Archive for April, 2010
European Debt Crisis Hammers Markets
Posted by Jody Eisenman | Filed under Uncategorized
About 2500 years ago, Greece was a world power and Greek culture was considered to be the finest in the world. Nowadays, Greece is a small country that is part of the European Union (EU).
Today, Standard and Poors downgraded Greek debt to BB+ and in a surprise move, dropped Portugal two notches to A-. As Greek bond prices plunged, the contagion spread to the US markets, where the Dow fell over 200 points, with the selling accelerating late in the day. The markets fell despite continued strong earning results from Ford and UPS. Treasuries soared as investors fled to safety. Right now, you can get a yield of 19% on 2 year Greek paper…if they don’t default.
The real fear is this: Germany is considered to be the strongest financial country in the EU, and one that has led the Greek bailout talks. However, should Portugal also need help, could weaker countries like Ireland and Spain be far behind? We are in a paradoxical situation, where the industrial nations of the world (including the US) are pretty much all heavily in debt. Simply put, these countries refuse to live within their means, and now must face the tough decisions of either raising taxes or cutting services. Of course, neither course is very popular but you cannot continue to have soaring deficits without plans to deal with it.
Although the US market dropped, one must remember the dramatic runup in prices over the last 13 months. Therefore, a correction is almost to be expected. How long it lasts will be played out shortly.
CDOs and First Jersey Securities
Posted by Jody Eisenman | Filed under Uncategorized
CDOs, of course, are Collateralized Debt Obligations. They are made up of either mortgages or credit default swaps (which are basically options on the value of underlying mortgages) which were sold to investors as safe yields secured by real estate. This of course ended in 2007-8 when real estate dropped and mortgages began to default at rates unseen since the depression in 1930s. First Jersey Securities was a firm run by convicted felon Robert Brennan, which sold penny stocks until they were shut down in 1987. What does one have to do with the other? They both seemed to have the same characteristics. I will explain.
First Jersey ran an incredibly efficient criminal enterprise. Their brokers would recruit clients to invest almost exclusively in companies that First Jersey underwrote. Almost invariably, these companies were not much more than a desk, a few chairs, and some fancy marketing. Here’s how a typical transaction might happen in the NYC office: Some fast talking First Jersey broker would call Joe Investor and try and convince him to buy stock in a company we will call ABC. Lets say the broker got Joe to agree to purchase shares at $1/share. Next month, the broker would call Joe and tell him something like this:
“Joe, I’ve got great news. ABC is now at $1.75. I suggest we take a profit”. Joe would eagerly agree; after all, didn’t he just make 75% in a month? Then the broker would tell him about his next idea, XYZ. XYZ would be selling at 4, and the broker convinced him it would soon explode. He would then try to convince Joe to send in much more money. Meanwhile, in the Chicago office, the brokers would be convincing their clients to buy ABC! However, the price wasn’t $1.75, it was 3. How is that possible? Simply because First Jersey and its’ affiliates were the only market makers in ABC (as well as everything else they pushed), and they price was whatever they said it was. Meanwhile, another office might be dumping XYZ at 2, and having the NYC office reselling it at 4. Eventually, Brennan was convicted and served time in prison.
OK, so what does this have to do with CDOs? Well, upon doing research, I discovered a curious fact. Very few people really knew exactly what was in any CDO. The CDO could consist of a hundred or more mortgage bonds, which in turn could have thousands of different loans. The rating agencies did very little die diligence into these, which made their ratings almost meaningless. However, it got even worse. Lets say an investment bank was trying to sell several tranches of a CDO called ABC. If they had problems selling the lower tranches, they might repackage these ugly tranches as part of a CDO called DEF. Another CDO called XYZ might contain pieces of ABC and DEF! If this sounds confusing, imagine how it sounds to the eventual buyer? I would venture that many, if not the majority of these buyers had no clue what was in the CDO they purchased. They simply relied on the investment bank, as well as the high rating issued by Moody’s or Standard and Poors. As I discussed last week (http://www.jodyeisenman.com/2010/04/the-securities-and-exchange-commission-vs-goldman-sachs/), these ratings were, by 2007, were simply wrong. A more jaundiced view might view them as criminal. These agencies were routinely giving AAA ratings to CDOS which managed to experience losses of most of their principal (sometimes all of it) in just a few short months. There are currently several lawsuits against these agencies still pending.
Meanwhile, the stock markets continue to “melt upwards”. After an inter day dip to 10,975 on the Dow Thursday, the markets rallied back strongly to close at 11,204 by the end of the week. The markets are now at an 19 month high, as earnings continue to be generally better than expected across the board. I have no idea where the top is, but thus far, every “expert” who has attempted to call the top has been dead wrong.
The Securities and Exchange Commission vs. Goldman Sachs
Posted by Jody Eisenman | Filed under Uncategorized
When I was thinking of this blog post on Friday, I was planning on writing about Goldman, but for a different reason. It seems that GS has an international real estate fund (called Whitehall Street International) which raised $1.8 billion in 2005. As of the end of 2009, the fund was down to a paltry $30 million, which means that it managed to lose 98% of their equity in about 4 years. However, the real news on GS came Friday, with the lawsuit of the SEC against the form and Fabrice Tourre. The charges are a bit complex, so I will try to break it down such that the average person can understand what all this is about. This is what the government is alleging that GS did:
1. In early 2007, GS was approached by Paulson and company, which is a large hedge fund run by John Paulson. Paulson has become famous for identifying the housing crash and making substantial bets against it. Paulson eventually made up making about $20 billion for his investors, while most Americans were losing their shirts. How did Paulson do it? In this case, he made about a billion by buying CDS (credit default swaps) on CDOs (collateralized debt obligations). Ok, lets define this! A CDO is mortgage backed security with a unique structure. Basically, the investment bank takes a large pool of mortgages and sells them to investors. However, the pools are then broken into tranche. To illustrate this, imagine the pool. consisted of just one mortgage. Lets say the mortgage was a total of $900,000 on a home worth $1 million. Now here comes the fun part. The investment bank takes the $900,000 mortgage and divides into three pieces, called tranches. Should the homeowner default, The first or top tranche would be paid off first. Only if there were sufficient funds, would the second tranche be paid, and so on with the third tranche. Clearly, the last tranche would be the riskiest, and would therefore carry the highest interest rates. Paulson allegedly helped GS select the portfolio of lower rated mortgages. He actually paid GS $15MM for this privilege. He specifically looked for mortgages that had homeowners with low credit scores. The person who put the portfolio together for GS was Fabrice Tourre. Paulson’s goal was to then buy credit default swaps on the portfolio, essentially betting that it would lose value.
2. GS designed this portfolio, and somehow managed to get a AAA rating from both Moodys and S and P. Why did the ratings agency do this? It’s hard to say in this case, but previous cases show that the ratings agency were both negligent and incredibly optimistic. In many cases, they never really analyzed the value of these securities in great detail. There were many cases of the agencies giving ratings on several million dollars of CDOs after analyzing these securities for less than a day! In addition, the agencies agreed to a conceptual argument by the investment bankers that went like this: “Yeah, it’s true that each individual mortgage in this portfolio is BBB rated, but its unlikely they will all go bad at once. After all, don’t real estate prices increase every year? So, in aggregate, they should get a really high rating, right?” Incredibly, the agencies bought this ridiculous argument. In any case, they did rate this CDO a AAA, the highest possible rating. The portfolio was called ABACUS 2007.
3. GS knew that it would be difficult to sell this CDO to any sophisticated investor if they disclosed that Paulson had helped design it only to bet against it. Therefore, they hired a firm called ACA financial to serve as portfolio selection agent. ACA had previously placed billions of dollars of these CDOs in the past. One of the investors in this was a German bank called IKB. IKB was nervous about investing in these products without having an independent third party (ACA) involved. Based to a certain extent on ACA. IKB invested $150MM in April of 2007. The total value of ABACUS was $909MM.
4. One month later, Paulson purchased a CDS on ABACUS for about 50 basis points, or half a percent. When ABACUS lost all its’ value a few months later (which would lead many to believe it was never worth what GS said it was at the time of sale), Paulson reaped a profit of about $840MM. By my estimates, he made about 200 times his money in a relatively short period. IKB, as well as the other investors in ABACUS who did not purchase CDS, were wiped out.
5. The SEC believes that not only did GS not disclose Paulsons’ role (which would have made selling this instrument next to impossible) but actually led investors to believe that Paulson was actually BUYING the a part of the CDO. If this is true, then GS committed fraud. Even worse, it would seem that GS’ pledge to put clients first would be severely questioned.
Based on this news, GS, the banks and the market got hit hard on Friday. GS stock was down over 23 points on Friday, while the Dow fell 125. All the banks dropped in sympathy, with the financial sector ETF (symbol:XLF) losing 3.65%, its’ biggest drop in a very long time. Whether or not this leads to the long overdue correction should be played out shortly.
