naked capitalism

Submitted by Edward Harrison of Credit Writedowns

John Meriwether, the 62-year old former Salomon bond trader and LTCM wizard is back for, what is this, his fourth go round.

For those of you who don’t remember the 1980s, John Meriwether was the biggest of the ‘big swinging dicks’ on Wall Street, leading Salomon Brothers to huge profits in its fixed income division. Lionized in the eponymous book “Liar’s Poker” and inspiration for Bonfire of the vanities, Meriwether and Salomon’s rise marked the change from a bulge bracket culture dominated by deal makers and IBD (Investment banking Division) white shoe bankers to one dominated by the foul-mouthed traders and math geek quants of fixed income.  The change at Goldman Sachs from a firm dominated by IBD to one dominated by trading is testament to this. Unfortunately for Meriwether, his career path since reaching the top has been rather rocky.

First there was the enormous Treasury bond scandal, in which Meriwether subordinate Paul Mozer put in fake Treasury bids on behalf of clients in an attempt to corner the market for on-the-run securities. Lax oversight got Meriwether a $50,000 fine and Salomon a $290 million fine, the largest ever to that date. Salomon head John Gutfreund resigned and Warren Buffett came in to serve as Chairman (Phibro which was recently offloaded to Occidental Petroleum by Citigroup is a Salomon Brothers company, by the way).  Meriwether left.

Soon, Meriwether was back at it at Long-Term Capital Management, the Greenwich-based hedge fund he founded in 1993 and which was famously leveraged 100 to 1, not including derivatives exposure of $1 trillion on a capital base of $5 billion. This company produced spectacular 40+% profits year after year before going spectacularly bust in 1998 after Russia devalued its currency and defaulted on its debt (see Frontline’s recent video which has a part on LTCM).

Meriwether miraculously was able to start again, literally the next year, helped by a bubble in shares which increased appetite for risk. He started JWM Partners in 1999. After years of gains, this fund too produced staggering losses (44% last year) and was liquidated.

Now that shares are up some 60% in US markets, guess what, John W. Meriwether is back… and he’s taking investors.  This one is called JM Advisors Management, also based in Greenwich.

The fund is expected use the same strategy as both LTCM and JWM to make money: so-called relative value arbitrage, a quantitative investment strategy Mr Meriwether pioneered when he led the hugely successful bond arbitrage group at Salomon Brothers in the 1980s.

The strategy, described by the Nobel Prize-winning economist Myron Scholes as being akin to a giant vacuum cleaner “sucking up nickels from all over the world”, can be highly successful in periods following market dislocations.

Relative value trades profit by betting on unusual pricing relationships between securities, anticipating a return to an historically modelled “normal” state between them.

Traders say the strategy has the potential to deliver huge returns in the current market, with many banks’ proprietary trading desks having scaled back their operations and far fewer hedge funds in existence.

I bet the money is pouring in.

The timing here is interesting given what is happening in mortgages and banking. Meriwether was at the center of the creation of the mortgage-backed securities market with his colleague Lewis Ranieri. Franklin Bank Corp., a bank run by Ranieri was recently seized by the FDIC as it ran into difficulties in the financial crisis due to poor lending. The seizure cost taxpayers $1.6 billion.

However, the much more important tidbit on the mortgages front comes in terms of foreclosure activity. Because of an August ruling by the Kansas Supreme Court (Yves linked out to a story on this today), we could be seeing some major changes in the way foreclosures happen. A post at Credit Writedowns, “Why mortgages aren’t modified and what a ruling stopping foreclosures means” chronicles the case in greater detail.

Sources

Meriwether setting up new hedge fund – Sam Jones, FT (also with the FT Alphaville Team)

Meriwether – FT Lex

Note that while this Bloomberg story discusses that some major hedge funds are skeptical of the theory that the recovery is on, for the most part, it is silent on how they are implementing that view. Recall that even if a trader does make a correct fundamental call, investing successfully on it is another matter. Soros notoriously got many of the basics around the credit crisis correct, including recognizing the oil price spike as largely a bubble, but nevertheless was reported to have wrong-footed the trades.

From Bloomberg:

[Paul Tudor] Jones’s Tudor Investment Corp., Clarium Capital Management LLC and Horseman Capital Management Ltd. are taking a bearish stand as U.S. stock and bond prices rise, saying that record government spending may be forestalling another slowdown and market selloff. The firms oversee a combined $15 billion in so- called macro funds, which seek to profit from economic trends by trading stocks, bonds, currencies and commodities….

Clarium watches the unemployment rate that accounts for discouraged job applicants and those working part-time because they can’t find full-time positions, Harrington said. July joblessness with those adjustments was 16 percent, according to the Department of Labor, rather than the more widely reported 9.4 percent.

The housing data isn’t as rosy as some see it, Harrington said. As existing U.S. home sales rose 7.2 percent in July from the previous month, distressed deals including foreclosures accounted for 31 percent of transactions, according to the National Association of Realtors, a Chicago-based trade group.

A report by the Mortgage Bankers Association, based in Washington, showed the share of home loans with one or more payments overdue rose to a seasonally adjusted 9.24 percent in the second quarter, an all-time high…

High unemployment, lower wages and potential missteps by policymakers around the globe may stifle economic growth in 2010, Tudor said….

Macro managers’ pessimism is fueled in part by the U.S. government’s response to last year’s financial crisis, which they say fails to address the root cause. Banks still hold hard- to-sell assets on their balance sheets, the managers said.

“Some critical initiatives have been cut short,” Tudor said. “As a result, toxic assets remain on balance sheets and credit growth is likely to be subdued for a long period.”

Some firms, including Brevan Howard Asset Management LLP, see the recession at its end while dismissing the likelihood of robust growth.

Brevan Howard, Europe’s largest hedge-fund manager with $24 billion in assets, told clients the U.S. could stumble when stimulus spending fades after the current quarter.

“If we have a recovery at all, it isn’t sustainable,” Kevin Harrington, managing director at Clarium, said in an interview at the firm’s New York offices. “This is more likely a ski-jump recession, with short-term stimulus creating a bump that will ultimately lead to a more precipitous decline later.”

Ooh, so there is gambling in Casablanca! I’m shocked, shocked!

An excellent bit of sleuthing comes at the Wall Street Journal, on how Goldman has for the last two years has had “trading huddles” that lead to ideas being presented to clients before analysts changed their grades on a stock. Proprietary traders also attend the meetings.

Now the funny bit about this is that this is an ongoing not so keen practice that Goldman that Goldman has pushed pretty far, in typical Goldman propensity to exploit any ambiguity in the regs.

One of the differences between big accounts and everyone else is access to the analyst. The idea that this article fails to highlight is that the written research report is much less meaningful than believed, except in the cases when an analyst does a big revision of earnings forecasts. Goldman seems to have played those changes to its key accounts, and maybe its own advantage.

But a second bit is that within a seemingly static rating, an account can get tremendous insight from talking to an analyst that a mere low level client who gets only the written product and participation in conference calls misses.

In other words, the two-tier system (or even three, since top accounts can get to analysts any time, but other institutional accounts will not get the same priority) has long been in effect. But Goldman appears to have pushed the boundaries yet again. Putting the prop traders with the top accounts onto hot trading ideas (by implication, everyone knows GS intends to pile in, hence it is safe for the big accounts to throw their weight int) smells like tan organized ramp of a stock.
From the Journal:

Every week, Goldman analysts offer stock tips at a gathering the firm calls a “trading huddle.” But few of the thousands of clients who receive Goldman’s written research reports ever hear about the recommendations.

At the meetings, Goldman analysts identify stocks they think are likely to rise or fall due to earnings announcements, the direction of the overall market or other short-term developments. Some of their recommendations differ from ratings printed in Goldman’s widely circulated research reports. Some Goldman traders who make bets with the firm’s own money attend the meetings.

Critics complain that Goldman’s distribution of the trading ideas only to its own traders and key clients hurts other customers who aren’t given the opportunity to trade on the information….

Since the trading huddles began about two years ago, Goldman has supplied “trading ideas” on hundreds of stocks to the traders and top clients, according to internal documents reviewed by The Wall Street Journal.

Yves here. Goldman defends this practice as merely giving “market color” and contends this practice is simply to cater to accounts with a short-term trading focus, versus long-term investors. Please, is anyone an investor any more? Average holding time for NYSE stocks is well under a year. Back to the story:

Goldman was looking for a leg up on rivals when it started the trading huddles in 2007. That year, Goldman ranked ninth in Institutional Investor magazine’s annual list of the best equity analysts, as determined by a survey of big institutional investors. Goldman was rated eighth in last year’s competition.

The huddles began in earnest around the time Goldman’s research department got a new boss, Mr. Strongin. He came to the firm in 1994 from the Federal Reserve Bank of Chicago, where he had been director of monetary-policy research. At Goldman, he had run the commodities-research operation, then was co-chief operating officer of the whole research unit, before being asked to run it in April 2007….

Compliance officers sit in on almost all the meetings, Goldman says. Research analysts say they have been guided on what language to use in the huddles. Words like “buy” and “sell” are to be avoided, while “run up,” “give back” and “oversold” are encouraged. Internal documents reviewed by the Journal initially tracked the trading-huddle tips as “buy” or “sell,” but now refer to them as “up” or “down.”

Yves here. You know when compliance sits in the practice is pushing the margin. And everyone on the calls understands the coded message. Complete form over substance.

Some other firms are more conservative:

At least one competitor discloses such trading tips much more broadly. Morgan Stanley’s research department sends blast emails with short-term views on various stocks to thousands of clients, and posts the information on its Web site. It doesn’t call customers to convey the tips, because Morgan Stanley officials decided that could expose the firm to questions about selective disclosure, according to people familiar with the matter.

Reader Peter A pointed out this New York Post article on Tyler Durden today. The Post has broken some hedge fund stories, like losses at particular well known hedge funds during rough trading periods, so it does have good connections in Hedgistan.

I would rather not get into this fray, but Tyler Durden has guest posted here, and his (or more accurately, their) stories have shed light on some questionable trading practices, and I applaud that effort. The Post story has now been picked up by other blogs, and at least in part confirmed by Felix Salmon, so I would be remiss in not posting on it.

Here is the nut of a story up today, “Blogger May Have a Past“:

A 30-year-old New Yorker who was barred from the securities industry last year may be behind an increasingly popular financial blog known as Zerohedge.com, which is catching flack for its obsession with anonymity.

Daniel Ivandjiiski, whose most recently listed address is on the Upper East Side, was barred last September by the financial industry’s self regulatory authority, FINRA, for insider trading….

Ivandjiiski didn’t return requests for comment, but he recently told industry publication Hedge Fund Alert that while he writes for Zerohedge, he’s not a founder.

“He denied that he was a founder. He said he was just a contributor,” Hedge Fund Alert Managing Editor Howard Kapiloff told The Post.

Ivandjiiski told Kapiloff that he’s one of several writers who contributes to the site under the pseudonym “Tyler Durden,” the charismatic, psychopathic alter-ego of the main character in the book and movie “Fight Club.”…

A manifesto on the Web site suggests Zerohedge contributors are seeking to avoid the backlash their comments could unleash, saying anonymity protects “unpopular individuals from retaliation — and their ideas from suppression — at the hand of an intolerant society.”

A man who answered the phone at Zerohedge declined to give his name or to comment. He offered vague statements like, “Zerohedge is not one person,” and, “For us, its not about the messenger, its about the message.”

A manifesto on the Web site suggests Zerohedge contributors are seeking to avoid the backlash their comments could unleash, saying anonymity protects “unpopular individuals from retaliation — and their ideas from suppression — at the hand of an intolerant society.”

It is quite clear just from the variety of writing styles associated with the name “Tyler Durden” that more than one writer is associated with that name, It is also clear that the folks at Zero Hedge are unusually well plugged in, independent of their sources. The operation appears to have had a Bloomberg terminal from its early days (no minor expense), suggesting the writer(s) at a minimum co-located with a trading operation. I had though initially ZH might be a former hedgie who was trading for his own account and posting, but the volume of posts (and effort required to produce them) now suggests that some writer/researchers there are close to full time.

Felix Salmon indicates he has known of the Ivandjiiski connection since March. Chris Whalen said he had lunch with Durden .(one of the Durdens, anyway) and the tone of the throwaway comment suggested he knew him fairly well. Andrew Cuomo also seems to be taking some of the Zero Hedge stories seriously, particularly the ones about high frequency trading.

And the timing of the release of this news story could suggest (in a watered down rerun of what happened to Eliot Spitzer, the public exposure of information damaging to someone who was stepping on too many influential toes) that this story is appearing now precisely because Durden is getting to close to some even more damaging stories than he has provided thus far.

I am hardly one to throw stones at psuedonymous bloggers, but it only takes a modicum of digging to figure out who I am (and I have appeared on TV and done a bit of radio). I am told by a reader that he appeared on Bloomberg radio yesterday, and a reader who heard the broadcast says he plans to reveal his identity soon

Zero Hedge is a costly operation (apparent access to data services, number of staffers working what appears to be close to if not full time) and that does raise questions about its ambitions. It may be seeking to become a new media type of platform, but the combination of missionary fervor and possibly commercial aspirations is a mix that (per comments I have gotten from readers) leaves some perplexed.

The mysteriousness has served Zero Hedge well thus far, but the messianic zeal and the sometimes strident tone serves to undercut their typically good content. It clearly boosts traffic (ZH has become popular in a very short period of time), but does it in the end serve his cause? In the long run, it raises question about credibility, and and I worry not just his/theirs, but of financial blogs generally.

I am sorry to make Roger Ehrenberg an object lesson as far as this post is concerned, because I am a fan of his work. He is articulate and insightful. I have often featured his posts in Links as opposed to in posts and felt a bit bad about it, in that I wanted to give them more attention, but had nothing to add.

However, I am sick and tired of the “sanctity of contract” theme as far as outsized bonuses from “dead other than by the grace of the US taxpayer” organizations are concerned, and Ehrenberg lobbed in a vote firmly in the “sanctity of contract” camp. And while he does argue for changes in what he calls the Wall Street trader compensation model, the record does not give much reason to think his suggested remedies will actually change behavior all that much.

First, to the “sanctity of contracts” bit. I don’t seem to recall many, or frankly any Wall Street types going on about sanctity of contracts when agreements with the UAW were reworked to save GM. So tell my why should big financial firms that would be toast other than by virtue of the munificence of the suffering American taxpayer be any different? The case that is getting everyone exercised is Andrew Hall of Citigroup, which is the lead candidate in the zombie bank casting call. Hall would have NO contract had nature been permitted to run its course. That inconvenient fact does not seem to be acknowledged by Hall defenders.

Being at a firm means all boats rise and fall with the fate of the firm, That construct was well understood in the days of partnerships and has gone completely out the window in the era of public ownership, aka Other People’s Money. If you did an A job in a C year, you did worse that if you did a C job in an A year. Unfortunate, but those were the breaks.

My beefs about Hall’s pay are not the level per se but the structure. He appears to have a firm within a firm, an arrangement that often leads to bad ends (Mike Milken at Drexel and the AIG Financial Products Group are the poster children, but I have seen smaller scale variants that also wound up causing trouble for the organizations housing them). He refused to comply with efforts to integrate his unit into the asset management group, which presumably would have been better for the bank, so he clearly wants to have his cake and eat it too: enjoy the advantages of Citi’s cheap borrowing costs (an important advantage in his business) and infrastructure (he is relieved of much of the hassle of running a business) and can focus on a year long horizon rather that worrying about Sharpe ratios and monthly NAVs. And his deal appears extraordinarily rich, with the cut for his group below but presumably not much below 30%, well above hedge fund norms.

Second, as I have said repeatedly here, employment contracts can and do get voided and renegotiated ALL THE TIME. I have seen this happen both at client organizations and in my professional circle. And this is true of contracts generally. Circumstances change, people of good will try to recut a deal, and if someone is a pig about it, then the aggrieved side moves on to more aggressive measures. There is nothing terribly unusual about this. It is an unpleasant fact of modern life. Having a contract does NOT mean it is sacrosanct. Please. How many of these people who are carrying on about sanctity of contracts are still on their first wives? “Sanctity of contract” means there are costs of modifying or exiting the deal.

Let’s consider another case where “sanctity of contracts” didn’t stand for much: credit default swaps. A little bit of history that has gone by the wayside: CDS written pre the Delphi bankruptcy required presentation of the bond for the protection buyer to collect. Delphi was the first large bankruptcy and was considered to be a test of the market. The industry realized the Delphi CDS outstanding greatly exceeded the amount of cash bonds. That meant first, there would be a mad scramble to buy bonds to present at the settlement, meaning a huge price squeeze, and second, the overwhelming majority of people who had bought protection would find it to be useless.

The powers that be came up with the cash settlement mechanism even though it was not permitted in the original swap documentation. The big dealers were very keen to keep the market going. Had they stuck with the original construct, CDS protection buyers who did not have bonds would not have profited, and the burgeoning of the market to significant multiples of the value of the underlying bonds probably would have come to a screeching halt. And notice how this was done. To go to cash settlement post Delphi would have been a belated recognition of a need to change procedures. But modifying it on the fly is quite another matter.

Ehrenberg argues that traders should be paid on a long-term basis, with their 80% bonuses reinvested in a capital account, He points out, and I agree, that stock based compensation does not influence trader behavior, They don’t ascribe much value to the shares.

But I am not sure the evidence supports Ehrenberg’s view, that that hedge fund compensation model actually leads to more prudence. The big and obvious benefit is it does allow for losses in bad years to be offset against gains in good years. That is undeniably an important gain. It would presumably put an end to certain year end tricks to pump up positions up and dump losses in the next year, with the idea that the trader has made enough from the chicanery to afford the worst case outcome, namely, a resume put.

However, I am skeptical of the further benefit that Ehrenberg asserts, that it will lead traders to take more of a long-term perspective. Now in fairness, he does say it is “more likely” to improve behavior, and I cannot disagree with that formulation, but I think the change in behavior would be less marked than he believes.

Traders are very fixated on maximizing their annual take, and also too often regard their past gains as money in the bank. The LTCM partners famously had pretty much all their money invested in the fund, and we know how that movie ended. And what is more striking is that both Myron Scholes and John Meriwether started new funds, each of which failed. Given their records, I would imagine they were expected to and did reinvest a fair bit of their earnings. Similarly, if you look at the level of hedge fund disasters last year versus those among traders at big firms, would you see much difference? I genuinely do not know the answer, but given the high rate of hedge fund failures, having a lot of cash tied up in the business did not seem to prevent widespread hedge fund implosions.

As much as philosophically anything is better than the current model, I am skeptical that relying on pay to create good incentives is an adequate check for having risk controls, in the form of someone skilled but more conservative act as a check. The egos and short term focus of traders of many traders makes them hard to contain, and unlikely to restrain themselves, even if it were rationally in their best interest.

I recall in the mid 1980s when people who should have known better (McKinsey consultants and analysts covering the banking industry) were adamant that banks would never cut their fees or interest rate charges (19.8%) on credit cards.

I remember thinking of the confidence over credit card pricing every time experts insisted that hedge funds (save maybe newbies) would never, never cut their famed “2 and 20″ fees (2% annual fees plus 20% of the gains). Talent, after all, would always be able to command a premium.

Those charges are proving to be less than sacrosanct after all. There had been reports earlier of big established investors winning concessions, but price cutting is becoming more widespread. From the Financial Times:

The hedge fund industry, infamous for imposing high fees, is finally beginning to cut these charges amid heavy outflows and investor complaints after a year of losses.

Three hedge funds contacted by the Financial Times admitted to cutting their fees for new investors, usually by lowering management fees by half a percentage point to between 1 per cent and 1.5 per cent, and performance fees from 20 per cent to 10 per cent…..what makes the current trend striking is that the number of special deals is proliferating fast….

Guy Haselmann, a principal at Gregoire Capital, a hedge fund that invests in fund of funds, said: “Fees are coming down, and they will continue to come down . . . generally the funds aren’t kicking and screaming too badly, they want more permanent capital.”

One hedge fund manager said: “It used to be that we gave our standard rate (2 per cent and 20 per cent performance fee) most of the time. Now, new investors paying that would be in the minority.”

Another manager who recently opened a new fund said: “We have cut our fees for our latest fund, though it would be catastrophic if that got out.”

Pension funds, under pressure to regain losses, are also making a push for lower fees. A few months ago, Calpers wrote to the 26 funds managing its $6bn in hedge funds with a list of demands, one of which was a fee cut in the form of a “clawback” on fees if the fund did well after a money-losing year.

As readers may know, secured lenders make loans against which specific assets are pledged. For consumers, mortgages and car loans are examples. If you default, the lender can seize the asset and sell it to try to recoup.

In bankruptcy, secured lenders are normally the top of the food chain, but in the Chrysler bankruptcy, the secured lenders failed to reach a deal outside of court (most of the big lenders agreed but a dissident group held out) and the court looks likely to approve a deal that arguable favors the junior creditor over the senior. The synopsis at the Financial Times is fairly typical:

George Schultze will think twice before lending to another troubled company such as Chrysler.

Mr Schultze is one of a group of dissident Chrysler creditors….He rejected an offer aimed at slashing Chrysler’s debt in order to allow the carmaker to be sold.

Mr Schultze and other investors – some of whom claim to have received death threats – say the deal is unfair because it does not honour their rights as senior lenders to get paid before other claims, such as a union benefit plan, are met.

They also argue that the deal was orchestrated by the US government, which held sway over the majority of the other lenders, namely a group of banks, following widespread bail-outs.

The question of whether the Chrysler creditors got a raw deal will be decided in a New York bankruptcy court over the next few weeks.

Already, the verdict on Wall Street and in the conference rooms of investment firms round the country is that, at the very least, the situation raises questions about the solidity of time-honoured lending principles and parts of the bankruptcy code…

“It will increase the cost of credit in the capital markets for lots of companies by tinkering with the well- settled priority system,” Mr Schultze said. “Our firm and many other lenders will think twice about lending to companies who have junior creditors that might get an unfair sweetheart deal.”…

“Given that so much of total borrowing across all asset classes is first lien in nature, the damage that would occur to the economy as a result of higher first lien borrowing costs resulting from lenders requiring a higher return to compensate them for an unknown interpretation of claim priorities could be substantial,” says Curtis Arledge, co-head of US fixed income at BlackRock, Inc. “Many lenders make loans by being investors in US financial markets where contract law has been sacrosanct, and deviation from that could have far-reaching implications to the US economy.”….

“It is particularly important at this stage of the distressed cycle for lenders to have confidence in pre-existing contracts and rules. We are entering a period of record corporate defaults and the need for bankruptcy financing and financing for distressed companies will only continue to grow,” says Greg Peters, global head of credit research at Morgan Stanley….

Investors, including hedge funds, began purchasing loans over the past decade. Previously, this arena was dominated by banks. Either way, the buyer accepts a lower interest rate for the perceived safety of the senior claim on assets.

The fear is that investors will demand a premium for senior debt such as loans, prompting a repricing of unsecured debt and general rise in the cost of borrowing.

“The financial interests of investors may conflict with what the government is trying to do from a social perspective,” says Steve Persky, managing director of Dalton Investors, a Los Angeles-based hedge fund that specialises in distressed debt…

And, in a downturn, lenders facing losses often say they will get tough and demand higher interest payments to compensate for risk. What is unique in this cycle is the new focus on the government’s role.

“Now there is a new risk: government intervention risk,” Mr Persky says. ”And it is very hard to hedge.”

Notice that everyone who is complaining is an investor. Not a single lawyer weighed in.

Now I am most decidedly not an attorney, and would welcome input from anyone who knows the bankruptcy code. I had thought that the deal depended on the use of Section 363, which is seldom used in Chapter 11. I have seen it argued that relying on Section 363 in Chapter 11 would gut a lot of existing bankruptcy practice and a judge would be cautious about using it. The flip side is that Chrysler may have been designed in such a way that this is considered to be a narrow application and does not set a broad precedent. It was used in Lehman, but Lehman was effectively a liquidation.

The folks at Credit Slips (and these are bankruptcy experts) aren’t troubled and argue the press has it wrong, Stephen Lubben notes:

I think these commentators have misunderstood the structure of the sale, no doubt in part because the overall structure of the deal has been somewhat “over-described.” There are obvious political reasons for this – in particular, the Administration needs to present a complete story of how Chrysler’s employees will keep their jobs when the dust settles. There is also a general lack of chapter 11 understanding among both politicians and the press.

As I comprehend the sale structure, based on the pleadings filed late Sunday, the debtor will transfer key assets and contracts to a new Delaware LLC in exchange for $2 billion in cash and various cure payments. As part of the deal, the new owner (the Delaware LLC) will assume some contracts, including the labor agreements.

The last piece of this does technically violate the absolute priority rule, but in a way that is mandated by the Bankruptcy Code. Contract counterparties always get their prepetition claims paid in full when their contracts are assumed and assigned in a §363 sale. §365(b)(1).

The sale will be free and clear under §363(f)(3), using the argument that “value” in that provision means economic value. Reasonable parties can disagree on that point. But notice that if the dissenting lenders win on the (f)(3) argument it does not necessarily stop the sale, rather it probably just means that the sale price gets lowered (because of the increased risk for the buyer). Also keep in mind that the objecting creditors would seem to have the burden of proof here. §363(p)(2).

I don’t see how (a) the new owner’s renegotiation of the labor agreement or (b) the distribution of ownership interests in the new owner are issues for the bankruptcy court to approve.

He does raise an issue in a later post:

I think that many of the arguments advanced against the Chrysler sale motion are largely noise, generated by confusion over the structure of the deal. But I also mentioned that one real problem I see here turns on the dissenting lenders’ apparent inability to credit bid.

The Bankruptcy Code expressly recognizes the right of a secured creditor to “credit bid” its claim in a §363 sale, just as a home lender can bid the value of its mortgage in a state foreclosure sale. § 363(k).

Thus, if the debtor moves to sell its assets worth $100 in a 363 sale, the bank with a $40 lien on the assets can bid “$40” and offset its secured claim against the bid, meaning that the bank only has to pay cash for the debtor’s assets if the auction price goes above $40.

Thus, if Chrysler were a typical chapter 11 case, the senior lending group would be able to credit bid up to $6.9 billion for the debtor’s assets. If the lenders won the auction, they could then sell the assets to Fiat or anyone else.

Here the lenders (as a group) decided to forgo their right to credit bid and instead accept $2 billion in cash. The offer was at one point raised to $2.2 billion, but that has apparently been taken off the table since Chrysler entered chapter 11.

Normally I’d say that the lenders’ decision to take the $2 billion was a strong indication that they expected Chrysler’s assets to sell for a price less than or equal to that amount, mooting their need to credit bid. But in this case the decision to take the $2 billion offer is being driven by the largest lenders, all of whom are to some degree under the control of the Treasury Department…..

I think we have to concede that this control, and the conflict it creates, and the President’s decision to publicly scold the dissenting senior lenders has tainted this process, making it unlike a normal chapter 11 case. The decision to scold the dissenting lenders – perhaps driven by the lenders somewhat juvenile press release – is perplexing, since it seems to blame them for a chapter 11 case that I believe would have happened anyway. Moreover, holdouts are a fact of life in workouts and chapter 11 cases – the trick is to figure out how to deal with them…..

The real issue is how much do we believe all this has tainted the process. In this case, you could argue that the Fiat price would be so low without the union agreement that the secureds are getting the same or even a higher recovery on an absolute basis. But we’ll never know for sure and in that sense the process is tainted, and I think this is not harmless. Future hedge funds may pay lower prices to buy distressed debt in large companies like Chrysler and future secured lenders may therefore require higher interest rates from borrowers. Moreover, the global story that we tell about the benefits of having a system like chapter 11 is diminished by this case.

If Chrysler were a one-off, this would not matter much, but the fact that GM now looks almost certain to file for bankruptcy and Section 363 is expected to be used again makes this much more nervous-making for lenders and investors. Indeed, Lubben suggests that the reason the deal was done this way was that Chrysler entered bankruptcy late in the process. That also will prove true for many cov-lite deals, since the absence of many normal covenants means lenders cannot force a restructuring or BK filing while the company is only in moderately bad shape (or is a decent company simply suffering from too much debt). We’ll see in due course how big an issue this becomes.

Submitted by Edward Harrison of the site Credit Writedowns

Yesterday, I posted a video in which two auto experts argued that the dissident creditors were getting a raw deal (See “A discussion about Chrysler’s bankruptcy plan on Charlie Rose“). The crux of the problem is their belief that they were being railroaded into a deal in which they, as secured creditors, would receive less than unsecured creditors, that they would also receive less than in a liquidation, and that the government was using extortionate strong-arm tactics to make this happen. Tyler Durden has written a few posts about this (See “Guest Post: The White House Threatened To Destroy Perella Weinberg’s Reputation“)

I don’t believe that these bondholders are going to get their way and there is good precedence for this in section 363 of the bankruptcy code from the case of Adelphia Communications.

Witness this article from the Am Law Daily:

Thomas Lauria, head of the restructuring practice at White & Case, is in a tough spot: the lead lawyer for the group of holdout lenders that the Obama administration is blaming for pushing Chrysler into Chapter 11.

The group, as you know by now, refused to take 33 cents on the dollar for the approximately $1 billion in Chrysler debt they hold. The four biggest bank lenders to Chrysler–all recipients of federal bailout money–took that deal, drawing praise from Obama for their decision.

Now Lauria is vowing to fight. Specifically, he says the holdout lenders will challenge the planned sale of Chrysler’s prime assets to a new company controlled by the auto workers union and Fiat, according to Reuters. The lenders say the sale is an “end run” around established bankruptcy law that gives secured lenders priority over junior lenders (including the union) when it comes to getting repaid.

Lauria has been here before. In the contentious Adelphia Communications bankruptcy, Lauria led a group of creditors that filed late motions calling for a special trustee to investigate whether each group of note holders was getting what they deserved, according to this 2006 story from the New York Law Journal. A judge dismissed his motion, calling it a “nuclear war button” that threatened to disrupt the planned sale of Adelphia’s prime assets to Time Warner and Comcast for nearly $18 billion.

This is the exact strategy University of Chicago law professor Douglas Baird predicted the holdout lenders would use when we interviewed him yesterday. As Baird noted, creditors have the right to challenge any bankruptcy reorganization plan that ends with them receiving less than they would have had the company been liquidated. The holdout lenders believe that to be the case here, Baird told us. But section 363 of the U.S. bankruptcy code allows for Chapter 11 debtors to sell assets before creditors can challenge the general reorganization plan.

That means Lauria’s only option is to object to the sale, Baird told us.

Lauria did not respond to a message seeking comment; he’s likely tied up at a massive hearing in federal bankruptcy court in Manhattan today.

On the other end of the lender spectrum is Simpson, Thacher & Bartlett, which is advising JPMorgan Chase, the lead lender to Chrysler. Peter Pantaleo, head of Simpson’s bankruptcy practice, is representing JPMorgan. He declined to comment.

So will Lauria’s plan work, or will only serve to delay Chrysler’s emergence from bankruptcy? Steven Gross, co-chair of the restructuring practice at Debevoise & Plimpton, told our colleague Brian Baxter he’s anxious to see the group’s motion objecting to the sale. But Gross says the press release the lenders put out Thursday was “not very compelling,” and that the chips may be stacked against their objection to the Fiat sale.

“People are saying this is just the government bullying people,” Gross says. “But there is still a statute, and if there are grounds to derail [the sale], you can be sure [the non-TARP lenders] will use it, although in bankruptcy if you get some many constituents to support something, that can be very hard.”

As always, stay tuned.

In essence, section 363 gives the bankrupt entity, in this case, Chrysler, the right to sell assets to another organization, in this case Fiat, BEFORE creditors can challenge the Chapter 11 reorganization plan. This significantly reduces the collateral against which secured creditors can make claims in bankruptcy.

The long and short is this:

• Secured creditors might have gotten more in liquidation than they were being offered before Chrysler filed for bankruptcy.
• However, because of section 363 of the bankruptcy code, Chrysler can sell substantially all of its assets to Fiat without creditor approval and before it has a definitive reorganization plan
• This leaves the secured lenders out of luck. They could end up with less money than had they accepted the deal offered them earlier.

Full disclosure: I am normally a fan of the Financial Times’ Gillian Tett, but her latest piece reveals she has been co-opted by the industry she covers.

While there are matters of substance I take issue with (we’ll get to those soon), the whopper is the positioning. How can Tett possibly depict Gordon Gekko as a model of any sort of remotely desirable behavior?

For those who never saw or have largely forgotten the movie Wall Street, Gekko is a crook. He engages in market manipulation and invests on inside information. His “Greed is good” speech is based on a lecture given by another criminal, convicted risk arb Ivan Boesky.

So Tett starts the piece by saying the markets need more marauding miscreants. Lovely.

Her point is that risk capital has dried up, and provides examples:

But some recent anecdotes are chilling. Last week, for example, a group of senior hedge fund players and chief investment officers gathered in Dublin – and collectively guessed that about 80 per cent of the risk capital that was sitting in the European system a year ago has disappeared….

What is even more dramatic – but less visible – is the disappearance of banks’ proprietary trading desks… traders in London say there is really only one bank in Europe which is even pretending to run an active prop desk now – namely Goldman Sachs. As a result, billions of dollars of risk-taking capital is believed to have quietly vanished.

That has had all manner of extraordinary consequences. Two years ago, a host of hedge funds and prop desks in London were building up their distressed debt-trading teams to take advantage of a future turn in the credit cycle. Logic might suggest such funds should be wildly busy right now, swooping in to buy distressed companies, or securities. Nothing could be further from the truth. As banks have slashed their risk-taking operations, they have also cut their distressed prop desks, and most have stopped making markets in distressed products. Hedge funds dealing with distressed assets have also folded, unable to raise funds.

As a result, there is a dire shortage of capital to organise – or fund – even “simple” restructurings of companies, distressed investment entities or anything else. Hence the gridlock on dealing with toxic assets.

But not just credit assets are being hit. As asset managers hunt for places to put their cash away from the carnage of the credit or property world, some have been tempted by the world of small-cap equities. But trading in small caps can only take place with market makers – and right now, banks are not just cutting prop desks but market making activity too. As a result, fund managers are sitting on their hands. “We would love to buy small caps but we just cannot tolerate the liquidity risk,” explains one large asset manager. “Almost any sector which needs marketmakers is half-dead.” Logic would suggest that eventually this pattern should change. After all, oodles of cash remain in the system. That cannot all stay in government bonds for ever, least of all in a world where the Fed is busy intervening in such a dramatic fashion to suppress yields.

What is wrongheaded about this is the assumption that hedge funds and proprietary trading desks are necessary and desirable sources of “risk capital”. In my view, their wild unsuitability for this role (save as arbitrageurs) is part of why we got in the mess we are in.

Until the recent, explosive growth of hedge funds, the folks who stepped in during down cycles were typically substantial individual financiers and investment-oriented families. It wasn’t hedge funds or proprietary trading desks that hoovered up the bad assets in the savings & loan crisis. Hedge funds were few and primarily global macro players; proprietary trading back then were small by today’s standards and would never have looked at taking assets that were illiquid.

Tett is failing for the same flawed thinking that bedevils many experts and commentators. They keep seeing a restoration of status quo ante (n a somewhat cleaned up and tamed form) as the best solution for our mess. Most expedient, maybe, but remedies like that have high odds of getting us quickly back in trouble.

All the players that Tett mentions have fatally flawed incentives. It’s the OPM (Other People’s Money), heads I win, tails you lose syndrome. Distressed investors in days of yore played substantially, if not entirely, with their own money (they might organize a syndicate, but they would act as lead investor, and would not take a huge promote).

In fact, hedge funds are wildly unsuited to be risk players except in the short term. Remember, they report results monthly to investors. I’ve spoken to hedgies, for instance, who have a very clear view of a market trend over the next say, nine to twelve months, and they often won’t play it (or will play it in smaller size than they would if it was their money) because they might show more than they’d like in interim losses. But waiting means they might miss the trade entirely.

Tett’s point on market making is fair but also misleading. A sudden drop in both number of market makers and the risk appetite of the ones that remain is a standard feature of markets adverse enough that many of the major firms have taken hits., such as the year after the Asian crisis (just about everyone, particularly Goldman, took big bond market losses). Spreads were elevated for a full year after the 1998 LTCM collapse, a casualty of the crisis.

Floyd Norris put the question better:

Where is the next J. P. Morgan?

In times of market crisis, the safest course for any one market participant may be the riskiest course for the entire market. If everyone wants to sell, prices can go in only one direction.

In past financial crises, it has fallen to someone — regulators, investment banks or even a single banker — to organize collective action and avert disaster.

Such moves involved persuading people to take steps that seemed to go against their own private interests. …

In 1907, Morgan demanded that presidents of New York trust companies — then a type of second-class bank — act together to save one of their own, the Trust Company of America, from a bank run.

The presidents, wrote Robert F. Bruner and Sean D. Carr in their book, “The Panic of 1907,” were “convinced that it was their primary responsibility to conserve their assets in order to survive the financial storm that was swirling around them.” Morgan said that would simply assure that all would fail, one by one.

Morgan, then the dominant figure in American finance, called the presidents to a Saturday meeting in his library — and locked the door. Not until dawn Sunday did he let them out, after they had committed the needed cash….

Mr. Bruner and Mr. Carr hailed Morgan’s actions, as well as the Fed’s 1998 move to salvage the [LTCM hedge fund. But they warned, presciently as it turned out, that the current environment might hamper similar efforts in a new crisis.

“In a globally complex financial system, will such collective action be possible if the crisis is triggered beyond the reach of any of today’s regulators?” they asked.

Even though one can argue, correctly, that JP Morgan was far from a paragon of virtue, he is a more estimable figure than modern Masters of the Universe. Morgan and his contemporaries had a sense of noblesse oblige and recognized that they needed to consider the broader social and institutional fabric along with their own interests. Indeed, Morgan, contrary to Gekko, backed men who understood the importance of good conduct :

One of the most famous exchanges in the history of finance took place almost a century ago on Capitol Hill. An aging J.P. Morgan, the most powerful financier in the world and America’s unofficial central banker, testified before a House committee investigating the tangled web of financial interests that dominated the economy of the emerging industrial nation. Morgan’s inquisitor was Samuel Untermyer, a tough corporate lawyer.

Untermyer: “Is not commercial credit based primarily upon money or property?”
Morgan: “No sir. The first thing is character.”
Untermyer: “Before money or property?”
Morgan: “Before money or property or anything else. Money cannot buy it…because a man I do not trust could not get money from me on all the bonds in Christendom.”

So for someone as smart and savvy as Tett to be invoking Gekko types as possible saviors points to the absence of alternatives. This is a variant on George Akerlof market for lemons. It became more attractive for financial experts to operate on an OPM basis, since they could both earn more and shift risk to investors. But now that investors realize that they have been had, and that it is difficult to tell good actors from bad. According to Akelof, the equilibrium is a no-trade market, and that appears to be where we are headed.

The Wall Street Journal tells us tonight something that is pretty obvious: hedge funds were often buyers of AIG credit default swaps, either directly, or indirectly, by purchasing structured products that had AIG guarantees, such as collateralized debt obligations.

While this report falls in the camp of peeling away yet another layer of AIG’s practices, as opposed to being novel, it does focus attention on the use of CDS to place speculative bets. If the public were to take offense at the idea of government money rewarding successful speculators, it might lead to restrictions on CDS writing in cases where the protection buyer did not own and continue to hold assets of the reference entity. One can only hope.

From the Wall Street Journal:

Some of the billions of dollars that the U.S. government paid to bail out American International Group Inc. stand to benefit hedge funds that bet on a falling housing market, according to people familiar with the matter and documents reviewed by The Wall Street Journal.

The documents show how Wall Street banks were middlemen in trades with hedge funds and AIG that left the giant insurer holding the bag on billions of dollars of assets tied to souring mortgages….

The transactions worked like this: Investment banks such as Goldman Sachs Group Inc. and Deutsche Bank sold financial instruments to hedge funds letting them bet that mortgage defaults would rise. These instruments were credit default swaps, a form of insurance that pays out in the event of a debt default.

Yves here. Note this article is not very well written. Only later does it say the banks laid some of these risks on to AIG. Back to the piece:

Some of the U.S.-government exposure traces back to the hedge funds that spotted problems in the U.S. housing market in 2005. They wanted to “sell short” — or bet against — securities backed by mortgages to questionable borrowers…..

The banks that had sold credit default swaps to the hedge funds wanted to turn around and hedge their own risks. But finding that protection wasn’t easy.

So at Deutsche, the German bank’s securities arm created a handful of offshore companies known as collateralized debt obligations, or CDOs. These companies carried a series of exotic names, according to securities filings, mostly based around the moniker “START,” short for STAtic ResidenTial CDO. They allowed Deutsche to neutralize its exposure to the hedge funds’ bets by buying swaps from START on the same securities its clients were betting against.

START held assets from a hit parade of lenders closely linked to the subprime crisis, including Bear Stearns, Countrywide Financial and New Century Financial, according to documents reviewed by the Journal.

In 2005, Deutsche found a willing taker for a chunk of the mortgage risks held by START: AIG Financial Products. The derivatives arm of AIG agreed to pay out up to $1 billion under two of the START vehicles, if underlying assets deteriorated or the insurer’s own credit rating fell below a certain threshold. AIG stood to earn a fraction of a penny each year for every dollar of protection it sold, according to securities filings, meaning it made less than $10 million annually on the $1 billion in insurance.

Up until AIG exited the market in 2006, “AIG was by far the single largest ultimate taker of risk in the [subprime mortgage] CDO space,” says a senior investment banker whose firm bought credit protection from the insurer.

Yves here. Note the truly awful subprime deals were written starting third quarter 2005 through end of 2006. Even though vintage 2007 deals were even worse, by then the market was under stress, origination volumes were down as defaults had started to rise. The bulk of the bad deal originated were in that 2005-2006 window, and AIG was in the thick of it. Back to the article:

Last fall, after AIG’s credit rating was cut, the insurer paid roughly $800 million to START, according to two people familiar with the matter. Much of the money is being held in escrow and will be used to pay off Deutsche’s swap contracts if mortgage defaults in the portfolio rise above a certain level. Some of that money could go through Deutsche to its hedge-fund clients.

If the housing market improves, AIG could recover some or much of the cash it transferred to START. But that outcome won’t be known for years. The portions of START to which AIG is exposed were originally rated triple-A by Standard & Poor’s. They’ve since been downgraded to “junk” status by the ratings firm.

The START CDOs share some similarities with mortgage pools created by Goldman named “Abacus” and also insured by AIG Financial Products….

Yves here. Do the math. Deal done in 2005. Annual premium $10 million, so AIG has received max $50 million (oh, and since it thought those deals were fine, some of the premiums received in prior years no doubt went out the door in AIGFP bonuses). AIG (actually now the US taxpayer) has had to pony up $800 million. And they have other deals like that.

On a separate topic, we have the lame defense of AIG by Timothy Geithner. I agree, as others have said, the bonus affair seems overdone, but on another level, it makes perfect sense. Intuitively, the public knows the execs and troops of the big financial firms were overpaid in recent years since the earnings were overstated, due to phony accounting and insufficient loss reserves. They can’t get that money back, but the idea of even more going out the door, even amounts small relative to the bailouts, now that the companies are bust, is offensive.

But this truly intelligence-insulting bit from the Treasury secretary is this:

“We will impose on AIG a contractual commitment to pay the Treasury from the operations of the company the amount of retention rewards just paid,” Geithner wrote. “In addition, we will deduct from the $30 billion in assistance an amount equal to the amount of those payments.”

The money at this point is all coming from the government. That is what is so patently foolish. AIG is being treated as if it is a normal company with all the attendant rights thereto, when it from an economic standpoint is nationalized (Uncle Sam has paid multiples of its market cap even in better days); the fictive minority ownership is to avoid consolidating the debt onto the Federal books. But now we are letting accounting contrivances drive substance.

So the US government is haircutting a teeny weenie bit the loans extended to AIG. We said the bonuses were rounding error, and the loan reduction reflects that.

But the American public does not want a penalty imposed on AIG (even if this were a penalty, which it isn’t). It wants one imposed ON THE EXECUTIVES. What about “no” does Tim Geithner not understand?

And what does a $165 million reduction mean, anyhow? If AIG says it needs more money, the government spigot will be opened again, and AIG never asks for less than 11 figure cash injections.