A Walk on the Wild Side of New Age Finance

A hustle here and a hustle there
New York City's the place where
They said hey babe, take a walk on the wild side
They said hey Joe, take a walk on the wild side
--Lou Reed

Maybe it's the unusual weather in New York. Or some kind of bizarre karmic connection. Or, simply, an interesting coincidence. Whatever the case, today seemed to bring forth a collection of news articles that could only be characterized as a kind of phantasmagorical walk on the wild side of new age finance.

In the first report, "Goldman:Aug Level 3 Asset Value $72.05B, 7% of Total," Dow Jones Newswires reveals that there is less there than meets the eye when it comes to the balance sheet of one of the nation's leading investment banks.

Goldman Sachs Group Inc. said Wednesday the size of its level 3 assets at the end of third quarter increased to $72.05 billion from $54 billion at the end of the second quarter.

In terms of percentage, the New York-based investment bank's third-quarter level 3 assets amounted to 7% of the total assets, compared with about 6% at the end of the second quarter.

Level 3 assets are those that trade so infrequently that there is virtually no reliable market price for them, and valuations for these assets are based on management assumptions.

The credit crisis has sparked concerns about the value of some of the assets investment banks hold on their balance sheets. Investors and analysts have been especially worried about banks' exposure to turmoil in the mortgage market and recent trouble in the financing of big leveraged buyouts....

Some firms began breaking down their financial assets into three levels at the start of their current fiscal year, which began in December, when they adopted early a new accounting standard related to fair, or market, value measurement. All U.S. companies will have to begin using it for financial years starting after Nov. 15....

Goldman Sachs said level 2 assets at the end of third quarter amounted to $494.6 billion. There may be some market activity for level 2 assets but the valuations often depend on internal models. Assets in level 1 trade in active markets with readily available prices.

In other words, the value of 55 percent of Goldman's assets depends on "internal models" or "management assumptions," rather than market prices. I wonder if that played a role in the much better-than-expected quarterly results they reported recently?

In the next article, "Morgan Stanley Traders Lost $390 Million in One Day," Bloomberg details an issue with the risk-control systems used by another of the nation's leading Wall Street broker-dealers.

Morgan Stanley, the world's second- biggest securities firm, said its quantitative strategy traders lost $390 million during a single day in August as their computer models failed to account for "widespread" investor selling.

The company's traders lost money on 13 days during the quarter ended Aug. 31, the New York-based firm said in a quarterly regulatory filing today. "The largest loss days resulted from losses associated with quantitative strategies in early August 2007, when these strategies were adversely affected by widespread portfolio reductions," the company said.

Morgan Stanley said last month that the quantitative strategies group lost $480 million during the quarter after being caught off-guard when other investors sold securities to reduce borrowings. Separate areas of the equity sales and trading unit made up for the losses, enabling it to report $1.8 billion of revenue for the third quarter, up 16 percent from a year earlier.

The firm's quantitative trading group, like hedge funds run by Highbridge Capital Management LLC, Tykhe Capital LLC and Goldman Sachs Group Inc., uses mathematical models to pick investments.

Such "quant" models began posting steep losses in late July and early August as surging defaults on subprime mortgages triggered a crisis of confidence in credit markets. Stock-market declines followed. The funds were forced to sell more-liquid stock investments to raise cash and reduce debt.

The selling confounded the funds' computer models. Stocks that they anticipated would decline in price rose, and shares that they expected to rise instead fell.

Morgan Stanley disclosed today that daily trading losses during the quarter exceeded the firm's trading value-at-risk calculation on six days during the quarter.

So, what they are saying is that on six occasions the daily loss exceeded the maximum amount their models predicted they would lose on any given day. And they call that risk management?

In another article, "Debt on Sale: Banks Grease The Leveraged-Loan Machine," the Wall Street Journal reports on the so-called "recovery" in a key market.

Against the gloom that descended on credit markets, banks have pulled off a surprising feat: selling $30 billion of loans for leveraged buyouts by offering some unusual bargains. They also accepted losses on the sales.

Now comes the hard part: what to do about the other 90% of the LBO loans in the pipeline.

The deal-spinning machine of private-equity firms, which was in high gear when credit markets seized up over the summer, was one of the first casualties of the credit-market problems. Gone was the buyout shops' access to cheap loans.

Gone, too, even more suddenly, was investor demand for the loans -- and the price for them fell in step. That left Wall Street banks such as Citigroup Inc., Credit Suisse Group and J.P. Morgan Chase & Co. holding some $400 billion in debt they had promised as financing for purchases private-equity firms had in the works globally.

Unless the pace of sales quickens in the coming weeks, banks could be stuck holding these hundreds of billions of dollars of loans for months to come -- a big risk if the economy slows and corporate profits weaken. That could reignite tensions with the private-equity firms they have agreed to finance the deals for and increase the possibility of a fire sale to unload the debt.

With the help of a Federal Reserve rate cut a few weeks ago, the banks have defied expectations and managed to sell significant chunks of the debt, including for closely watched deals such as Kohlberg Kravis Roberts & Co.'s $26.4 billion buyout of First Data Corp. Banks led by Citigroup and Credit Suisse sold $9.4 billion of loans for that deal to investors -- almost twice as much as they originally planned.

In late September, a $1 billion slug of the debt for Carlyle Group's and Onex Corp's $5.75 billion buyout of Allison Transmission also sold relatively briskly, helped by the same bargain price of 96 cents on the dollar as First Data, according to Standard & Poor's.

Nothing was more telling about the banks' apparent success than the scene at the W Hotel in midtown Manhattan last week. On Oct. 1, dozens of potential lenders crowded into the ballroom of the hotel, where Warburg Pincus was making its pitch for financing a planned $3.67 billion buyout of eye-care firm Bausch & Lomb Inc. The meeting was so crowded, according to people who were there, that the overflow had to be accommodated in an anteroom where a television set was set up.

Yet for all the relief among bankers, the sales haven't come easily -- or profitably. They have offered only the highest-quality portions of the debt for sale, and that at a loss. They have also made concessions that could come back to hurt them, such as selling the debt at a discount while the huge supply raises questions about how long both Wall Street's united front and the upbeat mood will last.

So far, what has been sold is a drop in the bucket. Standard & Poor's Leveraged Commentary & Data estimates that about $30 billion of a total of $310 billion in North American LBO loans have been sold so far. As much as $100 billion in debt is due to come to the market in the next 30 days alone.

In other words, less than 10 percent of the LBO debt that is in the pipeline and clogging up banks' balance sheets has been sold off, and a good chunk of that was traded away at a loss. Sure seems like things are back to normal, right?

Finally, in "The United States of Subprime Data Show Bad Loans Permeate the Nation," the Wall Street Journal reveals the dirty little secret about an allegedly small problem that was supposedly "contained."

Pain Could Last Years

As America's mortgage markets began unraveling this year, economists seeking explanations pointed to "subprime" mortgages issued to low-income, minority and urban borrowers. But an analysis of more than 130 million home loans made over the past decade reveals that risky mortgages were made in nearly every corner of the nation, from small towns in the middle of nowhere to inner cities to affluent suburbs.

The analysis of loan data by The Wall Street Journal indicates that from 2004 to 2006, when conventional lending slowed and subprime lending accelerated, more than 2,500 banks, thrifts, credit unions and mortgage companies made a combined $1.5 trillion in high-interest-rate loans. Most subprime loans, which are extended to borrowers with sketchy credit, fall into this basket.

High-rate mortgages accounted for 29% of the total number of home loans originated last year, up from 16% in 2004. About 10.3 million high-rate loans were made in the past three years, out of a total of 43.6 million mortgages. High-rate lending jumped by an even larger percentage in 68 metropolitan areas, from Lewiston, Maine, to Ocala, Fla., to Tacoma, Wash.

To examine the surge in subprime lending, the Journal analyzed more than 250 million records on mortgage applications and originations filed by lenders under the federal Home Mortgage Disclosure Act. Subprime mortgages were initially aimed at lower-income consumers with spotty credit. But the data contradict the conventional wisdom that subprime borrowers are overwhelmingly low-income residents of inner cities. Although the concentration of high-rate loans is higher in poorer communities, the numbers show that high-rate lending also rose sharply in middle-class and wealthier communities.

Banks and other mortgage lenders have long charged higher rates to borrowers considered high risk, either because of their credit histories or their small down payments. As home prices accelerated across the country over the past decade, more affluent families turned to high-rate loans to buy expensive homes they could not have qualified for under conventional lending standards. High-rate loans are those that carry interest rates of three percentage points or more over U.S. Treasurys of comparable durations.

The Journal's findings reveal that the subprime aftermath is hurting a far broader array of Americans than many realize, cutting across differences in income, race and geography. From investors hoping to strike it rich by speculating on condominiums to the working poor chasing the homeownership dream, subprime loans burrowed into the heart of the American banking system -- and now are bringing deepening financial woe.

The data also show that some of the worst excesses of the subprime binge continued well into 2006, suggesting that the pain could last through next year and beyond, especially if housing prices remain sluggish. Some borrowers may not run into trouble for years.

"We had an aggressive home-mortgage industry trying to get people into homes they couldn't afford at a time when home prices were very high. It turned out to be a house of cards," says Karl Case, an economics professor at Wellesley College. "We're in the early stages of the clean up."

I guess in today's financial world small means big and prudence means shoveling scads of money to borrowers with reckless abandon. Not exactly a recipe for a happy ending, right?

A hustle here and a hustle there...

Comments

[Mark Palermo]

I had the same reaction today. I keep thinking, "how are the markets reaching new highs?" I have recently commented on this at my fledgling blog, and also about the issues around a sub-prime bail out. If you are interested you can find those comments here http://polecolaw.blogspot.com/2007/10/its-different-this-time.html and here http://polecolaw.blogspot.com/2007/10/sub-prime-commentary.html

Great blog - keep up the good work.

[Mark Palermo]

I just noticed your link to the WSJ article about the SIV problem. This is scary. In addition to the off balance sheet conduits, banks are now marking liabilities to market. I think this is a sham and. I wrote a short on it here for anyone interested: http://polecolaw.blogspot.com/2007/10/hocus-poke-us.html A result of this could be lower capital requirements unless there is some rule about the impact of liability write-downs and capital. I am not aware of any.
PS - nice job on K&Co.