hurricanes created six spills of 1,000 barrels of oil, condensate, or chemicals, spills reported in federal offshore waters, with a total of 146 spills of one barrel or greater reported as well.
The report also said that no shoreline or wildlife impacts “were noted” from these spills, with an emphasis on “were noted,” as the government can’t have bureaucrats trolling round the clock through spill-damaged waters, so leave that as an open-ended question.
Note, too, that the report admitted that underwater damage assessments “have been delayed because of overwhelmed support resources, such as diving equipment, support vessels, and remotely operated vehicles.”
An apt correction in light of the recent news that the US Supreme Court reduced the fines owed by Exxon Mobil over its disastrous oil spill in Alaska. Though Exxon has paid dearly for this environmental crime, I have warned you before that US taxpayers are often left to foot the cleanup bill to deal with the oil slobs.
And it’s left to you and me to clean up after the nonsensical thinking that oil speculators alone are the reason why we may see $10 a gallon of gas soon, thinking that comes from certain precious media pundits, typically self serving and lazy, who have not done the needed rooting around to find out what is really going on with oil price spikes.
For instance, you’ve likely seen that the total value of index funds and other similar investments has grown exponentially to $225 bn. But that figure is still far less than the tens of trillions of dollars worth of trades in oil markets each year. Barclays Capital says the influence in commodity markets from investment in oil index funds is vastly overrated.
A conclusion is where the mind comes to rest, a smart person once said. But not for readers of this blog. More on oil speculators coming. Stay tuned.
June 27, 2008 10:39AM
By Elizabeth MacDonald
Minutes from a high-stakes Federal Reserve meeting on the emergency rescue of Bear Stearns are out this morning, and they are revealing.
They provide fresh detail on what went on behind the scenes of the Fed-orchestrated shotgun wedding between JPMorgan Chase and Bear Stearns, including fears of a “contagion” spreading through the market if Bear Stearns was allowed to collapse.
The contagion here refers to the fact that Bear Stearns operated one of the country’s largest clearing operations, and a collapse would have cascaded through the system, causing calamity in counterparty trades.
Let’s recap. Bear Stearns had $360b in assets and liabilities at the time it went belly-up. It had $12b in shareholder equity, or net worth, to support that book of business.
The bonds on its books were getting crushed by the subprime crisis, so much so that two of Bear’s own hedge funds went belly-up last July, with the two former hedge fund managers subsequently arrested for alleged securities fraud and conspiracy, among other things. A cash run on the bank leading up to its St. Patrick’s day rescue put Bear Stearns on the brink of bankruptcy.
JPMorgan Chase’s chairman and chief executive Jamie Dimon initially balked at the thought of his bank taking on Bear’s colossal balance sheet, and rejected a deal. “I tell people that buying a house is not the same as buying a house on fire,” Dimon testified before Congress later (Dimon sits on the board of governors of the New York Federal Reserve).
The Fed then stepped in with an initial $30b loan, and then JPMorgan agreed to buy Bear Stearns for $2 a share, or $236m. JPMorgan increased its offer to $10 a share a week later amid a revolt by the smaller firm’s shareholders.
Back to the $30b loan JPMorgan got from the Fed to seal the deal, supported by Bear securities that the two sides say were valued, or marked to market, at $30b as of March 14.
The Fed came up with as novel a rescue as it could. Using a creative read of section 13A of the Federal Reserve Act, the New York Fed agreed to lend JPMorgan $30 bn over 10 years at a small 2.5% rate, a loan backed by a similar amount of Bear Stearns’ assets. Never before had the Fed taken on mortgage-backed securities as collateral. The Fed is now holding those assets to maturity and is not marking them to market, analysts note.
JP Morgan subsequently agreed to absorb the first $1b of losses on that $30b if the value of the assets backing its loan declines. Again, if that portfolio drops in value, JP takes the first $1b in losses. If the portfolio zeroes out, the Fed takes a $29b hit. The assets now sit in a Delaware limited liability company.
The Fed minutes show that JPMorgan “had requested assistance in financing a specific pool of assets that Bear Stearns had difficulty financing in the market” and that JPMorgan Chase “believed added significant uncertainty to the level of risk it would assume” in its acquisition of Bear Stearns.
To seal the deal, the minutes show that the Fed gave JPMorgan Chase, among other things, an 18-month exemption from the Fed’s statutes requiring banks to hold a certain amount of capital on its books against its risk-weighted assets. Banks also must adhere to international debt to capital ratios under the Basel accords. The capital ratio is the percentage of a bank’s capital to its risk-weighted assets.
The Fed let JPMorgan “exclude the assets and exposures of Bear Stearns” from its risk-weighted assets for purposes of applying the risk-based capital requirements” at the bank. The Fed also let JPMorgan “exclude the assets of Bear Stearns from the denominator of its tier 1 leverage capital ratio” requirements, noting that “each exemption would be reduced over time.”
The relaxation of the standards was necessary to stop a disaster the Fed says it saw coming if Bear went under.
Also, “by agreeing to lend against a portfolio of securities, we reduced the risk that those assets would be liquidated quickly, exacerbating already fragile conditions in the markets,” New York Federal Reserve Bank president Timothy Geithner testified before Congress in defending the deal.
A fire sale would have created chaos in an already crazy market.
Now the debate is just what is in that $30b pool of assets, given that the Fed is taking on this credit at a time when the government is already levered to the hilt, what with what is going on at Fannie Mae and Freddie Mac. The New York Fed hired Black Rock, 49% owned by Merrill Lynch, to cherry pick the best assets off of Bear’s books to use as collateral. Both sides signed a confidentiality agreement covering those assets–-why tip your hand to the market and invite unwanted arbitrage?
Only broad descriptions are available. The Bear assets are collateralized mortgage obligations, the majority of which are obligations backed by the likes of Freddie Mac, as well as asset-backed securities with things like adjustable rate mortgages, as well as commercial mortgage-backed securities, collateralized bond obligations, and cash assets consisting of investment grade securities rated BBB- or higher.
But how sound is that $30b worth of collateral?
JP’s Dimon testified: “We could not and would not have assumed the substantial risks of acquiring Bear Stearns without the $30b facility provided by the Fed.”
That comment led Sen. Robert Menendez to ask: “JP Morgan would have never gotten involved [in the deal] but for your [the Fed's] guarantee” that it would swallow $29b in Bear’s assets and not hit up JPMorgan for other collateral if those Bear assets zero out. Menendez wondered, is that a vote of confidence in these assets?
And remember what Geithner said in testimony before Congress, in defending the central against criticisms that it should have opened its Fed window to investment banks, not just commercial banks, to help Bear Stearns survive. “We only allow sound institutions to borrow against collateral” at the Fed’s discount window, he testified, adding, “I would have been very uncomfortable lending to Bear given what we knew at that time.”
What suddenly turned Bear’s assets golden as collateral for the Fed’s $29b loan to JPMorgan, what turned those sows ears into silk purses over night?
June 27, 2008 9:01AM
By Elizabeth MacDonald
The new housing bailout bill would let mortgage lenders off the hook for sour mortgages, as it would let the Federal Housing Administration assume the risk for these bad debts, shifting the burden to taxpayers and bond investors.
However, two “discussion documents” about a potential housing bailout bill, both of which are stamped “confidential and proprietary” that Bank of America (BAC) authored and circulated among Congress, shows that the legislation now making its way through the corridors of Washington, DC is almost word for word what Bank of America wanted.
And in a revealing disclosure, the Bank of America documents state that “we believe that any intervention by the federal government will be acceptable only if it is not perceived as a bail-out of the bond market.”
The first Bank of America document is dated February 11, and is entitled “Federal Homeownership Preservation Corp.” The second is dated March 11, 2008, and is entitled “FHA Housing Stabilization and Homeownership Retention Act of 2008.”
It is not unusual for companies to weigh in on legislation affecting their industries, and elected officials have historically turned to industry insiders to craft legislation (most elected officials are lawyers, which is why we are dealing with a top-heavy, conflicted bureaucracy, but that is a discussion for another day).
However, the first of Bank of America’s “discussion” documents came within a month of its announcement that it would buy Countrywide (CFC), the nation’s biggest mortgage lender by volume, for $4 bn, a deal value that’s now worth about $2.8 bn, according to its terms.
Countrywide has been accused by state attorneys general of making tens of thousands of dodgy loans that are now being put on the backs of taxpayers with the new housing bailout bill. At the same time, the Federal Bureau of Investigation is investigating Countrywide, among other regulatory bodies.
The Securities and Exchange Commission is also investigating stock sales made by Countrywide chief executive officer Angelo Mozilo, which he has attributed to a pre-existing executive plan under securities laws (elected officials want the SEC to probe whether the bank broadened the plan so Mozilo could unload more shares. Unload bad loans onto taxpayers. Unload bad stock onto unwitting investors. You with me?)
The Examiner’s Tim Carney has been on this story, as well as the National Review. A source close to the situation disclosed the documents to me.
The chairman of the Senate Banking Committee, Sen. Christopher Dodd (D-Conn.), has helped shepherd the housing bill, and according to Douglas Weber, an analyst with the Center for Responsive Politics, has received about $107,800 in campaign contributions–nearly 50% higher than initially thought–from Bank of America’s employees and political action committee since 1989.
A call to Bank of America was not returned.
The new housing bailout would help borrowers unload tens of billions of dollars worth of bad mortgages onto taxpayers. It would let borrowers get their debt forgiven and also allow them to get cheaper mortgages via refinancings at lower rates backed with federal loan guarantees.
Bank of America’s “discussion” documents are revealing. Watch how Bank of America drops certain important language between the two reports as the legislation, too, evolved.
In the March discussion document, Bank of America says that “the program works by letting investors realize the losses on the existing mortgages” as the program takes “advantage of the Government’s unique ability to provide low cost financing for the replacement mortgages.”
Although the February document says that the program’s “mandate” would be to “minimize taxpayer cost,” among other things, there is no further discussion of how taxpayer costs would be minimized, and the March report drops that language.
Both reports talk about how the current securitized US mortgage market is about $2.6 tn, that about “$339 bn or 13%” of all mortgages are at “high risk of default over the next five years due to payment shock from rate reset or payment reamortization loans,” with about $739 bn, or 28%, “at moderate to high risk of default over the same period.”
Both BofA reports note that it expects “$400 bn, or 43% of subprime mortgages to default in the next five years.” Neither of the reports cite Countrywide’s role in approving these loans to borrowers who could not afford them.
Here’s where BofA advises Congress how to structure the legislation so it’s not perceived as helping Wall Street–meaning, money managers, pension funds, endowments, insurance portfolios and money market funds around the world that bought this landfill backed by bad loans, many of them from Countrywide.
And here’s where BofA starts to ask for the taxpayer’s help. As the current housing bill has it, the FHA would back adjustable rate loans that are refinanced through the program into fixed-rate loans. The FHA-backed refinancings would pay off the earlier ARMs.
The documents state:
“As a number of public and private individuals have suggested, the government can mitigate the social and economic costs of massive numbers of foreclosures by establishing a program with the mandate to:
“Determine an acceptable short payoff amount based on the current appraised value of the home for eligible loans in imminent risk of default (Translation: the short payoff amount would be used to pay off the earlier ARM).”
The document goes on to say that the FHA-backed refinancings would support new mortgages with, among other things, “current loan to value ratios less than or equal to 90%, reductions in monthly payment of at least 30%, along with certifications of willingness to pay, and a soft second mortgage that protects the government’s investment in the property along with an agreement that lets the government share in future appreciation of the property.”
The documents say that to be eligible, the home must be occupied by the borrowers as their principal residence and that the borrower and lender “must certify borrower’s need to refinance and ability and willingness to make payments on the replacement mortgage.”
Question: Certifications of willingness to pay. Does that include a pledge of allegiance to Countrywide? And does yet another piece of paper really stop borrowers from dumping loans back onto taxpayers?
The documents say the program would “insure replacement mortgages through FHA,” and would have them repackaged into securities backed by Ginnie Mae.
Now which bond investor is going to buy those Ginnie Mae securities, after BofA has effectively told the government to stick it to bond investors who bought these asset-backed securities in the first place?
The March document says: “bondholders and portfolio lenders will experience virtually the same losses as they would have without government intervention since the short payoff amount is based on the current value of the property and is economically equivalent to the value that would be recovered in a foreclosure–thus no bailout of the bond market.”
Duly noted, despite the pointed language. The program could help bond investors if it stops borrowers from going into foreclosure. Better to have bond investors get the scraps of what’s left over if the program does stop foreclosures.
The loan balance, the documents add, “must be reduced by at least 10%” and the “new loan payment must be at least 30% lower than the existing payment.”
Translation: cutting the loan to value ratio to, say, 90% from 100% means that the lender and bond servicers take the 10% hit here, they have to foot the bill for that 10% swing in the borrower’s reduced risk.
And in a revealing section entitled “high level concerns,” Bank of America suggests ways to surmount “significant legal and regulatory hurdles” in the new program.
For instance, it notes a future accounting strategy for lenders ready to dump sour loans by shoving them off the lenders’ balance sheet. The move would make further use of controversial off-balance sheet vehicles, which investors have already been blindsided with in the Enron debacle and in the recent structured investment vehicles used by banks such as Citigroup to house these bad asset-backed securities that went belly-up in the credit crisis.
The Financial Accounting Standards Board, which sets accounting rules used by publicly traded companies to book their profits and losses, are now forcing banks to wipe out these vehicles which house these mortgage-backed assets, forcing lenders to put them back on their balance sheets, wrecking important debt to capital ratios.
Inside Mortgage Finance, a mortgage industry publication, says the new rule could force lenders to place an astonishing $5 tn worth of off-balance sheet securitized assets back on their books under a plan by accounting standard-setters to eliminate qualifying special purpose entities, or QSPEs.
The BofA documents suggest that “although selling loans out of trusts can cause FAS 140 consolidation concerns (NOTE: see explanation of FAS 140 below), servicers can accept short payoffs without jeopardizing QSPE status.”
In the earlier February report, BofA notes that “the chief accountant of the SEC has provided an interpretation of FASB (sic) 140 that contemplates more elaborate modifications of subprime mortgage loans to address this issue in part.”
Translation: BofA is saying that the SEC may bend the rules here, as rules are being massaged right and left, given the guardrails fell off a long time ago, so what’s wrong with a little more rule-bending?
Here’s the deal.
Last summer, Rep. Barney Frank (D-Mass.), chairman of the House Committee on Financial Services working on the housing legislation, to SEC chairman Christopher Cox. In it he asked about the potential impact of relaxing accounting rules that guide securitizations when mortgage lenders modify loans to avoid default.
When a lender securitizes a loan, it puts them into an off balance sheet vehicle and it is not allowed to change the loan’s terms.
But as the subprime crisis went viral and lenders starting modifying loans en masse, lenders got nervous about having to take those loans back onto their books, as the rules require. The SEC has since said that lenders modify these loans if a default seems likely, without having to take those asset-backed securities back onto their balance sheets.
Back to the BofA documents. The March document adds another “high-level” concern, that the refinancings “must be tax neutral to the borrower,” and asks that the tax code as of December 2007 be amended.
It notes too that banks that securitized these loans subject to the new program “will be focused on minimizing any liability they may have from participating in his program,” but that those worries can be best addressed through industry associations such as the American Securitization Forum, to develop market guidelines.”
In a section entitled “avoiding unintended borrower behaviors” BofA notes a “concern” in the report, that the program “could encourage other borrowers to stop making their monthly payments.” Question: Why didn’t BofA put this issue under its section called “high level concerns”?
BofA says that issue can be fixed by forcing borrowers in the program to give the government 10% of the appreciation of the home if it is later sold, for example, if a borrower sells a house 10 years later for $450,000, if the appraised value as of the date of entry into the program is $250,000, the borrower would then have to give the government $20,000.
Question: Who does the borrower write the check out to? Joe or Jane Q Citizen Taxpayer?
Furthermore, the March document drops language used in the February report that would have forced borrowers to behave more responsibly if they want to be eligible for the new housing bailout program.
The February report suggested that possible remedies could include “reporting the existing loan as a default to credit bureaus when it is refinanced” through the program, and “making the new loan non-dischargeable in bankruptcy.”
In the end, the program, the BofA documents say, would keep “eligible borrowers in their homes,” and slow the “decline in house prices by reducing the increase in unsold housing inventories.”
And slow the pain to Countrywide from its bad lending practices–while maximizing the potential pain to taxpayers.
June 25, 2008 8:03AM
By Elizabeth MacDonald
Expect the Fed to not cut or increase rates today, as it indicates that inflation is a bigger concern than recession. Though market watchers expected a hike in rates to stop inflation, a hike would be an extraordinary move in advance of the US presidential election.
What this means is the economy will continue to muddle along for at least the next year or so, with flat to middling economic growth rates at best, as the Fed continues its agonizingly difficult task navigating the economy past the Scylla and Charybdis of inflation and recession.
And what this means is many market watchers got it wrong.
Did anyone in government give passing thought last August, after the Bear Stearns hedge funds blew up and the Fed opened the taps with a gusher of liquidity, that inflation would come bearing down like a freight train?
Was there an unspoken plan back then between the administration and the Federal Reserve that the central bank would open the money taps here to save the financials, and in turn administration officials would then travel to the Mideast and jawbone Saudi Arabia to open its oil spigots, to help avoid US inflation?
Instead, the US got promises of a tablespoon of increased daily oil productivity amounting to 9.7 mn barrels a day by July from 9mn currently, an amount that easily dissolves in a world that consumes 86 mn barrels of oil a day.
And with the plunging dollar and the haymaker of inflation due to oil price spikes cutting into profits–half the jump in FedEx’s operating costs recently was due to oil price increases–the self-appointed intelligentsia of the markets, the pundits who said a weak dollar would stop the economy from tipping over as it helps multinationals reap more overseas sales, don’t look so prescient after all.
Notably because oil price spikes are hurting economies struggling with rising inflation around the world, from Europe to Asia to the Middle East. These are the same countries that take the bulk of America’s exports, a sweet spot in the US economy.
And now, despite the most rapid Fed rate cuts in a generation, the financial sector must battle to continue to chop back its dodgy asset-backed securities propped up by all sorts of bad consumer loans, from mortgages to credit cards, securities Wall Street concocted that, on closer look, really are cut and paste jobs creating a drunken daisy chain of bad securities now sitting as landfill in investment portfolios extending to Australia, Asia, Europe, Scandinavian countries and the Arctic.
Frankenstein securities backed by deadbeat loans increasingly defaulting right and left as borrowers bail en masse, dead loans walking. Unloading these illiquid assets in a downmarket is an Olympian task.
Watch Wall Street’s bum’s rush out the door to the sovereign wealth funds, as the banks desperately seek to revivify their balance sheets. And watch whether the future holds yet another buyer parking its ambulance out in front of yet another Wall Street house to orchestrate another shotgun wedding.
The Federal Reserve has clearly crossed the Rubicon, as economist Ed Yardeni points out, by opening its lending facility to investment banks, a window the Fed had said it would shut by September, though it’s expected it will keep it ajar for any emergency.
But watch this move. The Fed is now letting both commercial banks and investment banks swap all sorts of asset-backed bonds backed by dicey collateral for safer Treasurys, bonds that go beyond those propped up by deadbeat mortgages.
The Fed is now taking on potentially more bad paper in the form of bonds backed by student loans, auto loans and credit card debt. The Federal Reserve banks now hold $549 bn in US treasury securities, down from $741 bn at the start of the year, Yardeni says. (Student loans have dried up, not good in a US presidential election year, as investors bolt from these asset-backed securities).
With these moves, guess which bank the government is girding itself for as it might need a rescue, due to its vulnerability beyond mortgages. Citigroup (C)?
And so back to the Fed’s statement, due out around 2:15p, when the Fed-parsers, the market Gnostics searching for hidden meaning in Fed chairman Ben Bernanke’s every intonation, come out in force. RBS Greenwich Capital, Merrill Lynch and Bank of America got it right.
Watch as the Fed jumps up on a ledge to peer down, far from the muddling, madding crowd (yes, one of my favorite authors is Thomas Hardy, who said “character is fate,” how true today).
The Fed won’t use language that says inflation risks now exceed the downside growth risks, which would indicate a possible rate hike soon, despite the fact that the Fed’s inflation hawks have descended, with two Fed board of governor seats still vacant and the hawkish Fed presidents bringing the overall Fed under their wingspan of influence.
Instead expect the Fed to use language that it is navigating that middle path, as it sits on the twin horns of a dilemma of higher inflation and recession, that it is balancing risks to both economic growth and inflation, as Merrill rightly points out.
Bank of America, too, says the Fed’s “statement will acknowledge a still weak economy and elevated headline inflation, without tipping its hand as to the direction or timing” of its next policy move.
And so the Tinkerbell of hope might be that the economic slowdown will reduce demand for oil and other commodities, bringing inflation down.
The stock market and the economy will come back after the financials stabilize. Which they will after the writedowns end sometime after 2009. And when that happens, so will end the chapter of the “Great and Costly and Crazy Freelance Experiment by Wall Street to Bring 100% Homeownership to America.”
And so begins the next bubble: Energy (alternative sources of all stripes) and biotech.
So all of the moves by the Fed and the government to repair the housing mess are laudable, noble and outrageously expensive, but the market in the end will fix itself.
And we will still have to deal with the worst spending bubble of all. The chuckleheads in Congress and the administration who have no more sense than a flock of geese when it comes to using taxpayer money like their own private ATMs.
And so we will have to continue to deal with a government that mindlessly foists on the backs of entrepreneurs, taxpayers and companies the largest budgets in history, as they build their Supersize-Me bureaucracy because they know better than you what’s good for you and they know better than you how to use your tax dollars.
That includes using tax dollars to bail out the housing mess.
So inflation pays that tax bill.
June 24, 2008 12:56PM
By Elizabeth MacDonald
If you had placed a bet that the financials’ writedowns would be kitchen-sinked this year, over, done, that’s it, you are likely mistaken.
That’s because the next wave of writedowns will come from negative amortization loans, a type of adjustable rate loan which require tiny monthly payments insufficient to even pay-off interest costs. Fox Business anchor Stuart Varney first alerted me to this story.
The bad loans are the reason why the government is moving to bail out homeowners with new housing legislation that would put this bad paper on the backs of taxpayers via a ramped-up Federal Housing Administration, which will help refinance and rejigger mortgages.
Lenders such as Countrywide Financial (CFC) have been racing to restructure these loans, as well as numerous other adjustable rate loans, since last fall.
And the loans are why you are increasingly seeing deals such as “100% financing” made to first-time home buyers, so neg am borrowers can unload their homes, and in turn their loans. The 100% financing deals are made possible via down-payment assistance programs run by nonprofit organizations.
These programs are funded largely by home builders and also by private homeowners desperate to sell. The seller-funded groups provide enough down-payment money to buyers so that they can qualify for a mortgage backed by the FHA, which requires at least a 3% down payment.
Supporters of the down-payment programs say they are vital to repairing a damaged housing market. Critics say the FHA, meaning taxpayers, will see more defaults in these loans, as today’s seller-funded loan is tomorrow’s foreclosure, reports the Wall Street Journal. Borrowers can just as easily walk away from down-payment assisted, no-money-down loans, as they sink virtually none of their own money into the house to begin with.
In a “neg am” loan, any interest not paid is added to the loan balance, a process called “negative amortization.” These loans were given to borrowers with stated income (meaning, borrowers merely told lenders what their income was, and presto, they got a loan), or low- or no-documentation–meaning lenders did zero income checks.
Often ARM loans give borrowers the “option” to set their own payment amounts. They can slow up paying on the principal of the loan, and they can even defer some of the interest payments.
These so-called “neg am” loans first became popular in coastal markets in 2003, says Sheila Bair, head of the Federal Deposit Insurance Corp. They reset after five years, meaning, they remain interest-only loans with no amortization for the first five years.
That means the first wave of these shoddy loans are resetting this year.
Many of these shoddily underwritten ARMs were made near the real estate market’s peak in 2005 and 2006. That means these loans will reset to higher interest rates in 2010 and 2011. FDIC analysis says that large volumes of these loans will undergo payment reset and require amortization beginning in 2009, “in market conditions that may not be much better than we see today.”
And that means the markets won’t see a halt in Wall Street writedowns or loan defaults until 2011. Is that when housing, and the financials, will find their bottom?
Remember, it’s estimated that Wall Street provided three-quarters of the financing for mortgages by repackaging them as securities.
Lenders made an estimated $581 bn in option ARM loans during 2005 and 2006 while shelling out an estimated $1.4 tn in interest-only ARMs, according to the mortgage research outfit First American LoanPerformance. Option ARMs are a type of interest-only loan.
A recent study estimated about $325 bn of these loans will default, leading to more than 1 million homeowners giving back their property to lenders.
The Federal Bureau of Investigation is looking into whether troubled lender Countrywide Financial (CFC) deliberately made loans to borrowers who did not have the assets or financial wherewithal to pay them back, the Wall Street Journal has reported. The FBI is trying to prove Countrywide knowingly ignored signs that borrowers would not be able to repay loans.
Countrywide redirected its conveyer belt of mortgages towards Wall Street, including players like Merrill Lynch (MER), which repackaged and securitized this junk, ending up in hedge funds, pension funds, endowments, money market funds and insurance portfolios around the globe–including Old Lane Hedge Fund, formerly run by Vikram Pandit, chief executive of Citigroup (C).
It’s been estimated that about half of the nearly $470 bn worth of loans that Countrywide made in 2007 had adjustable rates built in to its loan terms.
Looking at Countrywide Financial (CFC) alone, it has mortgages with unpaid principal balances that amounted to $87.2 bn as of March 31, 2008.
Of that sum, CFC has $27 bn in pay option loans, $24.8 bn of which were negative amortization loans.
Shareholders in Bank of America (BAC) are voting on the bank’s $3 bn acquisition of Countrywide on June 25th. The bank has reaffirmed that the deal is going through.
Countrywide Financial should have seen this coming. It saw a notable increase in the percentage of its mortgage book with some level of negative amortization back in 2006, increasing year to year from under 12% to over 20%.
Right now, servicers thought they could get recovery rates of 60% on subprime loans, but even 30% is thought to be currently unattainable. Some servicers have been selling loans for as little as three cents on the dollar.
Note: As of last fall, less than 4 % of the option and interest-only ARMs were delinquent, well below the 14 % rate for the subprime market, where about $1.5 tn in home loans are still outstanding, according to the most recent data from the research firm First American LoanPerformance.
But that’s because these negative amortization arms reset after five years. Again, the first wave of these neg am loans, issued in 2003, are resetting now.
June 24, 2008 7:13AM
By Elizabeth MacDonald
The Federal Bureau of Investigation’s probe of the subprime mortgage industry could uncover fraud involving Wall Street investment banks, private equity firms or hedge funds, the head of the bureau said.
The FBI probe comes as losses and write-downs from the housing and credit could eventually hit the $1 tn mark, the International Monetary Fund reports. More than 100 U.S. mortgage lenders have gone bankrupt, been sold, or exited the mortgage business since the end of 2006.
But who is on the regulatory radar screen? So far, the FBI has publicly acknowledged the name of only one company caught up in the dragnet, Doral Financial Corp.–its former treasurer was recently indicted for investment fraud. The former treasurer has denied the allegations.
As I’ve reported to you earlier, a senior law enforcement official told me that hedge funds now sit at the top of the hit list of federal investigations into the subprime crisis, including at the Department of Justice and the Federal Bureau of Investigation. Expect more announcements of hedge fund indictments in coming days, sources say (”Hedge Funds in the Crosshairs”).
Hedge funds made hundreds of billions of dollars in trades of hard-to-value subprime and credit assets that do not always carry market prices. Because hedge funds annually pay their managers as much as 20% of investment gains each year, the fear is that they helped overestimate the values of these securities to line their own pockets at the expense of investors.
At bottom you’ll see a list of companies involved in a range of regulatory probes; again, please note, it’s unclear which companies the FBI is looking into, and this list comes from a perusal of company regulatory filings as well as news reports. Word of caution: if you want to know who is really on the radar screen, use this list only as a potential lead. The regulatory probes come from a wide range of places, including the Securities and Exchange Commission and various attorneys general across the country. Do not stop your research here.
The FBI’s investigation of potential fraud in the U.S. home mortgage industry now encompasses 19 companies in “cases that may have a substantial impact on the marketplace,” FBI director Robert Mueller said. “We are targeting accounting fraud, insider trading and deceptive sales practices. These investigations may well lead to other instances of fraud, from investment banks and private equity firms to hedge funds.” The bureau is examining whether portfolios of mortgage-backed securities were properly valued, accounted for, and disclosed to investors, among other things.
FBI director Mueller recently told an American Bar Association conference he expected to see more corporate fraud cases in the future “because of the ripple effect” of the subprime mortgage crisis. Mueller has said the bureau is working to identify “large-scale industry insiders” in its probes.
Major investment banks Goldman Sachs Group (GS), Morgan Stanley (MS) and Bear Stearns (since bought for $10 a share by JPMorgan Chase (JPM) each indicated the government had asked them for information, but please be careful here. Reportedly none confirmed any FBI role, and financial disclosures make no statements about any FBI probe whatsoever.
To date, prosecutors have not brought any major cases against mortgage industry leaders. Last week, two former hedge fund managers at Bear Stearns were arrested in the connection with two funds that went belly-up, costing investors $1.6 bn, a bellwether event in the subprime meltdown. The subprime collapse was kicked off by the April 2007 bankruptcy of New Century Financial Corp., a lender which gave numerous home loans to dodgy borrowers with weak credit histories.
Separately, the Dept. of Justice and the FBI announced its “Operation Malicious Mortgage” involving more than 300 arrests and charges brought against more than 400 real estate industry insiders, midlevel players alleged to have committed mortgage fraud, which US Attorney General Michael Mukasey has deftly called “white collar street crime.”
Reported cases of fraudulent mortgages stretch from New York to Rhode Island to Illinois to Texas, and from California to Florida. Fraudulent loans amounted to more than $4 bn in 2007, up from $1.6 bn in 2006, says the website MortgageDaily.com. The FBI reports fraud has already cost $4 bn to $6 bn.
A roundup of reports flushes out who is on a regulator’s radar screen:
Countrywide Financial Corp. (CFC): The largest U.S. mortgage lender is reportedly under FBI investigation for suspected securities fraud as part of investigations into the mortgage crisis, although the FBI has declined to comment and Countrywide said it was unaware of any investigation.
Separately, the Securities and Exchange Commission is reportedly conducting an informal probe of suspicious stock sales by Countrywide chief executive Angelo Mozilo. At issue is Mozilo’s use of an SEC rule known as 10b5-1 that lets corporate executives file a trading plan for future sales of their stock. The plans are intended to prevent suspicions that executives illicitly traded on insider information. The question however is, “did Countrywide repeatedly adjust Mozilo’s prearranged selling plans at his request, such that the intent and purpose of these plans — the prevention of insider trading — was undermined?” Sen. Charles Schumer (D-NY) has asked. And separately, the Office of the U.S. Trustee, an arm of the Justice Department responsible for policing federal bankruptcy courts, will be able to interview Countrywide execs under oath and subpoena key documents from the lender after federal bankruptcy trustees in Florida, Georgia and Ohio have filed legal actions against the Calabasas, Calif.-based lender, saying the lender was abusing the bankruptcy process.
*Footnote: Since this story ran, the attorneys general of Illinois and California have filed suit against Countrywide and its officers, alleging unfair and deceptive business practices. The Washington State Dept. of Financial Institutions has also filed suit as well, alleging Countrywide engaged in discriminatory lending practices.
UBS (UBS): The U.S. attorney in New York’s Eastern District in Brooklyn is reportedly probing whether the Swiss financial giant booked inflated prices for mortgage bonds despite knowing their valuations had fallen. Prosecutors, who frequently work closely with the Securities and Exchange Commission, had yet to issue subpoenas. Separately, the FBI is reportedly planning to travel to Switzerland to probe a multi-million-dollar tax evasion case involving the Swiss bank.
American International Group (AIG): The Justice Department and the SEC are reportedly investigating whether the world’s biggest insurer overstated the value of derivative contracts linked to subprime mortgages, specifically, the way AIG valued credit default swaps. Prosecutors from the Department of Justice and the U.S. attorney’s office in Brooklyn, New York have reportedly asked for information the SEC is gathering, which reportedly could signal a criminal investigation. AIG spokesman said the company would co-operate in regulatory and governmental reviews on all matters. AIG has been hit with record writedowns from the credit crisis, and in 2006 AIG settled an accounting case for $1.6 bn. The accounting probe had led to the ouster of AIG’s longtime chief executive, Maurice “Hank” Greenberg.
Merrill Lynch (MER): The Securities and Exchange Commission has launched an investigation into Merrill Lynch’s subprime mortgage portfolio. The investment banker said in its quarterly SEC filing the probe was initiated on October 24. That was the day Merrill announced a net loss of $2.3 bn from continuing operations for the third quarter. Meanwhile, Merrill is facing a lawsuit from Massachusetts alleging the company committed fraud by selling esoteric debt products containing mortgage-backed paper to the Massachusetts city of Springfield. The New York attorney general’s office has also been conducting an investigation of the mortgage industry, which is focused on appraisals and the packaging of loans into mortgage-backed securities for sale to investors. New York attorney general Andrew Cuomo’s office has reportedly issued subpoenas to Merrill Lynch.
DB Zwirin: The SEC has been investigating the $5 bn hedge fund DB Zwirn, which ran a high-yield bond portfolio. The commission is requesting information about how the hedge fund valued its assets, sources say. DB Zwirn is winding down its fund after colossal redemptions. The fund had specialized in purchasing corporate loans and other illiquid credits. The fund had raised the valuation issue itself in a letter to investors last year that said a fund manager who left in 2005 had failed to “follow a systematic pricing methodology” for a portfolio of high-yield bonds, according to reports.
Beazer Homes USA (BZH): Said last year it received a federal grand jury subpoena related to its mortgage business.
Thornburg Mortgage (TMA): This provider of jumbo mortgages said it had received subpoenas from the Securities and Exchange Commission amid doubts about its long term survival. Nearly went bankrupt in March. Posted recently a $3.3 bn first quarter loss as the value of mortgages and other securities it owns plummeted. In a filing it said it was complying with the subpoenas for documents related to an ongoing regulatory probe and that it is cooperating with the SEC inquiry. Also notified in April by the SEC that the agency investigating its restatement of 2007 financial results and its accounting treatment of mortgage backed securities. Lender said it was defending itself against securities class action lawsuits alleging made false and misleading statements about its financial health, which results in inflated stock prices. It has said these allegations were without merit.
Wachovia (WB): Recently agreed to pay $144 mn to settle charges of turning a blind eye when telemarketers used the bank’s accounts to steal from customers. Telemarketers reportedly had obtained account information from consumers through a variety of ruses, and then used the information to write themselves fraudulent checks, which they deposited at Wachovia. Wachovia is also reportedly under scrutiny for money laundering by Mexican and Colombian money transfer companies move proceeds of US drug sales to Latin America. Wachovia had reportedly cultivated ties with the money transfer outfits.
Impac Mortgage Holdings (IMH): This struggling lender recently said its survival could be threatened following a $2.05 bn loss in 2007, and that the SEC was inquiring into its operations. Impac is a real estate investment trust that once specialized in “Alt-A” mortgages, which often go to people who cannot document income or assets. The Irvine, California-based company has reportedly struggled with falling housing prices, mounting delinquencies on mortgages once, and investors’ refusal to buy all but the safest home loans. Impac said its liabilities exceeded its assets at year-end, giving it negative shareholder equity of $1.08 bn. The company said it has provided information to the SEC this year in response to the agency’s informal inquiries into its business operations, related accounting policies and methodology. Last September, Impac quit substantially all mortgage lending operations.
Franklin Bank (FBTX): This Houston, Texas bank, overseen by mortgage bond pioneer Lewis Ranieri, said it faces an SEC probe related to its lending practices. Recently it has replaced its chief executive. Ranieri, the bank’s chairman and a former Salomon Brothers vice chairman, will become interim chief executive. The SEC inquiry came after a 10-week internal investigation that the bank said uncovered a variety of accounting errors, largely related to residential mortgage loans. Franklin said it has also been in communication with the Federal Deposit Insurance Corp. and the Texas Department of Savings and Mortgage Lending, and plans to cooperate with those agencies and the SEC. The company has been unable to file its first-quarter report because of the internal probe, and this month said investors should not rely on its reported fourth-quarter results, which included a $66.1 mn loss. It also said it working to restate its third-quarter report and complete its 2007 annual report, but does not know when it will complete either.
Olympia Mortgage: Two former principals of this now defunct Brooklyn mortgage lender surrendered to the FBI recently after being indicted on charges of conspiracy and fraud involving Fannie Mae and Credit Suisse First Boston, a federal prosecutor said. Lieb Pinter, 64, is charged with fraud in connection with the theft of $44 mn of payoff proceeds for refinanced mortgage loans financed by Fannie Mae and serviced by Olympia. Barry Goldstein, 59, is charged with fraud in connection with Olympia’s sale of a portfolio of non-performing mortgage loans to Credit Suisse using falsified loan histories.
June 23, 2008 7:43AM
By Elizabeth MacDonald
Did the Securities and Exchange Commission miss warning signs back in 2005 that could have helped it stop the meltdown at Bear Stearns?
It’s a question that arises from an SEC probe into Bear Stearns in 2005 alleging that the Wall Street firm may have fraudulently valued mortgage-related securities, the very same products that led to Bear Stearns’ collapse, forcing a rescue orchestrated by the Federal Reserve that involved getting JPMorgan Chase (JPM) to park its ambulance outside its doors.
The SEC subsequently dropped the 2005 case, prompting an inquiry from Senator Charles Grassley (R-IO), a ranking member of the Senate Finance Committee. But the senator’s inquiry went nowhere.
Allegations about the fraudulent valuations and disclosures of these securities also led last week to the arrests of two former hedge fund managers who ran two Bear Stearns hedge funds that collapsed and cost investors $1.6 bn last summer, triggering the downfall of Bear Stearns.
The funds at issue were the High-Grade Structured Credit Strategies Fund and its highly-geared cousin, the High-Grade Structured Credit Strategies Enhanced Leverage Fund.
The 2005 case involving Bear Stearns raises serious concerns for investors when it comes to the strength of the market police and its oversight of credit derivatives concocted during the housing bubble.
The case is a little known and little understood matter brought in 2005, one that critics say could have saved the SEC a lot of headaches now, if it had chosen to use its regulatory muscle at the time.
Award-winning journalist Michael Siconolfi at The Wall Street Journal broke this story in December 2007, “Did Authorities Miss a Chance to Ease Crunch? SEC, Spitzer Probed Bear CDO Pricing in 2005, Before Backing Away.”
The SEC has come under fire lately for not taking a tougher oversight role on Wall Street. The agency’s trading and markets division is supposed to regulate the biggest broker-dealers, which means it’s charged with keeping tabs on whether investment banks have enough capital on their balance sheets as well as the strength of their risk management systems.
The Federal Bureau of Investigation is now probing 19 large companies, including investment banks, credit rating agencies, accounting firms and hedge funds to determine their potential criminality in the subprime and credit mess.
The FBI, which is looking at large-scale, corporate insiders, has not disclosed which companies are the subject of these probes. Accounting fraud, insider trading and criminal failure to disclose appropriate valuations of securitized loans and derivatives are under investigation. The SEC has also opened numerous investigations.
At issue are collateralized debt obligations (CDOs), ultra-high risk credit derivatives that the investment banks sold to complacent institutional funds, including pension funds, endowments and insurance portfolios.
Back in July of 2005, Bear Stearns buried in a footnote a terse, cursory disclosure about a regulatory probe in a quarterly filing, after disclosures about things like fights with the Utah state retirement board and the state of West Virginia.
It noted it faced a possible civil enforcement action related to pricing, analysis, and valuation of $62.9 mn in CDOs, a series of high-yielding bonds supported by revenue streams from commercial, residential and mobile-home mortgages.
Bear Stearns reported too that then-New York Attorney General Eliot Spitzer had subpoenaed the firm about $16 mn in CDOs it had sold to an undisclosed client. The firm also disclosed it had set aside $100 mn in legal reserves to handle the investigation and possible litigation.
Bear Stearns didn’t provide any details or identify the customer that bought the CDOs.
Later, it came to light that the SEC’s Miami office allegedly planned to recommend that Bear Stearns be civilly charged for fraudulently pricing and valuing $62.9 mn of CDOs it sold to W Holding Co.’s Westernbank Puerto Rico bank unit, CDOs which reportedly later cost the bank $20 mn.
Bear Stearns was reportedly valuing these CDOs at more than 90 cents on the dollar, but when the client wanted to sell the securities back to Bear, the firm priced the CDOs in the high-30s. Hudson United Bank also had reportedly complained to Spitzer after trying to unload the CDOs and allegedly discovering they were worth far less than Bear Stearns claimed.
By that time, CDO sales were already posing trouble for the highly leveraged Bear Stearns. The firm’s leverage ratio rose from 26.0 in 2005, meaning that total assets were 26 times the value of its shareholders’ equity to 32.8 in 2007.
Bear Stearns went belly up largely due to a run on the bank, which exposed that it had little capital to support its ocean liner of debt, partly because of problems it had with CDOs backed by mortgages issued in 2005 and 2006 during the peak of the US housing bubble.
Recently, Sen. Grassley wrote SEC Inspector General David Kotz to look into the 2005 Bear Stearns matter.
“Given the later collapse and federally backed bail-out of Bear Stearns, Congress needs to understand more about this case and why the SEC ultimately sought no enforcement action,” he wrote, asking that the inspector general look into “the degree to which more aggressive action by the Enforcement Division may have led to an earlier and more complete understanding of the issues that contributed to the collapse of Bear Stearns.”
Grassley had cited a congressional probe which found that SEC investigators purportedly treated Morgan Stanley chief executive John Mack with “undue deference” in its inquiry into Pequot Capital Management, because of his “Wall Street prominence and ability to hire prestigious counsel,” implying the agency backed off from investigating Bear Stearns for similar reasons.
The SEC declined an enforcement action against Pequot Capital Management in connection with an insider-trading investigation in 2006.
Back then, Gary Aguirre, a former SEC attorney, told a congressional panel that he suspected John Mack, now the chief executive of Morgan Stanley , was a possible source of tips to Pequot.
Aguirre claims he was fired from the agency when his investigation got too close to Mack, a major fundraiser for President Bush. But the SEC denied giving Mack special treatment.
“I am particularly interested in this [the Bear Stearns] case in light of the SEC’s failed investigation of Pequot Capital Management,” Grassley wrote. “I need to know whether the same problems identified in the Pequot investigation were repeated in the Bear Stearns case.”
But citing confidentiality, SEC Chairman Christopher Cox rejected Grassley’s request for information in an April 16 letter, stating: “The Commission does not disclose the existence or nonexistence of an investigation or information generated in any investigation unless made a matter of public record in proceedings brought before the Commission or the courts.”
The alleged weakness in market oversight is chilling at a time when it’s clear even Wall Street doesn’t understand the Frankenstein products it has created, securities backed by loans given to borrowers with no compunction about mailing back the keys to their homes, dead loans walking.
Aggregate global CDO issuance exploded in dollar size along with the inflation of the housing bubble. CDO issuance totalled $157 bn in 2004, $249 bn in 2005, and $489 bn in 2006, says the Securities Industry and Financial Markets Association.
Many CDOs are cut and paste jobs. For example, they often are constructed on the backs of credit default swaps, which are bets about the direction of mortgage-backed securities, which are built on landfill, meaning, mortgages given to borrowers who got these loans even though they had no income and no assets and no credit history.
There is virtually no independent pricing information about these CDOs, as there is a limited secondary market for trading these specialized bonds. Many of these securities are not liquid or tradable as a share in, say, IBM or a barrel of oil is. Instead, investors must depend on the Wall Street firms that create and sell them to get an inkling of what they are worth, valuations the firms can cook up on their own, according to accounting rules
Check out this interview in the August 2005 edition of Wall Street & Technology with Ralph Cioffi, one of the former Bear Stearns hedge fund managers now under arrest. In it Cioffi reveals how rickety the whole process of creating credit derivatives really is:
The interview notes that Cioffi explained that in the dealer-to-customer market [for credit default swaps], traders mostly construct contracts over the phone and via Bloomberg e-mails. Transaction and settlement records are created through a good deal of cutting and pasting of documents, and confirmations sometimes do not arrive for as long as 90 days, he noted.
Question: Did Cioffi, or anyone else on Wall Street for that matter, vet the underlying collateral backing these securities, the mortgage debt taken out by shaky borrowers?
“When we execute via Bloomberg,” Cioffi continued, “we have to notify our back office through an e-mail, we calculate the settlement amount, the dealer sends us the amount and then we notify the buyer or seller of protection, so there are a number of steps.”
Really? Did any of those steps include checking in on homeowners who got loans with no money down and no assets?
