Posts filed under ‘derivatives’
Getting Paid to Eat Bon-Bons and Sell Options
I have a diverse set of interests, and two of my passions include eating assorted bon bons, and buying stocks low (selling them high). The only thing better than that is to also get paid for doing those same activities. Until I get paid for competing on the national bon bon competitive eating circuit, I’ll stick to getting paid for selling (“writing”) options.
The Mechanics of Option Writing
There are many places to learn about the basics of options, but for simplicity purposes think of options as tools for speculating, hedging, and generating income. Unfortunately, most people trading options lose money because of speculation and numerous shortcomings. Like guns, knives, or any other weapon, if properly used, these self-defense option tools can provide owners with significant benefits. If however the weapons are used irresponsibly, the consequences can be deadly. The same principles apply to options investing – beneficial in the right hands, disastrous in the wrong hands (see also Butter Knife or Cleaver article).
A Pricey Option Illustration
In order to illustrate the mechanics of option writing, let’s use Priceline.com Inc. (PCLN) as an example:
Suppose I did my in-depth fundamental research on Priceline and upon completion of my due diligence I realized that the stock is fairly valued at its current share price of $529. However, upon further consideration I realize I would love to buy 100 shares at a discount price of $500 if Priceline shares pulled back. In mirror-like fashion my fundamental valuation process may also indicate an adequate selling valuation level at a $560 premium.
Based on these previous assumptions, I could profitably sell (“write”) one naked put option with a strike price of $500 and an expiration date in October (approximately five months from today), in exchange for $3,560 in upfront cash less comissions.* That’s right, someone is going to pay me thousands of dollars to buy something I am openly willing to purchase at lower prices anyway. In bon bon terminology, speculators are paying me to eat bon bons, an activity I love even without upfront cash payments from others. In the case of an escalating Priceline share price, I prefer to sell covered calls (i.e. own underlying stock position plus simultaneously selling a call option), consistent with my valuation sell price targets (strik price of $560 per share).
Selling Insurance
Since writing options is effectively like selling insurance, it intuitively follows the best time to sell insurance is when people (investors) are the most nervous. If you were a fire insurance carrier and wanted to maximize collections, setting prices a week after a large fire in the hot, dry summer season around the firework-laden 4th of July may not be a bad choice. In the equity markets, the VIX (Volatility Index) is often referred to as the “fear gauge,” which can be used as an indicator to optimize premium collections from options sales.
Options, which are part of the derivatives family, get lumped into these wide set of financial instruments that billionaire investor Warren Buffett called “weapons of mass destruction.” The ironic part of that whole situation is that despite the evil titling of these instruments, Buffett has used these “weapons of mass destruction” extensively, more recently with his strategies related to selling index options – see Insurance Weapons of Mass Destruction. For those who followed the financial crisis of 2008-2009, observers fully realize that American International Group (AIG) was selling insurance on credit defaults (Credit Default Swaps). Regrettably, the CDS market was not regulated to a similar extent as the more sophisticated options and futures market.
Eating bon bons for pay can be satisfying, and so can trading stocks for cash, when buying them low and selling them high. On the other hand, these same activities can prove to be harmful if abused or misused. If you eat bon bons in moderation, and receive premiums from thoroughly researched naked puts and covered calls, then you have nothing to worry about.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: *Based on 5-9-11 closing trade data from Yahoo Finance. Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in PCLN, AIG, VXX or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Ball & Chaining the Rating Agencies
After sifting through the rubble of the financial crisis of 2008-2009, Congress is spreading the blame liberally across various constituencies, including the almighty rating agencies (think of Moody’s [MCO], Standard & Poor’s [MHP], and Fitch). The Senate recently added a proposed amendment to the financial regulation bill that would establish a government appointed panel to select a designated credit rating agency for certain debt deals. The proposal is designed to remove the inherent conflict of interest of debt issuers – such as Goldman Sachs Group Inc. (GS), Morgan Stanley (MS), UBS, and others – shopping around for higher ratings in exchange for higher payments to the banks. The credit rating agencies are not satisfied with being weighed down with a ball and chain, and apparently New York Attorney General Andrew Cuomo is sympathetic with the agencies. Cuomo recently subpoenaed Goldman Sachs Group Inc., Morgan Stanley, UBS and five other banks to see whether the banks misled credit-rating services about mortgage-backed securities.
Slippery Slope of Government Intervention
Many different professions, inside and outside the financial industry, provide critical advice in exchange for monetary compensation. In many industries there are inherent conflicts of interest between the professional and the end-user, and a related opinion provided by the pro may result in a bad outcome. If government intervention is the appropriate solution in the rating agency field, then maybe we should answer the following questions related to other fields before we rush to regulation:
- Should the government control which auditors check the books of every American company because executives may opportunistically shop around for more lenient reviews of their financials?
- Perhaps the Securities and Exchange Commission (SEC) should dictate which investment bank should underwrite an Initial Public Offering (IPO) or other stock issuance?
- Maybe the government should decide which medicine or surgery should be administered by a doctor because they received funding or donations from a drug and device company?
Where do you draw the line? Is the amendment issued by Al Franken (Senator of Minnesota) a well thought out proposal to improve the conflicts of interest, or is this merely a knee-jerk reaction to sock it some greedy Wall Street-ers and solidify additional scapegoats in the global financial meltdown?
In addition to including a controversial government-led rating agency selection process, the transforming regulatory reform bill also includes a dramatic change to ban “naked” credit default swaps (CDS). As I’ve written in the past, derivatives of all types can be used to hedge (protect) or speculate (e.g., naked CDS). Singling out a specific derivative product and strategy like naked CDSs is like banning all Browning 9x19mm Hi-Power pistols, but allowing hundreds of other gun-types to be sold and used. Conceptually, proper use of a naked CDS by a trader is the same as the proper use of a gun by a recreational hunter (see my derivatives article).
Solutions
Rather than additional government intervention into the rating agency and derivative fields, perhaps additional disclosure, transparency, capital requirements, and harsher penalties can be instituted. There will always be abusers, but as we learned from the collapse of Arthur Andersen on the road to Enron’s bankruptcy, there can be cruel consequences to bad actors. If investment banks misrepresent opinions, laws can lead to severe results also. Take Jack Grubman, hypester of Worldcom stock, who was banned for life from the securities industry and forced to pay $15 million in fines. Or Henry Blodget, who too was banned from the securities industry and paid millions in fines, not to mention the $200 million in fraud damages Merrill Lynch was forced to pay.
At the end of the day, enough disclosure and transparency needs to be made available to investors so they can make their own decisions. Those institutional investors that piled into these toxic, mortgage-related securities and lost their shirts because of over-reliance on the rating agencies’ evaluations deserve to lose money. If these structures were too complex to understand, then this so-called sophisticated institutional investor base should have balked from participation. Of course, if the banks or credit agencies misrepresented the complex investments, then sure, those intermediaries should suffer the full brunt of the law.
Although weighing down the cash-rich credit rating agencies (and CDS creators) with ball and chain regulations may appease the populist sentiment in the short-run, the reduction in conflicts of interest might be overwhelmed by the unintended consequences. Now if you’ll please excuse me, I’m going to do my homework on a naked CDS related to a AAA-rated synthetic CDO (Collateralized Debt Obligation).
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in MCO, MHP, GS, MS, JPM, UBS, BAC, T or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Goldman: Gambling Prosperity at Client Expense?
What a scene that 11-hour Senate subcommittee interrogation of Goldman Sachs (GS) executives was on C-Span – I’m still wondering whether a forklift was utilized to hoist in the multi-thousand page binders stuffed with reams of exhibits. With caffeine beverage firmly in hand, I watched as much of the marathon as possible until fatigue set in. Not all was lost though, because I managed to simultaneously conduct new stock research as I was glued to the hearings. After I saw the Goldman executives repeatedly wrestle open the gargantuan-sized binders of smoking-gun emails, I checked the paper futures markets and am now contemplating a purchase of International Paper’s (IP) stock.
Lead trader of the controversial Abacus/John Paulson deal, “Fabulous Fab” Fabrice Tourre, did not disappoint his supporters either, firmly addressing his responses in his French Pepe Le Pew accent. His Goldman trading counterparts (Daniel Sparks, ex-mortgage department head, Joshua Birnbaum, ex-managing director of the department, and Michael Swenson, current managing director of the department), like all Goldman witnesses, did their best at bobbing and weaving the intrusive, pointed questions. On the cozier side of the questioning fence, the Senators did a superb job of raking the Goldman execs over the coals with endless exhibits of emails. Judging by the shiny, sweating mugs of the traders, the Senators were successful in making the testifiers uncomfortable – either that, or the Senators had the thermostat in the room raised to 82 degrees.
Betting Away to Profits
At the heart of the questioning was the key issue of whether Goldman Sachs executives and employees were acting in the best interest of their clients (fiduciary duty), or were they making bets against clients with the benefit of privileged information. Senator Claire McCaskill compared Goldman to a bookie manipulating bets in their own favor without sharing their edge with bettors (investors). In the case of the Abacus deal, Goldman admits to not freely disclosing the involvement of now-famous, mortgage market short seller John Paulson (see the Gutsiest Trade) to the so-called sophisticated institutional investors, ACA Capital Holdings Inc. Was this lack of disclosure illegal? Perhaps unethical, but pundits have already established the high hurdle the SEC (Securities and Exchange Commission) will need to clear in order to prove Goldman’s guilt.
Based on the testimony and facts introduced in the hearings, and as I write in my previous Goldman article (Goldman Cheat?), Goldman’s behavior throughout the housing collapse and participation in the ACA deal reflects more about intelligent opportunism within a loose regulatory framework than it does about criminal behavior. Having managed a $20 billion fund (see my book) I dealt with the conflicts of interest and self dealings of the investment banks first hand. As I entered trade orders reaching into the millions of shares, do I naively believe Goldman and other banks altruistically kept that information in their trading vaults? Or is it possible that information leaked out to other clients or was used for the banks benefit? Suffice it to say, the regulatory structure and conflict of interest frameworks, as they stand today, are not stacked in favor of investors.
The Solutions
Although we wish our regulators and government officials could have been more forward looking, rather than reactive, nonetheless, some reforms need to be instituted to resolve the substantial risks built into our financial system today. Here are a few ideas from the 10,000 foot level:
Volcker Rule: Former Federal Reserve Chairman’s so-called “Volcker Rule” is looking better by the minute. Not a new concept, but as regulators shine the light on the opaque industry of derivatives trading and proprietary trading desks, the need for new reforms becomes even more evident. Derivatives are not evil (see Financial Engineering), but like a gun or knife, if misused these instruments can become extremely dangerous…as we have found out. The Glass-Steagall Act, which separated investment bank functions from commercial bank functions, was repealed almost 70 years after its introduction in 1932. The Volcker Rule would be a “lite” version of Glass-Steagall Act because the thrust of the proposal is aimed at splitting the risk-taking proprietary trading desk activities from the client based activities.
Heightened Capital: If you rented out an exotic car or motorcycle from a store, you would likely be required to commit a deposit or collateral to protect against adverse conditions. The same principle applies to derivatives, which generally raises volatility due to inherent leverage. The riskier the product, the larger the capital requirement should be. The collapse of Bear Stearns, Lehman Brothers, and AIG are painful lessons learned from situations of excessive leverage.
Central Clearing/Transparency: Derivative products such as options, futures, and swaps have existed for decades. The transparency gained by trading these securities on exchanges increases market confidence, thereby increasing liquidity and lowering costs for end-users. Standardization around complex derivatives like CDOs (Collateralized Debt Obligations), CDSs (Credit Default Swaps), and CLOs (Collateralized Loan Obligations) is a must to ensure the fact regulators can actually understand the products they are regulating.
Credit Rating Agency: It’s not entirely clear to me that the rating agencies play a critical role in the market place. In effect, the agencies serve as an outsourced research resource primarily for fixed income investors. If the agencies disappeared today, investors would be forced to do their own homework on each deal – not necessarily a bad idea. If the existing oligopoly structure of agencies ultimately survives, I suggest penalties should be incurred by firms with inaccurate ratings. Conversely, ratings could be structured such that compensation could be tiered (or escrowed) over time with payment incentives tied to the underlying deal performance relative to ratings accuracy.
Too Big To Fail: The massive bailouts and TARP (Troubled Asset Relief Program) money handed out to the financial and auto companies have left a sour taste in taxpayers’ mouths. A systemic risk regulator with the authority to unwind unhealthy institutions makes common sense. An insurance pool financed by self-inflicted industry taxes would assist regulators in achieving the reduction of troubled financial institutions.
Fiduciary Duty: Sidoxia Capital Management is a Registered Investment Advisor (RIA) and must act in the best interests of the client. Unfortunately, much of the industry is structured with a much lower “suitability” threshold, which provides a veil for firms to engage in less than ethical behavior.
Overall, regulatory reform urgency is in the Washington D.C. air and there is no question in my mind that a certain degree of witch hunting and scapegoating is occurring. Nonetheless, Lloyd Blankfein and team Goldman Sachs made it out alive from the Congressional hearing, but not without suffering some negative reputational damage. Former Goldman CEO alum and Treasury Secretary Henry Paulson probably sent roses to Mr. Blankfein thanking him for taking Paulson’s job before the 2008 market collapse. When regulatory reform eventually kicks in, perhaps Lloyd Blankfein and Henry Paulson will take a trip to Las Vegas to celebrate (or commiserate).
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds and in a security derived from an AIG subsidiary, but at the time of publishing SCM had no direct positions in GS, IP, AIG, JPM/Bear Stearns, LEH/Barclays or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Goldman Cheat? Really?
Really? Am I supposed to be surprised that the SEC (Securities and Exchange Commission) has dug up a CDO (Collateralized Debt Obligation) deal with $1 billion in associated Goldman Sachs (GS) losses? The headline number may sound large, but the billion dollars is not much if you consider banks are expected to lose about $3 trillion dollars (according to an International Monetary Fund report) from toxic assets and bad loans related to the financial crisis. Specifically, Goldman is being charged for defrauding investors for not disclosing the fact that John Paulson (see Gutsiest Trade), a now-famous hedge fund manager who made billions by betting against the subprime mortgage market, personally selected underlying securities to be included in a synthetic CDO (a pool of mortgage derivatives rather than a pool of mortgage securities).
Hurray for the SEC, but surely we can come up with more than this after multiple years? More surprising to me is that it took the SEC this long to come up with any dirt in the middle of a massive financial pigpen. What’s more, the estimated $1 billion in investor losses associated with the Goldman deal represents about 0.036% of the global industry loss estimates. These losses are a drop in the bucket. If there is blood on Goldman’s hand, my guess is there’s enough blood on the hands of Wall Street bankers to paint the White House red (two coats). The Financial Times highlighted a study showing Goldman was a relative small-fry among the other banks doing these type of CDO deals. For 2005-2008, Goldman did a little more than 5% of the total $100+ billion in similar deals, earning them an unimpressive ninth place finish among its peers. As a matter of fact, Paulson also hocked CDO garbage selections to other banks like Deutsche Bank, Bear Stearns, and Credit Suisse. The disclosure made in those deals will no doubt play a role in determining Goldman’s ultimate culpability.
Context, with regard to the fees earned by Goldman, is important too. Goldman earned less than 8/100th of 1% of their $20 billion in pretax profits from the Abacus deal. Not to mention, unless other charges pile up, Goldman’s roughly $850 billion in assets, $170 billion in cash and liquid securities, and $71 billion in equity should buttress them in any future litigation. These particular SEC charges feel more like the government trying to convict Goldman on a technicality – like the government did with Al Capone on tax evasion charges. At the end of the day, the evidence will be presented and the courts will determine if fraud indeed occurred. If so, there will be consequences.
Demonize Goldman?
How bad can Goldman really be, especially considering their deep philanthropic roots (the firm donated $500 million for small business assistance), and CEO Lloyd Blankfein was kind enough to let us know he is doing “God’s work,” by providing Goldman’s rich menu of banking services to its clients.
Certainly, if Goldman broke securities laws, then there should be hell to pay and heads should roll. But if Goldman was really trying to defraud investors in this particular structured deal (called Abacus 2007-ACI), then why would they invest alongside the investors (Goldman claims to have lost $90 milllion in this particular deal)? I suppose the case could be made that Goldman only invested for superficial reasons because the fees garnered from structuring the deals perhaps outweighed any potential losses incurred by investing the firm’s own capital in these deals. Seems like a stretch if you contemplate the $90 million in losses overwhelmed the $15 million in fees earned by Goldman to structure the deal.
Maybe this will be the beginning of the debauchery flood gates opening in the banking industry, but let’s not fully jump on the Goldman Scarlet Letter bandwagon just quite yet. Politics may be playing a role too. The Volcker rule was conveniently introduced right after Senator Scott Brown’s Senate victory in Massachusetts, and political coincidence has reared its head again in light of the financial regulatory reform fury swelling up in Washington.
Waiting for More teeth
There is a difference between intelligent opportunism and blatant cheating. There is also a difference between immorally playing a game within the rules versus immorally breaking laws. Those participants breaking the law should be adequately punished, but before jumping to conclusions, let’s make sure we first gather all the facts. While the relatively minute Abacus deal may be very surprising to some, given the trillions in global losses caused by toxic assets, I am not. Surely the SEC can dig up something with more teeth, but until then I will be more surprised by Jesse Jame’s cheating on Sandra Bullock (with Michelle “Bombshell” McGee) than by Goldman Sachs’s alleged cheating in CDO disclosure.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in GS, DB, Bear Stearns (JPM), and CSGN.VX/CS.N or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
California Checking Under the Derivatives Hood
[tweetmeme source=”WadeSlome” only_single=false https://investingcaffeine.com/2010/04/11/california-checking-under-the-derivatives-hood/%5D
Bill Lockyer, California’s State Treasurer, is in charge of driving “The Golden State’s” budget, but as he maneuvers the finances, he is hearing some strange knocks and pings as it relates to the pricing of Credit Default Swaps (CDS) on California debt obligations. CDSs, like virtually all derivatives, can either be used to speculate or hedge (see also, Einhorn CDS and Financial Engineering articles), so the existence of strange noises does not necessarily indicate foul play or problems that cannot be fixed.
Checking Under the Banks’ Hoods
At the heart of the CDS markets lie the major investment banks, so that is where Lockyer is looking under the hood and requesting information on the role the banks are playing in the municipal bond CDS market. Specifically, Lockyer has sent letters requesting information from Bank of America – Merrill Lynch (BAC), Barclays, Citigroup (C), Goldman Sachs (GS), JP Morgan (JPM),and Morgan Stanley (MS). California pays the banks millions of dollars every year to market bonds on behalf of the state. The I-banks operate in some way like a car dealership – the state produces the cars (bonds) and the banks buy the bonds and resell them to buyers/investors.
The financial transaction doesn’t necessarily stop there, because the banks can further pad their profits by selling and making markets in credit default swaps. After the state issues bonds, speculators can then pay the banks to place bets on whether the cars (bonds) fail (default), or investors can also buy insurance from the banks in the form of swaps. As you can probably surmise, there is the potential for conflicts of interest between the state and the banks, which partly explains why Lockyer is conducting his due diligence.
California…the Next Greece or Kazakhstan?
As the housing market came crashing down, credit default swaps were at the center of financial institution collapses and the billions made by John Paulson (see also the Gutsiest Trade Ever). More recently, CDSs were cited as negative contributors to the Greek financial crisis. Lockyer tries to deflect California comparisons with Greece by stating the European country’s budget deficit is 13 times larger than California’s (as % of GDP) and the foreign country’s accumulated debt is 25 times larger on GDP basis as well (read California’s Debt Hole story).
Beyond making sure the profit rules of the game are not stacked against California, Lockyer wants to understand what he perceives as a mispricing in the default risk of California debt obligations. He is worried that the state’s borrowing costs on future bond issues could be artificially escalated because he says the credit default swaps “wrongly brand our bonds as a greater risk than those issued by such nations as Kazakhstan, Croatia, Bulgaria and Thailand.”
Clarity on these issues is important because the state is exploring the expansion into taxable municipal bonds. The government has been subsidizing taxable munis, termed Build America Bonds (BABs), to stimulate the economy and bring down borrowing costs for municipalities. According to Thomson Reuters, BABS accounted for approximately 26% of overall muni bond issuance ($25.8 billion) in the first quarter.
If California were a car, I’m not sure how much cash they would get for their clunker ($16 billion budget deficit), but I tip my hat to State Treasurer Lockyer for holding the investment banks’ feet to the fire. All investors and financial product consumers stand to benefit by looking under the hood of their financial institution and asking tough questions.
Read Full Financial Times Article on California CDS Market
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
*DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct positions in BAC, C, GS, JPM, and MS or any security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Fishy Fuld Finances – Repo 105
The truth may set you free, or it may just send you to jail. Right now, Anton Valukas’s high profile 2,200 page report has unearthed a reeking stench surrounding a $50 billion fund shuffling scheme. Our legal system will ultimately determine the fate of Dick Fuld, former CEO of Lehman Brothers, and any potential co-conspirators. Anton Valukas, appointed by the U.S. bankruptcy court to get to the root causes of the largest bankruptcy in history (a 158 year old investment banking institution), spearheaded the year-long investigation.
While most observers have not shed a tear over the grilling of Fuld in the media, onlookers shouldn’t feel sorry for Valukas either. His firm, Jenner & Blocker, was paid $38 million for its troubles in researching the report through January of this year.
Completing the report was a Herculean task. Finishing the report involved narrowing down 350 billion pages of documents (spread across 2,600 systems) down to about 40 million pages, which were supplemented by interviews with more than 250 individuals, according to The Financial Times.
Repo 105 Crash Course
At the heart of the Valukas’s report is a unique accounting gimmick used by Lehman Brothers to conveniently shed billions in assets off its books at opportune times. The scheme distorted the firm’s financial position so Lehman Brothers could appear financially leaner than reality. This controversial practice is called Repo 105 (“repo” is short for “repurchase”). Here’s how it works:
a) The Right Way: In a typical legitimate repurchase transaction, widely used in the banking industry, a financial institution transfers assets (collateral) to a counterparty in exchange for cash. As part of the transaction, the institution that transferred the assets for cash agrees to repurchase the collateral from the counterparty in the future for the original value plus interest. These repurchase agreements are completely valid and function as an excellent short-term liquidity tool for the financial markets. What’s more, the transactions are completely transparent with the associated assets and liabilities in clear view on the publicly distributed financial statements.
b) The Crooked 105 Way: With toxic real estate values plummeting, and Lehman Brothers’ leverage (debt) ratios rising, Lehman executives became more desperate in hunting out more creative methods of hiding unwanted assets off the balance sheet. To satisfy this need, Lehman travelled across the Atlantic Ocean to court the legal opinion of a preeminent law firm, Linklaters, in order to have them sign off on the imaginative Repo 105 practice. Under Repo 105, Lehman pledged assets equaling 105% of the cash received from a counterparty. Based on the Repo 105 design, the transaction was considered a “sale” and therefore wiped Lehman’s balance sheet clean of the assets. Cash temporarily received by Lehman could then be used to pay down debt. Lehman conveniently used this strategy to pretty up the books (“window dressing”) around critical periods when financial results were shared with the public and investors. Shortly thereafter, Lehman would take back the discarded assets for a cash and interest payment (similar to the previously described repurchase agreement).
In a way, this Repo 105 transaction is like a teenage boy selling a Playboy magazine to his friend for cash right before his mom comes home, then agrees to repurchase the magazine from his friend as soon as the boy’s mom goes back to work. Sneaky, but effective…until you get caught.
Where are the Cops?
With the fresh corporate scandal wounds from the likes of Enron, WorldCom, and Tyco (TYC) still healing, a neutral observer might expect the auditors to more responsibly monitor the behavior of questionable client behavior. The death of accounting giant Arthur Andersen (former Enron auditor) was supposed to serve as a poster-child example of what can happen if irresponsible corporate behavior goes unchecked. Apparently Lehman Brothers’ “Big Four” auditor Ernst & Young didn’t learn a lesson from the carnage left behind by its deceased competitor. Not only did Ernst & Young sign-off on these transactions, but their neglect of whistle-blower allegations also serves to land E&Y in very hot water.
Frustratingly, this outcome wouldn’t be the first time a whistle-blower was ignored – Harry Markopolos the Bernie Madoff sleuth was rebuffed multiple times by the SEC (Securities and Exchange Commission) before Madoff confessed his illegal Ponzi scheme crimes. Although the SEC may feel some more heat relating to Lehman’s Repo 105 accounting fallout, the agency may catch a little break since Lehman surreptitiously neglected to disclose any of this controversial accounting trickery.The SEC and multiple state Attorney Generals may investigate Valukas’ findings further to see if civil or criminal charges against Fuld and other Lehman executives are appropriate.
The Ignorance Defense
Will ignorance be an adequate defense for Lehman executives? So far, this tactic appears to be the leading approach of 40-year Lehman Brothers veteran, Dick Fuld. Fuld’s lawyer claims the CEO had no knowledge of Repo 105 “nor did Lehman’s senior finance officers, legal counsel or Ernst & Young raise any concerns about the use of Repo 105 with Mr. Fuld.” The Lehman chief’s supposed unawareness becomes less credible in the midst of smoking emails such as the following one from a senior trader:
“We have a desperate situation and I need another $2 bn [balance sheet reduction] from you either through Repo 105 or outright sales.”
Other executives referred to Repo 105 as a “drug” that they needed to “wean themselves off.” When Bart McDade, a senior Lehman Brothers exec was asked about Fuld’s knowledge regarding the accounting gimmick, McDade had no qualms in explaining Fuld “knew about the accounting of Repo 105.”
The sheer size of these multi-billion dollar off-balance sheet transactions won’t make Fuld’s innocence campaign any easier. I believe when courts discuss values exceeding $50 billion in size, ignorance will not qualify as an excuse you can hide under – even in the context of a company holding net assets of $328 billion in June 2008.
Valukas doesn’t mince any of his words in the report when the conversation moves to Lehman’s objectives:
“The examiner has investigated Lehman’s use of the Repo 105 transactions and has concluded that the balance sheet manipulation was intentional, for deceptive purposes.”
Time will tell how the ultimate judgment will fall upon Dick Fuld and his partnering Lehman Brothers executives, but one need not be a bloodhound to smell the stale fishy odor of Repo 105. Fuld better find some potent breath mints, to quickly fight off the horrible seafood scent, or he might end up as fish bait himself.
Read Financial Times Article on Fuld & Lehman
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct position in TYC on any security referenced. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
John Paulson and the “Gutsiest” Trade Ever
Although the pain and suffering of the 2008-09 financial crisis has been well documented and new books are continually coming out in droves, less covered are the winners who made a bonanza by predicting the collapse of the real estate and credit markets. Prizewinning Wall Street Journal reporter Gregory Zuckerman decided to record the fortunes made by hedge fund manager John Paulson in his book The Greatest Trade Ever (The Behind-the-Scenes story of How John Paulson Defied Wall Street and Made Financial History).
Paulson’s Cartoonish Cut
Zuckerman puts Paulson’s massive gains into perspective:
“Paulson’s winnings were so enormous they seemed unreal, even cartoonish. His firm, Paulson & Co., made $15 billion in 2007, a figure that topped the gross domestic products of Bolivia, Honduras, and Paraguay…Paulson’s personal cut was nearly $4 billion…more than the earnings of J.K. Rowling, Oprah Winfrey, and Tiger Woods put together.”
As impressive as those gains were, Paulson added another $5 billion into his firm’s coffers and $2 billion into his personal wallet over 2008 and early 2009.
There are many ways to skin a cat, and there are countless strategies used by the thousands of hedge fund managers looking to hit the jackpot like Paulson. John Paulson primarily made his multi-billion fortune thanks to his CDS positions (Credit Default Swaps), the same product that led to massive multi-billion bailouts and government support for various financial institutions.
Bigger Gamble than Perception
One surprising aspect I discovered from reading the book was the uncertainty surrounding Paulson’s negative real estate trade. Here’s how Zuckerman described the conviction level of John Paulson and Paolo Pelligrini (colleague) as it related to their CDS positions on subprime CDO (Collateralized Debt Obligation) debt:
“In truth, Paulson and Pellegrini still were unsure if their growing trade would ever pan out. They thought the CDOs and other risky mortgage debt would become worthless, Paulson says. ‘But we still didn’t know.’”
Often the trades that cause you to sweat the most tend to be the most profitable, and in this case, apparently the same principle held.
Disingenuous Dramatic License
Before Paulson made his billions, Zuckerman uses a little dramatic license in the book to characterize Paulson as a small fry manager, “Paulson now managed $1.5 billion, a figure that sounded like a lot to friends outside the business. But the firm was dwarfed by its many rivals.” Zuckerman goes on to call Paulson’s hedge fund “small potatoes.” I don’t have the industry statistics at my fingertips, but I’ll go out on a limb and make an educated guess that a $1.5 billion hedge fund has significantly more assets than the vast majority of hedge fund peers. Under the 2 and 20 model, I’m guessing the management fee alone of $30 million could cover Paulson’s food and shelter expenses. Before he struck the payload, the book also references the $100 million of his personal wealth he invested with the firm. I think John Paulson was doing just fine before he executed the “greatest trade.”
What Drove the Greatest Trade
Hind sight is always 20/20, but looking back, there was ample evidence of the real estate bubble forming. Fortunately for Paulson, he got the timing generally right too. Here are some of the factors leading to the great trade:
- CDO Leverage in Subprime: By the end of 2006, the subprime loan market was relatively large at around $1.2 trillion (representing around 10% of the overall mortgage market). But thanks to the introduction of CDOs, there were more than $5 trillion of risky investments created from all the risky subprime loans.
- Liars & Ninjas: “Liar Loans” loans based on stated income (using the honor system) and “ninja loans” (no income, no job, no assets) gained popularity and prevalence, which just led to more defaults and foreclosures in the mid-2000s.
- No Down Payments: What’s more, by 2005, 24% of all mortgages were completed with no down payment, up from approximately 3% in 2001. The percentage of first-time home buyers with no down payment was even higher at 43%.
Overall, I give kudos to Gregory Zuckerman, who spent more than 50 hours with John Paulson, for bringing something so abstract and homogenous (a skeptical real estate trade) to life. Zuckerman does a superb job of adding spice to the Paulson story by introducing other narratives and characters, even if the story lines don’t blend together perfectly. After reading The Greatest Trade Ever I came away with a new found respect for Paulson’s multi-billion dollar gutsy trade. Now, Paulson has reloaded his gun and is targeting the U.S. dollar. If Paulson’s short dollar and long gold position works out, I’ll keep an eye out for his next book…The Greatest Trad-er Ever.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including VNQ), but at time of publishing had no direct positions in companies mentioned. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Financial Engineering: Butter Knife or Cleaver?
Recently, former Federal Reserve Board Chairman Paul Volcker blasted the banking industry for innefectual derivative producs (i.e., credit default swaps [CDS] and collateralized debt obligations [CDOs]) and a lack of true innovation outside of the ATM machine, which was introduced some 40 years ago. In my opinion, the opposing views pitting the cowboy Wall Street bankers versus conservative policy hawks parallels the relative utility question of a butter knife versus a cleaver. Like knives, derivatives come in all shapes and sizes. Most Americans responsibly butter their toast and cut their steaks, nonetheless if put in the wrong hands, knives can lead to minor cuts, lost fingers, or even severed arteries.
That reckless behavior was clearly evident in the unregulated CDS market, which AIG alone, through its Financial Products unit in the U.K., grew its exposure to a mind boggling level of $2.7 trillion in notional value, according to Andrew Ross Sorkin’s book Too Big to Fail. The subprime market was a big driver for irresponsible CDO creation too. In The Greatest Trade Ever, Gregory Zuckerman highlights the ballooning nature of the $1.2 trillion subprime loan market (about 10% of the overall 2006 mortgage market) , which exploded to $5 trillion in value thanks to the help of CDOs.
Derivatives History
However, many derivative products like options, futures, and swaps have served a usefull purpose for decades, if not centuries. As I chronicled in the Investing Caffeine David Einhorn piece, derivative trading goes as far back as Greek and Roman times when derivative-like contracts were used for crop insurance and shipping purposes. In the U.S., options derivatives became legitimized under the Investment Act of 1934 before subsequently being introduced on the Chicago Board Options Exchange in 1973. Since then, the investment banks and other financial players have created other standardized derivative products like futures, and interest rate swaps.
Volcker Expands on Financial Engineering Innovation
In his comments, former Chairman Volcker specifically targets CDSs and CDOs. Volcker does not mince words when it comes to sharing his feelings about derivatives innovation:
“I hear about these wonderful innovations in the financial markets, and they sure as hell need a lot of innovation. I can tell you of two—credit-default swaps and collateralized debt obligations—which took us right to the brink of disaster…I wish that somebody would give me some shred of neutral evidence about the relationship between financial innovation recently and the growth of the economy, just one shred of information.”
When Volcker was challenged about his skeptical position on banking innovation, he retorted:
“All I know is that the economy was rising very nicely in the 1950s and 1960s without all of these innovations. Indeed, it was quite good in the 1980s without credit-default swaps and without securitization and without CDOs.”
Cutting through Financial Engineering
The witch-hunt is on for a financial crisis scapegoat, and financial engineering is at the center of the pursuit. Certainly regulation, standardized derivative contracts, trading exchanges, and increased capital requirements should all be factors integrated into new regulation. Curbs can even be put in place to minimize leveraged speculation. But the baby should not be thrown out with the bathwater. CDSs, CDOs, securitization and other derivative products serve a healthy and useful purpose towards the aim of creating more efficient financial markets – especially when it comes to hedging. For the majority of our daily requirements, I advocate putting away the dangerous cleaver, and sticking with the dependable butter knife. On special occasions, like birthday steak dinners, I’ll make sure to invite someone responsible, like Paul Volcker, to cut my meat with a steak knife.
Read Full WSJ Article with Paul Volcker Q&A
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at time of publishing had no direct position in any company mentioned in this article, including AIG. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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