Is the Noose Tightening Around Countrywide?

One of the reasons for Bank of America to walk from the Countrywide deal is the rising tide of legal costs and potential for sizeable damages. Admittedly, at this juncture the prevailing view is that the Charlotte bank would renegotiate the acquisition rather than abandon it (particularly since it should be able to limit liability to the merger sub), but it still begs the question of why buy an operation that has the possibility of having zero financial value with considerable headache and embarrassment attached?

Some outstanding actions are moving forward. For instance, the US Bankruptcy trustee in three states have joined to accuse Countrywide of abusing the bankruptcy process. That's pretty unusual. There are also quite a few actions pending against the proposed merger; some have been halted as similar ones are litigated.

Established Countrywide hater Gretchen Morgenson provides an update on a class action suit alleging insider trading (!) and a failure to adequately supervise operations, as exhibited in lousy lending practices that (per the suit) simply cannot have gone unnoticed by management. While Morgenson has the mortgage lender in her crosshairs, she generally does an evenhanded job of reporting when working primarily from court filings, as in this case.

The significance of this suit, which can now proceed to the discovery phase, may be greater than it appears. Morgenson cites one level: this will be the few actions against the executives of a failed mortgage lender.

Another, less obvious impact: the suit will probe the bank's lending and management practices, and that will pave the way for further litigation. And it has the potential to confirm what are now only suspicions about abusive and misleading practices and thus further lower the value of the franchise.

Remember, once a suit is filed, testimony and exhibits filed in court become part of the public record unless sealed (unlikely in this instance). They can be used by subsequent plaintiffs at no cost, thus lowering the barriers for subsequent litigation.

Let me give you a mundane example. A recent Countrywide employee wrote me to describe many of the bank's bad practices. One was that the bank had launched a national campaign for a no-fee mortgage. He said he was certain not a single mortgage of the type promoted had ever been issued because the customer service people had all been given scripts to steer callers into other products (the no-fee loan had sufficiently high interest costs to make loans with fees look more attractive).

I called a litigator I know. She said the fact set would constitute advertising fraud and would indeed make for a good suit. However, most firms would wait for initial suits over more basic forms of fraud to proceed, since it would be easier to build the case for advertising fraud based on their causes of action and evidence.

That's a long winded way of saying that if Countrywide is indeed the serial miscreant many believe it to be, the lawsuits will build on themselves.

From the New York Times:

Directors and officers of Countrywide Financial, the beleaguered mortgage lender, must answer shareholder accusations of insider trading and an overall failure to monitor lending practices that led to the company’s collapse, a federal judge in California has ruled.

Rejecting the arguments of Countrywide executives and directors that they were unaware of lax loan operations that led to ballooning defaults, Judge Mariana R. Pfaelzer of Federal District Court in Los Angeles ruled Tuesday that she found confidential witness accounts in the shareholder complaint to be credible and that they suggested “a widespread company culture that encouraged employees to push mortgages through without regard to underwriting standards.”

Plaintiffs also identified “numerous red flags” that would have warned directors of increasingly risky loans made by Countrywide, according to the judge, who rejected a motion to dismiss the suit. “It defies reason, given the entirety of the allegations,” Judge Pfaelzer wrote, “that these committee members could be blind to widespread deviations from the underwriting policies and standards being committed by employees at all levels. At the same time, it does not appear that the committees took corrective action.”....

The plaintiffs in the case said they hoped to recover money for shareholders from Countrywide officials named in the case who sold $850 million in stock from 2004 to 2007. The plaintiffs contend that the directors and officers dumped shares even as the company spent $2.4 billion to repurchase its own stock in late 2006 and early 2007.

The chief executive of Countrywide, Angelo R. Mozilo, has argued that his $474 million in stock sales during the three-year period complied with securities laws under a planned selling program. But he revised the program, known as a 10b5-1 plan, several times, each time increasing the shares to be sold.

As a result, the judge wrote: “Mozilo’s actions appear to defeat the very purpose of 10b5-1 plans,” created to allow corporate insiders to sell stock regularly and without direct involvement.

Gerald H. Silk, who also represents the plaintiffs, said: “Corporate fiduciaries cannot expect to evade liability by blaming a general market downturn when there is specific and systematic misconduct taking place right beneath their noses.”

The suit names 14 current and former directors and officials as defendants; it is known as a derivative action because shareholders of Countrywide are suing its officers and directors on behalf of the company.

Some Informative Credit, Housing, and Mortgage Charts

Reader AK sent me a bit of Christmas in May: three hot-off-the presses reports, one from Morgan Stanley on the credit standing of US and European broker dealers, a Moody's report on RMBS, and a UBS report on the subprime crisis.

The Morgan Stanley report, although the shortest, was in some ways the most informative, since it provided a table that shows the marks that dealers are using for various types of securities. The paper argues that the gap between US (based on a universe of 7) and European (universe of 15) broker dealers has narrowed considerably, so the perception that European dealers were in worse shape than they appear to be is dated (note Knight Vinke disagrees vehemently as far as HSBC is concerned).

Morgan Stanley is suitably mysterious about its methodology, but claims it is +/-2% for those marks that have later been disclosed. Their approach no doubt includes sexual favors and the liberal use of alcohol.

Note this research does not necessarily contradict what my buddy with high level sources said about European banks sitting on a lot of undisclosed losses. The bulk of the lousy 2006 RMBS and CDOs were sold abroad, often to smaller institutions. So their could be trouble brewing in the next-tier institutions.

The Morgan Stanley chart (click to enlarge):



Note that these marks are generally higher than the haircuts required by the Fed per its collateral table, with the notable exception of CDOs. Of course, these marks are averages, and one would have to assume adverse selection in whatever was fobbed off on the central bank.

The report argued that broker/dealers are two thirds of the way through their write-downs, but warned that there was still the potential for trouble via basis risk and counterparty risk in hedges (code for possible CDS woes). And its other main caveat:

But as our equity analysts in the US and Europe have highlighted repeatedly, the looming concern is that of more traditional loss provisioning by commercial banks. Rising provisions and further deleveraging will make the earnings environment challenging for years to come, although with tail risk also reduced, we be believe this will be a greater headwind to financial equities than to credit.

I thought I'd lift the charts I found most interesting from the two other presentations (150+ pages in total, so forgive the arbitrary selection). From UBS (click to enlarge):





From Moody's (click to enlarge):

Jim Hamilton Scolds Bernanke for Regulatory Neglect

Jim Hamilton must feel like a Cassandra. Last August, he warned that the GSEs were in danger of having the ambiguous status of their implied guarantee tested. That came in January, and was finessed with various new Fed facilities.

Hamilton has also warned repeatedly that the Fed needs to consider institutional reform, not merely bailing out the boat as it continues to founder. He continued on that theme today in Econbrowser in parsing Bernanke's remarks on Tuesday. Most observers focused on his comments on the continued rockiness of the markets; Hamilton worried about other oversights:

Bernanke concludes that it's the responsibility of the central bank to stop such self-fulfilling instability. But he neglects to discuss the key feature of a healthy financial system that is supposed to prevent such a problem from ever arising. Specifically, any institution that is in this position of borrowing short and lending long needs to ensure that a certain fraction of the funds it is lending came not from borrowers but instead from the owners of the institution itself, in the form of net equity. The goal is for the size of this net equity to be larger than the losses the institution would incur from selling its less-liquid assets at steep discounts. As long as it is, no creditors ever have reason to demand cash, and there would be no need for the central bank to step in to prevent a self-fulfilling breakdown.

And the core reason we are in the mess we are today is that these equity stakes were nowhere near sufficient for this purpose. Instead, financial institutions were allowed to take highly leveraged positions whose details are largely opaque to readers of publicly available financial statements. Exhibit A here might be Bear Stearns, whose 2007 10-K reported that Bear had outstanding derivative contracts whose notional value was $13.4 trillion. Much of these were credit-default swaps, in which the seller receives a fee in exchange for promising to pay any losses incurred by the buyer on some specified asset and time interval. If every such asset lost 100% of its value over the period, then maybe Bear is supposed to pay or receive $13.4 trillion. In practice, the actual price moves and net sum owed would be a small fraction of that notional total.

Now, there is nothing inherently wrong in making financial investments in the form of derivative contracts rather than outright loans. You're doing something similar whenever you buy or sell an option rather than the stock itself. But, if you were to sell an option through an organized exchange, the exchange would require you to satisfy a margin requirement, delivering for safekeeping good funds such that if the price of the underlying asset against which the derivative is written moves against you, you are able to make good on your commitment.

If anything like a reasonable margin requirement had been in effect, Bear Stearns could not possibly have gotten into contracts totaling $13.4 trillion notional. But these weren't traded on a regular exchange, so there was no margin requirement, and apparently no real limit on the size of the exposures that Bear Stearns could take on, or the size of what they could bring down with them if they fell.

And that raises the question, Why were counterparties willing to accept these trades with no margin to guarantee payment? To this I'm afraid the answer is, they figured Bear was too big for the Fed to allow it to fail. And on this, I'm afraid they proved to be exactly correct.

I would feel better if Bernanke were less focused on how to "provide liquidity" and more focused on how to get the system deleveraged and more transparent.

A minor quibble: we looked at the footnotes on Bear's derivatives positions when it was going down for good, and much of it looked to be more plain vanilla interest rate swaps. But the general point is well taken. Bear was a significant CDS writer, and its equity was insufficient given the size of its derivatives book.

The Case Against a Citi Breakup

Before readers start throwing brickbats, let me set forth some general views:

1. I have never thought the financial supermarket was a good idea and have said so for at least 15 years

2. I was opposed to the sale of Salomon to Travelers

3. I was opposed to the merger of Citibank and Travelers

4. I have been saying for over 15 years that that the idea that bigger is better in banking is a head fake that serves only the top executives (bank CEO pay is correlated with the size of the balance sheet). Just about every study ever done of the banking industry finds, contrary to popular image, that the industry has a slightly increasing cost curve once a certain size threshold has been surpassed (the level varies by study, but trust me, it's low). That means that bigger banks, despite the supposed economies of scale, are actually LESS efficient. I can give you my pet theories if you care to hear them.

So how can I possibly be opposed to a breakup of Citi, a behemoth that is barely able to raise capital fast enough to offset the seemingly neverending writedowns? (Other banks are able to play the game of announcing losses and similar sized fundraisings with a tad more dignity ).

Shareholders have every reason to be angry (but really, you should have voted with your feet a long time ago). The frustration at the continued hemorrhaging is a big part of the impetus for the calls for a breakup.

Having worked in M&A and as a management consultant with very large financial institutions (Citi was a client in the 1980s), less is to be gained and more stands to be lost by a breakup (defined as hiving off core business units, such as retail banking or perhaps the credit card operations, to create businesses with much narrower product offerings) at this juncture. One of the dirty secrets of M&A is it's all about timing. Deals make sense when valuations are favorable. This isn't one of those moments.

Mind you, Ciit may still have to do that at a time not of its choosing. But as we will see, it's unlikely to be to its advantage. Consider:

1. Citi's big problem is that (like every large Western financial institution, but more so) it is undercapitalized. Yes, they managed to maintain the fiction of having adequate regulatory capital. But let's face it, banks wouldn't be hoarding cash, clamping down on lending, and going to the Middle East on bended knee if they really thought the credit crisis was over. We may escape further brushes with systemic meltdowns, but (per the post by Satyajit Das on nuclear de-leveraging), more writedowns are in the offing, and more assets will be involuntarily coming on their balance sheets, increasing the need for capital in the absence of business growth.

So the only way a break-up makes sense (in terms of helping Citi through its tsuris) is if you can sell the businesses and show a gain on its book value of those units, or at least come out whole. But who is a buyer of bank assets now? Private equity firms might buy operational units, but for the most part, they don't like regulated entities (with good reason) and have little experience with financial institutions. The possible acquirers of its credit card business are other big credit card players; that raises anti-trust issues and most either are in nearly as bad shape as Citi or, like BofA and JP Morgan, are otherwise occupied. HSBC might have been a buyer, but the chatter today about its latest earnings announcement says that it is in vastly worse shape than the official release indicates. The Japanese and Chinese have the dough, but this isn't a strategic fit (and the issues raised re the credit card ops apply to trying to sell the entire retail business). So who does that leave? Chris Flowers, and he isn't known for overpaying.

The proof of this assessment? The absence of a breakup plan. When a company allegedly has value that can be unlocked via a restructuring or split-up, plenty of people start putting pencils to paper. Someone, say financial analysts, shareholder activists, investment bankers trying to tee up a deal, will publish a breakup analysis. I've seen no evidence that one exists, and any reader that knows of one (a real one, with valuations of the parts versus the whole) is encouraged to speak up.

2. More important, if you believe Citi is a deep dodoo (and I do), you can't simultaneously stabilize the patient and do major surgery. These entities have combined overheads; Pandit's recent move to segregate the credit card business says that even t is fairly well integrated into the retail bank from a managerial and cost perspective.

Breaking up Ciit would a full employment act for a hoard of consultants, accountants, and bankers. I guarantee just producing the financials would be a huge exercise, and the drill would fully consume senior management and prevent them from taking needed action within the businesses.

And where do you get the management talent for these independent entities (if you assume spin outs)? The fact that Pandit has the CEO job says Citi is thin in talent at the top ranks.

Thus, Pandit's plan to offload 20% of the bank's assets isn't as self serving as it might appear. He's hiving off units that (presumably) are sufficiently discrete that they aren't (from an operational and transaction standpoint) ungodly difficult to be rid of them. While Michael Shedlock may assert that this is tantamount to a breakup, disposing of small to middling units and portfolios, even if they adds up to a lot of value in aggregate, is a very different task than separating core units.

Now in the end, Pandit's plan may all come to naught. Oppenheimer analyst Meredith Whitney, who has been spot on in her calls so far on Citi, says that Citi is too broken to fix:

Citigroup Inc. Chief Executive Officer Vikram Pandit faces an ``impossible feat'' in turning around the biggest U.S. bank as it faces ``seismic'' costs to restructure, Oppenheimer & Co. analyst Meredith Whitney said....

``I think it's an impossible feat,'' Whitney said. ``They don't have the revenue power, they don't have the earnings power in so many of their businesses. Even Stephen Hawking could not pull this off,'' she said, referring to the British physicist.

Whitney said she expects Citigroup, which lost a record $10 billion in the fourth quarter, to post ``de minimis'' profit during the next three to five years. She repeated her prediction that Pandit would be forced to lower the dividend again, and didn't give an estimate for restructuring costs. She estimated a loss this year of 45 cents a share.

While Citi's situation may be as dire as Whitney says (and note that some other analysts disagree), Citi is not going to be permitted to fail. Ironically, if it is as big a garbage barge as she claims, its size and systems issues will keep anyone from taking it on (many an otherwise enticing banking deal has been scuttled due to systems issues; it's a very serious consideration in financial services mergers. The multiplicity of systems would be very troubling for a potential partner, even if one assumed there weren't compatibility issues. After all, Citi is stuck with its mess; anyone else would be electing to take it on).

Thus Citi could continue to be a significant value destroying event for equity holders, yet limp on through this period.

How to Leash and Collar the Financiers? (Continued)

The fulminating over what to do about our miscreant socialized unrepentant and as yet unreconstituted financial services sector continues. Since massive subsidies have been extended in the form of help to the mortgage business and an alphabet soup of Federal Reserve facilities, with nary a demand made of the beneficiaries of this largess, it seems that the authorities have perilous little leverage over their wayward charges.

Of course, in reality that isn't so; a determined regulator can, if nothing else, harass a company into submission (the Japanese are masters of this technique) and they have more powerful tools at their disposal. But that presupposes the will to intervene, which despite the crisis, still appears to be sorely lacking.

The collective response resembles the storied boiled frog effect: the heat goes up, or in this case, the public outlays continue, yet legislators, regulators, and the public remain remarkably passive as the expenses continue to rise. Of course, it doesn't hurt that many of these costs are contingent liabilities, so the true damage will come to light only years later, when the perps have moved on to other roles.

But readers beware: the boiled frog is an urban legend. Real frogs have the good sense to hop out of hot water. But in a pot with high enough sides, even a frog that knows it is in trouble will be unable to escape.

The sightings today confirm the difficult of leashing and collaring a complex, sprawling, fast-moving industry. The Financial Times has a comment by Charles Dallara, the head of the Institute of International Finance, an international organization of financial institutions that verges on the sanctimonious. It confidently recites a list of four areas for action and asserts:

Thus, the debate is not about “self-regulation” versus “more regulation”. Instead, there is an emerging consensus on the benefits of reinforcing market-based corrections with improved regulatory incentives and structures.

A consensus among those who'd rather not be regulated, for sure.

Some regulators are getting mad enough to at least threaten action, but it isn't evident that they will be taken seriously. As the Telegraph reports in "EU to launch assault on bankers' bonuses":

A group of key EU finance ministers will today launch an assault on the rewards earned by bankers and top managers in a move that poses a potential threat to the City of London.

A confidential document prepared for the gathering in Brussels finds the "short-term" pay structure of modern capitalism has become deformed, causing firms to take on "excessive risk" without regard to the interests of stakeholders or society.

Note that these discussions do not include the UK.

Now one can correctly point out that this is silly; the main finance centers are not in Europe to begin with, and having the EU adopt even tougher rules will assure even less high powered finance take place there. But don't assume the EU is that naive. I suspect the credit crisis has at least another bad episode or two coming. The Fed has had to coordinate closely with the ECB on recent interventions. The EU may be trying to take intellectual leadership to force the US and the UK, which is also showing signs of financial distress, into taking more radical action. The EU may be taking a tough public posture while privately harboring more limited, realistic aims.

Ironically, the most sensible proposal comes from a US hedge fund manager. As reported by Ira Ross Sorkin in the New York Times:

Kenneth C. Griffin, who runs one of the biggest and most successful hedge fund firms, has a blunt assessment: “We, as an industry, dropped the ball.”

The breakdown happened, Mr. Griffin contends, when big investment banks gambled away money and jobs during the late great credit boom. The bosses let all those young gung-ho traders take far too many risks and now everyone is paying the price.

But the answer is simple, in his view. The entire industry needs to overhaul its thinking and, believe it or not, perhaps even accept greater regulation...

When you read that UBS did not even view parts of its mortgage portfolio as having market risk, it becomes very obvious that a number of firms were not dotting the i’s and crossing the t’s when it comes to risk management,” he said while on the panel [at the Milken Institute Global Conference] to a packed room.

How did it come to this?

A problem, he says, is youth and inexperience — and that’s coming from a former child prodigy.

“Walk across any of the trading floors — they are full of 29-year-old kids,” he said. “The capital markets of America are controlled by a bunch of right-out-of-business-school young guys who haven’t really seen that much. You have a real lack of wisdom.”

On top of that, many chief executives of big universal banks, the ones that combine all sorts of financial services under one roof, “only understand a small part of the business,” Mr. Griffin said, suggesting too many of them come from sales backgrounds. Put those two things together, the traders and the chiefs, and you have the making of an outright debacle.

The problem is compounded further by weak government oversight, he said. “The unwillingness of the Federal Reserve and the S.E.C. to require working capital” limits, he said, only exacerbates the risk-taking environment because the banks are playing the equivalent of no-limit poker. “The sad truth of the matter is it didn’t have to be this way,” he said.

But Mr. Griffin isn’t just a serial complainer. He has thought about solutions.

First, “the investment banks should either choose to be regulated as banks or should arrange to conduct their affairs to not require the stop-gap support of the Federal Reserve,” he says.

But that’s not all. He also wants new government oversight of the arcane world of credit default swaps, a business with a notional value and risk of $50 trillion. “Everyone is missing the elephant in the room,” he said.

It was the interlocking relationships between thousands of investors and banks over credit default swaps that pushed the Fed to help rescue Bear Stearns. In particular, Mr. Griffin wants the government to require the use of exchanges and clearing houses for credit default swaps and derivatives.

That way, instead of investment banks playing matchmaker between parties, an exchange will do it with strict rules in place, eliminating billions of dollars in exposure and creating more transparency.

“It’s not sexy, but it’s simple, it’s cost forward, its straightforward, and it’s what we should have done after 1998,” referring to the collapse of Long-Term Capital Management, a big hedge fund. He added that it “is a very sad commentary on where we are from a regulatory perspective” that such a move hasn’t happened already.

Of course, most big investment banks would hate such a plan, he acknowledged by telephone last week. “The investment banks and commercial banks benefit from the lack of transparency because they are the intermediary,” he said. (It also has the effect of making Mr. Griffin’s firm more money by cutting out the middleman.)

But he also wants to warn against going too far. “It may be a moment in time where there is quite a bit of fervor to put in place significant regulatory regimes that in my opinion could set this nation way back on the playing field,” he said.

He’s particularly nervous that excessive regulation could send more jobs overseas. “I see thousands and thousands of jobs at Canary Wharf and in downtown London, jobs that should have been in America in financial services. Derivatives really were developed in America and because of regulatory uncertainty left America.”

Note that, as readers have pointed out, moving CDS to exchanges isn't quite that simple. New contracts with different and more standardized features could be exchange traded; the current types don't lend themselves well to that. So the worrisome and potentially wobbly overhang of outstanding CDS would have to run itself off over time. Still, any progress on that front is welcome.

And to Griffin's point about regulatory arbitrage; that's where the EU's foray might prove useful. The idea of an international regulation, or failing that, greater international harmonization, is getting traction. But it will take a push, which may come in the form of another leg down in the credit crisis, for that to happen.

"Investor says HSBC undervalued loss by $30bn"

The Times of London reports that activist investor Knight Vinke accused HSBC of failing to mark down its subprime assets (due to its ill-fated 2003 acquisition of Household Financial) adequately, leading to its greatly understating its first quarter losses. Vinke isn't alone in being skeptical of HSBC's latest earnings release.

Amazingly, HSBC's denial was weak, arguing that the losses were in consumer loans and therefore weren't required to be marked to market. In other words, if HSBC kept its books on the same basis as a US bank, its losses would indeed be much higher. However, HSBC is also claiming to have only moderate delinquencies on its mortgage book.

From the Times:

Knight Vinke, the activist investor, launched a fresh attack on HSBC yesterday, accusing Europe's biggest bank of flattering its US sub-prime losses by failing to write down $30 billion (£15 billion) worth of mortgage assets.

The broadside came as HSBC revealed a $3.2 billion first-quarter writedown on loans by its US business to poor Americans.

HSBC's investment bank also took a $2.6 billion writedown on credit investments for the first three months, pushing the group's total losses on sub-prime to $25 billion.....

Knight Vinke said that HSBC should have been gloomier about its own prospects. The fund manager, which has been agitating for HSBC to sell HFC, said that the group was the only large bank not to make a fair value adjustment on its loans to customers and other banks.

If HSBC accounted for the loans at their market value, they would be worth almost $30 billion less than $1,218 billion book value that the bank ascribes them, Knight Vinke said. Of that loss, about $23 billion comes from HFC. Taking the writedown would have pushed HSBC into a $5 billion loss last year instead of a $24 billion pre-tax profit, the fund manager said.

Other problems at HFC include the need to refinance at least $80 billion of its own loans in the next 30 months and a potential $10 billion goodwill impairment, which Knight Vinke said would force HSBC to pump in extra capital. HSBC has spent $60 billion on buying and supporting the US bank.

Douglas Flint, HSBC's finance director, said that Knight Vinke's claims were based on a misunderstanding of accounting rules. He said:

“Customer loans are accounted for differently to trading assets. We wouldn't be permitted by current rules to account for our loan book in the way Knight Vinke suggests we should.”

The bank said yesterday that 5 per cent of its US mortgages were two or more months overdue at March 31, compared with 4.2 per cent at the end of last year. Bad credit card debts rose from 5.8 per cent to 5.9 per cent.

Carlyle's Rubenstein: Banks Still Have "Enormous" Unrecognized Losses

David Rubenstein of Carlyle Group doesn't have anything to gain by saying bad things about banks, and he is well connected, so odds are good he is on to something (hat tip reader Abdul).

He also repeated a theme that we've heard earlier: don't count on sovereign fund rescues. While they were active buyers in the first round of bank fundraising, they've been burned, and will hold back until they have clearer indications that the worst is past.

The article notes he was far more bullish on April 28. Wonder what he learned in the meantime?

From Bloomberg:

U.S. and European banks and financial institutions have ``enormous losses'' from bad loans they haven't yet recognized and may have a harder time wooing sovereign-fund rescuers, Carlyle Group Chairman David Rubenstein said.

``Based on information I see,'' it will take at least a year before all losses are realized, and some financial institutions may fail, Rubenstein said at a breakfast meeting of the Institute for Education Public Policy Roundtable in Washington. He didn't name any companies.

``The sovereign wealth funds are not likely to jump into the fray again to bail out these institutions,'' Rubenstein said. ``Many financial institutions aren't going to be able to survive as independent institutions.''...

On April 28 at a conference in Baltimore, Rubenstein said financial institutions and financial assets are ``the single greatest investment opportunities'' in the U.S. and ``a lot of private-equity firms like ours are going to try to make investments in these firms.''....

Rubenstein said today that the industry and broader economy aren't likely to turn around until early next year.

``The truth is, we're in some kind of economic slowdown,'' Rubenstein said. ``I don't think it's going to be over for quite a while.''

Citi Mulls Sale of $400 Billion of Assets

I'm in danger of sticking my neck out, but is it possible that Virkram Pandit, Citi's CEO, is doing a good job?

It's way too early to make a call. The markets and stock watcher have the attention span of a fruit fly, when corporate successes are built slowly, and the less fanfare, the greater the odds of good outcomes.

I was prepared to dismiss Pandit, who was clearly a battlefield promotion, relatively new to Citi, and with experience that could be argued to be less relevant than it seemed. Yes, he had headed much of the institutional side of Morgan Stanley (investment banking, fixed income, and alternative investments), but he was running a well managed (by Wall Street standards) operation during a bullish period. He didn't have any experience in some of Citis' major operations, such as retail, insurance, credit cards, nor had he ever run anything approaching Citi's scale. And that's before getting to the not-trivial detail that he inherited an organization in crisis.

From the outside, Pandit appears to be moving methodically but with sufficient speed to tackle the megabank's problems. I like some of his calls, admittedly because they conform with my prejudices; time will tell whether they were astute or not.

The first was that Pandit called on Hewlett Packard, rather than a consulting firm or PR powerhouse, or corporate fixer, to get advice on how to deal with demands to break up the bank (aside: Citi issued a denial, but the wording implies that Citi did not pay fees to HP). While Citi is clearly too unweildy and some aggressive pruning is in order, Wall Street goes overboard with the idea of separating companies into tidy pure plays or hiving pieces off that can be sold easily. For instance, I have serious reservations about the idea of selling Citi's credit card business. At this point in the cycle, it would fetch a terrible price. Conversely, customer profitability in retail banking correlates with how many products they decide to buy, and the best time to make the cross-sell is when they open an account. A card business thus makes sense as part of a retail banking operation.

Second is that Pandit appears set to announce plans to exit non-core businesses. Of course, the proof is in the pudding of how "non-core" is defined, and asset sales were expected to help the financial giant strengthen its damaged equity base.

So nothing exceptional from Pandit so far, but the absence of apparent major errors is encouraging. The real test is going to be whether he has the foresight and skill not only to repair the firm's financials, but to make progress in the far more difficult task of shifting the bank's culture and incentives.

Also note the complete absence of Robert Rubin. I cynically assume that the wily former risk arb sees only downside in getting involved in the "fix Citi" program. But he has also argued for asset sales, more aggressive that what Pandit appears to have on offer. So there may be more complicated reasons for Rubin's exceedingly low profile.

From the Financial Times:

Citigroup will on Friday identify as much as $400bn in non-core assets that could be sold as part of plans to reduce costs and restore profit growth to double-digit rates, according to people close to the situation.

At a long-awaited meeting with Wall Street analysts, Vikram Pandit, Citi’s chief executive, also plans to confirm his pledge, first disclosed in the Financial Times, to cut Citi’s cost base of over $60bn by about 20 per cent.

Despite his desire to prune Citi’s balance sheet aggressively, Mr Pandit will use the meeting to rebuff calls for a break-up of the company, say sources familiar with his thinking. They say he will defend Citi’s “universal banking model” combining consumer and wholesale banking.

Mr Pandit is likely to say that about 20 per cent of Citi’s $2,000bn-plus balance sheet consists of “legacy” assets – entire businesses or trading positions outside its core businesses in commercial, consumer and investment banking.

The sale of the assets is likely to take years, and some of the non-core holdings may never be sold, according to people close to the situation. Nevertheless, Mr Pandit’s decision to classify such a large portion of the balance sheet as non-core highlights his determination to root out underperforming businesses.

"Seven habits finance regulators must acquire"

I get worried when the Financial Times' Martin Wolf starts adopting Stephen Covey-esque sloganeering, particularly when he goes so far as to call his financial services reform proposal "the seven Cs." Eeek.

Earth to UK: one of the big hidden advantages you have is that the lingua franca is your language. That cloying business jargon so popular in America that we have managed to export is not an innovation, it is a debasement. Anyone who can speak and write in an unvarnished manner can trounce those who traffic in gobbledegook.

To be frank, this isn't one of Wolf's best columns, but that may be in large measure due to the near impossibility of setting forth how to fix the global financial system in his word budget. And I have omitted the liveliest part, namely, the set-up, in which he review Paul Volcker's recent speech at the Economic Club of New York, simply because it has been covered elsewhere.

Nevertheless, US readers are likely to find his recommendations to be thin gruel, but remember, there's a valid reason. The UK is a principles based system, so general, high level statements are more meaningful in that system than in ours, where sadly, the devil is in the details. But even giving that allowance, Wolf at points ducks questions he could have addressed. For instance, he mentions the problem of rating agencies, yet fails to mention any solutions. Several are on offer; surely Wolf could have given a thumbs up to one he likes.

Similarly, he sees the main problem in the "originate-to-distribute" model as bad incentives which can be solved by having the originators hold some of the riskiest tranches. Um, don't underestimate their ability to jigger the structures so as to still leave other parties holding the bag. The real problem with the originate to distribute model may be that it is seeking to create a free lunch by reducing the equity that needs to be held against loans. What if that in the end is a false economy? My sources with good regulator contacts tell me they expect to see a good deal more old-fashioned, on-balance-sheet intermediation. Mind you, that it not a view that is convenient for them to have; it implies that banks need to raise not only enough capital to cover their recent losses, but even more to allow for bigger balance sheets. Their view may be pragmatic, in that they see the market for securitized assets as sufficiently burned that it will not come back to its former size for quite some time. That degree of investor repudiation in turn suggests greater changes may be required.

Nevertheless, the advantage of a simple catchy list is that it provides a useful frame of reference.

From the Financial Times:

So here are seven principles of regulation. I call them the seven “Cs”.

First, coverage. Perhaps the most obvious lesson is the dangers of regulatory arbitrage: if the rules required certain capital requirements, institutions shifted activities into off-balance-sheet vehicles; if rules operated restrictively in one jurisdiction, activities were shifted elsewhere; and if certain institutions were more tightly regulated, then activities shifted to others. Regulatory coverage must be complete. All leveraged institutions above a certain size must be inside the net.

Second, cushions. Equity capital is the most important cushion in the financial system. Also helpful is subordinated debt. If Bear Stearns had had larger equity capital, the authorities might not have needed to rescue it. Capital requirements must be the same across the entire financial system, against any given class of risks. But there must also be greater attention to the adequacy of that other cushion: liquidity.

Third, commitment. The originate-and-distribute model has, it is now clear, a huge drawback: originators do not care sufficiently about the quality of loans they plan to offload on to others. They do not, in Warren Buffett’s phrase, have “skin in the game”. That makes for sloppy, if not irresponsible or even fraudulent lending. Originators should be required, therefore, to hold equity portions of securitised loans.

Fourth, cyclicality. Existing rules are pro-cyclical. Capital evaporates in bad times, as a result of write-offs, thereby forcing contraction of lending, worsening the economic slowdown and further impairing assets. Mark-to-market accounting, though inherently desirable, has a similar effect. One solution could be to differentiate between target levels of capital and a lower minimum level. Institutions that have minimum capital in bad times would only be required to aim for the higher target level over an extended period.

Fifth, clarity. Lack of information, asymmetric information and uncertainty are inherent in financial activities. These are why they are vulnerable to swings in collective mood. The transactions-orientated financial system is particularly vulnerable, because information has to flow freely across arms-length markets. So a big challenge is to generate as much clarity as is possible. One issue is the calamitous recent role of the rating agencies and the conflicts of interest under which they operate.

Sixth, complexity. Excessive complexity is a significant source of lack of clarity. It is particularly damaging, as we have seen, to the originate-and-distribute model, because markets in complex securitised products may, at times, seize up, forcing central banks to become “market makers of last resort”, with all the difficulties this entails. One possibility then is to insist that all derivatives be traded on exchanges.

Seventh, compensation. On this I can do no better than quote Mr Volcker: “In the name of properly aligning incentives, there are enormous rewards for successful trades and for loan originators. The mantra of aligning incentives seems to be lost in the failure to impose symmetrical losses – or frequently any loss at all – when failures ensue.” Whether regulators can do anything effective is unclear. That this is a challenge is not.

John Maynard Keynes wrote of an eighth “c”. He argued that “when the capital development of a country becomes a byproduct of the activities of a casino, the job is likely to be ill done”. He had a point. Features of a casino will always be present in a financial system that performs the essential functions of guarding people’s savings and allocating them where they can do most good.

Regulation will always be highly imperfect. But an effort must still be made to improve it.

Will BofA-Countrywide Deal Get Done?

We've never been a fan of the pending acquisition of Countrywide by Bank of America. In fact, BofA's apparent eagerness to buy a company clearly on the ropes seemed odd: why not wait until it went bankrupt, or at least was on the courthouse steps with a filing? We're clearly old-fashioned, but in our day, not reputable company would risk its good name (and substantial litigation costs) by buying a large business that can only politely be described as ethically challenged.

The alleged reason for the deal was for BofA to get its hands on Countrywide's servicing business. People who deal with servicers tell us they are now hemorrhaging cash. I am advised that it is a standard feature of servicing agreements for the servicer to guaranteed to pay whatever interest is promised to the investors for at least 90 days after default. Some agreements also require them to pay principal during that period. Even after the 90 days, the servicer has to continue to pay real estate taxes and insurance. The servicer can use any late payment or other penalties from the borrower to offset these costs. The agreements had built in some margin to allow for these outflows, but no agreements contemplated defaults at the level we are seeing. Of course, the other reason the Charlotte bank may have stepped forward is if it were encouraged by banking regulators, or if a fire sale of Countrywide would directly have a negative impact on BofA's book.

So it looks like Countrywide is a walking mass of liabilities. Institutional Risk Analytics discusses why the deal may not go through (the article also contains a wonderful discussion of the oxymoron of business ethics):

First, it becomes clear, to us at least, that BAC is unable to close the CFC transaction due to uncertainty regarding the target's liabilities....in our view: BAC (and its lawyers and accountants) is not willing to do a deal that leaves BAC shareholders facing a potentially staggering loss....

Second, run the numbers. If you accept that none of the funds of CFC's $120 billion asset bank unit are available to repay parent company liabilities, except the $9 billion or so in book value representing the CFC equity in the sub, then the calculus comes down to about $50 billion in debt, vendors and other liabilities vs. the remaining assets of the parent, roughly a similar amount of loan servicing rights, conduit and investment assets, and whatever CFC can get for the bank unit.

Thus two billion dollar questions:

1) What is the estimated haircut for the ex-bank assets of CFC?

2) What is the estimated cost of settling all pending litigation?....

For BAC, a risky but better strategy than the course at hand may be to withdraw from the CFC merger, pay the $160 million breakup fee, and allow the entire company to slide into a managed default. As CFC's funding runs away, the OTS will be forced to invoke its statutory authority to appoint the FDIC as receiver of the insured bank subsidiary, thus precipitating a bankruptcy filing by CFC.

In the event, BAC and no doubt a crowd of other suitors will be standing by, waiting to bid for some or all of the bank's assets and liabilities in a competitive regulatory sale. But the claimants on the CFC bankruptcy estate would have to await the resolution of the bank receivership to see whether there were any net amounts from the sale of the bank that could be reclaimed.

To that point, while retail depositors of Countrywide Bank FSB have little or no reason to be concerned in such a scenario, the jumbo depositors of CFC above the insured limit- if any remain - should take advice about their options. The jumbo deposit holders may or may not be paid immediately by the FDIC depending on their assessment of the bank's condition at the point of seizure.

Given the outline above, our view is that the equity of CFC is worth $0....if you are a fully cognizant bond holder of CFC... you... also understand that the equity holders are essentially toast....What are you waiting for?

If the BAC deal is not happening, then the only logical course is to pull the plug on the impossible dream of Ken Lewis, shoot the equity holders and get on with the CFC restructuring.

Is "The Credit Crunch is Over" Talk Premature?

Even though there has been a lot of whistling-in-the-dark talk that the credit crisis is past, the evidence is far from conclusive. On the one hand, BlackRock bought $15 billion of subprime debt at a mere 25% discount to face. In March, UBS was rumored to have sold $24 billion of Alt-A for 70 cents on the dollar. Has the market really gotten that much better or were sexual favors exchanged?

I had dinner last night with a very senior Japanese buddy fresh off the plane from Tokyo. He mentioned in passing several Japanese banks' writedowns of subprime paper, and in all cases, they marked it down to ten cents on the dollar. That isn't to say the Japanese are right, merely that different institutions have very different views of what conservative pricing amounts to. But the seeming consistency says regulators pushed for deep haircuts.

The issue is that the credit crisis being behind us is not the same as the credit crunch being over (and note I am not convinced we won't have a resumption of worries about systemic risk, given the possibility of an eventual GSE bailout, a CDS meltodown, and a downgrade of MBIA and/or Ambac, any of which would create turmoil). In the do-com bust, the economic recovery preceded an improvement in credit spreads by nearly a year. And unlike the last downturn, this time credit officers have been badly burned, and they tend to remain overly cautious long after the worst is past.

The fear factor is alive and well, and keeping bank lending in the US at bay, as reported in the Financial Times:

US banks tightened lending standards in the early months of this year in near-record numbers, a Federal Reserve report indicated on Monday, suggesting that the credit squeeze in the economy continued to intensify.

The senior loan officers’ survey reported that the fraction of banks tightening lending standards was “close to or above historical highs for nearly all loan categories” – including corporate loans, commercial real estate, mortgages, credit cards and other consumer loans.....

The loan officers’ survey was conducted in early April and covers the previous three months. It shows that banks not only continued to tighten credit terms but did so in increasing numbers relative to the last survey in January. In particular, the proportion tightening standards for consumer and commercial/industrial loans increased strongly as the credit squeeze broadened out beyond home loans.

Moreover, banks continued to tighten credit standards on mortgages across the board, reducing the availability of funds to finance purchases of homes. About 62 per cent said they tightened standards on prime loans, while 76 per cent tightened standards on “non-traditional loans”.

A historically high proportion of banks said they were tightening terms on credit cards and other consumer loans, while many also pointed to reduced involvement in the student loan business.

The odd bit is at the Milken Institute Global Conference, several participants mentioned ample liquidity. I suppose if you are a big enough fish and/or can borrow in yen, that may well be true, but for mere mortals limited to US lenders, the going looks to be rough.

"Credit crisis shows that banks need wise men not wide boys"

Although we have spoken from time to time about the managerial and cultural failings of the financial services industry, an article today in the Telegraph by Roger Bootle provides a nicely balanced, colorful, and deceptively insightful overview of the issue, while also giving a taste of how the British variant of the problem differs from its Yankee counterpart.

From the Telegraph:

Don't get me wrong. I haven't got it in for all senior executives and corporate board members. Some of my best friends are chief executives. Really. But I have come to wonder whether their colleagues are all quite what they are cracked up to be.

We all get things wrong. Even the most brilliant general or politician fails in some respect or other. Never mind economists. For us, getting it wrong is a way of life.

But for someone trying to analyse how good or bad a great leader was the key question to ask is why they failed. Was it bad luck, or bad judgment, or bad information - or what? Similarly when they succeeded, was this rooted in good decision-making or in good luck? The same is true for corporate leaders. But who makes such careful and critical assessments of them?

In practice, my concerns are most acute regarding financial businesses, and principally banks. I could be wrong, but I suspect that the degree of incompetence there is greater.

I do not mean to imply that the quality of people involved is necessarily lower, but rather that there is more chance that skills and practices do not match up to requirements. Financial businesses are inherently more complex and they can change that much faster. Accordingly, it is probably easier to make catastrophically bad decisions in finance than in any other business.

What has prompted these thoughts is the recent news of large-scale losses by banks. The shocking thing is that in the case of major corporate decisions we know so little. We don't really know whether individual senior bankers are culpable. Stock market analysts have, as so often, failed to ask the pertinent questions. Major shareholders, who have often been part of the problem by pushing managements to deliver short-term performance, could ask key questions. But their activities seem to be mainly confined to pushing for the occasional executive scalp, without really knowing whether that person was the root of the problem. On the whole, journalists have given corporate executives and their decision-making processes an easy ride too.

About the only powerful source of scrutiny is the Treasury Committee of the House of Commons (to which I act as an adviser on monetary policy). A grilling by those rottweilers can rattle the most confident of chief executives and raise a mighty stink. But the Committee does not have the time or resources to conduct major investigations into corporate decision-making.

Even though they have a clear self interest in understanding why they made a bad decision, I doubt whether even within the corporations themselves there is much self-analysis.

I have more than a suspicion that in most cases the answers would make your hair stand on end. There are several characteristics of senior bank executives which should make you worry.

First, they are not by nature very ruminative and not normally given to self doubt. This can, of course, be a good quality, but not when the world is so uncertain and the consequences of bad decisions so serious. Second, they do not lightly tolerate dissent and tend to attract sycophants among the ranks of other senior executives. Third, they normally have distinct blind spots in the two areas where a financial organisation can most easily be brought to fail, namely IT and complex financial instruments. Fourth, if an activity is making money they usually give it the benefit of the doubt.

In a properly functioning corporate world these failings of the executive would be both recognised and counter-balanced by the wisdom of the board. But many boards are best regarded as a form of club. The City is a peculiar mixture of geekish quants and rocket scientists, wide-boy traders who would otherwise be selling apples and oranges down the Commercial Road and time-serving apparatchiks. Typically a board consists of no one from the first two groups but quite a few from the third. In what position is Sir Thingummy Whatnot to question the real risk exposure of a bank? Does Dame Noditthrough really know her onions on complex derivatives?

And for presiding over all this, of course, senior bank executives get rewarded on a scale that ordinary mortals find fantastical. And when they fail, they get packed off into the sunset, often begonged, with a very comfy nest-egg indeed.

The inability of most normal human beings to understand what the quants are up to is devastating. Of course, the banks all have their risk assessment teams and procedures. But they are also highly quantitative and to normal people speak gobbledegook. More fundamentally, their model-based approach rests on the continuing relevance of recent experience - often over pathetically short runs of data - with scant regard paid to the "off-the-model risks" which in the real world are the usual sources of upset. Personally, I would sack at least half of the risk assessment boys and replace them with historians and people versed in English literature. Their brief would be to think the unthinkable - not to measure the easily quantifiable.

Not long ago, banks and other lenders were falling over themselves to lend on wafer-thin margins to people and propositions which their predecessors would not have touched with a bargepole: 125 per cent mortgages; huge multiples of earnings; self-certification. Now the lenders are shutting up shop and fancy mortgages have disappeared like melting snow. Both approaches cannot be right.

The silence about the corporate behaviour which led us to this pretty pass is scandalous. Come off it boys, you were sucked into a bubble of the classic sort. You were persuaded to believe that nothing could go wrong. Yet any study of financial history would have set the alarm bells ringing. But do you ever read any? To his great credit, the Governor of the Bank of England warned explicitly and publicly of the risks. But did you listen? Outside commentators and analysts, and even, in some cases, your own in-house experts, pointed out the over-valuation of property. But did you pay any attention?

We cannot go on like this. There are all sorts of ways in which banks must be restrained and regulated to be better behaved in future, including with regard to their remuneration packages. But the structure and behaviour of boards and banks' procedures for assessing risk should also be an important part of this reform.

Supposedly the justification for the gargantuan pay packages of recent years has been the supreme cleverness of bankers. Yet so much of modern banking is a form of gambling. Those clever bankers, nodded on by their gilded boards, have done the equivalent of put a few billion quid on the 3.30 at Newmarket - and lost. Clever or not, what they really need more of is not cleverness but wisdom. And what they need less of is money.

Why Such Timid Financial Reform Proposals? (Alan Blinder Edition)

Here we are, in the midst of the worst financial crisis since the Great Depression, and what do we see? Central banks madly pumping water out of leaky, listing vessels, some discussion of how to patch the most visible holes, but perilous little consideration of how to correct the defects of construction, poor choice of shipping routes, or recklessness of the crews and their captains.

Moreover, one has to wonder if the last two weeks' outburst of "the credit crisis is just about over" chatter isn't merely to talk up the markets, but also to forestall regulation. After all, if the worst is behind us, we clearly don't need to do anything, now do we? Of course, that view conveniently ignores the massive subsidies to the banking sector by the Fed's, the Bank of England's and now the ECB's willingness to create new liquidity facilities, and in the case of the Fed, accept increasingly dodgy collateral (I gasped out loud when I heard that the list had been expanded to include securitized credit card and car loans). But the Street knows full well that now that they have the dough, they have the advantage. It's rather difficult to renegotiate a loan once the proceeds are in the debtor's hands. Yes, technically, the Fed could refuse to roll outstanding loans, since, for example, the TAF is a 28-day facility, but the whole point of this exercise has been to avoid upsetting the financiers, so tough disciplinary measures will not be forthcoming.

The problem is that the ugly truth discovered by William Gladstone when he became Chancellor of the Exchequer is now on full view:

The government itself was not to be a substantive power in matters of Finance, but was to leave the Money Power supreme and unquestioned.

The latest example is the half-heated proposal set forth by Alan Blinder in today's New York Times, "The Case for a Newer Deal." The reference to the New Deal is disingenuous, since it brought a slew of radical, large scale interventions, some of which did not survive the 1930s. However, the securities law reforms implemented in 1933 and 1934 have not only proven to be durable, but became the template for public securities markets around the world.

Yet what Blinder recommends bears perilous little resemblance to the sweeping 1933 and 1934 acts. In fact, he even stoops to apologize for even daring to suggest regulation:

A warning to laissez-faire-minded readers: The following is mostly about the dreaded “R” word — regulation. But I’m afraid that we need more of that, starting in the mortgage market.

His first suggestion is to have a federal mortgage regulator (the notion being that the many of the worst mortgages were originated by unregulated brokers). Fine, but that's already on the table. Indeed, there is robust debate as to whether the Feds or the states should act as the supervising adults (states are arguably more motivated, give that mortgage abuses affect their communities and thus their tax bases; mortgages are subject to state, not federal law. Real estate broker licensing is also a state matter. An understaffed or half-hearted federal regulator might be even worse than the status quo).

Blinder's next observation:

Next, we should resist calls to scrap the “originate to distribute” model, wherein banks originate mortgages, which are then packaged into mortgage pools and turned into mortgage-backed securities that are sold to investors around the world.

There is good reason for us to keep it. As the refreshingly honest Lew Ranieri pointed out at the Milken conference, the securitization model saved America's bacon by distributing dodgy deals all over the world. Ranieri said the US financial system could not have withstood the amount of losses had the paper remained at home (although in fairness, I recall reading that by 2006, mortgage debt was being sold primarily overseas because US buyers weren't keen to acquire more. So the sales might have dried up sooner in the absence of access to foreign buyers and kept domestic exposures to a level we could bear).

But what Blinder misses is that model depends on credit enhancement. That's why Fannie and Freddie are being asked to assume a larger role, since they have an implicit Federal guarantee that is likely to be tested soon. Two of the three sources of credit enhancement – monoline insurance and credit default swaps – aren't an option right now (CDS are costly because few are willing to write protection right now). The only method of credit enhancement readily available right now for non-agency deals is overcollateralization, and investors appear more leery than they were in the past.

Blinder argues for having everyone in the securitization pipeline retain a piece of the mortgage pool. Um, Merrill and Citi DID wind up holding very large pieces of "super senior" tranches that they convinced themselves were fine and went out and originated more with the amount they would up retaining growing even larger. The magnitude of the fees led them to underestimate the risk. To have "keeping a piece" constitute enough of a check on behavior, the players along the pipeline would have to retain a fairly large piece, which means undermines the purpose of the approach. And Blinder fails to address another big failing: the difficulties of doing mods.

Blinder seems curiously blind to what this model hath wrought:

This seemingly convoluted model has given the United States the world’s broadest, deepest, most liquid mortgage markets. And that, in turn, has meant lower mortgage interest rates and more homeownership. These are gains worth preserving.

Liquidity is not a virtue in and of itself unless it produces a benefit to the real economy. And these vaunted lower interest rates were the result of deliberate distortion: the Fed pushing short rates to 1%, which was negative in real terms, combined with the industry pushing ARM structures for weak borrowers. This pattern, including the increase in homeownership, was a misallocation of capital, and anything but a virtuous outcome.

Reader Richard Kline gives a far more accurate picture of what happened:

How did the financial industry come to the pass we now face? This is the first question to ask in considering what structural or regulatory changes are desirable. The fundamental issue, to me, is the unwillingness of firms lending money to set aside appropriate reserves against losses, at any level. We have 300 years of modern banking history which has without exception indicated that unreserved lending is to a financial institution what the absence of an immune system is for an organism; a scratch can kill you (default cascade or credit cut off), while a real virus not only kills you but infects your neighbors. So we see again. This behavior, an unwillingness to reserve against losses, suggests its own trajectory of solutions but let’s do a brief review for context.

Loan retailers, including mortgage brokers, set aside very little for losses because they weren’t going to hold the debt; instead, they pushed it up the chain, typically for securitization. Banks skirted their reserve requirements by opening conduits with pitiful liquid reserves to park debt of various kinds while shopping it or bundling it to be shopped. Similarly, banks underwrote huge volumes of inherently risky and unstable LBO debt against which they compiled no adequate reserves because, again, they expected to sell the debt at a profit not retain it.

CDOs are the freak show exhibit for tortured ill-thinking about how to reserve against losses. The principle benefit, initially, from securitization was overcollateralization against losses. Yes, really. This had at least three legs, of unequal size. In many cases, default swaps were bundled into the CDO as a shock absorber to take first losses. The CDO was sold at a discount to the face of the underlying debt, so that a further cushion against loss was bundled in. Both of these provisions were unequally distributed to tranche buyers, but in principle offered significant reserves against loss risk. Finally, some CDOs had limited recourse provisions against the originators of the original debt in case of fraud, high failure rate or the like. These mitigation options were small and hardly universal, but again they in principal reserved against risk.

All of these ‘reserves’ have failed massively in the present circumstance, and for much the same reason: they weren’t real reserves---cash or near equivalents tied to the debt---but promises of payment. Issuers of default swaps as we see never expected to pay off more than a tiny fraction of their swaps, and to the extent that they themselves had any ‘reserves’ these proved to be not cash but debt which in a pinch they have been unable to sell to raise money. The swaps on any one CDO may pay out, but on the instruments as a whole _cannot_ pay out. Then the underlying debt bundled in CDOs has tended to be overconcentrated in single asset classes, and thus totally, even ridiculously, exposed to price declines in the same asset class. The ‘excess collateral’ has been wiped out and far more by overall price declines. And many loan originators have simply gone out of business, or are accident