The demand increases may slow soon if the U.S. economy continues to slow and drags the rest of the world down with it.  Furthermore, the high price of oil and gasoline may lead some businesses and consumers to switch to substitutes like natural gas or electricity for their energy needs that were previously met by oil.  Higher prices may also lead to less demand from consumers as they make decisions about energy use which conserve energy such as driving less.  So the rise in oil/gasoline prices may ultimately serve to decreases in demand if it induces conservation or substitution.

Given this rudimentary analysis, the Prince looked on with disgust as Hilary Clinton and John McCain lined up to endorse a plan to suspend the federal excise tax on gasoline for the summer travel season.  How do they plan to make-up for the tax shortfall that will be created by cutting the 18.4 cent per gallon tax?  You guessed it, by introducing legislation to impose a "windfall profits "tax on oil companies.  The Prince puts "windfall profits" in quotes, unlike the New York Times, because The Prince thinks that framing oil company profits as "windfall profits" is misleading.  What does "windfall profits" even mean?  Does it mean undeserved, unexpected, higher than normal and/or ill-gotten?  The Prince really has no idea what this phrase means.  As far as The Prince is concerned it is nothing more than a label trotted out by politicians to vilify the oil industry to appease ignorant voters.

It has been awhile since the Prince has seen such a transparent attempt to pander to voters by proposing legislation that is stupid and inequitable.  Let’s go to wonderland for a second.  "Look at me! I am on the side of the working man who weeps when he has to fill up his truck with $4,00 gas.  I am going to take ill-gotten gains from the big bad oil companies and give them to the working man by dropping the excise tax."  Let’s just throw the shareholders of these terrible oil companies under the bus.  Doing that will definitely lead to the kind of investment in extraction and refining that we need to increase supply.  Right.  Does this sound as crazy to you as it does to the Prince? 

Let’s go back to the real world for a real statement from the McCain campaign as quoted by the New York Times.  “It’s clear Barack Obama’s not strong enough to provide immediate relief at the pump, and it shows he doesn’t understand our economy or have the ability to deliver for hard-working Americans,” said Tucker Bounds, a McCain aide. “Senator Obama’s arguments against John McCain’s gas tax holiday are complete fiction, and the reality is that he used to support a gas tax holiday before he was running for president.”  Really, he doesn’t understand the economy?  Any middle school economist could tell you that this plan is stupid and does nothing to lower the long-term demand for oil or encourage more investment to bring on more supply.  Statements like the one made by Mssr. Bounds absolutely disgust The Prince and give him no confidence in his representatives ability to make decisions based on reason.

"Gas tax holiday" there is another phrase that does not make sense.  It makes this legislation sound like a sweet deal for everyone like a free trip to the Hawaii or something.  Anyone who sat down and took a look at the history of boom followed by over investment then bust in the energy sector would never argue for a "Gas Tax Holiday" financed by a "windfall profit" tax.  The truth is profit desert has nothing to do with this question.  Oil companies have to have incentives to make investments in bringing more supply online.  They will only make the investments if they think they will get the returns on this investment.  The government changing the game by taking profits from the oil companies when times are good and not giving the companies any help when the industry is over-invested should give oil company investors fits.  The oil companies’ shareholders deserve the return on the investments their companies made.  Politicians should not have the authority to take from these shareholders who took the risk and give this to consumers who want cheaper gas.

This proposed legislation is so obviously political and it does nothing to solve the problem of high oil and gas problems.  In fact, in choosing to impose a windfall profits tax on oil companies the legislation makes it less likely that supply will be increased in the future and offers decreases incentives to conserve energy.  Removing this excise tax may make sense as a way to stimulate spending on non-energy purchases.  Yet, it’s purpose clearly is just to appeal politically to consumers who want short term savings on gas and are not looking at the long-term implications of this savings.  Politicians should be looking at the long-term costs of this legislation.  While the Prince is an independent and does not support Obama, Mssr. Obama does get it right by opposing this legislation.  It takes courage to take this stand considering how damaging it may be politically.  Mssr. Obama makes the decision for the right reasons too.  While he doesn’t argue that the industry should be protected from a "windfall profit" tax, he does firmly argue that the plan would save consumers little and do nothing to curtail oil consumption and imports.  Let’s get back to reasonable energy policy and not these politicized concessions that offer short-term political gains but no real long-term solution to the problems we face in the energy sector.

This morning in the New York Times, Andrew Ross Sorkin draws attention to the the fact that the Fed was calling the shots behind the Bear Stearns "bailout."  This point was obvious last week.  Just because the price moved from $2 to $10 and there is speculation about whether or not the Fed set the offer prices does not make this any more or less of a "bailout."  It was pretty obvious the Fed was pulling the strings from the beginning.  Just take a look at the original $30bn backstop (now $29bn with JP Morgan on the hook for first losses of $1bn on risk derived from illiquid BS assets).  By meddling in the Bear Stearns mess again the Fed has entered a quagmire of competing interests.  The parties it must politically handle are Bear Stearns’ shareholders, J.P. Morgan, Wall Street, neo-liberal economists who want the Fed to stay out of this mess, those that want to give relief to homeowners, and congressman trying to figure this out.  To wit, the consequences of Bear going bankrupt would have been catastrophic for economies and markets around the world.  However, The Prince doubts chapter 11 was ever an option for a Bear Stearns, which was careening towards insolvency (he is not alone and BS could only seek Chapter 7 with the trustee being SPIC).  Were the actions the Fed took in the "national economic interest" of the U.S.?  It does not matter much to The Prince—what is done is done, and its implications are enormous.  

After reading Mssr. Sorkin’s column, The Prince is convinced that by focusing on the intrigues of how the Fed called the shots on the offer, he is missing the long term implications of the Federal Reserve’s actions in the Bear Stearns debacle.  It is interesting that the Fed did not inform Bear of its plans to open the discount window the night it signed JP Morgan’s bid.  These actions clearly favor the argument that the Fed preferred the first bid, as Mssr. Sorkin points out.  The Prince couldn’t agree more with Sorkin when he states the fact that, "The Fed is officially in the deal-making business."  But why is this problematic? 

Most of the stories about this mess have spoken vaguely about "moral hazard" and setting a precedent which will increase risk taking in the future etc.  Very few columnists, journalists, or bloggers have looked at what the actions of the Fed forebode for Investment Bank regulation going forward.  The Prince does not care what happens with the Bear Stearns takeover because the long-term implications of the actions taken by the Fed in this debacle are far more ominous and important.  Please allow The Prince to illustrate some of the most problematic implications.

First, the Fed has now become the lender of last resort to the entire financial system, not just the bank holding companies that it normally regulates.  This is a landmark event in American monetary and economic policy.  The Fed as a lending last resort has fundamentally altered the on-the-ground reality of counterparty risk, and this will forever change the environment in which investment banks operate.  The Prince does not know when the current credit crisis will end or when the Bear Stearns will be put down, but one thing is beyond clear.  At the end of this mess the regulatory environment governing the financial sector will be dramatically different from what we have now.  While many on Wall Street may like the safety that the Fed provides as a lender of last resort, many on Wall Street will not like the changes that are coming.

Let’s analyze the situation more closely.  The Fed has rescued an entity with almost $30bn in credit and the entity is not regulated by the Fed.  Remember BS is regulated by the SEC.  The SEC’s required capital levels are roughly a third of what the Fed requires of the commercial banks it regulates.  The Fed has taken these steps because of its concerns over counterparty risk.  That is the worry that Bear Stearns liquidating would impose enormous burdens on its counterparties and throw the financial system into a frenzy.  This is the second time The Fed has done this (the first time being LTCM where it helped to orchestrate a Wall Street bailout of the hedge fund).

We will soon learn that the Fed has learned its lesson when it comes to counterparty risk.  Such risk will have to be managed much better by banking regulators around the globe.   This will bring an end to the free-wheeling days of fixed income derivatives.  The Prince predicts that most of these derivatives are pretty much over and will be the whipping objects of many analysts of what went wrong at the investment banks.  More robust (regulated) settlement and clearing processes are coming and the Fed/Treasury will be driving these changes not the ISDA, the SEC, or the broker dealers themselves.  Fixed income derivatives are likely to go the way of other securities markets.  This means they will be non-levered hedging and speculation tools.  Leveraging through derivatives will probably end with an order from the regulators against such actions.

Second, the Fed has crossed the Rubicon in regards to the type of financing it is providing for the transaction.  The financing of $29bn is almost equity type financing.  It is a $29bn non-recourse line to finance toxic parts of the balance sheet of Bear Stearns only protected by $1bn cushion of first loss collateral from JP Morgan.  What would happen if a broker deal is going down and there is no other broker dealer to buy the company like JPM?  This BS deal better work or we are may be seeing the Fed explicitly recapping financial institutions by directly injecting equity or taking over the institution.

Third, the days are gone when an independent investment bank could have a large trading book.  The Fed will ensure that if it is required to bailout such institutions, not having regulatory of capital jurisdiction over such entities would be wholly unacceptable.  The Prince also sees no real way for the investment banks to opt out of the protection that the Fed has now extended because any investment bank is subject to counterparty risk in the financial marketplace.  Investment banks will turn into banks, through consolidation driven by non-stressed, distressed, or regulatory realities.  Under this new regulatory system Goldman Sachs, with its large trading book, is no longer the model investment banking and JP Morgan now assumes that title.  JP Morgan is the correct model to the Fed in an "everybody is too big to fail" regulatory regime.  As a result of this new regulatory regime, a big round of consolidation among financial services is coming in the U.S. and probably globally.

To conclude this argument, The Prince must say that the credit risk of any modestly sized financial institution, that is a player in the capital markets, is a good buy now that we are living in an era free of moral hazard.  If a company is big enough, there is no credit risk with the Fed waiting there with a bailout.  So go forth and sell protection on LEH, GS, and MS CDS at these levels.  Also go out and buy Agency credit risk.  It may be some of the last good money to be made before the regulators begin to burn and pillage the investment banking community.  If BS is too big to fail and the Fed has to provide $30bn in effective equity in a bailout then what large financial institution is a credit or a counterparty risk?  That is all my loyal subjects.

The Prince, like many financial bloggers, has followed the plight of the increasingly burdened  U.S. consumer for some time. (See this post, this post, this post, and this post for examples).  Yesterday we got more important news that signifies that the U.S. consumer is overextended with little access to more credit and will be forced to cut spending.  The press (WSJ, HousingWire) and financial bloggers (Barry Ritholtz at The Big Picture, Calculated Risk) have commented on the default rates for Home Equity Line of Credit (HELOC) loans.  From a lenders perspective these loans are toxic because they are subordinate to the claims of the lender on the house.  So if a homeowner can only afford to make their regular mortgage payment they will not make their HELOC payment. This will negatively impact the homeowners credit score but none of their assets, especially their home, cannot be taken by the HELOC lender.  HELOCs used to taken out to finance home improvements or pay for high health bills.  In recent years with housing prices rising across the country they were taken out to subsidize discretionary spending.  Buy the hummer, take the vacation, get the plastic surgery, etc. and don’t worry because housing prices will keep rising and you’ll get to refinance your Option ARM once it is about to reset.  We no longer live in that fantasy world and many consumers are overleveraged and barely making their payments.  Or they are trying to decide which loans to default on since they are unable to make payments on all the loans.

This is just the latest sign that the consumer in the U.S. is under serious pressure.  The tightening or credit and the credit crisis have certainly contributed to the recession which the WSJ poll of economists confirmed today.  Yet, what will really decide the length and severity of this economic downturn will be the actions of U.S. consumers.  Consumer confidence has been down.  Consumer lending and mortgage lending are also way down which is making it increasingly difficult for the overlevered U.S. consumer to continue to consume beyond his or her income.  HELOCs were just one of many instruments that consumers tapped to drive the U.S. personal savings rate even lower.  Investing in a home used to be a form of forced savings, with HELOCs that has ceased to be the case.  Give the American consumer a dollar and he or she is going to spend two.

Now with incomes not rising and home values falling it is becoming more and more difficult to keep consuming with little new consumer credit available.  Plus, to all those homeowners under pressure to make their ARM mortgage payments after reset and their home equity loan payments, don’t even think about selling your home and paying off your home equity loan since reports out yesterday showed demand for homes is at a 5 month low.  The Prince is going to do it.  He is going to bet against the U.S. consumer.  Many may think this is folly but The Prince believes the consumer will not be able to spend the U.S. out of this recession this time.  Dropping consumer spending in the U.S. is going to take a toll on international markets obviously.  Countries like China that are export economies and have not developed a large enough consumption base will be hit hardest by the American consumer with empty pockets and no access to new debt.  Given the pressure the U.S. consumer is under, the technocrats in Beijing must be a bit apprehensive right now.

More Excerpts from the WSJ article:

Other types of consumer loans also are souring, including credit cards and auto loans. But delinquent home-equity loans are rising faster, representing 12.5% of all delinquent loans in the fourth quarter at Bank of America Corp., the largest U.S. bank in stock-market value. That was up from 9.4% in last year’s first quarter, according to research firm SNL Financial.

…

Meanwhile, financial institutions are refusing to provide home-equity loans to homeowners whose residences are already weighed down by big mortgages in states like California and Florida where home values are falling fast.

"This product was meant to help people do construction on their house, [and] do debt consolidation — not to take out every last dollar of equity in their home to finance a different kind of lifestyle," Mr. Scharf said. J.P. Morgan is "rolling our changes back to represent that kind of product."

Here is an interesting article from HousingWire about Fitch downgrades related to HELOCs.

Want to know who lent the money for all these HELOCs?  Take a look at these charts from Mortgage News Online.

Richard Bitner recently released a book about the mortgage meltdown from the perspective of an originator of Mortgages.  The book, entitled Greed, Fraud & Ignorance: A Subprime Insider’s Look at the Mortgage Collapse, gives investors some food for thought in considering the faults in the originate, securitize, and issue to investors chain that mortgages went through.  The Prince is intrigued by Mr. Bitner’s book mainly because he seems to confirm much of what investors assumed and observed about originators once mortgage securities began to plummet in value. 

Richard Bitner spent 14 years in the mortgage industry, five of those as the president of Kellner Mortgage Investments, a subprime mortgage company. He was also a Director for GMAC Residential Funding and the National Training Manager for GE Capital Mortgage Insurance (Genworth Financial).

Certainly Mr. Bitner hits on some of the problems The Prince has harped on when talking about the mortgage crisis.  For example, he discusses stated income loans given to those with high FICO scores, occupancy fraud, teaser rates, NegAm loans, Option ARM loans, the lack of skin in the game for originators or rating agencies, fraudulent loans and finally incentives that did not reward originators for saying no to prospective borrowers who presented dubious risk/reward profiles.  We would all do well to learn from the mortgage crisis we are going through now by studying accounts like Mr. Bitner’s so we can figure out how to fix the industrial organization of the mortgage financing industry to prevent another meltdown.  A recent post by Mr. Bitner entitled "FICO - The Late, Great Credit Score?" sheds some light on what we can learn from the mortgage metldown by looking at how originators used FICO scores.

Here are some excerpts The Prince has selected from Mr. Bitner’s recent blog post on FICO score use by the originators (bold added by The Prince):

It’s been 12 years since Fannie and Freddie began requiring FICO scores on every loan they purchased. Interestingly, the subprime industry took much longer to completely wrap itself around the use of credit scoring. Some of the early subprime pioneers, guys like Vince DiMare at Equity Secured Investments, were skeptical of FICO, and for good reason. As he mentioned to me on numerous occasions, “why do I need a score to tell me what is an acceptable level of risk, when I already know how to underwrite these loans.” No truer words have ever been spoken.

Having worked for GMAC Residential Funding Corporation in the late 90’s, I saw enough performance reports on billions of dollars in loans to become convinced that FICO was a reliable indicator. But even given the volume of data, RFC took years until it moved away from a traditional subprime underwriting methodology to one that was FICO based. I remember a three-year span in which the company had two underwriting manuals for subprime, one for the traditional method and one for the FICO approach. RFC was reluctant to pull the trigger on FICO because even with all the performance reports to support its use, the old-line risk guys weren’t completely bought in.

The erosion in loan performance we’re seeing is not a fault of a poor scoring model, but an industry that forget it was not an absolute. Even when RFC had two underwriting manuals, they were still very similar in structure. While the traditional method didn’t pay attention to credit score, both manuals still understood the importance of how all the other credit factors fit into the picture – down payment, performing trade lines, etc. Whether FICO was part of the picture or not, the loan still needed to make sense at every other level and that’s where the industry went askew. It may be the most overused term in the business, but common sense underwriting meant putting borrowers into loans they could afford. FICO wasn’t needed to tell us that.

However, when all of the other credit factors were held constant, FICO was dead nuts on, and that’s perhaps the most critical part of this discussion. The failure was on the part of the industry taking FICO as gospel and forgetting that it was still necessary to underwite the file as if we really were mortgage bankers.  Ironically, Equicredit, the former subrime division of Bank of America, experienced six years ago what the rest of the industry is now going through. When I opened my subprime company in 2000, they were the most FICO driven company around. Putting all of their eggs into the FICO basket and ignoring the fundamentals of underwriting meant their loan performance tanked. What’s interesting is that their performance stunk at a time when property values were rising and interest rates were dropping. If this strategy fails under optimal circumstances, what makes anybody think it will work under abysmal conditions like we’re seeing today?

Last week I wrote about a 2007 Alt-A pool of loans from Washington Mutual that is performing horribly – 15% foreclosure rate with 8 months of seasoning. I was taken aback by how a pool of 705 loans could deteriorate so quickly. But I was reminded by readers that I had forgotten the very things I wrote about in Greed, Fraud & Ignorance: A Subprime Insider’s Look at the Mortgage Collapse, the same things I’ve written about in this paper. Somehow I diluted myself into thinking that scores in this range couldn’t perform this poorly (and so quickly). But the loan characteristics were indicative of just how far we’ve fallen as an industry. Most of the loans were stated income (90%), CLTVs north of 90%, likely closer to 100% but we can’t tell for certain, and mostly pay option ARMs with of course, super-low teaser rates. How many were investor loans and were they really stated income loans or something akin to NINAs? I don’t know but I’ve got a strong suspicion this played into it.

So is FICO still relevant to the mortgage industry? I think it all depends on whether the industry and the securitization process function as they are supposed to. If the rating agencies have a vested interest in the loans they rate (e.g. they rate them with some level of competency so investors all over the world don’t buy the bonds believing they’re something that they’re not) and the rest of us remember the basic fundamentals we learned in Underwriting 101, then yes, FICO is still relevant. If not . . . well, maybe it’s time to fire up the snow cone machine. After all summer is just around the corner.

Many of the applicants, at least the competitive ones, will pour over resources like the Vault Guides, Wall Street Oasis, Mergers and Inquisitions, and maybe even this site in search of an edge in the process.  The Prince has blogged before that the odds are not good in the regular recruiting process when it comes to bulge bracket banks and especially when it comes to the top groups within these banks.  If the deck is stacked against even someone from a target (i.e. Harvard, Princeton, Stanford, Yale, etc.), then for a non-target (i.e. state schools, liberal arts colleges, Indian country, educated and raised by wolves etc.) the odds appear downright disheartening.  Nevertheless, some non-target applicants will make it through this grueling process and secure offers with the right combination of connections, interviewing skills, finance knowledge, academic record, and character traits.  The target versus non-target distinction may not be fair and no one disputes that applicants from both groups will be able to do the work.  Like an old coworker said to me once during my summer analyst job: "I can’t believe I get paid this much to just add, divide, subtract, and multiply in a model then put that into a pitchbook."  I even have one really quantitative friend with a double major in math and financial economics who was told in a banking interview that he was too bright for the work, would get bored, and would be better off going into sales and trading or a hedge fund.  Please check out the Prince’s two older posts about getting interviews and then killing them if you want to explore this further.

Now that we have set the scene, The Prince wants to offer some gross speculation on what this year’s recruiting season was like.  This is mainly based on anecdotes, the fortune or lack thereof of friends, and insight from some friends that are currently bankers.  Typically, the regular recruiting process for full-time analysts starts in late August and wraps up before Christmas.  It consists of interview drops, followed by on-campus interviews, and then ’superday’ interviews at the firms for target schools’ students.  For non-targets, it looks more like a resume passed to HR by a contact, a phone interview, and then maybe a ’superday’ if the applicant is exceptionally impressive or has a great connection.  Summer analyst recruiting starts in the middle of January and runs till about the middle of March normally at the bulge-bracket banks.  Some banks will take some people off cycle for full-time or summer analyst jobs but this is fairly rare.  The Prince has known one person who left Google after only 3 months on the job after graduation and was taken off cycle to start at a bulge bracket as a 1st year analyst.

By all accounts this was a brutal recruiting season.  Full-time offer rates to summer analysts were down sharply.  In some regional offices I heard of groups giving offers to 1 in 4 summer analysts.  Many summer analysts who did get offers jumped on them and didn’t wait to try their luck for better offers in the regular process.  So there were fewer slots left for the full-time process.  The number of full-time analysts hired was also down across the street.  The Prince has friends at targets that had summer analyst jobs at top banks but didn’t get full-time offers after the summer, and then didn’t get any full-time offers in the regular process.  By all accounts it was a bloodbath this year in recruiting. The Prince and a few of his friends were fortunate enough to get summer analyst jobs and full-time offers at places they wanted to work.  Others were not so lucky and many are still looking.  This was not the case last year when banks were hiring at higher rates not seen in years.

Yet, why was it so brutal?  The response seems obvious—if banks figure out bonuses by placing 50% of their weight on the past year of performance and the other 50% on the outlook for future performance, they probably do the same thing with analyst recruiting.  The forward calendar looks weak.  The LBO game is shut down and certain fixed income products may never come back.  This also looks to be a sleepy year for M&A.  So things look bad and banks are cutting back on their analyst classes.  Does this really make sense?  Well, it is possible to argue that this is a dumb reason to cut back on analysts that are the cheapest form of professional labor employed by a bank.  For example, take a bulge bracket bank with 100 investment banking and 100 capital market summer analysts.  If the total cost of training, paying, relocating, and hiring each of these 200 summer analysts is $18,000, which is probably high, the total cost of this program for a summer is $3.6mn. 

That seems like a small expense to get to do a three month job interview of the most qualified candidate your bank can convince to come.  It looks even cheaper when you consider that many no name managing directors get bonuses is excess of that every year.  Albeit these managing directors do normally bring in business and don’t just crunch numbers but you get the Prince’s point.  Also, do we really believe that all those summer analysts don’t ad any value to the firm in excess of their $3.6mn cost.  My summer experiences had me doing the same work but slower than my full-time analyst peers. 

If everyone else is cutting back, should an opportunist bank increase hiring of summer analysts to get stellar candidates that in past years it would not have had a shot at? This seems like a great time for HR and the leaders of banks to think strategically about how to improve the quality of their talent at the analyst level.  Now for full-time analysts, cutting back may be more prudent because the costs per analyst are higher.  Yet, analysts are still the cheapest labor a bank has, and getting top quality talent in at the ground floor will improve the firm if the talent stays.  It may also help the firm if the top talent does leave after 2 years to head into PE or HFs, since these former analysts will rise into positions of power on the buy-side with, if their experience is good, a preference for their old firm.  Certainly no one gains friends by firing their incoming analyst class but a bank also sacrifices potential future high quality talented friends by cutting back on full-time and summer analyst positions.  Maybe The Prince is full of it and less work for a bank on the forward calendar must translate into fewer analysts getting hired.  Yet, that seems like a pretty short term outlook, and banks that act strategically now to hire more analysts may reap long-term benefits by getting more quality talent than they could expect to attain in previous years.

Today at a Morgan Stanley Technology Conference, Microsoft finance chief Chris Liddell brought up, completely voluntarily, the company’s bid for Yahoo. Here is the conversation between Liddell and Morgan Stanley technology analyst Mary Meeker, from an SEC filing:
MARY MEEKER: In our remaining minute, anything that you’d like to address that we’ve missed?
CHRIS LIDDELL: Well, no one asked me about Yahoo, which is interesting. But I’m sure everyone is vaguely interested in it. You know, their…"
MARY MEEKER: What was that? What was that?
CHRIS LIDDELL: Yeah. The small company that we’re looking to acquire. There is — there?s no fundamental news. I mean, the — you know, the company has not yet formally responded to our offer. So you’ve seen the same press reports we have in terms of their view of it. You know, we continue to look at our options, and that’s something that I’m incredibly systematic about. That’s something that we look at, those alternatives, every week on the basis of what’s happening in the external market: what the opportunities for us are both in our customer business and through acquisition. So, you know, we’ll continue to look at those alternatives as we go forward, but there’s no news, per se, on Yahoo.
We like Liddell’s understatement that people might be "vaguely" interested in Microsoft?s acquisition of a "small company." But, humor aside, Liddell’s comments don’t tell us about any talks. After all, Liddell only talks about a "formal" response. And what to make of his indication that he has heard about Yahoo’s opinion of the deal only in the media.

The recent failures of many municipal bond auctions combined with the pulling of many expected municipal bond issuances has created more turmoil in the market related to the insurers.  The spike in rates has caused the cancellation of one bond offering planned for this week.  The Houston Independent School District said that it had withdrawn a planned $385.4 million municipal-bond issue, saying the rapid rise of interest rates had made the cost of such an offering prohibitively expensive.  For those who are unfamiliar, municipal issuers finance such things as hospitals, road construction, schools, sewer systems and sports facilities.  Local governments seek bond insurance to reduce the perceived risk of owning their debt. That can attract more investors, resulting in lower borrowing costs and saving taxpayers money. 

Now had the bond insurers not moved beyond their municipal bond insurance roots by insuring more leveraged and complicated securities most municipalities would not be facing higher borrowing costs on new issuances and refinancings.  To give everyone some idea of how bad things have become in the secondary market for municipal bonds check out these numbers from two recent WSJ articles here and here:

Municipal debt generally pays out interest that is 10% to 20% less than comparable U.S. Treasurys because holders don’t pay federal taxes on the interest income. Friday, top-rated 30-year municipal debt was yielding about 16% more than 30-year Treasurys, and two-year municipal notes were paying out 60% more than comparable Treasurys.

When the tax benefits are taken into account, the result is eye-popping yields. At an average yield of 5.14% on triple-A-rated 30-year municipal bonds, a California resident in the top federal income-tax bracket earns the equivalent of 8.72%.

As a result of that surprising forced selling, yields on debt from municipalities and other tax-exempt issuers jumped to their highest levels in history, when compared with safe debt issued by the U.S. government. The average AAA-rated, 30-year municipal bond yielded 5.14% Friday afternoon, compared with 4.42% on a U.S. Treasury 30-year bond.  In normal times, municipal-bond yields are much lower than Treasurys.

No wonder many veteran bond investors love the state of municipal bond, so long as they were not long before the sell-off (the average long-term national municipal-bond fund is down 3.83% this year).  These investors have little doubt they see the greatest buying opportunity of their careers.  Think about this trade, which only an institution could undertake, you go long against municipal notes and you financing by borrowing in the Repo market against your lower yielding Treasurys of comparable maturity.  Needless, to say The Prince is sure that many of the best brains in credit investing are now employing similar strategies or far more sophisticated strategies.  If you need evidence look at these quotes from the WSJ articles: 

Shelia Amoroso, a portfolio manager at Franklin Templeton Investments, says she has never seen anything like this in her 21 years in the market. "It’s a compelling buying opportunity."

Hugh McGuirk, head of the municipal-bond division at T. Rowe Price Group Inc., Friday bought bonds issued by the state of Florida yielding 5.85%. Two weeks ago they were at 5%. "We’ve been waiting for a market like this."

This puts the municipal market in the odd place of competition with struggling stocks. "Munis are offering a risk-adjusted return that probably exceeds equities under more normal circumstances," Cumberland Advisors said in a weekend market update.

A number of players said they also are looking at an area known as "pre-refunded" municipal debt, in which interest payments are effectively guaranteed by a pool of U.S. Treasurys or other government securities held in an escrow account.

Late Friday, the average 5-year pre-refunded bond yielded 3.23%, compared with 2.47% on a five-year Treasury. Throw in the tax benefit, and for a New Jersey resident, the pre-refunded debt pays the equivalent of a 5.31% yield on Treasurys. George Goncalves, an interest-rate strategist at Morgan Stanley, calls it "the dislocation of a lifetime." The market, he says, "has thrown out the good with the bad."

"The muni market is at relative values that I have not seen in my career before," said Evan Rourke, municipal-bond portfolio manager at MD Sass in New York. At current valuations, he said, investors can earn 5% or more on tax-exempt municipal bonds, roughly equivalent to an 8% taxable yield. "At that level, you’re approaching long-term [stock] returns," he said. 

Brokerage firms issued all-points bulletins to their sales forces Friday suggesting they send clients into municipal bonds. One Morgan Stanley strategist described it as "the dislocation of a lifetime." Bill Gross, managing director of Allianz SE’s Pacific Investment Management Co., or Pimco, said Friday the bond titan is moving out of Treasurys and corporate debt into the muni market.

It is worth noting that these municipal bonds do look attractive since the fundamentals have not changed.  The credit quality of municipal borrowers has not changed substantially even though the pricing in the secondary market for municipal debt has fallen off a cliff.  Default rates on municipal bonds tend to be low, even without the bond-insurer guarantees. S & P says municipal debt carrying a BBB rating has a long-term default rate of about 0.32% of outstanding bonds. That is lower even than the 0.6% default rate on AAA rated corporate bonds.  Buying municipal bonds looks better than buying high yield corporate debt, which also has exceptionally high yields right now, since corporate defaults may substantially rise in the wake of the credit crunch and slowing economy. 

So why are municipal bonds so cheap?  The market chatter says that two hedge funds (Duration and 1861) have been doing recent forced selling (to meet margin calls on bad trades in other securities) by having their broker dealers shop sell lists of these hedge funds’ municipal securities for bids to their clients.  The WSJ remarks that, "in recent years hedge funds had flocked to a trading strategy that hinged on the normally reliable wide gap between yields on short-term and long-term municipal securities.  The hedge funds sought to profit from that gap by borrowing at the lower short-term rates, buying longer-term higher-rate municipal debt and pocketing the difference. They magnified this trade by borrowing heavily to make this bet, sometimes using 10 times debt for every dollar of investor money they were putting to work. At times they also layered on bets against U.S. Treasury securities."  This trade would be a terrible place to be lately since both sides of this trade would bleed money as Treasurys strengthen and Municipal debt weakens.  Clearly the weakening of municipal debt has been partially caused by the struggling bond insurers.  Yet, forced selling is playing a role.  However, if the likes of PIMCO start buying municipal bonds en masse then we can expect the yields to drop on the bonds.  The current pricing of municipal bonds related to Treasurys is about the clearest market inefficiency The Prince has ever observed.

Yet, what The Prince is most interested in right now is the future of insurance for municipal bonds.  Is it necessary?  Can it be used to achieve a lower cost of borrowing for municipalities, governments, school districts, and the like?  First, we have to ask if being in the business of insuring solely Municipal bonds right now is a good business.  Warren Buffet seems to think so.  He recently launched a bond insurer that would help state and local governments lower their borrowing costs, and possibly lure business from established rivals struggling with failing credit markets.  Berkshire Hathaway Assurance Corp guarantees the bonds that cities, counties and states use to finance public works.  The new company avoids investing in structured products, such as bonds backed by cash-generating assets such as mortgages and credit-card receipts.  Berkshire Hathaway Assurance Corp., or BHAC,  has effectively been taking market share from incumbents such as Ambac and MBIA which have been struggling to keep their triple-A credit ratings.  In recent days, rating agencies have bestowed triple-A ratings on municipal bonds insured by the new Berkshire venture, months before competitors and some analysts predicted. Last Friday, Maryland’s insurance department granted BHAC a license to do business in that state. The company has already guaranteed more than 100 municipal-bond offerings, including debt issued by New York City, where it received its first license.  The Prince would have to agree that business is good for an insurer with a strong balance sheet, that isn’t trying to raise new capital, and is not taking a six month hiatus from issuing new paper at the behest of the rating agencies.

If we accept as a first premise that issuing bonds with insurance issued by a well capitalized insurer does lower borrowing costs, then The Prince thinks he sees a better way to lower borrowing costs.  While The Prince is not an expert on this topic, he would love to get some feedback on this idea.  Why do we not see the big issuers of municipal bonds i.e. the Port Authority of New York and New Jersey, the State of California, tollways, etc., forming a coop together to issue insurance.  This coop would take the form of a public "utility".  Why give all the rents to Warren Buffet’s insurer or another insurer when the issuers can effectively cut the middle man out.  In theory, if we could get the top 100 issuers of municipal bonds to contribute capital to an entity controlled by the contributors that entity could then provide insurance to the members at a lower cost than private insurers.  The contributions would serve as the assets that would insure the bonds from default.  The effective borrowing costs for issuers would have to decline under this cooperative self-insurance scheme.  Under this scheme Tom Dresslar, spokesman for California state Treasurer Bill Lockyer, wouldn’t have to say "we’re prepared for higher rates than we’ve paid in the past."  California could buy insurance from this cooperative public "utility" entity which would lower the State of California’s cost of borrowing even when you consider the fact that California had to buy shares in the cooperative entity.  The market may be pricing insurance from unsound insurers as if it doesn’t exist right now but they could not ignore insurance issued by a well capitalized public "utility" like the one The Prince has outlined above.  If nothing else there would be serious savings for those that still want to issue debt that has insurance.  This is the case, because Before the bond-insurer crisis, bond insurers charged about 30% of the interest-rate savings an issuer would get.  This has climbed to about 80% or 90% as the bond insurers try to extract as much premium as possible. For the issuers, though, that has reduced the value of the coverage. 

If all the major issuers setup the scheme The Prince has discussed above, not only could they save the premium that insurers extract, but the value of their bonds’ insurance would not be subject to the poor business decisions of a third party bond insurer choosing to insure riskier non-municipal instruments.  All the questions in the market like those intoned by California’s deputy state treasurer, Paul Rosenstiel, "as to the value of insurance and whether it would save us money" would be silenced.  Please, to those who are more knowledgeable about this than The Prince, tell him why his scheme above would not work.  He wants to believe that a scheme as this simple can’t work in our time of sophisticated and evolved finance.

The New York Times ran an interesting story (Mergers in a Time of Bears) yesterday morning by Andrew Ross Sorkin.  The article comments on a recent study, which examined how successful mergers were based on when in the merger cycle they were announced.  While the findings of the study are not exactly earth-shattering, they do confirm what many investors have long believed: many mergers that were completed when acquirees were cheap at the beginning of a merger boom have been successful.  Some of the best IRRs on investments by private equity firms have been achieved when the PE firm purchased the company in a recession or at the beginning of buyout boom.  Buying something cheap when no one else is buying it makes perfect sense; you could earn a larger return than if you bought it at the peak of valuations in a merger boom. 

The study, published in this month’s Academy of Management Journal, found that deals struck in the first 15 percent of a consolidation wave tend to do well—at least measured by the acquirers’ share performance against that of the broad market.  The value destroying deals come later, when other companies join in the buying spree.  The undeniable existence of first mover advantage seems obvious.  The study examined 3,194 public companies that purchased other companies during acquisition waves between 1984 and 2004.  “Our findings suggest that the market rewards executives who perceive opportunities early, scan the environment for targets and move before others in their industry,” said Mr. McNamara, one of the professors behind the study.  “Conversely, the market severely punishes followers, those firms that merely imitate the moves of early participants in the wave, who jump on the acquisition bandwagon largely because of pressures created by competitors. Such companies typically lose significant stock value.”  To define a merger, wave the professors looked at 12 industries over the 20-year period. To qualify as a wave, merger activity had to show a pattern in which the peak year had “a greater than 100 percent increase from the first year followed by a decline in acquisition activity of greater than 50 percent from the peak year.”  Waves were as long as six years for some industries.

If it is the case that buying early in a merger wave is beneficial then why don’t we see more of it?  Why are CEOs hesitant to be contrarians and sit back when other CEOs in their industry are not acquisitive?  During volatile markets it seems like many CEOs are hesitant to act because of uncertainty in the market.  However, by completing a merger when there is uncertainty, CEOs would certainly increase the possibility that their mergers would be successful.  It may be counterintuitive to believe that deals consummated in volatile markets will perform better but this study certainly supports that postulation.  However, many CEOs may take this all with a grain of salt since even the quintessentially successful CEO, Jack Welch, didn’t follow the counterintuitive nature of this study’s findings.   The study found, however, that serial acquirers like General Electric don’t seem to do well through consolidation waves. Companies that “undertake acquisitions on a regular basis as part of their core business routines” are less likely “to either seize early-mover benefits or suffer from the costs associated with bandwagon pressures.”   

The Prince completely agrees that most mergers fail to increase shareholder value.  It also makes sense to him that mergers completed when assets are cheaper do have a higher probability of being successful.  By this logic, one could suggest that consolidation now in the mining industry will probably result in mergers that destroy shareholder value.  Timing is everything in trading, so why shouldn’t this apply in larger mergers?  Anyway, here are some interesting excerpts from the article. 

Most mergers fail.  If that’s not a bona fide fact, plenty of smart people think it is. McKinsey & Company says it’s true. Harvard, too. Booz Allen Hamilton, KPMG, A. T. Kearney — the list goes on. If a deal enriches an acquirer’s shareholders, the statistics say, it is probably an accident.

But a new study puts a twist on the conventional wisdom. It’s not that all deals fail. It’s just that timing appears to be everything. Deals made at the very beginning of a merger cycle regularly succeed. It’s the rest that fall flat.

….

Notwithstanding Microsoft’s $44.6 billion takeover bid for Yahoo or Electronic Arts’ $2 billion offer for Take-Two Interactive, 2008 is going to be an abysmal year for deal-making. Volume in mergers and acquisitions has plummeted 37 percent this year in the United States, according to Dealogic. (Factor out Microsoft-Yahoo and the drop is a whopping 56 percent.) That’s partly a result of the private equity folks’ being taken out of the equation because of the credit crisis. But it is also because C.E.O.’s and boards become paralyzed when the markets turn turbulent. Instead of making investments, they hunker down and focus on putting their houses in order. Remember those pundits who said corporations would fill the void left by private equity? They were wrong — only they shouldn’t have been.

…

Take the telecommunications industry. AT&T’s acquisition of Cingular (now AT&T Wireless), which was announced in February 2004, has turned out to be an unqualified winner. But the merger of Sprint and Nextel, unveiled 11 months later, was and is a disaster.

The numbers tell the story. Early movers — companies that made acquisitions in the beginning of a consolidation wave within their industry — found their stock up, on average 4 percent relative to where the shares would ordinarily trade, according to the study. Shares of latecomers, who bought at the end of a wave, fell by an average of 3 percent during that time. Of course, at the end of every wave there are bigger and more deals. After all, stocks are usually up, and so is boardroom confidence (read: exuberance). “There’s a social pressure,” Mr. McNamara said. “They like to be in the herd.”

…

There are a couple of caveats to the study. The professors measured the acquirers’ stock appreciation or deprecation by using a fancy calculation of what they call “abnormal returns,” which examined share prices five days before the announcement of the acquisition and prices 15 days later. The math is complicated, but they say the “abnormal return” is predictive of stock performance in the future. Of course, critics could argue the study doesn’t measure a long enough period after a deal is made.

Nonetheless, the point is clear: C.E.O.’s should stop being such scaredy-cats. While everyone else is battening down the hatches, go make a deal. The wave is just starting.

If you need specific examples of the problems that are plaguing other LBOs in the pipeline The Deal and The Deal’s Dealscape Blog have done some great work on this subject, which I link to below in the summary of problems with pending deals.

First up, is Bain Capital’s $2.2 billion buyout of 3Com Corp.which has raised the ire of a U.S. national security panel.  The panel is concerned about the Chinese company that is Bain’s co-investor.  The U.S. Committee on Foreign Investment recently made it clear that proposals to preempt concerns about Huawei Technologies as a minority investor were unconvincing.  CFIUS doesn’t want Huawei to gain access to 3Com’s sensitive encryption technology.  This concern prompted Bain and 3Com to withdraw their application for approval by CFIUS on Wednesday.  This move certainly is ominous for the prospects of this buyout actually getting done.  It could be the case that Bain will use the regulators as the scapegoat to walk away from this deal.  What is unclear is if Bain still wants 3Com even though technology spending is bound to slow given the recession.

A far bigger and more market moving deal is also on the ropes.  Clear Channel Communications $26 billion buyout has been plagued by problems at every step of the way.  This deal was supposed to close months ago, but everything from deal price, to shareholder approval has been a problem.  Now marketing the debt for the LBO by Thomas H. Lee Partners LP and Bain Capital LLC is looking predictably dicey. Since Blackstone’s failed purchase of Alliance Data other problems have been encountered on the Harrah’s Entertainment and Intelsat deals.  Clear Channel’s troubled sale of its television unit to Providence Equity Partners, now the subject of a Delaware lawsuit hasn’t helped ease the banker’s concerns.  Add that to the fact that ad spending is declining as the economy falters and companies operating in radio look like a poor place to be deploying money at such a high multiple.  Remember the Clear Channel buyout was and still is the poster child for an LBO with a purchase price that was a sky high multiple of EBITDA in a cyclical industry.  If you need proof that radio is tough, the Radio Advertising Bureau just announced that industry revenue fell 5% in January, and national ad sales dropped 13%.

This deal has been in the pipeline forever.  This deal was announced in November 2006.  The bid was boosted from $37.50 to $39 after shareholders complained.  Finally, the bid was raised to $39.20, and the investors were allowed to retain minority equity.  The deal is now supposed to close in March but the Prince is very doubtful on this one.  The Federal Communications Commission also held the deal up for more than 380 days and was finally cleared in late January.  The Justice Department just gave approval in February.

Yet, we still haven’t got to the marketing problem for the debt to finance this deal.   Needless to say there are not debt investors lining up to take down the debt of an over-levered company facing industry headwinds.  The banks are going to push back on their commitments and it will be interesting to see how hard a line Bain and Thomas H. Lee take with the banks.  The debt will be marketed until March 26 but financing this much paper doesn’t seem possible given the state of the markets and the weakness of the operating company in this LBO.  Citigroup, Deutsche Bank, Credit Suisse, Morgan Stanley, RBS and Wachovia have committed $22.13 billion in financing, including senior secured credit facilities, in an aggregate principal amount of $18.53 billion, a receivables-backed credit facility with a maximum availability of $1 billion and a senior bridge loan facility of $2.6 billion.  The banks want covenants tightened in the deal (because there isn’t a bid for debt that is of the covenant-lite variety peddled successfully to debt investors during the height of the LBO boom) and the PE shops are rumored to still want the deal to get done.  The Prince is highly doubtful that this thing will get financed.  However, this deal has already cleared so many larger road blocks that he thinks it will still go through with the banks taking a bath if they try to syndicate the debt or writing bridges to get the deal closed.

Now let’s move on the big elephant in the room.  That is the enormous loan package needed for the LBO of BCE.  The $23bn loan needed by Ontario Teachers’ Pension Plan, Providence Equity Partners and Madison Dearborn Partners for the buyout of Canadian telecom BCE Inc.   The looming financing, which was expected to hit the market in the first quarter, is drawing more scrutiny.  However, a lawsuit by Canadian bondholders, who claim they have been oppressed by the adverse effect the new debt will have on existing bonds, has scrambled the timeline somewhat.  A ruling by a Quebec court is expected in coming days, but the appeal process could drag the case out for some weeks. Bondholders and BCE agreed to an expedited appeal process, with a final ruling expected within 30 to 90 days after the appeal is filed. If bondholders lose, financing arrangements will be finalized soon after.  Yet, who knows if this debt will get sold to investors.  The deal is in a more stable industry and isn’t as absurdly levered as Clear Channel so this one’s debt may have a chance of getting sold to investors.  However, the buyers have said publicly that they won’t complete the LBO if the bondholders win the suit.

Finally, we end with the deal that seemed doomed from the start: Goodman Global.  San Francisco private equity firm Hellman & Friedman, a firm which The Prince really likes and respects, finally completed a $25.60-a-share, $2.65 billion leveraged buyout of Goodman Global.  It bought the air-conditioning equipment business from Apollo Management which had acquired it in 2004.  Barclays, GE Commercial Finance, Crédit Agricole’s Calyon New York subsidiary, GSO Capital Partners and Farallon Capital Management arranged $1.6 billion of debt financing for the LBO. An $800 million term loan garnered more than $900 million in interest after the banks sweetened the terms: launched at LIBOR plus 375, with a 98.5 original issue discount, the five-year loan eventually was placed at LIBOR plus 425 and at a discount of 96. In addition, a LIBOR floor of 3.25% was set for the life of the loan.  The relatively small size of this financing and the stableness of Goodman’s business probably contributed to the banks’ success in selling these loans.  It is ironic that the deal that seemed on the ropes when the buyout boom was still strong and constantly plagued by problems is the standout success in a sea of trouble for other PE LBO deals.

The Prince has contributed his own commentary on the bond insurers here.  However, this information and analysis is outdated now that many of the monolines are considering and some have proposed splitting into separate entities.  The Prince’s analysis pales in comparison to some of the work done by his fellow financial bloggers.  Here is a brief sampling of some of this work with comments from The Prince.

1) This post by Information Arbitrage gets to the heart of the problem with separating the insurers into two companies i.e. one company to insure toxic debt like CDOs and one to insure safer municipal/government debt.

Bond Insurer Break-up vs. Super SIV - Beware Unintended Consequences

2) There is a ton of great material on Alea blog.  Here is a sampling even though some of it is a little bit dated:

MBIA vs. Ackman

AMBAC CDS update

Monolines: CDS Improving

ACA: CNBC Commentary Factually Incorrect - Here Alea highlights just one instance of the traditional financial media being dead wrong about the insurers.

3) Perhaps the best analysis out there comes form Naked Capitalism who has been doing some great work on the monolines.  His analysis and depth of coverage is truly inspiring.  One day he put up 4 posts in one day on monolines.

Monoline Capital Finesse

Monoline Death Watch: Is There Really a Plan Here?

Calculating Damage of Monoline Meltdown - This is a great article assessing how much pain will be caused by the monolines getting downgraded or going under.

Fresh Credit Market Turmoil

Ackman Proposes Breakup Plan

The bond insurance debacle is just the latest iteration of the credit crisis that began this summer.  The knock-on effects of mortgage paper and the CDOs which depended on it for valuations being so grossly overvalued has had far reaching effects on all aspects of the U.S. economy.  There may even be more unintended consequences on the horizon because of the credit crisis.  For example, we are already seeing banks pull back from lending money to corporation.  We have also seen that it is much more difficult to raise money for companies with junk or questionable credit.  All these factors contributed to the recession the U.S. finds itself in now and serve to worsen the crisis.  It is worth reading the links above and staying appraised of the situation as it continues to develop at the monolines.

Excerpt from the WSJ:

Fitch Ratings said U.S. life insurers have an estimated $7 billion to $8 billion in unrealized losses on subprime and Alt-A investments.

The credit rater said that amount totals 13% of exposure and 3% of total industry capital. Fitch expects the industry to have recorded losses of $2 billion to $3 billion in the fourth quarter.

Life insurers have been among the many investors burned by investing in securities backed by subprime or Alt-A mortgages. As delinquencies on those loans have surged, the securities’ prices have tumbled amid slack investor demand.

Fitch’s report comes on the heels of one of the biggest insurers, American International Group Inc., saying it will have to write down the value of financial instruments tied to mortgages by some $5 billion.

Fitch "continues to believe" the industry’s subprime and Alt-A exposure "is manageable." But it noted numerous subprime securities have seen their prices and credit ratings slump, particularly in the fourth quarter.

Although the firm anticipates further subprime deterioration, especially for loans issued in 2006 and 2007, "our analysis suggests that the industry is well positioned to withstand current market volatility given its focus on high investment-grade securities, relatively stable liability profile and positive cash flow." Fitch added the industry is "well capitalized."

Societe Generale missed 75 warning signs on the activities of rogue trader Jerome Kerviel, an independent report has found, as France’s second-largest bank posted a 82 per cent fall in last year’s profit.

A preliminary report by a three-personal panel appointed in the wake of the scandal found that there were 75 alerts between June 2006 and the beginning of this year that should have alerted Mr Kerviel’s managers to his unauthorized trading. The 31-year-old Frenchman sent the bank to a €4.9 billion trading loss after running up bets worth €50 billion on the future direction of various European indices.

Risk control procedures were followed correctly, the report said, but compliance officers rarely went beyond routine checks and did not inform managers of anomalies, even when large sums were concerned. Nor were follow-up checks made on canceled or modified transactions.

"No initiative was taken to check JK’s assertions and corrections he suggested, even when they lacked plausibility," the report said. "When the hierarchy was alerted, it didn’t react."

The panel supported Mr Kerviel’s claim that he acted alone and that he did not profit personally from the trades. There has been speculation that the trader had been disappointed by an earlier bonus and had hoped that his ambitious bets would win him favor with his bosses.

The report said that Mr Kerviel got a €60,000 bonus for 2006 and had asked for a €600,000 bonus for 2007 but received half that amount.

"At this stage of the investigations, there is no evidence of embezzlement or internal or external complicity," the report said.

The investigation found that Mr Kerviel has started building up non-authorized trading positions in 2005 and 2006 for small amounts but the positions he took grew in size from March 2007 onwards.

According to Mr Kerviel, by Christmas he was in profit by €1.4 billion but his activities were discovered on January 8, fully identified by January 18, and SocGen was forced to secretly unwind the positions between January 21 and 23 in falling markets, taking it to a €4.9 billion loss.

The red flags that should have alerted bosses to the rogue trades included:

• A trade with a maturity date that fell on a Saturday
• Bets without identified counterparties
• Trades with counterparties within SocGen itself
• Trades that exceeded the limits of counterparties
• Missing broker names and large increases in broker fees.

There were also differences of up to €1.1 billion during reconciliations of Mr Kerviel’s trading books with SocGen’s online derivatives broker. The panel found seven false emails sent by Mr Kerviel that attempted to explain his trading and counterparties.

Mr Kerviel has been placed under formal investigation and is currently being held in a Paris prison. He is being investigated over computer hacking, falsifying documents and breach of trust but not fraud, despite SocGen describing his activities as fraudulent when it first revealed the biggest rogue trading scandal in banking history.

The trader has claimed that he believed that his bosses were aware of his activities. The panel’s report, released last night, continued, however, to describe Mr Kerviel’s trades as fraud.

The panel, which is due to report to SocGen shareholders on May 27, gave warning that it might uncover further small unauthorized activities. SocGen has already started shoring up its risk controls.

The bank this morning reported a net profit of €947 million last year, down from €5.2 billion in 2006. It unveiled a record fourth-quarter net loss of €3.3 billion, in line with its earlier forecast.

This is down from a €1.1 billion profit in the same three months of 2006. The 2007 dividend fell to €0.90, down from €5.20 per share. SocGen’s corporate and investment banking business had €2.6 billion worth of writedowns and losses on its investments in US subprime mortgage-related assets, in line with an earlier estimate supplied by the company.

Rival French banks BNP Paribas and Credit Agricole are considering making a bid for the troubled bank but Daniel Bouton, the chief executive and chairman of the bank, said that he would push ahead with SocGen’s standalone strategy.

The bank’s board rejected his offer to resign in the wake of the scandal.

Mr Bouton said this morning: “I am completely determined to continue with our strategy because, even taking into account our very bad year in 2007 due to the financial crisis and this fraud, it’s this strategy which creates and will create the most value for shareholders".

The bank is currently raising €5.5 billion in a fully-underwritten rights issue designed to recapitalize the bank after the trading loss.

SocGen’s independent investigation in being lead by Jean-Martin Folz, the former chief executive of Peugeot Citroen, assisted by Jean Azema, the chief executive of Groupama, the insurer, and Antoine Jeancourt-Galignani, chairman of the real estate company Gecina. PricewaterhouseCoopers, the accountancy firm, has been retained as an adviser to the investigators.

One angle of the mortgage crisis that has been incredibly under-covered by the financial and mainstream press is the adverse role that fraud and speculation played in the crisis.  The Prince first began to seriously consider the scale and reach of fraud in obtaining mortgages by single home homeowners, originators, originating mortgage brokers, wholesale originators, and speculators after a call done by Deutsche Bank on CDOs during the heat of the mortgage crisis.  In this call some anecdotal information was provided by some of the analysts about what kind of color they were hearing from mortgage originators about the actions of the owners of foreclosed properties.  Now it is already acknowledged in the industry that many people with negative equity in their homes who are unable to pay high monthly servicing payments because of resets on their ARMs are walking away from their houses.  They are not stripping the homes or living in them until they are foreclosed—they are simply moving out and beginning to rent or live with family.  Sure their credit is taking a hit but that can always be mended the next time they get a cheap credit for a house purchase when the cycle swings back the other way.  Also, consider that if they are already a borrower of subprime or questionable credit worthiness even a hit like a foreclosure is not going to knock their FICO score much lower.

What was unique about the Deutsche Bank call was not their description of the empty houses that were about to be foreclosed but the presentation of anecdotal evidence that many of the homes that were being foreclosed in new subdivisions were owned by speculators who had accumulated 3, 5, or even a dozen homes in one or multiple subdivisions using stated income loans (aka "liar loans’ as described by many in the industry or Alt-A loans).  Some had used Option ARMs or even subprime fixed rate mortgages.  It was suggested by the DB analysts and some questioners on the lines at clients of the firm that many of these speculators grossly exaggerated their stated incomes to qualify to purchase so many homes.  Many of these speculators were clearly reasoning that price appreciation over many houses, even if small, would provide enough income to allow them to resell the house before their case for servicing payments ran out.  When prices stopped rising many of these speculators had to walk away from the homes they had accumulated.  In new subdivisions where speculators were active the downward price pressure exerted on homes is enormous and particularly damaging to homeowners who bought in the subdivision with a mortgage that was responsibly matched to their proven income.  Lenders poring over their defaulted mortgages are already learning that the number of people who bought homes as investments (i.e. speculators) is much greater than previously believed. Well, Duh!  If you participate in a market where the incentives are so ripe for fraud and speculation because you as a lender don’t say no and allow fraudulent misstating of income you are going to see more defaults from speculators.

Furthermore, we must take note that many of these speculators used stated income loans or Alt-A loans.  The speculators may have had high FICO scores so they qualified for Alt-A loans but their actual income was usually far lower than the income they stated on their applications.  There are even claims among mortgage broker whistle blowers that mortgage brokers colluded with speculators to state high incomes when the originators knew that actual income was much lower.  This collusion is to be expected when the brokers and originators incentives give them no reason to say no since the risk of giving loans dolled out with dubious information was going to be passed onto investors.  When we consider that speculators used Alt-A stated income loans it is no wonder that the derivatives tracking the value of Alt-A CDOs have experienced sharp declines similar to subprime CDOs.  Many investors who were short subprime CDOs were and are short CDOs predominately composed of Alt-A loans.  Some of the pain in Alt-A loans experienced by long investors in the paper and originators that hold the paper in their portfolios (i.e. Countrywide, IndyMac, etc.) may be offset by refinancings and workouts that may allow speculators to keep some or all of their houses from being foreclosed.  This is especially the case since the new stimulus plan raised the limit on GSE guarantees which will allow many home mortgages that could not be guaranteed originally by GSEs more easy to guarantee which will make refinancings much more attractive.  That is attractive in the sense of lower more affordable payments as a result of lower interest rates caused by the added credit protection of a GSE guarantee.  However, it is doubtful that this relief will be large enough to substantially support the value of Alt-A CDOs in the secondary market or increase the actual cash flows from the underlying assets.

The speculation numbers reported by the WSJ are almost beyond belief.  About 20% of mortgage fraud involved "occupancy fraud," or borrowers falsely claimed they intended to live in a property, according to an analysis by BasePoint Analytics, a provider of fraud-detection solutions in Carlsbad, Calif.  Another study, by Fitch Ratings, looked at 45 subprime loans that defaulted within the first 12 months even though the borrowers had good credit scores.  In two-thirds of the cases, borrowers said they intended to live in the property but never moved in.  The lenders knew this was happening and did nothing to proactively prevent it.  Home builders have reached similar conclusions.  Many believe that as many as one in four home buyers in some markets were investors during the boom, up from their earlier estimates of one in 10 buyers.  Obviously the home builders knew "occupancy fraud" was occurring because there was no way they could possibly sell all the new houses they were building in subdivisions in hot markets like Southern California without this form of fraud.  They too turned a blind eye to get homes sold at the expense of protecting subsequent investors in the repackaged loans from increased credit risk.  Although this isn’t surprising since not short-term incentives existed for homebuilders to stop the speculators from committing fraud.   If you want more numbers to wrap your head around how widespread this was check out this excerpt from the WSJ.

Much of the occupancy fraud was concentrated in markets such as Florida, Nevada and Arizona, where prices were appreciating by double-digit percentages annually, said Kevin Kanouff, president of Denver-based Clayton Fixed-Income Services, a unit of Clayton Holdings Inc. that reviews about seven million loans a month on behalf of investors.

In Las Vegas, as many as 60% of the foreclosures last year involved non-owner-occupied homes, according to Applied Analysis, a real-estate-research firm. The Las Vegas firm compared the addresses of the borrowers with the locations of their homes. Where the addresses didn’t match likely indicated a speculator.

The temptation to lie can be substantial and may have been encouraged, or at least tolerated, by mortgage brokers and real-estate agents eager to close a home sale. Standards tend to be tougher for borrowers purchasing investment properties, since these loans are considered riskier.

Lenders typically allowed investors to finance no more than 90% of a home’s value, but if borrowers said they planned to live in the property, they could buy a home with no money down, even if they had scuffed credit and didn’t document their income, said Pete Ogilvie, a mortgage broker in Santa Cruz, Calif., and president of the California Association of Mortgage Brokers.

The bottom line is that the incentives in the mortgage industry for the originators and speculators were so skewed that creative innovations like Alt-A stated income loans were ripe for fraud.  The story about this fraud that is not being prominently covered by the financial media with the benefit of time will be seen as a lesson and warning sign for mortgage market participants once the mortgage credit market rebound.  Speculators lied to get more favorable loan terms or just qualify of loans period and the lenders turned a blind eye.  The lenders did this to pursue short-term profit and now the lenders & investors are paying the price.  In some cases speculators failed to provide required proof of income on non-stated income loans and mortgages were still issued by lenders which were later resold to investors as loans that had proven income as part of their terms.

Source: WSJ taken from MBA report

Basically, the jist of the story is that CS is earning more than UBS for the first time in 10 years mainly as a result of UBS’ missteps in the recent credit crisis and weakness is some of its main businesses.  CS was able to avoid the writedowns that forced UBS to report the biggest quarterly loss by a bank at 12.5bn francs.  The bank will give details about its loss on Valentine’s Day.

In the last year the investment banking unit at UBS has struggled.  Many attribute their poor performance to the departure of veteran rainmaker Ken Moelis.  Moelis setup a new firm by his name which is competing in LA with UBS LA.  He also took his top deputies with him and many of his ex-DLJ co-workers.  UBS has cut about 1,500 jobs in its securities business and probably still has a headcount that is too large given current market conditions.  UBS also has lower profit margins in banking than CS which will serve CS well if a slowdown in M&A is on the horizon or has already begun.  Private banking revenues have also not grown as fast as competitors in a business where UBS has normally been a standout.  IUBS is still the world’s largest asset manager.

Credit Suisse was going in gangbusters in 2007 with advisory roles on many of the largest sponsor related transactions.  Sponsors and Leveraged Finance had banner years at CS and are now considered among the top groups in the industry in these areas.  Even accounting for losses on leveraged loans the investment banking business had a wonderful year.  If you need more proof Credit Suisse was recognized as the "Global Investment Bank of the Year" in The Banker magazine’s annual Global Investment Banking Awards published in October 2007.  Credit Suisse also won three house awards, including Best Leveraged Finance House, Best High Yield Bond House^, and Best Convertibles House.  To lend more prestige to its investment banking division, in 2007 CS also ranked #6 and #4 in worldwide and U.S. completed M&A based on imputed fees.

CS also significantly brought down its mortgage and CDO exposure in the spring.  They historically were not a big player in mortgages or structuring so it is unclear how much exposure they initially had.  They were also early on seeing problems with origination.  In 2006 and 2007 the bank significantly reduced the amount of mortgage paper it issued.  It interesting to consider that First Boston (acquired by CS) along with Salomon Brothers were the original creators of the collateralized mortgage obligation a precursor to MBS and CDO securities and one of the most important financial innovations of the 1980s. 

The numbers simply speak for themselves.  UBS reported on Jan 30 it had a loss of 4.4bn francs in 2007 while CS is expected to post a profit of  8.65bn francs.

The trouble at UBS has caused the bank to seek shareholders’ approval to sell 13 billion francs in bonds that will convert to shares to investors in Singapore and the Middle East.  UBS stock is down 50 percent in the past twelve months, while Credit Suisse is down 36 percent.

Credit Suisse is certainly decimating UBS in investment banking globally and is growing its private wealth business faster.  Credit Suisse’s current fortune is surprising when you consider that this bank was in crisis as recently as 2002.