Wed June 28, 2011

I am convinced that a subscription to the WSJ needs to be mandatory for all accounting and finance students. That would lead to required reading and discussion of current topics. 

I am also convinced that the existing accounting textbooks are about thirty years out of date. Mind numbing exercises involving  odd combinations of LIFO and FIFO pricing seem obsolete in these days of bar coding and point of sale database computers. Does one's career really hinge on calculating the liability for cereal box coupons for customers to obtain the latest movie themed toy?  I think not.

What I do think is that the current course profiles are way way short on the topics of selling all kinds of securitized debt,  leverage, and derivatives. Let's take a quick stroll through the last two days of the WSJ reports. 

June 27 2011

The real story is not that Greece seeks to sell everything from islands to airports but just how wide their circle of creditors really is, more on that in the June 28 edition. 

On page C1 Greece considers all sorts of debt juggling such as insisting bondholders re invest half of the maturing proceeds, ie, a structured 50% default. 

On the same page Stifel Financial  is under investigation for selling now worthless  securities to Wisconsin School Districts.  This is the precisely the sort of article that requires critical thinking, an understanding of credit and derivative markets, and leverage, all at the same time. Read about it at

Stifel Now as the saying goes, connect the dots. 

In 2006 the School Districts bought the CDOs collateralized debt obligations to 'generate returns that would help them meet health care obligations and other retirement liabilities.' Now stop and think, in other words, the Schools were under water, had more liability than they could pay. So what did they do, well they took the cash they had, $45 million, borrowed $165 million from Depfa, a German bank, believing that after their own interest costs the 'returns' from the CDOs would fund their liabilities. 

Now class, why is such a transaction sheer folly?  Because higher returns in debt only come from assuming higher risk. Thinking that one can leverage with 75% debt, three to one, and still come out ahead, is naive at best. So one is borrowing at three to one to buy another debt instrument that is probably leveraged much more than that or more if in fact there was any equity in the CDOs. 

Incredibly the CDOs carried an investment grade rating, more than Baa. Yet the suit alleges the Districts were told it would take '15 Enrons' before they could lose any money. Well it took a lot less than that, today the CDOs are worthless, their $45 M is gone as is the $165 M from the German bank. And of course the German bank wants to be repaid. 

This genius scheme was hatched by the Royal Bank of Canada. Stifel sold 'slices' of the CDOs to the Districts. As you can see this is debt stacked upon questionable debt. If anyone can't pay, everyone loses. 

Now critical thinkers, why would all these supposedly reputable firms like RBC and Stifel, get into such a mess, and what were the CFOs at the School District thinking?  This is my point, clearly the Financial Professionals at the schools were Babes in Toyland to think this would work. 

Well, here is your answer. RBC made fees by re packaging the loans into CDOs. They made even more by creating various divisions or tranches, you know the same way General Mills makes seventeen different cereals from the same kernel of wheat. RBC then promoted these CDOs to former conservative firms like Stifel. With brokerage commissions a long gone relic of the landscape, firms like Stifel were eager to get in on the mortgage money machine. 

Meanwhile school districts in Wisconsin had so over promised their employees golden packages of health care and retirement there was no way they could pay for it. What to do? They were sold the idea that they District could borrow three to one, buy a very high yielding CDO, so high that that the returns would pay both their borrowing costs to the German Bank AND bring in enough money to pay the health care and retirement benefits. They would have had a better chance at the horse track….

But back to why the firms would do such a thing. 

RBC marked up the bonds they re created from mortgages. The more varieties they created the more they made, think Salem, Winston, Marlboros, all from the same tobacco leaf but all variations on a theme. Then they solicited naive brokers like Stifel. RBC marked up the bonds to Stifel as RBS acted as a principal not an agent. I promise, there was no commission shown on that trade confirm. Then Stifel sells the CDOs to the School. Stifel is acting a  Principal so again no commission on the trade confirm. And you can bet (gee a lot of betting going on here, right?) Stifel and RBC garnered feeds for 'arranging' the loan from the German Bank. The Bank of course charged  a higher rate of interest, why else would they be in Wisconsin instead of say Stuttgart? So everyone had cut themselves in by raising the price as the CDO was passed around. And even more debt was created as all were betting on what may have well been mortgages with zero equity to begin with, why else would they be worth nothing today?

Now, another reason I told you all that was to make this final point about just how far brokers have come from what they used to be. In 1984, I believe it was, I worked for Stifel for a  few months. Stifel is one of three brokers headquartered in St. Louis. They were originally  a conservatively run mid west municipal underwriter and broker. They made  a quiet but respectable living brining sewer and water bonds to market and selling them to income customers. I was buying Ginnie Mae bonds for instutional clients at the time. Back then those really were government guaranteed. But Stifel was so unprepared they could not properly transact the trade. A confirmation would be cancelled and replaced sometimes multiple times on the same trade. There is a (whoops make that there used to be) a considerable amount of information about the bond pool on a trade ticket including mortgage pool numbers of speeds of paydown and such. My manager friend and I ended up in the St Louis office where Stifel decided that GNMs were not a product they wanted to deal with. I parted their company and went on to successfully trade tens of millions of dollars in bonds via another firm. But my point here, is that a mere 30 years ago Stifel would not do a guaranteed Ginnie Mae. Now the sky is the limit, they don't really know what they were dealing in.

 And so, RBC claims it acted appropriately. Stifel claims the problem is the structure of the instrument, not their marketing (hey I drove the getaway car, I didn't actually rob the bank), the German Bank has a worthless loan, and the School Teachers have a claim on $45 M less than they had. Welcome to Ben Bernanke's Stimulus World. 

June 28, 2011

On the front page, Bank of America, whose stock has dropped one third this year, is paying $8.5 Billion to settle similar claims. 

on page C1 we have my favorite indicator. A NYC Maserati dealer reports only 15 sales in June, down from 23 in April.Well there you have it, demand for  luxury goods which we have been tracking, fall . Wall Street layoffs increase amid lower 'trading profits.'

Auditors have difficulty confirming bank balances in China. 

The Treasury Auction goes poorly, the long bond down 200 basis points in two days. 

Groupon amassing cash by slow pay to creditors, citing high marketing costs. Hmm, sounds like AOL redux to me, remember all those AOL CDs we used to get in the mail?

And so it goes. The Gathering Storm gains strength.