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The Economy Won’t Recover Because It, Well, Can’t. Unless We Restructure It

by on Aug.10, 2010, under Editorials

You read it right. It can’t.

Of course there has been some growth in GDP over the past year.  All that government stimulus was going to goose the numbers at least a little, and inventory restocking started to look good for a couple of quarters. But if you look at the major components of GDP you can see why only the cheerleaders think that this supposed recovery is either powerful or self sustaining.

By definition, GDP is the sum of Consumption by individuals, Investment by businesses in plant, equipment, and inventory, Government spending, plus Exports minus Imports. Economists write this as Y = C+I+G+X-M.  Note to the math challenged: you have just read the only equation in this article.

Both Drivers of Consumption Are Weak

Since consumption accounts for 70% or so of GDP, let’s look at it first. Consumers fund consumption out of income and wealth. Income not spent, by definition, is saved. Obviously the wealth of most consumers has taken a hit and is not about to recover any time soon. The S&P is still down 29% from its 2007 high.

Moreover, for most people the family home is the principal asset and home prices have not really budged from the bottom at this point. I am far from the only person to have said that home prices can’t recover until we work off the huge “shadow inventory” of delinquent mortgages, homes in foreclosure, borrowers with adjustable rate mortgages that have not yet reset, and homes owned by people who would sell if a price rebound allowed them to take their money out.

On the income side, most people depend on jobs, and the employment outlook remains poor. Total non-farm employment has grown all of 600,000 since December 2009 low of 129.6 million. Which is worse than it looks, because we need something like 200,000 new jobs per month just to keep up with population growth.

Offshoring Has Weakened our Ability to Recover, When Compared with Previous Recessions

In my view off shoring is a major culprit here, and it really shows up in the last twenty years of employment numbers. About 22.7 million jobs got created during the Clinton Administration. Only 8 million got created under Bush and the recession erased all of those. And yes, a big portion of the jobs created under Bush were in residential construction, a sector not expected to lead us out of recovery this time. But my point is, less jobs got created under Bush than Clinton, largely because US corporations are less and less eager to hire Americans even when business turns up. No one sees that trend reversing unless the government steps in.

For example, you’d think that Apple’s (AAPL) dazzling new product introductions would create American jobs. Not a chance. As former Intel (INTC) chief Andy Grove says, Apple Computer (AAPL) has 25,000 US workers and ten times as many in other countries. While AAPL keeps key engineering, design, and management people here, the actual work of stamping out Macs, ipods, iphones, and ipads gets done elsewhere. Which is why US computer manufacturing employment sits at 166,000, lower than it was 35 years ago. In my view, this example illustrates the long-term downtrend in the job growth numbers as well as anything possibly could.

Business Investment is in Low Gear

So far we have shown that wealth and employment, the principal consumption drivers, remain weak for long-term, structural reasons. How does the rest of the economy look? Well, business investment in plant and equipment has not moved far from trough levels either. I suspect that the picture is the same here as it is for employment: Increased US demand for goods is less and less likely to result in new US plant and equipment. Think of all the new AAPL factories in Asia.

The other main component of investment is inventory. We have had our spurt in inventory investment, and I don’t see how it continues without a sustained increase in consumer demand. Therefore I don’t expect business spending (investment) to contribute much to GDP either.

Net Exports Actually Subtract from our GDP

As for trade: the first thing to remember is that we import about 12 million barrels of oil per day, a cool billion dollars’ worth. By the definition of GDP  we listed above, that billion (like all imports) gets subtracted from GDP, every single day. That won’t change unless we change our energy policy or a supply problem changes it for us.

The next thing to remember is, that the world trade system is set up so that the US imports far more than it exports, and many other countries depend heavily on US consumption. As former IMF consultant Richard Duncan points out in his book, The Dollar Crisis, the US current account deficit approximately equals the surpluses of all the other countries in the world. Again, this is a structural issue.

I think some change in that structure is inevitable, and it won’t be painless. But until and unless it does change, the international sector will continue to be a considerable net minus for GDP. We aren’t going to grow the economy by exporting to other countries, because on balance, they make a point of selling to us more than they buy from us.

Government Spending Can’t Make up for Private Sector Weakness

What about government spending? While the federal government is doing a fair amount of spending, state and local governments have had to cut back. They can’t print money the way the feds can, and so when state and local tax receipts fall, their spending falls too. Much of the stimulus program has in fact gone to help states and localities. Otherwise the states and localities would have let go  more firefighters, police, and teachers than they already have. So yes, federal spending makes a difference (Economists Alan Blinder and Mark Zandi say that the program prevented 2.7 million public and private job losses), but it is less stimulative than spending totals make it appear. What will the federal government do as the stimulus program winds down?

At some point the President will almost have to propose another stimulus plan. That begs at least three key questions: the program’s structure, whether Congress will enact it, and how it will be funded. I think that a wisely structured and funded stimulus would be helpful in the short to intermediate term, but wouldn’t it be nice if the Administration also tackled the long-term, structural problems? Not very likely, since the Geithner/ Summers team talks as if it faces a “normal” cyclical downturn.

The Fed Can’t Help Much Either

So much for the components of GDP,  on to the Fed. Like many others I expect that on August 10 the Fed will say that it will reinvest the proceeds of its maturing MBS rather than let its balance sheet shrink. But whether I am right or wrong, the Fed can no longer pump up the “real,” non-financial, economy by creating money. Banks don’t want to lend and few creditworthy customers want new loans.

Our economy is stuck and our government is clueless.

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Gold Falls as Traders Realize the Euro Will Live Another Day

by on Jul.08, 2010, under Editorials

The early July pullback in gold to 1190ish has at least some people scratching their heads. My take is this. Gold ran up $100 to its all-time high of $1,268.50 as worried Europeans dumped Euros and bought gold in May. Then the European Central Bank (ECB) signaled that it will protect the Euro, and its own existence, by any means necessary, see this, and this.

And so, the Euro dissolution trade is dead, at least for now. I suspect that traders who bought gold because they feared the end of the euro, are selling gold and buying euros back.

To understand what is going on, look at the ECB’s secondary market purchases of sovereign bonds, which began in early May. I think the purchases may be a decisive element in the measures that have preserved the Euro, at least for now, and also led to gold’s pullback.

Recall that in response to the PIIGS (Portugal, Ireland, Italy, Greece, and Spain) debt crisis the EU put together its bailout package in April. The package had an impressive headline number, $1 trillion in assistance. Many traders thought the headline number was more impressive than the substance. The euro kept falling and gold kept screaming higher.

Then in early June, it became clear that the ECB’s purchases of sovereign bonds on the secondary market were part of a continuing program, not a one time event (h/t naked capitalism). The Euro bottomed on June 7. I don’t think this is coincidence. Furthermore, gold, which made an intermediate high of $1,254.50 on June 7, can now be seen to have struggled since then, before finally selling off on July 1.

I would argue, though, that while the ECB punished gold holders in the short-term, ECB bond purchases are a positive for gold in the long-term. The purchases smack of “money printing” and amount to a backdoor aid package for the financially weak PIIGS. They peg the debt of the issuing countries to artificially high prices, and might even allow PIIGS to issue new debt at artificially low rates – assuming the ECB stood ready to buy bonds to support their prices. All of this can only lead to further debasement of the Euro versus gold.

Moreover the rebound in the Euro corresponds to at least a possible topping in the dollar. It almost has to, given the Euro’s large weight in the Dollar Index. (Hopefully this dip in the dollar will not bring to the fore, my longterm concerns about the dollar.) Some analysts suspect the Euro’s bounce mean that the risk trade is back on, and maybe it is for at least a little bit, given this week’s corresponding bounce in stocks.

The European bank stress tests also demonstrate Europe’s determination to save the Euro by propping up both the banks and financially weak PIIGS. The guidelines say that European banks may value Spanish Government bonds at 97% of par, and Greek bonds at 87%. That way the banks can, well, lie about the value of these assets and artificially prop up their equity. Of course, the banks will say that if the bonds will pay off at par (and if the EC can make that happen, they will) who needs to mark the bonds to market?

Allowing Europe’s banks to value the weak sovereign debt at such generous numbers, will also provide incentives for the banks to keep holding these bonds rather than dump them. Therefore the stress test guidelines provide a backdoor subsidy for the debt issuing countries as it would help keep their borrowing rates down. Of course, no one believes that these bonds are worth anywhere near that much.

But, in addition to the subsidy for issuing countries, the stress test guidelines matter because they indicate that Europe is following the US playbook on stress tests and bank bailouts. Last year, US regulators announced stress tests for US banks that would supposedly show that the banks would stay “solvent” under various economic scenarios.

As most readers know, these tests were ludicrously easy. Not many analysts thought that the major banks (with the possible exception of Wells Fargo, WFC) were viable at the time – not without government assistance, at least. But the stress tests provided a fig leaf to justify government help through TARP, the alphabet soup of Fed lending programs, and more lenient accounting treatments for banks’ securities holdings.

The change in bank accounting also marked the US stock market bottom in March 2009. Clearly the Europeans hope that European bank bailouts will make the financial markets happy as well. And in the short to medium term, if the US experience is any guide, the bailouts may enable the Euro bottom to hold (at least when measured against other paper currencies) longer than many people think. Even if, as in the US, European banks will continue to hold their fair share of underwater assets. In other words, short-term measures that kick the can down the road, can have important short-term results, even if they don’t solve long-term problems.

The European moves to bail out their banks tell you something else: not to worry about those reports that the Bank for International Settlements (BIS), is lending to commercial banks and taking gold as security, under repurchase agreements. Some gold traders seemed to fear that if the banks failed to make good on these loans, the BIS would dump the gold collateral on the market. My response: the EU will not let a big European bank fail anytime soon; that’s the whole point of their stress test charade. And if big European banks did start going down, I suspect the demand for gold would soar.

So what’s an investor to do? Chartists note that the June top was not much higher than the previous highs in December 2009, and point to what looks like a double top.  In response to this and the July 1 gold selloffs, gold timing newsletters turned understandably bearish. Of course, the Hulbert Letter holds up this pessimistic timer consensus as a contrarian indicator, and calls it a buy signal (h/t Daily Crux). Still, if you are a long gold, the chart has to concern you.

My thinking is,  if you are a trader and you don’t like gold’s double top (not to mention its closes below the 50 day moving average), why not lighten up? The chart doesn’t tell me that gold is going higher anytime soon. But I wouldn’t sell a core position, because the European move only underscores the long-term weakness of paper money around the world.

Disclosure: long GLD, SGOL

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by on May.23, 2010, under Editorials

A number of investment newsletter writers would like the peak oil theory to go away. As their argument runs, the worldwide annual rate of oil production will not peak because, higher prices will induce the invention of enhanced technologies and bring forth new oil supplies.  Some of these folks even seem to believe that higher oil prices will allow US oil production to rebound, though no one comes out and states that.

Before I deal with this “cornucopian” argument, kindly let me review my understanding of what peak oil is. The Shell Oil geologist M. King Hubbert predicted in 1956 that US onshore oil production would peak in 1970, because he believed that annual oil production in a given region follows a bell curve over time. Annual production would expand, peak, and then eventually decline. “Hubbert’s Law” says that when about half of a reserve’s original oil in place has been lifted, annual production rates  fall.

As it happened, US oil production peaked at 9.6 million barrels per day in 1970, precisely when Hubbert said it would, and except for the temporary bounce in the early 1980s from  Prudhoe Bay , it has been falling ever since. In 2008 we produced 4.95 million barrels per day, the first dip below the 5 million mark. Here are the figures:

U.S. Field Production of Crude Oil(Thousand Barrels per Day)
Decade Year-0 Year-1 Year-2 Year-3 Year-4 Year-5 Year-6 Year-7 Year-8 Year-9
1850’s 0
1860’s 1 6 8 7 6 7 10 9 10 12
1870’s 14 14 17 24 30 33 25 37 42 55
1880’s 72 76 83 64 66 60 77 77 75 96
1890’s 126 149 138 133 135 145 167 166 152 156
1900’s 174 190 243 275 320 369 347 455 488 502
1910’s 574 604 609 681 728 770 822 919 920 1,037
1920’s 1,210 1,294 1,527 2,007 1,951 1,700 2,112 2,469 2,463 2,760
1930’s 2,460 2,332 2,145 2,481 2,488 2,723 3,001 3,500 3,324 3,464
1940’s 4,107 3,847 3,796 4,125 4,584 4,695 4,749 5,088 5,520 5,046
1950’s 5,407 6,158 6,256 6,458 6,342 6,807 7,151 7,170 6,710 7,054
1960’s 7,035 7,183 7,332 7,542 7,614 7,804 8,295 8,810 9,096 9,238
1970’s 9,637 9,463 9,441 9,208 8,774 8,375 8,132 8,245 8,707 8,552
1980’s 8,597 8,572 8,649 8,688 8,879 8,971 8,680 8,349 8,140 7,613
1990’s 7,355 7,417 7,171 6,847 6,662 6,560 6,465 6,452 6,252 5,881
2000’s 5,822 5,801 5,746 5,681 5,419 5,178 5,102 5,064 4,950

And note well, the crude oil price in 197o was about $1.35 per barrel, depending on the grade you pick. The current price is  over fifty times higher — okay, call it “only” 10 times higher if you adjust for inflation. Despite the higher prices US production has decreased  year after year almost without  relief. I haven’t  heard the cornucopians explain that.

Of course there will always be some oil left in the ground. Hubbert did not say that US or worldwide production would go to zero any time soon. He simply said that once the peak was passed it would no longer be possible to produce at the same annual rate.

After Hubbert succeeded in forecasting the US peak, other geologists tried to forecast the worldwide production decline curve.  There is a range of predictions regarding the date when worldwide production will peak. Some experts like Princeton professor Kenneth Deffeyes even say we’ve already peaked. But within the universe of respected energy specialists, nearly all agree that world production will peak at some point (sounds obvious, doesn’t it?). Even Cambridge Energy Research Associates (CERA), which is known for optimistic production forecasts, agrees with this statement. They just predict a later peak than most others do: around 2040.  It’s hard to be a more sanguine than CERA but  the cornucopians do try.

The cornucopian argument has two glaring weaknesses. First, Mother Nature doesn’t care how much money we humans pay one another for oil. The oil that is in the ground now is the amount we get to enjoy. Higher prices make it economic to drill for oil in remoter regions and to develop new extraction methods but they don’t change the amount of oil in place.

The second weakness is a bit more subtle. Though peak oil is a geological theory, it also follows from a bedrock principle of economics, the law of diminishing returns. That principle is associated with  nineteenth century economist David Ricardo.

Ricardo declared that in agriculture, there were diminishing returns to cultivation. Farmers would first till the most fertile land, and as population grew farmers would begin working less productive land, until farming the most marginal acreage became uneconomic. The crop yields wouldn’t justify the effort needed to till such parcels, even if the farmer added additional labor, fertilizer, or irrigation.

Diminishing returns show up in oil just the way they do in agriculture. A concept called the Energy Return on Energy Invested (EROEI) illustrates the diminishing returns to oil exploration effort through the history of the oil industry.  EROEI measures the energy content of an oilfield divided by the energy needed to get the oil.

In the 1930s, US oil production is now estimated to have yielded an EROEI of about 100; the number dropped to 30-ish in 1970 and to the range of 11-18 by the year 2000. Think about what happened when Colonel Drake drilled the first oil well in Pennsylvania,  or when Chevron (CVX) made its early Saudi Arabia discoveries. All they had to do was stick a shallow well in the ground and oil flowed freely to the surface. You’d expect a very high yield on prolific reserves that demand next to no effort to get.

As one might expect, prospectors found the easy oil first, and as one drills deeper, EROEI falls. But even in the life of what was once an easy oil field EROEI tends to fall over time. As an oil field  matures, natural pressure falls until oil no longer flows to the surface without a push. Oil companies extend the life of oilfields by injecting water or carbon dioxide to force oil toward the well bore. Another enhanced oil recovery (EOR) technique is directional drilling, where the angle of the well bore  is set to maximize the length of pipe that has direct contact with the layer of oil bearing rock being tapped.

EOR requires additional energy expenditure and so it  reduces EROEI. This increased energy expenditure increases the denominator in the oilfield’s EROEI ratio. Eventually the oilfield owner can get nothing more out of the reservoir. He has passed the point of diminishing returns like Ricardo’s farmer.

Higher prices have made resources such as the tar sands of Canada and Venezuela economic to exploit even though their EROEI is only about 5, quite a comedown from Saudi Arabia or East Texas in their glory days. Tar sands deposits are not even oilfields, at least as one normally thinks of oilfields. Typically they are more  like strip mines, where companies like Suncor (SU) and the Canadian Oil Sands Trust (COSWF) dig up a solid called bitumen. They load the bitumen into special, giant trucks, crush the big pieces into small pieces, separate out the sand and debris, and then run the separated product through an “upgrader.” The early stage processing requires substantial inputs of water and heat. Only then can the crude be refined into products such as gasoline, heating oil, and jet fuel.

The Horizon drilling rig and its tragic explosion  illustrate diminishing returns in another way. One needs elaborate and expensive equipment to drill for oil that is miles below a seabed that is itself thousands of feet below the ocean’s surface. These rigs take lots of energy and steel to make. Horizon even needed to expend energy by continuously running powerful thrusters to keep it in position. It wasn’t feasible to anchor the rig to the ocean floor in that depth of water. And in difficult locations like this, as we have been reminded, workers die when things go really wrong. So while higher prices make deepwater drilling feasible, one gets less usable energy per unit of effort than from conventional on shore oilfields, especially when all costs are factored in.  Ricardo would understand all too well.

No one doubts that higher prices promote EOR, and EOR extends the life of aging oilfields. EOR also enables midsized outfits like Denbury Resources (DNR) to work over largely depleted fields that the oil majors no longer care to bother with. I’ll also grant that higher prices make that business economic. Nor does anyone doubt that higher oil prices encourage people to substitute coal or gas for oil, to increase energy efficiency,  and develop new energy sources.

But if you want to say that US oil production has not peaked,  you have to go really far out on a limb. You have to argue that we will return to, and surpass, the halcyon days when the US could produce ten million barrels per day. Good luck selling that story.

So in my view, the total oil supply is not only finite, it gets harder to obtain with each passing year. And that’s why I continue to like oil companies with long lived reserves that are also located in poltically stable countries.  I particularly like the major players in Canada’s tar sands; of course I liked them better at May 2009 prices and said so at the time,  here. But if you have to own some stocks, these are the kinds of companies that will do well long term even if the market’s correction deepens. If stocks recover from last week’s turbulence and keep going up, so much the better.

Dislosure: Long SU


Sideline Cash: What is it and Where Will It Go

by on Apr.12, 2010, under Editorials

If you watch CNBC, you often hear commentators say that the small investor sits on the sidelines with oodles of cash in his money funds, and he is feeling left behind in this rally. Then you hear, either that this cash will fuel the next leg up, or, when the public gets in, that will be time to sell, because the little guy is always wrong.

And skeptical as I may be, the bulls are getting some support for this argument. According to the current Barron’s, money recently started flowing into equity mutual funds, about a year into the bull run. Not much, only about $11 billion over the last eight weeks, but the shift in direction might matter, especially with the Dow holding 11,000 today. Just to be clear, I’m not expressing an opinion on market direction here, only about the cash-on-sidelines theory itself.

First, as a matter of simple accounting (or arithmetic), there never was and never will be cash on the sidelines in the way many people discuss it. Think about this: if I buy stock with cash, the seller now has this cash. Is HE now holding cash on the “sidelines?” In any case, the cash still exists, the owner of it changed. Thereafter if the investor who sold the stock to me, buys other stocks with it, then a third party will have the cash. And so on.

Secondly, I’m not sure that the small investor’s target asset allocation is as heavily weighted toward stocks as it used to be. In other words, a smaller maximum percentage of investors’ money fund balances will go to stocks than in the past; more assets will be reserved for safety.  In this video (h/t Barry Ritholtz) David Rosenberg states that for nearly all of this rally, cash had been not only standing pat, but flowing OUT of equities. One key reason is demographic. As we baby boomers get older, our risk tolerance naturally decreases. Our appetite for stocks goes down and our appetite for fixed income goes up, because we have a shorter time horizon, with less time to make up for losses than we did when we were younger. And so advisors who specialize in asset allocation (which is most of them, since the old fashioned brokers who knew something about stockpicking are long gone) just about have to tell many of their clients to re-balance, out of equities.

These facts rest against a well-known backdrop, that stocks have had two bad crashes in the last decade, and the SPX is trading about 200 points lower than it did ten years ago in April 2000. Buying and holding stock index funds has been a losing long-term strategy for most investors who are active now, but bonds have been in a VERY long bull market that dates from the early Eighties. In other words, stocks have burned you and bonds haven’t. The “easy” trade is to buy the asset that has treated you well for as long as you can remember. That’s Treasurys. (I didn’t say, buying T-bonds is the right trade, but we’ll get to that.)

Furthermore it would seem that institutions are already committed to stocks. In this chart it seems like the institutional investors – at least those who run mutual funds –don’t have much more ammunition to throw into equities. Of course new fund inflows, presumably from individuals, could change this.  And as long as companies can benefit by slashing costs without running out of customers for their goods, stock buybacks can help goose stock prices too.

Of course there is one caveat regarding mutual fund cash percentages. Funds always have to have some cash on hand to satisfy redemptions. And if the market pushes up the value of the fund’s portfolio, and cash measured in dollars stays constant, the portfolio’s cash percentage falls. So this could be part of the reason for current low percentage levels of mutual fund cash.

But back to the video, which recorded a debate between Rosenberg and bond bear James Grant. Rosenberg said that portfolio rebalancing will support demand for bonds, and he also says that the Japanese experience (banking crisis, bank bailouts, economic stagnation, and easy ability for the government to borrow huge amounts) bodes well for the Treasury getting its bonds sold even the unprecedented amounts it now seeks.

Grant took the other side (as I did here):  Japan is a poor analogy for us, because it is an export powerhouse. With a large current account surplus, the Japan of the “Lost Decade” didn’t need the kind of international help we do, to get bonds sold. Japan’s GDP and the Nikkei average stagnated in the 1990s but its world-class exporters forged ahead as if nothing had happened (to pick the auto industry, for example, look at Nissan, Honda, and Toyota).

Having said all that, I wouldn’t be surprised if the Fed were thinking the same way as Rosenberg. On the one hand, by keeping rates low, the Fed is forcing institutions out on the risk curve, and this pushed stocks up. But on the other, the Fed could be thinking that fund flows from individual savers will support bonds; the Euromess, which for the moment makes America look good by comparison, could amplify those flows. The Fed and the Treasury can have their cake and eat it, or so that argument would run. I’d be more willing to buy the argument if the Treasury didn’t need to raise trillions of dollars of fresh cash annually to fund deficit spending, while additionally rolling over the $4.5 trillion or so  in debt that will mature over the next four years. Is there that much investable money in the world, or will the Fed have to print it? Rosenberg bets that there is, but I am reluctant to take the Japan analogy as far as he does.

Sooner or later, bond rates almost have to go up (do they really have much room to go down?). Assuming Treasury can raise its funds, it will almost certainly have to begin paying more for them in the next several years. Some of us remember that before the secular decline in rates we have enjoyed since 1981, there was a secular increase in rates that lasted  from 1941 to 1981. By the end of that bond bear market people called bonds “certificates of confiscation.” I would expect at least some kind of replay eventually.

As far as Treasurys go, I would short TLT if it gets close to resistance at 91. A trader would want to stop out somewhere above 92.50  but I think  it’s worth trying to hold longer term, if you can stand the news driven zigs and zags which are sure to keep coming.

Disclosures: Long TBT, short TLT

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NY Times blogger William Cohan Hearts Poor, Abused Goldman Sachs

by on Mar.07, 2010, under Editorials

In a story that smells awfully like a press agent’s plant, New York Times blogger William Cohan apparently decided it’s time to rehabilitate Robert Freeman. Once the partner in charge of Goldman Sachs’s (GS) risk arbitrage department, Freeman pleaded guilty to one count of mail fraud (the case was actually about insider trading) and served four months’ jail time in 1990.

Cohan tries to prove that Freeman was the victim of a prosecutorial “witch hunt.” Is he also trying to say that public opinion is also tarring GS unfairly now? Hard to say, but why else would anyone bring up Freeman of all people, twenty years after the fact?

No one doubts that Rudolph Giuliani, then a crusading US Attorney, played hardball and made some crucial errors in going after white collar crime on Wall Street. Nevertheless, Freeman admitted to breaking the law on insider trading, and the case seemed pretty clear.

Therefore I don’t see how Cohan can call Freeman’s prosecution a “witch hunt.” The more accurate metaphor would be a “fishing expedition” that expanded perhaps too far afield from its central targets: uber risk arbitrageur Ivan Boesky and Michael Milken, the wildly successful junk bond promoter at Drexel Burnham Lambert. Freeman proved to be unlucky but not exactly innocent. A guilty bystander, as it were.

Here are the facts that matter, whether Cohan likes it or not:

As Cohan states, risk arbs in those days did a great deal of research on the phone, trying to ascertain the latest news, the small details, the so called “color” of the deal related stocks they were trading. New color could cause a significant move in the stock, and sometimes provided clues that researchers could assemble into a mosaic of intelligence on whether deals would close.  On the other hand, arbs could take things only so far: SEC rule 10b-5, forbids trading on “material, non public information.”

In the case that ended his GS career, Freeman bought shares of Beatrice Foods, which Kohlberg, Kravis, Roberts (KKR) was in process of taking private in 1986. After Freeman bought, rumors leaked that the deal was not working out. So Freeman did his job and hit the phones to learn what he could. He spoke with Bernard “Bunny” Lasker, a former NYSE chairman, who suspected the rumors were true. Freeman cut his stake in Beatrice. Then Freeman talked to Marty Siegel, an investment banker who represented KKR. (Siegel eventually went to jail for selling inside information to Boesky.)

Siegel confirmed that the Beatrice deal was in trouble, with the now classic line, “Your Bunny has a good nose.” At which point, Freeman sold his Beatrice call options (and some more of his stock, too depending on which account you read), in clear violation of the law. When KKR announced it was reducing the cash portion of its offer for Beatrice, the share price fell. Freeman may have had reason to fear for the option position: if the calls were short dated and near or out of the money, they might have gone worthless on the news.

Wall Street firms have elaborate controls to prevent trading on inside information when they have it. I suspect GS procedure would have required Freeman to tell the firm’s lawyers about his chat with Siegel, at which point GS would likely have considered itself to be “restricted” in its trading of Beatrice shares until the information became public. (If any readers worked at GS then you are welcome to weigh in about this.)

Furthermore, key court precedents established that trading on inside information is forbidden when that information was obtained in a “breach of duty.” That’s common knowledge among Wall Street professionals.  In this case, Siegel, a banker who represented KKR, betrayed KKR’s confidence by passing privileged information to Freeman. As clear a case of a breach as you can find. And yes, Cohan omits this issue from his article.

What Freeman did was illegal and really, really stupid. Yet notwithstanding all this, Cohan says that Freeman deserves a presidential pardon. Yeah, right.

One of Cohan’s whoppers – and this one destroys the credibility of his whole article – has to do with his treatment of Marty Siegel – and by extension, Giuliani. Cohan insinuates that Siegel was an entirely unreliable witness and that Giuliani went out and arrested all the subjects of his insider trading investigations, including Freeman, based on Siegel’s say-so, without corroboration.  Was Giuliani really that foolish? Well, no, not really.

Along with Drexel banker Dennis Levine, Siegel turned state’s evidence on Ivan Boesky, who was certainly dirty. Boesky in turn helped finger Milken (a prosecution that leaves me uncomfortable to this day) and many others. The Boesky and Milken cases were among the biggest white collar prosecutions of the decade, front page news that went far beyond the world of finance. After winning these cases Giuliani ran for Mayor of New York and won. Incredibly, Cohan omitted any mention of Boesky or Milken.

In other words, Cohan failed to tell his readers that Siegel had hit pure gold for Giuliani. Giuliani had every reason to take Siegel seriously.

Having said that, Cohan correctly judged that Giuliani overreached. Giuliani blundered badly by failing to corroborate Siegel’s assertions sufficiently before arresting Tim Tabor and Richard Wigton, both of Kidder Peabody, and then Freeman. Neither Tabor nor Wigton went to trial – the cases fell apart before that – but neither man worked on Wall Street again. Giuliani had ruined them.

So Cohan may well be right when he says that  Giuliani did everything he could to nail Freeman once the Tabor and Wigton cases proved weak. A contemporaneous Times editorial concurred, saying that Freeman was “abused.” But odious as these facts are, they don’t erase what Freeman did.

Cohan also tries to dance around Freeman’s guilt by saying that Freeman got caught only because his subordinate was given immunity in exchange for testifying against Freeman. But that’s standard procedure in any investigation: prosecutors threaten little fish with stiff sentences to get evidence against big fish. More cogently Cohan notes that several other allegations against Freeman proved false. Which may be why even the judge who sentenced Freeman termed him, “basically decent.”

Here’s an intriguing nugget Cohan noted but didn’t pursue. Apparently Freeman’s position limit was $50 million. Yes, quaint as it looks now GS partners really cared about sums that size back then, especially when all of them were potentially liable for the firm’s mistakes. Yet Freeman risked $66 million on Beatrice including his stock and options positions. Did Freeman’s partners know of the limit violation before the investigation?

If not, one could understand how Freeman might have been driven to sell Beatrice options before the bad news hit the wires: fear that his partners would see that Freeman’s excessive risk taking brought with it excessive losses, which is exactly what position limits are designed to prevent. Or maybe Freeman got prior permission to exceed the limit, but wanted to avoid embarrassment when his big bet went bad. Either way, the risk of an insider trading scandal was greater than that of a trading loss, but even very smart traders make mistakes under pressure.

GS lawyers defended Freeman, but then, according to Cohan, Freeman copped his plea to avoid further anguish for his family when Giuliani threatened to bring racketeering charges. So Freeman served only four months; Judge Pierre Leval suspended the rest of the one year sentence and fine him $1 million. The Times actually approved of that sentence when it came down, saying that Freeman deserved “a taste of prison” but also citing Giuliani’s “outrageous tactics.” My sentiments exactly, but that was back in the day when the Times was more able to call things as it saw them.

As for Goldman, it came up smelling like a rose. Giuliani never brought charges against the firm, and so it was spared the fate Giuliani had visited on Drexel Burnham. But in hindsight it would likely not have gone any other way.

GS management committee member Robert Rubin, also Freeman’s boss and mentor, moved up to vice chairman in 1987 during the Freeman investigation (in 1990 he became the firm’s co-head) and Rubin never paid for any of the things that went wrong on his watch. These would include the insider trading at GS, the financial deregulation Rubin championed as Treasury Secretary,  and the de facto bankruptcy at Citigroup (C) where Rubin was vice chairman. Just a thought.

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Justices Enrich Admen and Kill Bank Tax

by on Jan.26, 2010, under Editorials

No, the Supreme Court hasn’t ruled lately on these two issues to my knowledge, at least not directly. But unless you’ve been living in a cave, you know that last Thursday, the 21st, the Court struck down longstanding restrictions on corporations’ political campaign spending. The headline highlights some likely results.

The Citizens United decision allows corporate (and union) donors to pay for ads that will run within 30 days of a Presidential primary or 60 days of a general election. Previously such spending was barred by the McCain-Feingold campaign finance reform law.

As political spending increases, its recipients in old media will benefit. I’ll tell you which companies are best positioned, but it’s too early to say just how much more they can make.

Some restrictions on campaign spending remain. Corporations cannot donate directly to candidates, though they can donate to issue oriented political action committees (PACs) that are at least nominally independent of candidates and their parties. Also, the sources of a PAC’s funding have to be disclosed.

A few numbers illustrate the new potential for political ad spending. A combined total of $5.3 billion was spent for the Congressional and Presidential elections of 2008. By way of contrast, Exxon (XOM) earned $45.2 billion in 2008 on that year’s record oil prices, and $13.2 billion for the first nine months of 2009. Goldman Sachs (GS) will pay out $16.2 billion for wages and salaries, or $498,000 per employee, and still record $13.4 billion in profit for 2009 after making these payouts. My point is, many major corporations can afford to break expenditure records on any given race if they care to.

And many of them have reason to care. For example, if  five votes on a congressional committee stand between you and, say, an arcane tax law change that would yield $40 million annually, what’s $15 million of campaign spending?  One heck of a good investment. Or, take environmental law. To pick an outsize but obvious hypothetical, even $100 million in campaign funds would be chump change for, say,  Chevron (CVX), if in return it got to extract a billion barrels of oil in the Alaska National Wildlife Refuge and earn profits, of, say, $10 per barrel.

But who needs hypotheticals? Last week the President proposed a tax on repurchase agreements, a form of collateralized lending used by large financial institutions. He also proposed bank size limits and talked about preventing banks from using federally insured deposits to finance speculative trading, the so called “Volcker rule.”

Citizens United gave banks new weapons to fight proposals like these. If, come election time, a tough bank regulation bill gets close to enactment (though it’s not likely to get too close, in my view), look for anti-regulatory commercials. They’ll be brought to you by PACs with names like “Depositors for a Sound Banking System.”

Having said all that there are two reasons why I could be wrong about the increase in campaign spending I expect. First,  interest groups already know how to exert influence while working within the pre Citizens United rules. Therefore, it’s possible that the new decision won’t change much.

Secondly, politicians understand the new, post Citizens United campaign economics and many of them will begin to censor themselves, even more than they already do. Expect even some of the bravest to pander to the money that talks on key issues, rather than face deep pocketed opposition. As former Treasury Secretary Paulson once said, “If you’ve got a bazooka and people know you’ve got it, you may not have to take it out.”

So, how to play this? Ad agencies and broadcasters should expect a noticeable, recurring revenue increase during election cycles. I don’t know how anyone could predict exactly how large a bump they will get, and what effect that bump will have on earnings per share, because we are in new territory here. If this type of play interests you, look for pure media companies with heavy domestic exposure and put them on a watchlist.

CBS (ticker symbol, also CBS) would be an obvious beneficiary of this trend; the other networks are part of large conglomerates. Therefore new political ad revenue at those broadcasters might not have much effect on parent company net income. If you want to stretch a point, however, you might also look at News Corporation (NWS), since its Fox News division contributes a disproportionate share of profits to NWS.

Among ad agencies, billboard owner Lamar Advertising (LAMR) would seem to be among the purest domestic plays that could benefit from increased political ads, but be forewarned, it is losing money due to the recession and has a leveraged balance sheet. Two ad majors, Interpublic Group (IPG) and Omnicom (OMC) would seem to be safer bets, but both of them generate around half of their revenues from abroad. IPG has more domestic exposure than OMC.

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Delinquent Mortgage Borrowers Find it Harder to Catch Up

by on Dec.30, 2009, under Editorials

If you think housing will bounce back in 2010, check out this graph from Michael David White at


The graph shows cure rates, the percentage rate at which delinquent borrowers repay past due amounts so as to restore good credit standing on their mortgages. As recently as June 2007, 80% of borrowers who fell behind one payment were able to catch up. The graph also seems to show that as of September 2007, homeowners who counted on eager buyers to bail them out of overpriced homes began to have a tougher time of it.

In hindsight, the difficulties of borrowers who were two or more payments behind began to intensify a year earlier, in June 2006. One suspects that the graph captures the experience of the really junky mortgages whose borrowers went into early payment default (EPD).  EPDs happen when the borrower defaults within only a few months of taking the loan out.  If their lender sells the mortgage to another investor, that investor may have the right to put the mortgage back to the lender in the event of an EPD.

Thinly capitalized firms can’t survive too many EPDs. It was the epidemic of EPDs that forced a rash of undercapitalized mortgage bankers out of business.  Their bankruptcies helped mark the beginning of the housing crisis.

What does the graph tell us now? Most striking to me is that more than 90% the borrowers who miss two payments fail to catch up. As recently as March 2007, at least half of them succeeded in catching up. Data from the recent monthly Mortgage Bankers Association (MBA) survey and the quarterly FDIC banking industry profiles seem to bear this out. The MBA surveys show that about five million borrowers, or roughly 10%, are at least one payment behind on their mortgage.

The FDIC data show that the current delinquent population presages many more foreclosures to come. We know this because the aggregate amount owed by borrowers 90 days or more past due is in fact much larger than the amount owed by borrowers 30-89 days past due. That’s the reverse of what we expect during normal times.

The FDIC’s third quarter “profile” shows that 8.06% of the home mortgages held by FDIC insured institutions were “non-current,” 90 or more days past due as of September 30. FDIC institutions had $1.929 trillion in home mortgages outstanding then, so there were $155 billion in non-current loans. If we assume that the average borrower owes $200,000 on a mortgage, that would make for 777,000 non-current loans. (The FDIC data don’t count loans made by non-bank financial institutions that are also covered in the MBA survey.)

The FDIC numbers additionally show that 3.15% of the outstanding mortgages are 30-89 days past due. That would be $61 billion worth, and these borrowers correspond to the top two lines of the graph. White used data from MBA and the National Association of Realtors, so the correspondence is close but not exact.

Since the FDIC’s 90+ days late group owes more than twice as much as the 30-89 days group, it only makes sense to guess that lots of people in the 30-89 days late group, just stop paying their mortgage. By definition, everyone who is 90+ days late, was once 30-89 days late, and then fell further behind.

These FDIC data square well with White’s graph. The graph tells us that 30-59 days of delinquency indicate more borrower stress than they used to, and 60 days of delinquency is now a point of no return.

The MBA cites the job market as the culprit for this change in behavior. High levels of long-term joblessness (six months or more out of work) mean that that those who stop paying because they have lost their job, are less likely to find work again in time to catch up on their mortgage than in previous postwar recessions.

Our data have some important implications for the housing market and for housing related stocks. The data help show that there is a large “shadow” inventory of homes that will eventually come onto the market, or that owners would sell if they could. The number of homes officially listed for sale is only part of the supply that weighs on the market .  Clearly the homes that secure loans 60 or more days past due should be counted in shadow inventory, though they are only one part of it  (the Calculated Risk blog does a good job of explaining shadow inventory and all its components).  And a large shadow inventory means, new homes will have to compete with homes offered in distressed sales over the foreseeable future.

Obviously I don’t expect homebuilder earnings to rebound anytime soon. On the other hand, I wouldn’t short the major builders because the government has given them massive tax breaks and seems hell-bent on bailing them out. That’s why I am also reluctant to short banks that got TARP money. Investors who want to exploit this situation, need to short overvalued housing-related stocks that are not likely to benefit from government assistance.

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Key Saudi Oilfield Continues to Show Signs of Aging

by on Dec.03, 2009, under Editorials

Some largely overlooked news shows that worldwide oil production capacity continues to plateau if not fall. Of course it might be bad form to back up the truck right now on oil stocks, given that oil and stock prices have rebounded so smartly since March. But the long term oil news is bullish.

The news I refer to came out of Saudi Arabia on Friday, November 6. The Saudis all but confirmed the accelerating decline of the Ghawar oil field. With an estimated production capacity of 5.2 million barrels per day (mmb/d), Ghawar accounts for about half the Saudis’ production, give or take, and is the most prolific field ever found. Many experts believe that when Ghawar’s production decline curve accelerates, worldwide oil production, which now runs about 85 mmb/d, will tip into decline as well.

The Saudis expressed their concern, not with an explicit press release, but by concluding a five year, integrated turnkey contract with Halliburton (HAL) to redevelop Ghawar. In other words, Saudi Aramco, which is among the more sophisticated national oil companies (NOCs), felt the need for some outside extra help to keep Ghawar’s oil flowing. The contract calls for HAL to do directional and horizontal oil drilling and to drill 153-185 oil and water injection wells, among other things.

When Ghawar oil production began back in 1951, it might not have been much of an exaggeration to say that all the reservoir managers had to do was stick wells in the ground and enjoy. As time went on, Aramco resorted to enhanced oil recovery (EOR) techniques such as injecting water or other substances into the field to force the oil towards well openings. Aramco also employs other EOR techniques such as horizontal and directional drilling, both of which can be used to angle the well so as to maximize the length of oil well pipe in contact with the “pay zone,” the layer of oil bearing rock.

EOR is standard procedure especially over the later history of many if not most oilfields. It’s natural to pump the easy oil first; as a field matures the rest gets harder to extract. Over time as the oilfield owner pumps out the crude, the pressure which drives oil to the well and up to the surface falls off. In addition, the early, higher quality product of crude oil and natural gas liquids, often gives way to a product increasingly mixed (or “cut”) with water, which must then be separated from the crude before refining takes place. With this background in mind, oil analyst Michael Lynch of GLG Group (h/t, has some choice words about the HAL contract.

“The contract makes no mention of Ain Dar, the most mature part of Ghawar…  Ain Dar has been under pressure maintenance by peripheral water injection for over 40 years. Ain Dar began producing salt water in the late 1970s and by 2005 the cut was 42%… Once water became a major problem, many existing vertical wells were converted to short lateral horizontals running along the top 10 feet of the Arab D zone, the main pay [zone for both Ain Dar and other parts of the Ghawar]…Today the entire field still contains a great deal of crude oil but it is much harder to get and the production rates continue to fall off. Halliburton’s mandate will be to deal with the higher and higher water cuts, utilize all known new technology to hold [production] rates as high as possible… It’s a good, long-term contract and a tall order for the company.”

As a side note, the Saudis objected fiercely in 2005, when Matthew Simmons stated in his book, Twilight in the Desert, that Ghawar was in decline and that the Saudis were making strenuous efforts to maintain production. Simmons also highlighted difficult geological problems that the Saudi petroleum engineers faced. The HAL contract would seem to confirm Simmons’s work.

If Ghawar were still in its early phase when oil flowed easily to the surface through highly productive wells, Aramco most likely would not need an EOR program like this. The need for this program is evidence that we may indeed be facing “twilight in the desert,” and that Saudi Arabia’s glory days as a leading oil exporter are winding down. Can “peak oil” be far behind?

Nonetheless, there is reason to be cautious about oil stocks in the short to intermediate term: demand for crude is down. US refineries processed 14.2 mmb/d of crude in October 2009, which is down about 200,000 b/d year on year and down 800,000 b/d from the October 2007 level. No surprise for a weak economy. Furthermore, both Sunoco (SUN) and Valero Energy (VLO) have in fact closed refineries recently. US crude oil inventories sit at about 24 days’ supply, 2 days above the year-earlier level. These numbers don’t indicate tight markets, and I have to wonder if current prices are sustainable.  I just don’t know how far they fall from here, and how long they stay down.

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SIVs, the Capstone of the Credit Bubble

by on Oct.02, 2009, under Editorials

You have to hand it to the humble SIV (structured investment vehicle). To create one, you must employ just about all the abuses the credit bubble made famous.

SIVs had everything: regulatory arbitrage, opacity, reaching for yield, multiple opportunities for bankers to generate fee income, multiple layers of leverage, rating agency incompetence, credit default swaps (CDS), collateralized debt obligations (CDOs) that packaged dodgy mortgage- or asset-backed securities (MBS or ABS), the “originate to distribute” model of lending,  offshore domiciles, borrowings of different priority arranged in tranches (remember tranches?), the global dollar glut  and yes, whimsical names that should have warned investors to stay away.

I mean, who could forget the Whistlejacket SIV? When Whistlejacket failed, someone must have regretted not knowing, just what is a “whistlejacket,” anyway?

But why write about SIVs now, aren’t they soo 2007? I would give three reasons. First, banks are not done unwinding SIVs (not to mention CDOs and CDS) from their balance sheets. They may be out of sight but they are still out there creating mischief. Second, SIVs are still being litigated: as I wrote several weeks ago, a lawsuit over the now-bankrupt Cheyne SIV may help dethrone the bond rating agencies. Lastly, nothing epitomized the credit bubble like the SIV.

SIVs were to the credit bubble what Goldman Sachs Trading was to the Roaring Twenties, the Nifty Fifty to the ‘60s “go-go” markets, and to the internet bubble.

Ten or twenty years from now, when the consequences of all our actions have become clearer, someone will write the definitive history of the credit bubble. In such books, writers often organize their narratives around a particular item or incident. If any financial historians are reading this, I nominate the SIV; it wins hands down.

Why create an SIV? Commercial and investment banks (often the same company) enjoyed many benefits from SIVs, none of which passes the smell test now. Investment banks got to earn fees on the things, coming and going. Consider: they bought mortgage loans (or car loans, or loans against credit card receivables, among others) and got fees when these were packaged into ABS or MBS. They got fees again when they packaged the ABS or MBS into CDOs. They even got yet another level of fees when these were sometimes packed into, you guessed it, CDO-squareds or even CDO-cubeds. And at this point the investment banks were just getting started.

So the investment bank created the vehicle in which the SIV would typically invest, the CDO. The investment banks then sold notes to finance its CDO purchases. These notes usually came in several tranches such as short term senior notes, subordinated capital notes, and then at the bottom, some equity. The i-banks collected fees on each of these financings too. Not incidentally, the i-banks also had in the CDOs and  SIVs, buyers, or more accurately, stuffees for all that dodgy loan product they had for sale. Oftentimes that loan product was originated for sale because the lender didn’t want to own it in portfolio.

Therefore  in the SIV we had a special purpose investment company that was leveraged up, say, four to one (that is, they had four dollars of debt for each dollar of equity) to purchase CDOs that no one really understood (they were opaque). You couldn’t understand a CDO because each CDO typically owned pieces of dozens of MBS, which in turn were created from hundreds if not thousands of loans. So a CDO could comprise pieces of tens of thousands of loans, which no one had the time to evaluate; and that’s before we even get to an SIV that might own pieces of a number of CDOs. So if a CDO was impossible to analyze, an SIV, was, well,  incomprehensible.

Finally, the amount of leverage SIVs had was not always apparent at first glance. Of course SIV note buyers knew that SIVs were leveraged; they were financing that leverage. But in addition, CDOs often incorporated leverage also. Therefore, an SIV often had multiple layers of leverage, because it owned leveraged vehicles like CDOs.

The SIV would sometimes hedge its credit risk with CDS that supposedly guaranteed the CDOs that it owned against default. That way, in theory, it was safe to borrow so much money and buy bonds with it.

Someone had to manage the investments of the SIV once it was launched, and commercial banks often seemed to benefit by doing that.  Banks normally are limited by law, as to how many dollars’ worth of assets they can have per dollar of equity but by setting up SIVs banks could control additional assets beyond the legal maximum (here’s the regulatory arbitrage). Legally, the SIV owned the assets, the bank did not.  The banks accounted for SIVs as “off balance sheet” items. The banks earned their money by charging the SIV a fee for managing the SIV’s assets. As an aside, banks often domiciled the SIVs offshore, typically in London.

On the other hand, SIVs posed a potential problem for the commercial banks that managed them. The bank was expected to step in if the SIV couldn’t repay its notes. When that happened the SIVs then “migrated onto the banks’ balance sheets.” While the banks were not always obligated legally to back the SIVs, they faced reputational risk if they failed to do so. Bank of America (BAC) and Citigroup (C) are among the banks that became reluctant owners of SIV assets.

Why buy notes issued by something like this? Three reasons come to mind. First of all, the i-banks would find some way to set up the SIVs (and the CDO components too) so that the senior tranches got AAA ratings from Moody’s and S&P. Secondly, the SIVs often had the implied guarantees from commercial banks. There was also the “safeguard” provided by the CDS (another item in our abuses list)  hedge in some cases.

Because the i-banks (and the rating agencies) sprinkled so much holy water on these things, that they could find buyers who didn’t bother analyzing the SIVs seriously. With all the supposed safeguards, the buyers were happy to get a yield that was, well, a bit higher than what you could get on Treasurys because, after all, the SIVs were triple-A. A classic example of reaching for yield.

Thirdly, some of the SIV buyers, particularly international buyers, had LOTS of money to invest, courtesy of the worldwide dollar glut. During the good times they didn’t think much about where they put that money. For example, one of the plaintiffs in the rating agency lawsuit is the Abu Dhabi Commercial Bank.

So there you have it: a product that embodied just about every sharp (or stupid) practice of the late stage credit mania. While we’d love to see financial markets heal even more, not even the wildest green shooter dreams that banks will bring new SIVs to market again. No one will miss them, either, except those of us who fancy the trivia of financial history.


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Judge to Rating Agencies: Free Speech not Freedom to Defraud

by on Sep.08, 2009, under Editorials

On Sept. 2, US District Court Judge Shira Scheindlin ruled that a lawsuit filed by institutional investors alleging fraud by Moody’s(MCO), S&P, and Morgan Stanley (MS) may go forward, dismissing the rating agencies’ traditional First Amendment, freedom of  speech defense. MCO and McGraw-Hill (MHP), which owns S&P, declined when the ruling hit the wires, on fears that without the free speech defense the agencies could be open to unlimited legal liability.

The plaintiffs, Abu Dhabi Commercial Bank and King County, Washington (which includes Seattle)  purchased notes issued by the then AAA-rated Cheyne Structured Investment Vehicle (SIV) beginning in 2004. Cheyne went bankrupt only three years later, and that bankruptcy helped spark the money market crisis of 2007.

On the face of it, the investors have cause for anger. Triple-A ratings traditionally mean, safe to buy, forget, and clip the coupons. Having a triple-A issue go bankrupt at all  is an embarrassment for the agencies. Having the issue go from triple-A to bankrupt so quickly means the agencies blew the call about as badly as they possibly could. The court will decide if the blown call happened through incompetence or something worse.

Here’s another reason why I think the investors have a case: the rating agencies have access to gobs of confidential information that other investors don’t see. Their analysts can ask an issuer just about any question and get the answers they want. So the agencies ought to have known, and certainly had every resource to find out, about the flawed mortgage backed securities (MBS) that were folded into the collateralized debt obligations (CDOs) that Cheyne owned. Nonetheless the agencies stamped the junk with a triple-A.

The agencies claim that they relied on models of the housing market that didn’t allow for a nationwide decline in home prices, as opposed to a regional one. Lame as it sounds now, that model had some merit (though not that much), before, say, 2003 when mortgage lending standards started to deteriorate. But if anyone was in a position to know that the game had changed, it was the agencies. They could have demanded sample loan files to get a feel for the underlying collateral, and no doubt the investors will ask about this in court. Loan files are normally highly confidential, kept between the borrower and lender, but that is exactly the kind of thing that the rating agencies can see (and bank examiners certainly do see) but outside analysts can’t.

The agencies’ bank analysts also should have known about deteriorating home loan underwriting. After all, the agencies also rate bonds issued by banks.  If I were representing the investors, I’d ask if the agencies’ bank analysts had learned about weak home loan collateral, and if they talked to the analysts in the groups who rated SIVs. You’d think that someone, somewhere in S&P or Moody’s had some idea about this. Yet they continued to bless structured products with triple-A ratings as quickly as the bonds could get cranked out.

My guess is, a fair number of people at S&P and Moody’s knew quite well that the mortgage markets had gone bad.  After all, some colorful internal S&P e-mails came out in October 2008. One of them mentioned a “house of cards” and another, that “a cow could come up with this structure and we would rate it.”  But who would dare raise a stink, when the agencies’ structured product groups were making the real money (more on that below)? The court will have to decide whether such general awareness in the firms evidenced fraud or not.

The deterioration in loan underwriting standards enabled the housing bubble and made a subsequent collapse almost inevitable. Back in the ‘Sixties and ‘Seventies, Fannie Mae and Freddie Mac ran large databases on loan experience through their computers, and figured out what a sound home mortgage loan looked like. From this exercise came the guidelines that many of us grew up with: 10-20% down, a maximum of 28-33% of income needed to service debt, and a stable work history, among other things.

When Fannie Mae and Freddie Mac’s standards ruled, that meant that in the nation as a whole, house prices had to be related to borrowers’ ability to pay the loans. The advent of liar loans with initial teaser rates, and similar unsound products, broke the relation between house prices and income. Therefore, at least for a time, there was almost no limit to how high prices could go. Again, the rating agencies were in as good a position as anyone to know about this problem early on.

Contrast the recent bubble to the S&L crisis in the 1980s. We did see a housing bubble in Texas, based on the energy boom and bust; there were also problems in a few other areas, notably New England. But bad as the Texas home loan problem got, it did not go national. The recession of 1990 was less severe in other parts of the country, and in any event, home prices remained tethered to borrowers’ incomes in the country as a whole. But that was your father’s home loan problem and the rating agencies are paid to know the difference.

Rating agencies have a tighter relationship with issuers of structured bonds than they do with, say, corporate bond issuers and that may be examined in this case too. In corporate bonds, the agencies heavily consider the ratios of cash flow to interest expense and other fixed charges such as capital leases when they make their bond ratings. IBM, for example can’t grow more cash flow out of thin air in order to make S&P happier. If they want to borrow money in the bond market, they give the agencies their financials and the agencies decide how strong the bond is, and that is mostly that.

But structured product issuers can do all sorts of things to make their issues stronger and get higher ratings for the top tranches. They can assign more cash flow to the top tranches, or they can increase the overcollateralization factors, to name two. So the issuers could and did rejigger a structured product until they got the rating they wanted. Meanwhile, one has to wonder: if the the agency effectively blessed the structure, are they invested in that structure? And would they be reluctant to downgrade the issue even when  new information casts doubt on the issuer’s ability to repay the debt? That’s the subtle potential for conflict of interest that an agency faces when rating structured products.

The more blatant potential conflict, and Judge Scheindlin cited this in her ruling, is that structured product ratings pay the agencies about three times as much as other ratings do.  So the agencies may have had at least some incentive to curry favor with the issuers of structured products — as in, give them a triple-A on the Cheyne SIV, get more SIV business next week. If that turned out to be the case, the agencies came awfully close to selling top ratings for cash.

I only wish that the ramifications of this case stopped with the rating agency business model, but they also strike at America’s influence and reputation for probity. Think of it this way: corporations — and sovereign governments around the world — care about what their bond ratings when they want to borrow money. Despite their flaws, the rating agencies provided a baseline opinion that was respected, and having institutions like those domiciled here, was one of many things that made the United States a country that others wanted to emulate. When the rating agencies fail so grossly, like it or not, it reflects on us. This is the sort of thing China and Russia talk about when they question America’s legitimacy as custodian of the world’s reserve currency. These are the sorts of things that the leading power needs to get right — or fix quickly — if it wants to stay in the lead. Which is why prompt and credible rating agency reform (and a few criminal prosecutions if evidence warranting that emerges in this case) would be a small but significant gesture that could do us a world of good.

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