The great uncertainty about the value of subprime mortgage-based securities both to investors as assets and to lenders as collateral heightens market fear. How can positions be marked to market when there is no active market? What does value mean when there are few or no bids? Should positions be marked to fire-sale prices? What happens if everybody does that at the same time and numerous insolvencies result? (Alex Pollock, Resident Fellow, AEI, FT, Letters, 09/10/07)
First we note with sadness the passing of Frank Fernandez, 53, who succumbed unexpectedly to complications following heart surgery. A reader of The IRA, Fernandez was chief economist and director of research for the Securities Industry Association for almost a decade and one of the best informed market observers around. When our nation's leaders, in Washington or elsewhere, wanted to know what was happening in the financial markets, they called Frank. He will be greatly missed.
Within the financial community, thoughts about mortality have become more common in recent weeks, prompting a number of comments about the state of various financial institutions and their likelihood of failure. Our friend David Kotok of Cumberland Advisers, for example, worries in his usually upbeat missive that the Fed's decision to waive Section 23A of the Federal Reserve Act (Reg W) and allow Bank of America (NYSE:BAC), Citigroup (NYSE:C), and JPMorgan Chase (NYSE:JPM) to make large loans to their broker dealer units may be a sign of impending trouble.
Kotok sees these loans, which are apparently to support collateralized debt obligations ("CDOs"), as an indication of mounting liquidity problem among the larger Sell Side shops, this despite the highly publicized efforts by the Fed. Click here to read the Fed's letter to BAC.
Section 23A is one of the most important parts of the Federal Reserve Act. It prohibits "covered transactions" with any one affiliate of a Fed member bank in excess of 10% of the bank's capital and surplus, and up to 20% in aggregate for all bank affiliates. The purpose of the section is to protect the capital of the bank, even if that means allowing non-bank units or the parent holding company to be decapitalized or even fail in a "market resolution."
The problem facing the US markets is a lack of liquidity available to finance CDOs and other types of complex structured assets containing subprime or non-conforming mortgage paper, and other types of loans and derivatives, an asset class totaling well over $1 trillion. As we've been saying for some time now, the relationship between the hedge funds which temporarily own this illiquid paper and the prime brokers who finance same and are the true, economic owners, is under growing pressure.
Simply put, a sale of securities to hedge funds which use leverage to support the position clearly does not constitute "good placement." The valuation fiction supported by many Sell Side margin loans to hedge funds grows more difficult to support with each passing day. More, we wonder when regulators and the Big Media will accept that much of the liquidity problem facing the markets stems from the nature of structured assets themselves and not a temporary crisis of confidence.
"Many of the brokers who sold paper to hedge funds and other agents had to offer some type of 'put' or other liquidity provision to the buyer," Kotok writes. "The broker was interested in the underwriting fee and commissions so it agreed to the terms in order to make the sale. At the time the broker's mathematical models indicated that this was a minor risk."
"All that has changed," Kotok continues. "Now the hedge fund has a demand for cash from its investors who want to get their money out. The hedge fund has used its lockout period to delay payment to its investor. Those lockouts are starting to run out of time. The hedge fund will have to raise cash. It doesn't want to be forced into selling the security in a market which will penalize it severely. Instead the hedge fund will activate the liquidity provision in its contract with the broker. Now the broker has a problem and the liquidity demand has transferred from the hedge fund to the broker."
The Fed's August 20, 2007 letter to BAC allows the lead bank to extend up to $25 billion in collateralized loans to affiliates, an amount equal to 30% of the bank's regulatory capital. The "securities financing transaction" will effectively allow the securities affiliate of BAC to "serve only as a conduit" for the bank to lend to "unaffiliated third parties." The letter notes at the bottom of Page 3 that any such loans will be eligible for excemption from the automatic stay in the US Bankruptcy Code, a comforting legal distinction that may have little impact on the increasing rancid economics of financing CDOs.
Since we are talking here about the possible bankruptcy of a bank holding company, an event which as not occurred in decades, and since several readers have asked us to elaborate on the "in the bank" phrase made so memorable by Countrywide Financial Corp (NYSE:CFC) Chairman Angelo Mozillo, let's outline the issue with an example or two.
At the end of 2006, CFC had total consolidated assets of about $200 billion (and averaged $220 billion during the year), including the $99 billion assets of CFC's bank unit, Countrywide Bank FSB. The table below shows the consolidated assets and capital of CFC at year end 2006, the bank unit, and CFC on a "parent only" basis, excluding the FDIC insured bank, in millions of dollars.
Looking at table, you can see why Mr. Mozillo is trying so hard to push the remaining CFC businesses back "in the bank," reversing the move of several years ago to increase parent-level leverage when he converted his former national bank to a thrift charter. This fact of parent-company leverage explains why nobody in the financial markets wants to lend money to CFC -- or any financial holding company with significant exposure to real estate, especially subprime, or complex structured assets like CDOs or the hedge funds which own them. Creditors today demand that the FDIC-insured bank be the counterparty in any transaction.
For example, were CFC to take a significant loss on loans or other assets currently held at the parent level, the public shareholders of CFC could not "raid the bank" to offset such loss -- and instead could face a fire sale or even bankruptcy. Indeed, this is precisely the situation envisioned by the Congress when Section 23A was enacted into law, to prevent the non-bank affiliate of a bank from causing a bank failure and thus a loss to the FDIC.
So, for example, were CFC to become unprofitable and eventually suffer a $5 billion loss due to loan losses or, even better, an unforeseen loss from a complex structured financial transaction, the parent's $7 billion in capital would be seriously impaired. In the event, the FDIC, using its power as receiver of the insured bank, might then intervene, either extending an emergency loan to facilitate a sale of CFC's bank unit or even taking over the bank to safeguard depositor funds (not to mention $30 billion in FHLB advances).
The latter course would leave CFC crippled and facing default, but without the assets of the insured bank as part of the bankruptcy estate. Such a scenario gives new meaning to the term "loss given default." Just remember that as and when a bank or thrift holding company files for bankruptcy protection, the FDIC will probably already have taken over the insured bank.
Let's look at BAC on the same basis, first at the consolidated parent BAC, then the bank only roll-up calculated by the IRA Bank Monitor for the insured bank subsidiaries, and the parent only as of June 30, 2007, again in millions of dollars. (*Note: The consolidated Tier One Capital for BAC includes $11 billion in valuation losses on available-for-sale equity securities and cash flow hedges as of June 30, 2007.)
Once you take the subsidiary banks out of the equation, BAC does not look nearly so attractive as it does on a consolidated basis. Indeed, on a parent-only basis, CFC looks a lot better than does BAC! Maybe Mr. Mozillo should be putting $2 billion into BAC? But neither bank has a particularly large capital base compared with the inflated risks swirling around the derivative marketplace.
With just $7.7 billion in parent only capital and $107 billion in non-bank assets (excluding the $200 billion invested in or due from bank affiliates), BAC's parent only balance sheet would barely support the $25 billion loan limit for advances by the lead bank, Bank of America NA, which had Tier One capital of about $77.7 billion at June 30th.
So, worst case, let's imagine hypothetically that BAC sees profitability disappear this year and that the lead bank takes a $5 billion loss on one of these pass-through loans made to the hedge fund clients of BAC's broker-dealer, some 27 year-old heggie with a "AA" rated CDO nobody wants at any price. And $5 billion is a mere 20% of the total allowed under the Fed's letter. Remember, the Fed's letter allows BAC's lead bank to make loans on any CDO or other complex structured asset so long as it carries a rating and subordinates BAC's interest to that of the insured bank affiliate.
Such a loss, if it occurred, would leave BAC badly decapitalized, a situation that the subsidiary banks could not act to repair thanks to Section 23A. In the event, BAC would almost immediately be placed under a prompt corrective action by the Fed et al., would face a severe credit downgrade by the major agencies, and might be forced to sell assets to raise cash. At a minimum, BAC could not pay any dividends to common shareholders until it had rebuilt its parent-level capital.
So now you know why Mr. Mozillo prefers to be "in the bank" and why investors are wary of doing businesses with bank holding companies, broker dealers and other thinly capitalized, publicly listed non-bank corporations which use leverage to support their risk-taking operations and lend money to hedge funds. The message from the markets is "flight to quality," which is another way to say "in the bank." More on this subject soon.