07/25/2002 Structured Finance in the Crosshairs *

It was a most chaotic week in U.S. and global financial markets, with extreme volatility and extraordinary divergences here at home. Some groups rallied sharply, while the technology collapse continued. For the week, the Dow gained 3%, and the S&P500 added 1%. The Utilities gained 2%, and the Morgan Stanley Consumer index surged 8%. The Morgan Stanley Cyclical index added 1%. The small cap Russell 2000 and S&P400 Mid-Cap indices declined about 1%. The tech sector was hammered, with the NASDAQ100 declining 5%, the Morgan Stanley High Tech index 9%, and the Semiconductors 13%. The Street.com Internet index declined 9%, and the NASDAQ Telecommunications index dropped 12%. At the same time, the major Biotech index gained 3%. The financial stocks were under pressure, with the Securities Broker/Dealer and S&P Bank index declining 3%. With bullion sinking almost $25, the HUI gold index was slammed for almost 27%.

The Treasury market melt-up runs unabated, with two-year yields sinking 25 basis points to a record low 2.16%. The five-year saw its yield drop 26 basis points to 3.39%, while 10-year Treasury yields declined 14 basis points to 4.38%. The long-bond yield declined only one basis point to 5.31%. Mortgage-back and agency yields underperformed, with benchmark yields declining 4 and 10 basis points. The spread to Treasuries for Fannie Mae’s 5 3/8 2011 note widened 5 to 60. Dollar swap spreads widened significantly, with the 5-year swap spread surging 14 to 69 and the 10-year widening 12 to 66. Spreads widened significantly throughout the corporate market, with notable increases throughout the financial sector. The yield on the December 3-month Eurodollar contract sank 19 basis points to 1.84%. The dollar index gained 2% for the week.

Broad money supply (M3) increased $13.6 billion last week, with savings deposits adding $12.6 billion and retail money fund deposits increasing $2.3 billion. Institutional money fund deposits declined $1.2 billion, and repurchase agreements dipped $1.9 billion. Commercial paper outstanding increased $12.2 billion last week, of which $8.2 billion was borrowed by the financial sector. Financial sector commercial paper borrowings have increased $17 billion during the past three weeks. Financial speculation is alive and well. However, with new issuance at a trickle, year-to-date convertible issuance of $43 billion is running down 30% from last year. Interestingly, bank “loans and leases” rose about $25 billion last week, likely in response to dislocation in the Credit markets (security Credit rose almost $18 billion!).

Freddie Mac reported y-o-y quarterly earnings-per-share up 26%. The company’s total mortgage portfolio (retail and MBS sold into the marketplace) expanded at a 14% annualized rate to $1.203 trillion. Similar to Fannie Mae, Freddie chose to aggressively sell mortgage-backs into the market rather than to expand its balance sheet. With today’s heightened financial market stress, we would expect both institutions to quickly return to their “normal” operations of ballooning their balance sheets (“reliquefication”). Freddie Mac reported record low mortgage rates this week, with 30-year conventional rates dropping 15 basis points to 6.34%.

Countrywide Credit Industries reported EPS up 48% y-o-y. During the past two quarters, total assets have increased at a 25% annualized rate to $41.9 billion. The company ended year-2000 with total assets of $15.8 billion. Countrywide certainly has one of the more “intriguing” collections of assets. The company holds $1 billion of “cash,” “mortgage loans and mortgage-backed securities held for sale” of $7.4 billion, “trading securities” of $5.95 billion, “securities purchased under agreements to resell” of $4.7 billion, “mortgage servicing rights” of $6.1 billion, “property, equipment and leasehold improvements of $503 million,” “investments in other financial instruments” of $8.9 billion, and “other assets” of $7.3 billion. Looking into the detail of “investments in other financial instruments,” we see an asset “home equity line of credit senior security” valued at $3.2 billion, “principal-only securities” of $1.4 billion, “derivative instruments” of $558 million, “sub-prime AAA interest-only securities” $547 million, “home equity line of credit residuals” $323 million, “interest-only and principal-only securities” $254 million, “home equity line of credit transferor’s interest” $164 million, “subprime residuals” $56 million, “home equity line of credit AAA interest-only security” $31 million, “collateralized mortgage obligations” $1.68 billion, “mortgage-backed securities” $230 million, “Treasuries...obligations of U.S. government, corporations and agencies” $92 million, and “corporate securities” $213 million. Other assets are comprised of “mortgage loans held as investments” $2.46 billion, “defaulted FHA-insured and VA-guaranteed loans repurchased” $1.65 billion, “warehousing lending advances” $1 billion, “reimbursable servicing advances” $489 million, “derivative margin account” $316 million and other “other assets” of about $1 billion. How are these financial assets financed? The company owed “notes payable” of $16.2 billion, “securities sold under agreements to repurchase” almost $12 billion, “drafts payable” of $1.3 billion, “accounts payable, accrued liabilities and other” of $2.9 billion, “income tax payable” of $1.8 billion, and “deposit liabilities” of $2.5 billion. It is worth noting that “deposit liabilities” jumped from the year ago $675 million. Similar to the subprime lenders, we do not believe it is appropriate for such an aggressive “non-bank” to finance a balance sheet of “structured” instruments with deposits.

Countrywide’s “volume of loans produced” jumped 38% y-o-y to $42 billion, with “e-commerce loans” up 30% to $18.5 billion. We hope aggressive online mortgage lending is much more successful than the Internet Credit card fiasco. New Century Financial will provide another lending “experiment” for us to follow. This sub-prime mortgage lender originated a record $3.2 billion of loans during the quarter, double the amount from one year ago. Total assets are up 58% y-o-y to $1.5 billion. The vast majority of New Century’s borrowers have poor Credit, while more than two-thirds of this quarter’s originations were two-year adjustable rate mortgages. We don’t see how peddling adjustable rate sub-prime mortgages is a good idea today. Nonetheless, the company has been granted significantly increased Credit lines from Bank of America, UBS Warburg, and Salomon.

There was data this week that supports our contention that the surprise going forward will be the rapidity of the economy’s slowdown. We will not dismiss yesterday’s much weaker than expected existing home sales data. The National Association of Realtors reported seasonally adjusted annualized sales of 5.07 million, about 12% below both May’s sales and June’s expectations. This was the weakest reading since September, and down 4.3% y-o-y. Keep in mind that May’s sales were up 6.3% y-o-y. The slowdown was broad-based, with m-o-m sales down 11.8% in Northeast, 13.6% in the Midwest, 7.3% in the South, and 16.1% in the West. The supply of homes available increased from 4.5 to 5.2 months. Not since May of 1998 has the months supply of home inventory been higher.

We will now be watching the vulnerable California real estate Bubble with added attention. While median prices set another record ($324,370, up 21.3% y-o-y), the number of sales during June declined 13.9% from May. Condo prices declined 2.6% during the month, with sales dropping 14.7%. The Mortgage Bankers Association’s weekly refi application index last week surged almost 30% to the highest level since November. Interestingly, however, the purchase application index declined almost 7% to the lowest level in eight weeks. The index of adjustable rate mortgage applications rose to its fourth record of the year, comprising 18.5% of total applications. It is our sense that we have now passed the manic stage of the mortgage finance Bubble. It is worth noting that the 325,000 available new homes to be sold is the highest number since December 1996.

We would also pay special attention to yesterday’s dismal report on Durable Goods Orders. With expectations of a 0.6% increase, the actual report was reported down 3.8%. The detail is even more discomforting than the headline number. This was the largest drop in new orders since November, and comes at a critical time with hopes running high that a sustainable increase in business spending had commenced. With our focus on the troubled Credit system and contracting Credit availability, we are of the view that there is much worse to come. Looking through the data, “Ex-defense new orders” were down 4.8%, with “machinery” orders down 6.7%, “computers, products” down 7.1%, “communications” down 12.9%, “transportation” down 5.6%, “motor vehicles” down 3.4%, “nondefense aircraft” down 46.8%, and “capital goods” down 6.2%. “Unfilled orders” declined to the lowest level since December 1996. Earlier in the week, the ABC News/Money Magazine index of consumer confidence dropped three points to negative 11, the lowest level since February. Looks like the start of recession.

July 25 – “Moody’s Investors Service changed the outlook of all of the long-term ratings of J.P. Morgan Chase & Co. (senior unsecured at Aa3) and its subsidiaries to negative from stable. The outlook change reflects Moody's concern about asset quality within J.P. Morgan Chase's wholesale banking portfolio. Credit risk concentrations may lead to increasing credit expense, potentially pressuring net income. Particularly worrisome concentrations are the troubled sectors of telecommunications, media and technology, and within the merchant energy industry. J.P. Morgan Chase's management has pursued a strategy of leveraging its commercial banking franchise to build its position in investment banking. This strategy is falling short of expectations, as evidenced by relatively weak income performance by the investment bank in the second quarter. Given recent problems in financial markets, and the sharp downturn in wholesale activities, successful execution of this strategy will be even more challenging, the rating agency says. Moody's says that J.P. Morgan Chase might also suffer damage to its image and reputation, as well as higher legal expenses and litigation settlement costs, resulting from its role in Enron and other high-profile corporate defaults. This may hinder the business momentum and ongoing profitability of the investment bank, even when markets recover.”

July 25 Business Wire – “Standard & Poor’s today lowered its rating on the class A tranche of Bistro 2000-7's credit derivative CDO. The downgrade reflects the valuation prices of previously defaulted reference credits as well as credit deterioration in the $6.726 billion pool of reference credits. The notional amount of the reference pool has been reduced as a result of the defaults. The downgrade also reflects the level of credit enhancement provided by subordination, Bistro 2000-7's ability to meet its payment obligations as issuer of the notes, and its commitment to follow strict guidelines established for maintenance of the pool of reference credits.”

JP Morgan was instrumental in developing sophisticated Credit default “structured transactions,” with the development of its BISTRO product back in 1997 (convenient for the imminent telecom debt Bubble!). From JP Morgan’s website: “JP Morgan's BISTRO product is a synthetic CLO [collateralized loan obligation] where risk transfer is achieved via a credit default swap on a large portfolio of reference entities rather than through a sale of the specific assets. This allows banks to buy credit protection to mimic the regulatory capital treatment of a traditional securitization while preserving its competitive funding advantage. Specifically, an originating bank buys protection from JP Morgan on a portfolio of exposures via a portfolio credit default swap and JP Morgan, in turn, purchases protection on the same portfolio from the BISTRO SPV [special purpose vehicle]. The originating bank provides credit enhancement through retention of the first loss risk. The BISTRO SPV is collateralized with government securities that it funds through the issuance of notes, whose notional is substantially smaller than the notional of the reference portfolio. The BISTRO Notes are credit-tranched and sold into the capital markets.”

Back in 2000, Asia Risk Magazine rated JP Morgan “Best Credit Derivative House” and Risk Magazine chose the company “Credit Derivatives House of the Year.” From the January 2002 issue of Risk Magazine: “JP Morgan Chase was hard to ignore in 2001. With total notional derivatives positions of $24 trillion, and a one-day 99% trading book value-at-risk of more than $90 million in late December, the bank continues to dominate the derivatives market. According to co-head of credit and rates Bill Winters: ‘We’ve taken more risk this year than we have in other years, and we’ve done well on it.’”

Other notable quotes from this article: “There is something about the kinds of deals that JP Morgan does in interest rates and currencies that makes its clients want to talk – a degree of cleverness and audacity that, one suspects, they don’t find forthcoming at other dealers...” “JP Morgan never says no to a trade.” “But it was the way JP Morgan exploited a clever loophole in US derivatives accounting rules that really impressed Baxter’s assistant treasurer.” “JP Morgan’s FASB-busting solution...The beauty of this arrangement was that it was covered not by hedge accounting rules, but by investment accounting, which did not require a mark-to-market during the interim.” “In the hedge fund community, the face of JP Morgan Chase is that of an eager facilitator, particularly for convertible arbitrage, where the effect of credit swaps as hedging tools has been nothing short of revolutionary...Using default swaps, hedge funds have taken over the convert market...”

Well, only time will tell as to the extent of the unfolding derivatives fiasco, but it is clear today that this sordid historic episode of financial “fun and games” is coming to an end. The rules of the game are changing – Wildcat Finance is on its way out - with enormous ramifications for the U.S. financial system and economy. With politicians now hot on the trail, Structured Finance is truly in the Crosshairs. It is, at the same time, worth noting that Marc Shapiro, head of JP Morgan Finance and Administration, stated on CNBC Wednesday morning that Structured Finance was the “linchpin of the American economy.” We, unfortunately, must concur.

July 23 Bloomberg (Robert Williams): “Citigroup Inc. and J.P. Morgan Chase & Co. shares plunged, erasing $58 billion in combined market value this week, as the banks disputed allegations in Congress that they helped Enron Corp. hide debt. As lawmakers charged the two largest U.S. banks with deceiving investors in financing the bankrupt energy trader, bank executives insisted they had done nothing wrong. The transactions were ‘standard practice in structured finance,’ said Jeffery Dellapina, managing director at J.P. Morgan Chase Bank. Rick Caplan, a Citigroup managing director, said Enron financings were arranged for a top U.S. company, using a common structure approved by a leading accounting firm.”

“The congressional hearings may help Enron shareholders, bondholders and employee pension funds in civil litigation against the banks alleging fraud and claiming as much as $36 billion of damages... Congressional investigators allege Citigroup and J.P. Morgan helped Enron disguise loans as commodity trades and skirt legal and accounting requirements through so-called prepay transactions. They ‘knew what Enron was doing, assisted in the deceptions and made money from their actions,’ said Senator Carl Levin...”

“Under prepay arrangements, the financing is booked as deferred income and recognized once the underlying commodity such as oil or natural gas is delivered. With Enron, Citibank and J.P. Morgan Chase created third party entities to help the company make the transactions look like cash flow from energy trades, investigators said. Lawmakers questioned bank executives on the independence of an offshore entity, Mahonia Ltd., created and controlled by J.P. Morgan to participate in trades with Enron and other of the bank's clients, Levin said. It had no employees, office or independent business operations and was run by a paid agent of J.P. Morgan, he said. ‘In fact it was a shell,’ Levin told J.P. Morgan executives. ‘This goes to the heart of the deception.’”

“Levin questioned J.P. Morgan executives on an e-mail written by George Serice, a vice president in the bank's global syndicated finance department, that read in part: “‘Enron loves these deals as they are able to hide funded debt from their equity analysts because they, at the very least, book it as deferred revenue, or better yet bury it in their trading liabilities.’”

From Thursday’s American Banker (Rob Garver): “...‘They (J.P. Morgan Chase and Citigroup executives testifying before the Senate subcommittee on investigations) could not have done any worse,’ said one Washington insider... ‘Their current message is totally unbelievable: ‘We are not accountable for the accounting treatment here, it is not our job.’ That’s as believable as 2 plus 2 equals 5...They have just guaranteed that they made a bad story worse. There will be more questions asked, more documents subpoenaed. It will be drip, drip, drip of information. Sound familiar? It’s called ‘scandal’ in Washington. The only way to beat it is to get out there and tell the truth.’”

“In a moment reminiscent of 1994’s tobacco industry hearings, when executives were forced to swear that that they did not believe cigarettes are addictive, a trio of J.P. Morgan Chase executives told the subcommittee Tuesday that their bank had never had control of Mahonia, a controversial partnership implicated in the collapse of Enron... If the bank asked its outside attorneys to create a partnership called Mahonia; if all of Mahonia’s legal fees were paid by the bank; if the partnership never did any deals that didn’t involve the bank; and if bank executives discussed ways to make sure that Mahonia ‘seems independent,’ could they reasonable claim that the bank did not control Mahonia? One by one the three Morgan Chase executives...insisted that despite its ties to J.P. Morgan, the Channel Islands-based Mahonia entered into prepaid energy contracts with Enron of its own accord, and could have declined to enter those contracts if its board of directors so chose.”

“Sen. Levin then delivered an impromptu lecture on corporate responsibility. ‘You continue to repeat that you believed it was independent despite overwhelming evidence that you control it,’ he said. ‘The evidence we were able to obtain dramatically demonstrates that Mahonia was created by Chase, controlled by Chase, run by Chase’s agent, [had its] fees paid for by Chase. Yet, you sit here and repeat the mantra ‘we believe it was independent.’”

Representatives from Citigroup then followed those from J.P. Morgan. “They faced equally tough questioning from Sen. Levin, who rolled out similar circumstantial evidence indicating that Delta Energy Corp., a special-purpose vehicle similar to Manhonia, was actually under Citigroup’s control. In the undisputed low point of the hearing, a Citigroup executive was reduced to answering Sen. Levin’s charges by claiming that whether they were correct depended on how the word ‘deceptive’ is defined.”

We certainly don’t expect any pleasant surprises as other rocks are discovered and turned over. This is one ugly unfolding mess that is most unfortunate for the largest derivative and “Structured finance” players, the U.S. financial system, and economy. Like the unfolding economic dislocation, this legal quagmire will drag on for many years to come.

Yesterday Bloomberg ran a story “Prince Alwaleed Has No Plans to Buy More U.S. Shares.” The wealthy Prince made a fortune taking a large stake in Citibank back in the depths of the early nineties banking crisis. He has in the past profited handsomely from buying after declines. The Prince recently announced that he had purchased another $500 million of Citigroup stock, as he adds to his huge losses in AOL and Priceline, among others. Not appreciating the unfolding environment, the Prince shot his bullets much too early. In this regard, he has much in common with Alan Greenspan.

I was reading Credit market research this week that mentioned that the recent dramatic widening of financial sector and other spreads in the past marked a point of central bank intervention (interest rate cuts). Systemic stress this week reached such extremes that nothing would now surprise us.

But it is today important to appreciate that Greenspan has lost control of the Credit system unlike at any time during his extended term. While the banking system struggled in the early nineties under its worst crisis since the Great Depression, Greenspan was content to look the other way as Wall Street and the GSEs took dominant control of the Credit mechanism. With each subsequent financial crisis, Alan Greenspan was quick to act aggressively in the best interests of Wall Street and the leveraged speculating community. He maintained at all times the power to keep the Bubble expanding. He was king, his power absolute, and he meted out his favors on the likes of JP Morgan and Citigroup. But the environment has changed profoundly. Financial regulators are now moving aggressively on their own accord, perhaps aghast at the Fed’s reckless permissiveness and negligent lack of leadership. Meanwhile, politicians are keenly focused on their clamoring constituents. “Wanted: Dead or Alive,” anyone associated with Enron, WorldCom, or any of the other corporate crooks. The public is sour and wants justice. Importantly, “Structured Finance” is in the process of being unearthed as a critical part of the problem. The risk markets will never be the same.

Measures of stock market risk (volatilities) and many Credit market spreads blew out this week to the widest levels since September 11th and the Russia/LTCM crisis back in October 1998. Wednesday’s dramatic stock market recovery and the dollar’s resurgence held financial dislocation at bay. We can’t help but to think there is today very much riding on the performance of the dollar. Similar post-Bubble crises that wrecked havoc on other financial systems (and economies) invariably led to collapsing currencies. Hopefully the dollar will prove the exception, but we certainly haven’t seen much in the way of fundamental developments that support a bullish view. With the U.S. Credit system in disarray and the economy at the brink of The Great Recession, the dollar will be vulnerable for some time to come.

In conclusion, I will make a general comment on the stocks of JP Morgan and Citigroup. We are certainly not surprised that these stocks have suffered huge declines. However, we find it most disconcerting that this amount of damage has been done so early in the down cycle. After all, we have barely passed the peak in the mortgage finance Bubble, there has yet to be any meaningful de-leveraging in the highly speculative Credit market (agencies and mortgage-backs!), and consumer spending is basically at record levels. While the dollar has declined somewhat, there has yet to be anything remotely resembling panic selling, and the general economy is not that weak. And, importantly, interest rates are at historically low levels. For those that would like to believe we have now experienced the worst of this financial crisis, I can only say I hope you are proved correct. I, however, fear we remain quite early in the adjustment process. We expect the surprise going forward will be a newfound cautious consumer and much more nervous lenders. These are the ingredients for recession – not a “double-dip” but The Great Recession. Thus far, the U.S. consumer has repeatedly exhibited a Pavlovian response to Washington and New York’s “confidence game.” But, like the Prince’s stock purchases and Greenspan’s rate cuts, we think the confidence trump card has been played too early, too often, and much too aggressively. This is not the type of environment conducive to confidence for consumers, businesspersons, or lenders. Retrenchment has, regrettably, been postponed one time too many.