Monthly Archives: March 2009

A Scalping, Not a Haircut

In an auction that took less than two minutes, the best office building in New England, Boston’s John Hancock Tower, traded today for $640 million, or roughly half of what Broadway Partners paid for it in 2006. The building traded before that, in 2003, for $935 million.
But even those numbers don’t tell the whole story. The CMBS desk of one highly regarded Wall Street firm calculates that if you reduce the stated purchase price to reflect the value of the assumed debt (97% loan-to-value, 5.6% rate), the value of the building by itself is closer to $470 million, which would be 67% below peak pricing and half of its 2003 value.
No one in the commercial real estate business that I know of thinks that values have fallen that much. But when not much is trading, it’s hard to say for sure. To the extent that this trade is at all reflective of the market in general, things could get really, really ugly before it’s all said and done.

P-PIP for Dummies

The Financial Times website has a cool animated explanation of the Public-Private Investment Partnership program here. It takes about three minutes to watch and is narrated by a guy with a terrific English accent. Things always seems more understandable when they’re explained by the English, for some reason.
Although having seen “Quantum of Solace” for the second time last night, I’m still not sure I understand that, even though it was quite obviously the product of an English imagination.
The chase scenes were fun, though.

Mama Always Said I’d Be the Chosen One

Carl: Welcome to this edition of Squawk Box. I’m joined this morning by Joe Kernen. Becky Quick has taken the day off to work on applications to law school.
Joe: In the studio with us today is one of the giants of the Jersey waste-hauling business, Tony Soprano. Thanks for joining us today, Mr. Soprano.
Tony: Don’t mention it.
Carl: Tell us what’s new in waste-hauling these days.
Tony: We’re settin’ up to do a big business in dese toxics.
Joe: You mean, nuclear waste, that sort of thing?
Tony: Naw. I’m talkin’ about the toxic assets, all dese banks need to get rid of right away. Uncle Sugar is stakin’ us himself, and there’s some sweet deals. Me and the boys at the Bada-Bing, we’re gettin’ in on it, this P-PIP thing.
Carl: You mean the Public-Private Investment Partnerships that Secretary Geithner announced last week?
Tony: Yeah, dat’s it. You heard of leveraged buy-outs, right? Well, this is more like a leveraged give-away. The government puts up 93 cents on th’ dollar, you put up the other 7. You buy dese toxics and hope for the best. It don’t work out, you walk away, raise the rates on your shy business to cover your lost 7. And if it works? Well, you wouldn’t believe the vig. I’ll be able to afford whatever Carmela wants to buy plus an extra Russian girl or two. Maybe get a new boat. All on account of buying dese toxics on the cheap.
Joe: Just for information, they’re not called toxic assets anymore, you know. The word is “legacy.” Say, you can’t smoke in here.
Tony: (Lighting up a cigar) Who cares what they’re called. All I know is, we are bellying up to the trough, along with the big hedge fund players. Was dem that designed the whole thing anyway, dese hedge fund guys, then they just give the plan to little Timmy and said, here. Dis is what you’re gonna do if you wants the likes of us to get you some liquidity back in the system. Where’s the ash tray?
Carl: There’s a trash can right-
Joe: But do you guys have any real experience in working out bad credits?
Tony: (Laughing until he chokes) Sorry. Dat was a good one. We got an entire collections department. Reports to Paulie Walnuts. We have a high recovery rate. One hundred percent from the deadbeats who are still breathing.
Carl: You think the banks are really going to sell at prices that will look attractive?
Tony: Whadda you t’ink? The buyer is owned and largely controlled by the government. It so happens the government regulates and in many cases also owns the banks that are the sellers. How the banks gonna say no, with the government holdin’ a gun to their heads? They don’t play ball, they might find themselves in receivership. The fix is in, see. This is sweeter than anything we ever thought up in the business. I mean the waste haulin’ business.
Joe: But aren’t you worried about populist rage and Congress maybe taxing away your winnings some place down the line?
Tony: I take it you don’t know too much about how political campaigns are financed.
Carl: Well, thanks for spending part of the morning with us, Mr. Soprano. Please join us tomorrow when we will interview Christopher Moltisanti about making it as a screenwriter in Hollywood.
Tony: Umm, you might want to think about bookin’ someone else. Just in case.

Notional Value of Derivatives

I was in the audience at the Spring meeting of the Pension Real Estate Association in Washington, DC, when Tim Ryan, CEO of the Securities Industry and Financial Markets Association, addressed us about the current situation in the financial markets and the governmental response. He was modestly positive that the new Public-Private Investment Partnership and TALF programs will work, so the general message was reassuring.
In response to one question from the audience, he said that the book value of derivative positions tend to be the “notional value” of those positions. This set up a little alarm bell in my head, so when I got back to Houston I looked this up here.
As I understand it from this explanation, the $1.6 trillion book value of AIG’s derivatives overstates substantially its total credit risk exposure, which is some small fraction of that number- so my Tuesday morning post about the amount at risk if the book is mismanaged by new and less competent staff clearly exaggerated the potential size of the risk. Actually to calculate the risk would require a level of understanding of each position that only those involved in the trades could possibly have.
As to this flawed analysis, apologies, and mea culpa. I was erroneously applying the accounting we use in commercial real estate to derivatives. My bad.
I think the main point does remain the same, however- as seen by the mad scramble in the AIG Paris office today to replace the two guys who resigned there, thus potentially triggering defaults in their derivatives contracts. The question of whether the taxpayers will be called upon to prop this company up to the tune of even more billions rides in large measure on whether the current book gets unwound as competently as possible. Whether the replacements Banque AIG finds for its two resigning executives will be good enough to satisfy the French banking regulators and thus avoid a default, and who knows what additional damage to this company, is a risk we, as 80% owners of the company, wouldn’t be running but for all this whole bonus anger.

Get a Grip

This morning’s edition of The Wall Street Journal reports that AIG’s Paris unit is scrambling to find replacements for two executives who have tendered their resignations in the wake of the bonus “outrage.” Apparently, something like $264 billion in derivatives contracts will be declared in default if the two men are not replaced to the satisfaction of French bank regulators. This is because such contracts typically contain “key man” or “change of control” clauses that are triggered if certain important personnel leave and aren’t satisfactorily replaced.
Here is one example- among many- why it was more than just stupidity or greed for AIG to pay retention bonuses. Losing some of the people it currently has puts billions of dollars at risk.
So, listen up people. Your outrage about these bonuses may be “justified.” But by indulging yourself in it, instead of controlling it, you are potentially costing yourself (and me, and every other taxpayer) money.

The Dude Abides

Carl: Welcome to this morning’s edition of Squawk Box. My name is Carl Quintanilla and I have with me Joe Kernen. Becky Quick is out ill today. Get well quick, I guess you’d say, Beck.
Joe: Funny, Carl. I’ll have to remember that one. With us in the studio today is a man who is sort of a symbol of the recent problems in our nation’s housing market. He’s agreed to come on camera and tell us his story, which is a pretty brave thing to do, considering the facts. This is Mr. Jeffrey, uh, Lebowski, is it?
The Dude: Call me the Dude, man. Or Duder, or his Dudeness. El Duderino if you’re not into the whole brevity thing. Listen, man, I have to, like compliment you. You’re Green Room has everything. Even the Dude’s favorite beverage.
Joe: Milk? On ice?
The Dude: Yeah, man. Something like that. But, look, there’s no Credence on the sound system back there. You need to work on that, man.
Carl: So, Dude, as we understand it, you refinanced your house in Southern California in 2005 through what is known as a subprime loan from Countrywide Mortgage.
The Dude: It was Walter’s idea, man. Oh, and, hey. Hope you don’t mind the, you know, shades. These lights are too bright for the Dude’s eyes.
Joe: Who’s Walter?
The Dude: Bowling buddy of mine. He went to work as a mortgage broker. Answered an ad in the paper and they set him up, like, overnight. Desk, cards, cell phone.
Carl: So Walter solicited you for a new loan on your home.
The Dude: Yeah, man. Said, like, everybody’s doing it.
Joe: Were you employed at the time?
The Dude: No, man. I’m between gigs.
Joe: When did you last work?
The Dude: Roadie for Metallica’s Ecstasy of Gold Tour. ’89.
Carl: But even though you had no income, you were able to refinance your house. At an appraised value several hundreds of thousands of dollars greater than your cost.
The Dude: The Dude has, like, expenses, man. The cost of living has shot way up. Pie stick for example. Costs twice what it used to. And Walter said whatever the house was worth, it would be worth double that in two years. It’s Southern California, man. Real estate never gets cheaper.
Joe: How did you expect to service the mortgage?
The Dude: The Dude is not quite following you there.
Joe: Your house payment. How did you expect to be able to make your house payment?
The Dude: Oh, that. Walter said not to worry about that, man. No one cared, he said. His job was to close the loan and then these Countrywide people would sell it on to somebody else and he’d move on to the next borrower. Pretty sweet, huh? Say, um, could I maybe get, you know, a refill? The girl in back knows how to make-
Carl: But now your lender is threatening foreclosure, is that correct?
The Dude: Yeah, man. Greedy, blood-sucking bastards. It’s corporate greed, man, bringing this country down. These people need more regulation. We said this years ago, in the Port Huron Statement. The first draft, not the watered down second version. Everybody knows this. They say it all the time on TV. It’s the banks fault for being greedy, man. Now look at the mess we’re in.
Joe: But, Dude, don’t you feel somewhat responsible? I mean, taking out a loan that you had no means to repay? Isn’t it in some measure your own fault that now you’ll lose your house to the bank? And isn’t it true that the reason we are in the shape we are in now, when you get to the bottom of it all, is that millions upon millions of Americans did what you did? Leveraged themselves to the eyeballs with debt they couldn’t pay? So they could buy more and more STUFF? And now these self-same people are the ones jumping up and down about Wall Street being bailed out of so-called “toxic assets” which is just a euphemism for a whole lot of bad IOU’s from people like you?
The Dude: Hey, easy, man. Look, this whole subprime thing- it’s complicated, man. Lot of ins, lot of outs, lot of what have yous.
Joe: Well, your revolution is over, sir! The bums lost! And stuck the rest of us with the check!
Carl: Joe, hey, it’s okay. Now, Dude, do you know where you will live yet?
The Dude: Hey, man. The Dude abides. Say, about that refill-
Carl: Thanks, Dude. And thanks for joining us, ladies and gentlemen. Please join us again tomorrow when our guest will be Congressman Barney Frank, who has a new seven point plan for making housing more affordable to people of modest means.

The Long Awaited Return of Duke & Duke

Carl: Good morning and welcome to this edition of Squawk Box. I’m Carl Quintanilla and I’m joined this morning by Joe Kernen. Becky Quick has the morning off.
Joe: With us in the studio today are Mortimer and Randolph Duke, of Duke & Duke Strategies, LLC. Good morning, gentlemen.
Mortimer: Good morning.
Randolph: Morning.
Carl: Thanks for being with us. So, catch us up on what you’ve been up to.
Mortimer: Well, as you may remember, our portfolio was substantially wiped out by the Great Concentrated Frozen Orange Juice short squeeze on the first day of trading in 1983.
Joe: We all remember that. They had to carry you off the trading floor on a gurney, didn’t they Randolph? How’s your health now?
Randolph: Oh, much better, thanks. I went to Pritikin. Lost some weight. Got into yoga. That sort of thing.
Carl: And as I understand it, you guys have been back in the business for a few years?
Mortimer: That’s right. We started a hedge fund in the late eighties.
Joe: How would you characterize your strategy? Is it long-short? What?
Randolph: We don’t really care to discuss it. All we’re prepared to say is, it is a variation on split-strike trading.
Carl: Uh-huh. How much capital do you all have under management? From what kind of investors?
Mortimer: Oh, north of $10 billion. Our investors are a very select group of high net worths and endowments. Only the best people, who are extermely high class. It’s in the blood, you know, that kind of quality. Like racehorses.
Randolph: They all come from two parent households. Were read to as toddlers. Eat a balanced diet. No smokers. Environment is as important as genetics, Mortimer. Don’t forget that.
Joe: How has your performance been?
Mortimer: Very steady. Our annual returns have not deviated from a 10%-12% range since inception.
Carl: Not one down year? Through all those market cycles?
Randolph: That’s right.
Joe: Wow. That’s incredible. Do your investors conduct a lot of due diligence before they commit their capital?
Mortimer: They’re not permitted to ask any questions other than about our golf handicaps.
Joe: That’s it?
Randolph: Well. We do send them quarterly statements, after all. And a Christmas card. And did we mention they are part of a very select group? We only allow people who we know and trust to invest with us. You have to be very highly recommended. We turn away many, many accounts.
Carl: I assume your books are audited by a Big Four firm.
Mortimer: Actually, no. Our books are done by a firm the lead partner in which is our housekeeper’s nephew. Based in Hackensack, New Jersey. Clarence Beeks, CPA.
Joe: I hope you don’t mind if I say so, but this has kind of an eerie ring to it. The Madoff situation sort of comes to mind.
Randolph: (Laughing) Oh, please. The SEC has been into see us three times.
Mortimer: They mostly wanted to know if we could get them Eddie Murphy’s autograph. Strange request, but we did our best to accommodate them.
Joe: Well, I guess if what I was suggesting were really true, there’s no reason to get upset. The first big wave of redemptions will bring the scam to light and then the “in-crowd” investors will start crying that they’re innocent victims and it’s all the government’s fault and they should be bailed out like everyone else. Whereupon their Congressman will go scrambling to hold a press conference to bleat about the unfairness of it all.
Mortimer: You said it, we didn’t.
Joe: But then you guys would go to jail, right?
Randolph: Not if we die first.
Carl: Good point. Well, thanks for coming in fellas. Be sure and tune in tomorrow when we will be interviewing Billy Ray Valentine and Louis Winthorp about how they are trading this market.

Be Careful What You Wish For

Politicians have climbed over one another to express their outrage. Confiscatory tax legislation has been whooped through the House. One Senator has helpfully suggested that the offending executives make him happy by taking their own lives. Bus tours have been organized to deliver placard-toting protesters to the driveways of the guilty.
Now comes the news that AIG executives are coughing up their bonuses rather than endure further vilification. CNBC further reports this morning that a quarter of the senior executives at AIG’s Financial Products unit have also tendered their resignations. More resignations are predicted.
And there was much rejoicing, right?
Well, let’s think it through.
The Times article puts the value of AIG’s derivative book at $1.6 trillion. Let’s assume that this could have been fully recovered in time. If, because of the resignations of veteran staff and their replacement with less capable (but cheaper) traders, the company recovers 1% less of the value of those positions than it would have recovered had the bonuses been left intact and the senior executives who quit had remained, then the cost to the company of this uproar will have been a cool $16 billion, or 100 times the disputed bonus amount. If the recovery is 10% less than otherwise it would have been, the cost is $160 billion- 1000 times the bonuses.
Now the hapless taxpayer is on the hook to the tune of 80% of this at risk amount.
Meaning that by bending to the will of the mob and hounding the AIG traders into the wilderness our so-called leaders have risked hundreds of billions of losses in order to save hundreds of millions of dollars in bonus payments (half of which would have been taxed away under existing laws anyway, at least for those traders living in the New York area).
If he is to be held to his own standard of outrage concerning the waste of taxpayer money, perhaps Senator Grassley should be asking, in the words of Shakespeare: “Hath no man’s dagger here a point for me?”
One hopes that the backpeddling from this madness that we saw over the weekend will continue, at least as respects the other institutions that have taken TARP funds (in some cases, at the point of an executive branch gun).

Financial Crisis Guest Blogging

Many have complained about the lack of posts on this blog of late, but one reader has stepped up to do something about it. Watch this space for guest posts from novelist, finance veteran, and regular commenter JSpur, who has volunteered to share his thoughts on the current state of the markets and economic policy. Meanwhile, I will continue to post on my somewhat erratic schedule.
Content disclaimer: I’ve given JSpur keys to the blog so that he can post at will; therefore his posts are not edited by me, and my approval or endorsement is not required to post here.
Technical disclaimer: I moved the byline up to the top of the posts to avoid confusion. Please let me know if this isn’t working somewhere. Also, I apologize if this causes old posts to reappear on the RSS feed.

Physics, quants, and the crash

I am pretty much required to blog about this piece in the New York Times entitled “They Tried to Outsmart Wall Street”: “they” being physicists who left science for Wall Street. And the not-so-subtle implication of the title is that we failed to outsmart Wall Street (and possibly wrecked the economy in the process). To that I say, in the words of Bart Simpson: it was like that when I got here.
More seriously, while I have no doubt that there were crappy quant models out there that contributed to the current crisis by maximizing short-term gain over long-term risk, this was true all the way up and down the chain and the quants don’t deserve any more of the blame than anyone else. Quants respond to incentives the same way everyone else does, and the compensation structure on Wall Street can incentivize immediate profit and deferred risk. (My employer is trying to curb this effect by instituting a clawback provision on bonuses; I don’t know how widespread this is, but it seems like a good idea to me.)
The Times article is curiously focused on ex-physicists, as if quants don’t come from any other fields. In my ten months on the Street I’ve met quants from a broad range of science and engineering fields, and physicists aren’t a majority. That might be a peculiarity of my department’s hiring practices, with physicists being much more common elsewhere, but I’d be surprised. Anyway, Kevin Drum noticed this too and wonders why physicists are so suited to quant roles. He has a theory that it’s the culture:

Even among the number crunching set, physics has a reputation as the most aggressive, male dominated branch of geekdom: only 14% of physics PhDs are women, the lowest of any of the sciences. (Math is pretty male dominated too, but pales compared to physics: 29% of math PhDs are women.) If the first thing that “aggressive and male dominated” reminds you of is the big swinging dick world of high finance, give yourself a gold star. Call this the testosterone theory: physicists are attracted to Wall Street because they like the atmosphere.

I don’t think this is right: the atmosphere in a typical physics department is nothing like the stereotypical Liar’s Poker trading floor that Drum is alluding to. To the extent that the environment I work in is like academia, it’s because I’m lucky enough to work with a group run by ex-academics rather than people with a typical trader’s background. Instead, what Drum calls the “affinity theory” really is the right one. The work I do now is a lot like the problems I worked on as a physicist. It’s not just (as Drum suggests) about math; it’s about the ability to work with huge data sets and make sense of them, and to find signals in a noisy system. This is a much bigger factor than testosterone levels.