Christopher Flower’s short memory

I play in bank stocks.  Christopher Flowers is a name I see again and again.

He is a private equity guy - and he buys banks.  Big banks.  Lots of money.  And superficially that is appealing from a policy perspective.  After all private equity (Carlyle, Flowers, Cerberus et al) have capital and the government is usually pleased when new private capital comes into banks in the height of a banking crisis.  The issue was played in the New York Times (hat tip to and some decent analysis from Felix Salmon).  

Its just that private equity make very unsuitable owners for a bank.  Frightfully unsuitable.

The problem is that banks take guaranteed deposits (or at least deposits that need to be bailed out if the bank is insolvent) and private equity owns a whole lot of levered buy-outs and the like.  And if a small private equity firm owns a bank it could become a large private equity firm by lending to related parties.  There are very few entities as complicated and with as many conflicts as a large PE firm borrowing money from banks they control.

Mr Flowers puts his case in the New York Times article:

“I don’t think the Republic is going to be brought to its knees if private equity owns banks, personally,” Mr. Flowers said from his Midtown Manhattan office with its expansive views of Central Park. “We invest around the world — Japan, Germany, England, no problem.” 

Effectively he says the conflicts can be managed.

Well – if you really want to be sure of that just go have a look at the results of Shinsei and Aozora.  These were Japanese banks with controlling stakes from Flowers and Cerberus respectively.  When Aozora floated it had made very good profits by investing in other American private equity ventures.  

Flowers also invested in relatively risky structures in the US and Europe through his effective control over Shinsei.  Indeed the memory is very short – this Bloomberg article talks about Shinsei’s and Aozora’s recent results in the light of this conflict of interest.  It seems the bailout of Japan’s banks last time caused a sowed the seeds for another round of problems in Japan’s banks.  The New York Times alludes to this conflict of interest – but the conflict of interest has been around a long time – in good times and bad.  Aozora’s float – laden with what were then private equity profits – was years ago.  These guys are hardened professionals at conflict of interest in banking.

Or as the Bloomberg article puts it:

Shinsei racked up profits in its first six years under foreign ownership. The bank gave funds to J.C. Flowers to invest and had no discretion where Flowers placed the money, Flowers said. Neither Shinsei nor Flowers would give the amount.

The New York Times notes that the Federal Reserve strictly controls who can own a bank – and for good reason.  They also note that Mr Flowers has hired top tier Washington Lobbyists to try to get regulatory changes that suit him.  

If he manages to get Washington to listen to him then I fear for your republic.  This might not – as Mr Flowers notes – bring the Republic to its knees – but it is another step on the way to lemon socialism owned and controlled by the plutocracy.

J

Muddling through – why the American banking system will not turn Japanese – Part II

Welcome again to TPM readers.  My first post on TPM got more comments than the average post on my own blog.  And because the goals of the readership (policy/politics versus investing) are different I get a different perspective in the comments – which I find valuable.  

In the last post I described an absolutely typical Japanese regional bank (77 Bank).  The bank had massive excess deposits.  The marginal cost of funds to the bank was about 10-15bs and almost all of that was deposit insurance fees.

The place was awash in cheap funding (deposits).

Well somewhere in my economics undergraduate degree (like the first week) I learnt that marginal costs tend to determine the price of things – and yet I see lots of fairly big name macroeconomists forgetting this.

In banking the biggest single determinant of the price of a loan is the marginal cost of funds.  Its not the average costs of funds that matters – it is the marginal cost.

Loans are usually quoted in spreads – which is spreads over some index (swaps, treasuries).  But in almost all times the spreads are a (under) a few hundred basis points and the biggest determinant of the rate is the risk free rate not the spread.  

Now in a land where the banks are awash in funding the marginal cost of funds is pretty close to zero.  Welcome to Japan.  

But American banks are not awash in funding – and given the profligacy (especially historic) of the American consumer – not to mention tax cut funded Iraq wars and the like – the US financial system is almost always going to be an importer of spondulicks.  That might change in twenty five years – but it is not changing now.  

Because American banks – at the margin – are simply not awash in funding the marginal funding will be expensive – whereas in Japan the marginal funding is cheap.

And because of that loans will be expensive.  They will always cost at least a few percent (whereas in Japan you can often get mortgage funding for less than one percent).  

Now the average cost of bank deposit funding will not necessarily be high.  Banks with large deposit franchises (such as Bank of America) have a lot of very cheap deposits.  At Bank of America the interest free deposits are almost 250 billion dollar.  The marginal funds are expensive – the average funds may not be.  Loan spreads at the margin may be low one day (not yet) but loan spreads on average will remain healthy.

Banks in America have – at least by Japanese standards – very fat margins.  Wells Fargo has the fattest margins of pretty well any major bank in the world (which is why Warren Buffett likes it so much).  I have previously written about the large and increasing revenue of Bank of America here (and other places).  

The high levels of revenue are what is recapitalising the American banking system.  It is why the American system will muddle through and be right again within a couple of years.* Whereas the low revenue in Japan (resulting in 3% returns on equity in fully capitalised banks without credit losses) means that recapitalisation takes decades.

Now the banks can’t muddle through in America without government support – and they could not muddle through in Sweden or Korea or any other funding short country with collapsed banks without government support either.  The reason is that the government support is necessary to raise the funds that the banks are (at the margin) short of.  The crisis is precisely when the market no longer trusts the banks with funds without a government guarantee.  But provided they get that government support they recapitalise nicely.  Even in extreme cases like Norway where the banks were largely nationalised the government wound up making a profit on the bailout.  [The nationalised banks were guaranteed.]

In Japan by contrast the banks were desperately insolvent – but for the large part they did not need government support.  Why?  Because they had excess deposit funds and it is very hard to go bust when you are awash with cash.  You can however stay a zombie for decades because you do not have enough profit to recapitalise yourself (of to deal with small losses which are inevitable in banking).  

It’s a paradox… the banking systems that are short of funding (such as America, Scandinavia, Korea and Thailand) have the highest need for government support in the crisis and the greatest prospects to muddle through without being zombies five years hence.  

The policy question is how much government support the banks should get and for what fee to the government.  One view (sometimes expressed on this blog) is that real capitalists nationalise.  The returns should – in a capitalist system – go to the party that takes the risk.  With government support that party is the taxpayer – and the returns should thus go to them.  That is what the real capitalists in Norway did.

But in Sweden some banks were supported without being nationalised – and private shareholders did very nicely.  Most countries wind up with a combination of public support for private shareholders and nationalisation.  (In Korea for example Woori is a combination of banks that were fully nationalised whereas Kookmin is by and large a combination of banks that were only partly nationalised.)  

That said – the US government policy is to support the banks largely without taking ownership (Citigroup excepted).  If they keep this policy (and there seems little doubt that they will) then the banks will recapitalise over time through their very high revenue bases.  Bank shares will – in most cases – recover.

Sure the taxpayer takes the risk without getting (much) upside.  Its lemon socialism – take the risks and the losses at the taxpayer level – and given the full benefit of the bank revenue expansion to shareholders.  It is not a great policy.  I do not approve – but I approve more than I might otherwise because I am an Australian (and hence not an American taxpayer) and I managed to buy some Bank of America shares real cheap.

And for that, this non-American taxpayer thanks you.

Disclosure: still long BofA.  It goes back to its all time high market capitalisation – and if they manage to avoid too much dilution (ie new share issuance at low prices) then it will go back somewhere near its all time high stock price.

John

*Muddling through within a couple of years may not be a desirable macroeconomic outcome (though it may be a good political for Democrats because the system will come good for the next Presidential cycle).  In Korea the recession was great-depression deep.  But the system came through.  Countries that dealt with problems quickly (by a combination of nationalisation and full bank guarantee) tend to deal with the macroeconomic crisis better (though sometimes at the expense of bank shareholders).  

PS.  The really observant will notice that both Kookmin and Woori have English language websites whereas 77 Bank does not.  The reason is that the Korean banks need to raise money - and they thust must talk the language of capital markets (English) whereas 77 Bank is awash in funds and can afford to speak Japanese only.

Why American banks will not wind up looking like Japanese banks - Part 1

I have to welcome a few readers from Talking Points Memo.  They are reproducing my posts at least to the extent that they go to explaining banks and the financial crisis to a policy/politics driven audience.  Given the purpose of the Bronte Capital blog is primarily to explore investment ideas the policy/politics wonks at TPM might find my posts a little odd.  [My purpose is largely to make lots of money.]  

Nonetheless I do have things to say which I think are important from both an investment and a policy/politics perspective.

To this end I want to explain why I do not think the American banking system will wind up looking like the Japanese banking system at the end of this crisis – and what the implications of that are both in a policy and an investment sense.  

To start with thoguh most American readers have no idea what Japanese banks look like.  So I will repeat the second substantive post on this blog – a post which looked at 77 Bank – a regional bank in Japan.  

Next week I will do a post which explains why American regional banks will not look like 77 Bank at any time in the next twenty five years.  So enjoy a post that is almost a year old.  I have annotated it where appropriate.

Old post - originally titled "Japanese regional banks - a mirror on America"

77 Bank is a regional bank in Sendai (the capital of Miyagi prefecture). The Japanese guys I know think of Sendai as a backwater – a place where the “cool guys” hang out on motorcycles wearing purple clothes. Economically it is just another rapidly aging backwater where the young (other than those that hang out on motor cycles wearing purple clothes) are moving to Tokyo.

The name 77 Bank harks to tradition. During the Meiji restoration the Emperor gave out numbered bank charters. Traditional regional banks still label themselves by the number. www.77.co.jp and many other numbered sites belong to banks.

77 Bank has a very large market share (near 50%) in Sendai. The market is more concentrated that the great oligopoly banking markets of Canada, Australia, Sweden etc. It should be profitable – but isn’t.

Here is its balance sheet:

(click for a more detailed view).

Note that it has USD42.6 billion in deposits. This compares to $35.8 billion for Zions Bancorp – as close to an American equivalent as I can find.  [Disclosure - I had been short Zions Bank at various times - but not for the great collapse in its local commercial property market.  I lost money.  I thought Zions modestly risky - but it wound up very risky.]

77 only has USD26.4 billion in loans though. If you take out the low margin quasi-government loans it probably has only USD20 billion in loans.

This bank seems to be very good at taking deposits – but can’t seem to lend money.

This is typical in regional Japan. It is also a problem – because when interest rates are (effectively) zero the value of a deposit franchise is also effectively zero.

So – guess what. It sits there – just sits – with huge yen securities (yields of about 50bps) doing nothing much.

It’s a big bank. It has next to no loan losses because it has no lending.

Here is an income statement:

(click for a more detailed view)

Profits were USD87 million on shareholder equity of 3251 million. You don’t need a calculator – that is a lousy return on equity for a bank without credit losses.

You might think that given that they have no profitability and no lending potential they might be returning cash to shareholders. Obviously you are new to Japan. Profits are 27 yen per share and the dividend is 7 (which they thoughtfully increased from 6).

In a world where banks everywhere are short of capital 77 bank is swimming in it. Here is the graph of capital ratios over time:

This bank has an embarrassment of riches – and nothing to do with them.

Welcome to regional Japan.

An American Mirror

The title of this post was “An American Mirror”. And so far I have not mentioned America.

America is a land with little in deposits and considerable lending. There are similar lands – such as Spain, the UK, Australia, New Zealand and Iceland.

There are also mirror image lands – 77 is our mirror image.

Macroeconomic investing calls

We live in a world with considerable excess (mostly Asian) savings. Banks with access to borrowers made good margins because the borrowers were in short supply. Savers (or banks with access to savers) were willing to fund aggressive Western lenders on low spreads.

77 Bank has been the recipient of those low spreads. It has not been a fun place for shareholders as the sub 3% return on equity attests.

The economics of 77 Bank (and many like it) will change if the world becomes short on savings. There is NO evidence that that is happening now – and so 77 Bank will probably remain a lousy place for shareholders.  

The market produces what the market wants

This is an aside really. We live in a world with an excess of savings. This is equivalent to saying that we live in a world with a shortage of (credit) worthy borrowers. So we started lending to unworthy borrowers – what Charlie Munger described as the “unworthy poor [whoever they might be] and the overstretched rich”. We know how that ended.

Unfortunately the financial system cannot make worthy borrowers. It can only lend to them when it can identify them.

This Subprime meltdown heralds the death (for now) of lending to the unworthy. The shortage of the worthy however is as acute as ever – and money for the worthy is still very cheap.  [Money for the worthy is now difficult to obtain (at least outside Fannie/Freddie space), but still relatively cheap once obtained.]

The subprime meltdown does not solve 77’s problems.

John

One year later postscript:

The basic call that the global savings glut was not going away was right.  The global glut of savings - which found its way into endless dodgy subprime mortgages and other problem loans - still exists.  Chinese people still save to excess.  Americans are saving more.  The fundamental imbalance that drove the world financial crisis is still there.  It is not obvious how that is fixed.  

Japanese banks however have found that low margins are particularly dangerous - as there is little profitability to offset losses (even small losses).  And Japanese banks are now having losses.

How might the BofA stress test work

THERE ARE ALL SORTS OF THINGS WRONG WITH THIS POST.  BEST IGNORED.  LEFT FOR POSTERITY...

There is a joint press release from the Tim Geithner, Ben Bernanke, Sheila Bair (who I think really deserves to be in this company) and John Dugan (who is always wondering what he is doing in this company).  It outlines the stress test.  You can read it (word for word like me) if you are into self flagellation.

But here is the guts of it:

The bank must be able to have 4% tangible common equity and a 6% tier one ratio by year end 2010 in the adverse macro (that is stress) circumstance.  At bank of America there is plenty of preferred shares (both government and privately issued).  So the only constraint that matters is the 4% tangible common equity ratio.

The 19 Bank Holding Companies (including BofA) don’t need to meet the 4% test now – they only need to have enough capital now that they will in an adverse circumstance meet the 4 percent test later.  In other words when counting the losses that they might have in an adverse circumstance they are also allowed to count the earnings they will receive in the adverse circumstance.

That is good for a few banks.  Bank of America doesn’t meet a 4% tangible capital ratio now.  Not even close.  But its revenue is rising fast and it will be allowed to count three more quarters of revenue in its calculation. 

Unfortunately they are not allowed to count anticipated near term increases in revenue (they are having them and in adverse circumstances bank revenue typically goes up).  Presumably they are allowed to count revenue (net of “abnormal” trading gains and losses) at the run rate that they generated it in the first quarter – which is – as noted elsewhere on this blog – is a record.. 

There does not seem to be a provision against counting near term changes in pre-tax pre-provision earnings derived from cost changes.  That means that Bank of America should be able to count the cost synergies but not the revenue synergies from the Merrill Lynch merger.  That is about 6 billion per year – but probably only next year.
If a bank does not pass a stress test there are a few capital management options that are not open.  The most important is to shrink the lending book.  The stress test must be able to met whilst maintaining lending at prudent levels to keep the economy ticking along.  I guess the government doesn’t want to discourage a crash by forcing lending down.  They can however meet the tests by selling assets or raising third party capital or even (as is the shareholder’s greatest fear) by turning the preference shares that the government owns into new mandatory convertible preference shares as per the last Citigroup bailout.

Well everyone “knows” that the BofA shortfall is 33.9 billion.   That number has been leaked widely – and is so precise that it would be embarrassing for the journalist to get it wrong.

Anyway I want to have a little think about what that number means…

Here is the balance sheet of BofA

 

The company has a total balance sheet of 2,322.0 billion – but only 977.0 billion of loans (less after provisions).  By the time you add in an investment bank you get an awfully big number of assets (trading and other).  But 86.9 billion in goodwill and 13.7 billion is other intangibles.  The tangible assets are thus 2221.4 billion.  4% of this is 88.9 billion. 

The shareholder equity is 239.5 billion but you need to subtract off the same intangibles.  You then wind up with 138.9 billion in tangible equity.  There is a whack of preferreds (including TARP) and you have 65.6 billion of tangible common equity.  Prima facie the company has 65.6 billion in tangible common equity.  The bank is prima facie short 23.3 billion of capital.  I have put this in the following spreadsheet. 

 Summary

Balance sheet data in billions Total assets 2322.0 Goodwill 86.9 Other intangibles 13.7 Tangible total assets 2221.4 4% of this is  88.9 BofA shareholder equity 239.5 Goodwill 86.9 Other intangibles 13.7 Tangible equity 138.9 Preferred stock (including TARP) 73.3 Tangible common equity 65.6 Current tangible common equity ratio 3.0% Prima facie current shortfall 23.3

This number differs a little from the numbers in the last quarterly report.  Here they are.

This suggests that we have a 3.13 percent tangible common ratio – and the difference is tax assets and liabilities associated with the intangibles – see the footnote.  I am just going to accept the number.  Addition - main difference is the risk weighting of some of the off balancec sheet stuff...

Using that number we have 3.13 percent tangible capital, somewhat better than the 3.0 percent calculated above – and the shortfall is “only” 19.3 billion rather than 23.3 billion.  The widely mooted current shortfall is about 20 billion.

But it is not the current shortfall that matters.  It is the projected adverse circumstances shortfall at the end of next year that matters.

Now suppose that BofA has zero growth between now and the end of next year.  Then the required capital will not have changed – and the bank will have had some pre-tax, pre-provision earnings. 

It will in fact have had a lot of them.  Pre-tax, pre-provision earnings are running about 13 billion per quarter at the moment ($39 billion for the rest of this year plus another 52 billion next year for a total of 91 billion).  It will also have a further 6 billion in “earnings” from the Merrill Lynch synergies.* So they will have 97 billion in earnings before losses.

But lots of losses – an amount that none of us really know.  If they have 77 billion in losses they will still recover the 20 billion current shortfall and they will thus pass the stress test. 

Now is 77 billion possible?  Yes – but it is pretty bad if you think it has to come from the loan book.  The loan book is 977 billion and already has 29 billion of provisions against them.  The loan book might be that bad in an adverse circumstance – but frankly I doubt it.  The actual losses last quarter were way less than that rate – though the company provisioned considerably more than they charged off and they projected the losses would get worse.   Expost addition - the loss here is more or less what they think will happen in the stress test.  I happen to think the stress test loss estimate is just too high - but that is one of those things that people will differ about.

The non-loan book (and the off-balance sheet credit card book) could cause distress in the stress scenario.  The particular issue is the credit card book – and I would expect profits to go away – but this is MBNA not Metris – and my guess is that the book will hurt but not kill.  A credit card stress test here is solvable with 5mg of valium (a very small dose – read a mg for a billion dollars and you get it about right).

Far more problematic is the possibly they could blow up the (Merrill Lynch) trading book again.  Merrills – rather than anything else is the black box at BofA.  I suspect/hope that Bank of America has been steadfastly trying to de-risk the Merrill Lynch book.  Sure they shouldn’t have purchased it – but they have taken a whack of charges against it and the trading book is likely – at least in the next thirty days – to show some reverses.  After all –what were those year end charges about.  And they can sell good slabs of this book reducing total assets and hence required tangible common equity.  Still it is the trading book that is the black-box here and I have no idea how much valium is required to remove stress. 

The best thing though about the non-loan book is that it is easy to liquidate.  They can shrink it.

Indeed the easiest thing to shrink is the cash balance.  I have pointed out that the cash balance of BofA is enormous – and in the stupid rule of the week the 4% TCE ratio includes 4% of cash.  The rule is pretty clear – 4 percent on total assets including the huge excess cash balances BofA is holding.  Just by increasing risk (through shrinking cash balances) BofA can solve $6 billion of its shortfall.

But in the end it comes down to the trading book which should, after some run-off, be shrinkable.  The only question being how much do they lose by shrinking it?  And that depends where it is marked.  And to that – well I think you need to be an insider to know.

 

 

Disclosure: still long BAC.

 

 

John

 

*I think those earnings are as dodgy as they sound – but I think they can count them in working out stress test capital. 

 

 

All lies and jest

Please note - I am aware this note provides a selective interpretation of a New York Times article - and being selective is likely to be wrong.  

In The Boxer (from Bridge over Troubled Waters) Art Garfunkel sings that a man hears what he wants to hear and disregards the rest.  Like many a good song lyric it holds an underlying truth.

And I risk hearing what I want to hear about Bank of America.  I could be wrong.  I am long the stock for a few dollars so far – and being long probably have selective hearing.  But there are plenty of people intellectually (and financially) committed to the idea that BofA is insolvent – and they are also hearing what they want to hear.  

There is a lot of talk about Bank of America failing the stress test.  The number that they need to raise varies from more than $10 billion to $45 billion with $34 billion being the consensus number of today.  [I round $33.9 to $34 billion - what is a hundred million dollars between friends?]

The New York Times seems to quote original sources … and manages to pin down a senior BofA executive (Alphin) by name.  That is better than most papers have done.  The usual source is “people familiar with the matter”.

Now here is a quote:

Mr. Alphin said since the government figure [$34 billion] is less than the $45 billion provided to Bank of America, the bank will now start looking at ways of repaying the $11 billion difference over time to the government.

So lets get this straight…

A while back Ken Lewis was talking about repaying the entire $45 billion in TARP money.

He backed off.  He said at the annual meeting that the required capital was not in BofA’s hands.

Now they are talking about repaying $11 billion.  That leaves $34 billion – capital which the government says that they need.

This hardly sounds like they need fresh tangible common equity.  Just that the TARP money is a decent buffer and will convert if the tangible common ratio falls below some threshold.  

This interpretation is consistent with the denials the other day by BofA that they were looking to raise $10 billion.

Incidentally this is way better than I originally thought.  The tangible common to tangible assets (not including excess cash balances) is well below 4% now.  Even as a long I think some dilution is warranted.

That said - the quality of leaks on the stress test to date has been awful. 

And maybe Mr Alphin’s comment is also misquoted.  And maybe I am way off base.  In my interpretation.  

Maybe Simon and Garfunkel were right – it is “all lies and jest”.  That is about par for bank accounting and behaviour.

The real economy sucks

But banks don’t.

The Pragmatic Capitalist has up his results from his study of insider buying versus selling.  Insiders are selling at a rate not seen since the top in 2007.  

Some of this selling reflects the usual diversification of some super-rich executives.  Bill Gates is the biggest seller on the list.

Some of this selling reflects the insiders looking at the abyss.  Many a CEO this cycle has been levered to their stock and many have moved rapidly from the genuinely wealthy to the ordinary no-substantial-assets masses.  

Only some of this selling reflects the economic prospects of the businesses in question.  However I think we can conclude by just how skewed the ratio is that even that sucks.

What was not noted though is that there is not a single bank executive on the list of sellers.  Not one.  

Now partly that is that the forced selling of bank stocks happened early.  But partly it has to be that the prospects for banks have improved – at least off the catastrophic situation of a few months ago.

My slogan for analysing banks is to watch what they do not what they say.  I think that is about right.

In an odd coincidence

Francesco Rusciano is out on bail – released to the custody of his parents who have put up their house to stop him fleeing.

This is a guy – who according to SEC filings – has been able to raise $30 million from 15 high net worth customers.  [Maybe raising hedge fund money is easier than it appears to this start-up… however if any rich folk from jurisdictions we can accept money from want to stump up we are keen to talk…  good terms for early customers...]

Anyway – the picture of Mr Rusciano with an unidentified female.

 

 
The report comes from a Connecticut paper.  Rob Varnon (the journalist) also notes (without credit) the detail first observed on this blog: 

In an odd coincidence, Rusciano was a sub-tenant of New York City investment adviser Paradigm Global, a subsidiary of a holding company owned by members of Vice President Joe Biden's family. Marc LoPresti, Paradigm's general counsel, said Monday Paradigm was subleasing space and Ponta Negra was referred to it by one of Paradigm's third-party marketers. LoPresti said "Paradigm is not under investigation."

 The Journalist thinks that the link between Paradigm and Rusciano is an odd coincidence. 

 In full treatment of the link we should also remind the journalist about a few more odd coincidences

(a)    That Paradigm and Rusciano shared more than an office - they shared marketing arrangements and a phone number,

(b)   the third party marketer in question (or at least its corporate office) was not licensed

(c)    the third party marketer in question (or the individual in charge) had previously been a full time employee of Paradigm

(d)   that this individual had caused their previous employer to settle claims for abuse of client funds in six figure amounts (whilst the marketer in question denied guilt)

(e)    that the individual had also been suspended from the securities industry and sacked for allegedly fraudulently abusing the bonus system of a previous employer (and in this case accepted a fine but neither accepted nor denied guilt)

(f)     that the third party marketer in question (company or individual uncertain) also introduced Paradigm to Alan Stanford’s organisation and that

(g)    Paradigm thought sufficiently highly of the Stanford organisation that they had a cobranded product

 

To this we can add the following odd coincidences:

 

(h)    that Paradigm had lent its name and reputation to another alleged fraudulent hedge fund – this one being Paradigm Global (Canada) renamed as Portus Asset Management and that fraud had been more than CDN700 million

(i)      that Paradigm claimed that it had 28 full time staff when very soon after it probably had less than ten

(j)     that Paradigm similarly had offices in Monte Carlo and Tokyo whereas the only places I can find sales staff from the period are in Orlando Florida and similar and the Tokyo and Monte Carlo offices were rapidly closed

(k)   that Paradigm until only a few days ago claimed on their website that they had never had a down year and they had decreasing volatility (a claim that disappeared only when pointed out on this blog)

(l)      that Paradigm claimed in public documents to have over $1.5 billion under management when it (at least very soon after) had less than one fifth that amount, and that the decline happened despite the positive returns better than indices and with decreasing volatility

(m)  that Hunter Biden and James Biden in sworn affidavits alleged that James Park (then the manager of Paradigm) was mostly absent and had a substance abuse problem but that all is well with James Park now as he is back at Paradigm

(n)    that Hunter and James Biden in the same affidavits alleged that Paradigm had misrepresented their returns

(o)   that Paradigm claimed its domestic outsource arrangements were with Global Fund Services LLC – a company supposedly in Atlanta but which is no longer in Georgia at Whitepages.com, (they do have some relationships with BISYS – now Citigroup)

(p)   that Paradigm’s offshore fund administration is supposed to be at Folio Administrators and they claim in marketing documents that they have had that arrangement since 2002 whereas Folio Administrators in an email to me claim it only since 2004

(q)   that on the SEC database exists an audit statement qualified as to the security of asset custody, and

(r)     that Paradigm hired at least one other marketing staff member with long histories of alleged violations of broker conduct rules.

 

These odd coincidences were made clear on this blog.  Full documentary backing for these coincidences is provided in this post – a post which almost nobody linked to or commented on – but which took a considerable time to write and which I largely researched before Ponta Negra was prosecuted by the SEC.

In an odd coincidence I am frustrated.  Partly because it is all odd coincidences.

Mr LoPresti says that “Paradigm is not under investigation”.

In an odd coincidence I believe him.  He is a lawyer and there is no reason why I should not believe him.

Stress test results: Who is leaking?

The FT has yet another story about the stress test results – this one being that Bank of America and Citigroup have to raise $10 billion each.  Apart from the obvious which is that Citi appears to need more than Bank of America the whole story (and most of the competitor stories) have left me perplexed.

It’s not the numbers.  There are too many assumptions in bank accounting to make their capital position anything other than an educated guess.

It’s the source of the leaks that perplexes me.

We have had a (minor) scandal about Bank of America being instructed by Paulson (then Treasury Secretary) to consummate their marriage to Merrill Lynch.  

We know that somebody breached disclosure laws.  But in this case the somebody was Ken Lewis under instruction from his political overlord.  

I can’t think of anything more market sensitive than stress test results.  If some banks get massively diluted and other banks do not then some stocks will fly and others might languish.  This information is incredibly valuable.

Leaking is a market regulation breach of the first order.  Prison time.  And there is the odd State Attorney General prepared to investigate.

And yet the leaks seem to come thick and fast. 

I have no really good theory (though lots of bad ones) as to who would be breaching fair disclosure regulations on this scale and why they would be doing it?

And if you are going to be taking that risk why wouldn't you do the obvious trades and get filfthy rich?

Suggestions?

Paradigm Global, the Bidens and allegedly fraudulent hedge funds – a summary

This is a summary of the situation to put all the posts in one place.  You can read this as an alternative to the other posts – though I will leave the original posts up for posterity.  There are some versions on the web that are wildly inaccurate.  All I will assert is that the Biden's firm has been shockingly sloppy about basic due diligence issues.  Unsurprisingly the inaccurate versions are coming from right-wing politics driven blogs (who like the idea that Biden's family is in trouble) and who reinvent complex facts to fit their simple world view.  Some of the financial blogs have been much better.  

The short version is that an allegedly fraudulent hedge fund (Ponta Negra) shared an office and a phone number and a common marketer (Jeff Schneider) with Paradigm Global a fund of hedge funds owned by the Vice President’s family.  

Paradigm Global have said that they were subtenants – and that they were introduced via their common marketer.  

The story however is murkier than that simple explanation.  However it is consistent with repeated and extreme sloppiness by the Vice President's family and the fund of hedge funds they control.

First we run through the players in this drama.

1.  The small alleged fraudulent hedge fund: Ponta Negra 

Ponta Negra is a hedge fund run out of a unit in Connecticut that just had its assets frozen by a Federal Judge and had the SEC accuse it of fraud.  The Justice Department has yet to file criminal charges and unless criminal charges are filed you would have to wonder what the point of the current crackdown is.  

The alleged fraud is brazenly simple.  The company simply produced fake return numbers and doctored accounts from their counterparty brokers to over-represent funds under management. The last set of published return numbers I have access to is here.

(click for detail and you can find the original here)

Ponta Negra was run by Francesco Rusciano – who is also alleged to have faked trading data whilst working for UBS.  Francesco Rusciano sometimes goes as Krancesco.  

Ponta Negra was marketed by Jeff Schneider and Jared Toren.  More on those individuals later.

  

2.  The fund of funds owned by Joe Biden’s family: Paradigm Global 

Paradigm Global is a fund of hedge funds headquartered on the 17th Floor of 650 Fifth Avenue. It was founded by Dr James Park who for a while had a reputation as a guru on hedge funds. Paradigm in marketing documents claim particular expertise in “due diligence” allowing them to source the best hedge fund managers.  

Paradigm claimed as recently as 2006 in marketing documents that it had over $1.5 billion under management and 28 full time staff as well as offices in New York, Monte Carlo and Tokyo. Now (according to its IARD filing) it has about 300 million in 210 discretionary accounts and 6-10 employees.  There are no offshore offices.

As recently as a few days ago their website claimed that they had never had a down year and that their volatility had decreased over time.  This is not impossible – but if it is true that last year was a year of decreased volatility then the performance is truly remarkable.  Consistently positive returns with low volatility make an 80% reduction in funds under management somewhat difficult to explain.

Paradigm was purchased by Hunter Biden and James Biden who are the Vice President’s son and brother respectively.  Hunter Biden was CEO was for a brief time at the end of 2006 and in early 2007.  The original press reports implied that was a permanent position but it was later described as an interim position.  The leadership of the firm since then has been moveable.

In the latest IARD filings Hunter and James Biden are listed as owners.  Markus Karr is listed as the chief investment officer and CEO.   Dr Park is listed as an investment consultant.  

Hunter and James Biden purchased Paradigm when they wanted to get out of the lobbying business.  Having your son as a highly paid registered lobbyist was incompatible with Joe’s (Vice) Presidential ambitions.  The purchase was problematic and litigated.  During the litigation James Biden signed an amazing affidavit which you can find here.  

In it he alleged a few things including that:

• The Paradigm Hedge Funds had only between two and three hundred million dollars under management, which were leveraged to over five hundred million, not the more than $1.5 billion under management represented to us by Lotito and Fasciana.  

• The returns on the Paradigm Hedge Funds were not as represented to us by Lotito and Fasciana; and

• The primary manager of the funds, Dr. James Park, had an apparent substance abuse problem and had been an absentee manager for several years...
  

These are things which is would make continued ownership of the business untenable.  If James Biden is alleging that the returns have been misrepresented to clients and potential clients then he is alleging a crime.  It’s a crime not fundamentally different the crime which Ponta Negra is alleged to have committed.  The only responsible course of action for the Bidens would be – after being made aware of the problem – call the regulatory authorities, sack the offending staff and write a letter to clients indicating that they can have what is left of their money.  Even a small misstatement of returns to prospective clients constitutes a crime.

If the Bidens were to continue to own the management company – and to take the benefit of that ownership – without taking these steps then the Bidens are accessories after the fact to that crime.  

The alternative hypothesis (clearly possible) is that the returns were misrepresented to the Bidens but were not misrepresented to clients.  Then no crime has been committed on clients and it is possible to keep running the fund.

Anyway given one possible misrepresentation I figured I would go looking for other misrepresentations. 

If the number and depth of the staffing was misrepresented when potential customers did due diligence that would also constitute fraud.  Certainly there is a reasonable possibility of that.  For instance this due diligence document asserts 28 full time staff – and names them.  Here is an organisational chart:

(click for detail - you can find the original in this document)

 

This organisational chart differs dramatically from the current structure as described in IARD filings (6-10 employees).  It is unclear when the employee numbers were scaled back so dramatically.  Moreover it is very difficult to trace many of these employees in FINRA’s database which means if the people exist they are no longer licensed within the industry.  Again it is possible that the firm used to have 28 staff and now has 6-10.  Indeed the rapid decline in staff numbers might be the reason that there was space to sublet to Ponta Negra.    

Another inconsistency worries me.  As at August 2005 Paradigm warranted that all custody of client asset assets – including subscription and redemption funds and the computation of net assets is done by reputable third party custodians.  This is an important element of due diligence for prospective investors.  See this extract…

(click for detail - the original can be found here)

This looks kosher and highly comforting except that I can’t find out much information about Global Fund Services.  [I looked in the obvious places like the White Pages.]  Folio Administrators however does have a presence and I have written to them to confirm their role.  I will report any reply...  Reply reported below... see postscrips.  Folio has confirmed the relationship which is highly comforting...

My main concern though is that these custody details differ dramatically from the (much later) IARD filing.  Here is the extract from the IARD filing:

   

(Click for detail and you can find the original here by following obvious prompts.)  

 

In the IARD filing they handle client cash and a related person handles client securities.  Moreover that related person is not a broker dealer subject to SIPC protection.

Whilst holding client assets in house is not a certain indicator of fraud it is a huge red flag.  The lesson of Madoff (or Stanford for that matter) was that a fund that actually controls custody of client assets is dangerous – whereas a fund which has custody at a reputable independent custodian or prime broker is unlikely to outright steal your money (though they sure can lose it).  The really big frauds have been funds with inadequate external controls over custody.  Bayou for example was another hedge fund with controlled its own custodian.  

There are legitimate reasons why a financial institution might use in-house custody.  A bank for instance really does take custody of your cash.  However I can’t see any good reason for bringing custody in-house as your staff numbers shrank by two thirds and your business model remains unchanged.  However telling people you have third party custody when they do due diligence but not having it is fraud.  I presume no fraud and that they must have bought the custody in house possibly to save money.  

However I am still worried about custody.  This audit report lodged with the SEC specifically mentions material weakness with respect to safeguarding of securities.  Having material weakness in custody arrangements allows theft.  That makes it a very bad audit report.  

All of these red flags – the decline in staff numbers (28 to 6-10), the decline in funds under management (over $1.5 billion to 200-300 million), the returns that James Biden alleged were misrepresented and the unusual change in customer asset custody probably happened before the Bidens had purchased the management company.  They must have all happened despite the fund making positive returns better than indices and with reduced volatility (as claimed on the website). 

There is one more red flag – again pre-Biden ownership – which I have not previously discussed on this blog.  That is the Canadian fund called Paradigm Global.  Canadian Paradigm Global was associated with James Park’s Paradigm Global and often claimed that James Park (then the hedge fund guru) had a consulting relationship with them.  That relationship ended and the Canadian Paradigm changed its name to Portus Alternative Asset Management.  Portus was later discovered to be a ponzi which – in typical ponzi fashion – paid its distributors well over the odd to distribute its toxic product.  James Park was clearly involved in this fund in its beginning and lent his reputation to it – but he was safely (and probably reasonably) distant by the denouement.  You can find press reports here, here and here.

Player 3 – the distributor of dodgy hedge funds: Onxy Capital and Jeff Schneider

Onyx Capital was how I found this mess.  Onyx – was a firm based in Austin Texas but also subleasing space from Paradigm.  Onyx was a marketer of hedge funds to relatively unsophisticated clients.  I say “was” because Onyx appears to be running dead – and its website died a few days before Ponta Negra was closed by SEC action.  

The typical sort of client was someone who had sold a medium sized business for a lot of money (a few million) and was looking for investment advice including what the smart money (that with a New York address presumably) was doing.  Sharing a New York address with a firm owned by the Bidens probably helped.

The principal of Onyx was Jeff Schneider.  To complicate research he spells his name multiple ways.  Onyx – being a seller of hedge funds and financial advisor – was almost certainly required to be licensed but never was.

Jeff Schneider has a past which would raise eyebrows in most people doing a due diligence.  He was “allowed to resign” from Merrill Lynch after allegedly being party to fraud by foreigners.  In that case he denies guilt.  He was sacked from CIBC, fined and given a 90 day industry suspension for allegedly defrauding CIBC’s bonus system.  In that case he neither accepted nor denied guilt but accepted the fines.  You can find the details in his FINRA broker registration statement.

Anyway Jeff Schneider was a full time employee of Paradigm Global from 2004 to 2007 or 2008 (his FINRA regulatory records say Feb 2008 but Felix Salmon gives a different date).  After that he worked for other firms, notably Puritan Securities.  He also set up Onyx – but his FINRA record states that was working at Onyx only from March 2009 though other records suggest he established Onyx much earlier.  I have an email from Ponta Negra dated June 2008 giving Schneider an email at Onyx.  The FINRA CV (compiled by Schneider) is thus false.

The decision to allow Schneider to cease being a full time employee but to maintain an office within Paradigm Global’s office and to continue to state in some marketing documents that he is an employee was made when the Bidens controlled Paradigm.

Felix Salmon is characteristically blunt about Onyx and Schneider.  He describes it as the hedge fund equivalent of a chop shop.  

That said – it was probably Onyx that turned Ponta Negra into investigators.  Because Onyx is largely based in Austin Texas the Texas division of the SEC is taking the Ponta Negra case.

Onyx distributed other dodgy product – most notably the head of investor relations at Onyx (Justin Hare) was also a full time sales employee of Stanford.  Justin Hare’s myspace page (which has since been made private) is the source of the photos of the glamourous life of a Stanford salesman that I posted here.  

Anyway Onxy and Jeff Schneider introduced Paradigm to Alan Stanford’s organisation.  Paradigm obviously thought fairly highly of Stanford and vice versa because they launched a cobranded product – the Paradigm Stanford Core Alternatives Fund.  

According to the Wall Street Journal no Paradigm money got sent to Stanford though some Stanford moneys were sent to Paradigm and I gather have since been returned.  

This suggests carelessness on the part of Paradigm.  Financial institutions are fundamentally based on trust.  If people do not trust you then you do not have a business.  The Stanford relationship was the second time that Paradigm had lent its name to a large-scale ponzi (the first being Portus).  Remember that Paradigm – being a fund of funds – is meant to be an expert in due diligence.  And they failed.  Badly.

There was one other ex Paradigm employee who later worked at Onxy – that is Alla Babikova.  If you go back and look at the org chart above she essentially runs the sales function.  She was Schneider’s boss in those days.  At Onyx Schneider it seems became her boss.  I have saved Alla Babikova’s FINRA record here.  Unlike Schneider’s it is clean.  

Jared Toren was also an employee of Onyx – though I gather he might have left Onyx to market for Ponta Negra.  He also has a clean FINRA record but one that does not mention for instance that he once shilled for Onyx.  I have emails from him in that function.  The record is – at best – incomplete.  At a minimum Jared has made minor false representations to regulators.  

Paradigm in the pre-Biden days also used to employ John Page.  He had the same rank as Jeff Schneider in the above org chart.  His 30 page long FINRA record (which you can find here) is full of customer complaints settled for six figure sums.  His regulatory problems existed both before and after his employment by Paradigm.  John Page was eventually forced to bankruptcy by UBS who sued him for repayment of bonuses and commissions that they had previously paid him and I think for moneys that they had paid out to clients as a result of his infractions.  As noted above – Paradigm appears to be careless about who it employs and associates with.

The Ponta Negra/Paradigm/Schneider connection

This blog observed for the first time that Ponta Negra was (a) housed within the offices of Paradigm Global, (b) had a phone number that was the Paradigm Global switch and (c) used the same marketing agent as Paradigm – a marketing agent who is often listed as a full time employee of Paradigm.  That marketing agent was Onxy/Jeff Schneider.

This was news because the SEC says that Ponta Negra was run from a unit in Stamford Connecticut.  (The address is on an early marketing email I have and also linked above.) 

Moreover this is the third time that it has been publicly confirmed that Paradigm has associated itself with an alleged fraud.  The prior two were Portus and Stanford.

This suggests a degree of clumsiness – and it is a real problem for funds of funds.  Funds of funds have – as their single most important skill – the ability to do due diligence.

And the due diligence on Ponta Negra was really easy.  My original post on Ponta Negra is repeated at the end of this post.  Pretty well everyone with any real expertise I showed this to came to the same conclusion as me.  It was highly suspect.  The marketing literature failed basic requirements – not mentioning consistent custodians or auditors and having returns inconsistent with the strategy.

The Paradigm/Onyx/Ponta Negra/Biden story has hit the main stream press (at least if you consider FT Alphaville and Felix Salmon at Reuters to be mainstream press).  

I see little to object to in any of their stories (FT here and here and here, Felix here).

The line they take is essentially that Paradigm Global – owned and controlled by the Vice President’s family – is less than careful about who it associates with and who it lends its name to.  

However they accept that Paradigm Global itself did not know that Ponta Negra was a fraud marketed out of their offices.  They accept the “we were dumb” view of how Paradigm got caught up with Ponta Negra (and also with Stanford before them).

I have no evidence that Paradigm Global knew anything was wrong with Ponta Negra anyway. But plenty of evidence that they were sloppy.

That in itself is a problem.  Paradigm pitches itself as a highly sophisticated fund of hedge funds with superb due diligence processes.  That they did not suspect that Ponta Negra was a fraud almost immediately suggests that their marketing spiel (excellence in due diligence) is only marketing spiel.  

When I wrote my original post on Ponta Negra (preserved below for posterity) it was blindingly obvious (to me at least) that Ponta Negra made no sense whatsoever.  

It should have been blindingly obvious to Paradigm too – but it wasn’t.  About half the readers thought it was a scam – and the lawyers for Ponta Negra were sure I was implying it was a scam.  Even the most cursory check on Ponta Negra would have identified it as suspect.  Moreover in its literature Paradigm claims to have a database of just about every hedge fund and special skills at identifying scams.  They were – it seems – just too gullible and they failed at their core function.

I guess their advertising material – detailing extensive expertise at detecting scams- is just plain crap.  Like their $1.5 billion under management and their custody arrangements and even (as alleged by James Biden) their stated returns. 

The Paradigm defence

Paradigm rejects that the notion that they actively participated in the alleged Ponta Negra scam.  That is an accusation I do not make.  I only make the suggestion that – through clumsiness and the failure to perform even the simplest due diligence that they lend their name to alleged scammers.  I also note that James Biden himself has sworn that Paradigm misrepresent their own return and makes allegations consistent with them misrepresenting themselves in marketing material.  

Paradigm’s only statement to date is simply to observe that Ponta Negra was a subtenant introduced to them by their common marketer.

That defence would be entirely plausible to even the accusation of clumsiness except that Paradigm Global has a history of lending its name or reputation to (alleged) scam hedge funds.  By far the most important was Portus Alternative Asset Management – an association that pre-dates any Biden involvement in Ponta Negra.  But to pick Stanford and Ponta Negra suggests above average carelessness.  

And employing chop-shop operators like Schneider – who operates from an unlicensed investment advisory firm (Onyx) is also in great contrast to the due diligence that they claim they undertake when they invest their own money.

This place is littered with red flags.  There are more – but I think this should be enough to get the mainstream media and the SEC involved.

Oh, and if I were Rusciano from Ponta Negra I would be busy finding a lawyer with experience plea bargaining.  This story has a long way to run.  

I for one though will be signing off.  I have real stocks to look at.  The whole point of being a digger – and I am a digger – is to make money from that which other people have not worked out.  And unfortunately I see no way to make money here.

John

My original note on Ponta Negra – which was posted under the title “Hedge Fund Marketing Material”

I regularly read the letters from fund managers more successful than me.  I like to know what they are doing.

Sometimes I cannot work it out at all.  Maybe that is because I am stupid - or maybe that is just because they are making it up.  I have identified a couple of frauds that way...

Here is the letter from a fund (name withheld for now) which I do not understand.  Can anyone explain this strategy to me?

Dear Fellow Investors:

The global economic stress as measured by FX short term volatility, sovereign and corporate CDS spreads and VIXX indices persisted in the month of February, as the barrage of negative economic indicators remained unabated.  

Continued stress on the financial sector that peaked with the record quarterly loss of AIG and the collapse of Citigroup equity valuations has left policy makers and market participants perplexed as to how the current turmoil will be resolved.

The month of February marked one of the most complex environments in foreign exchange that we have experienced since the inception of the Fund, as the ambiguity in governmental commentary on interest rate decisions and the measures being considered to aid the distressed economic climate caused abnormal gyrations in the G10 arena.  

We remain committed to our long DXY bias but as was mentioned in last month’s commentary, we have preferred to express this through a short EUR/USD bias and selectively partially imperfectly hedge it with a lower weighted long GBP/USD trade. 

We believe that the euro zone will continue to be weighed down by the massive 1.3 tn. EUR of outstanding debt of Eastern Europe that will be a challenge to refinance at reasonable yields in the current climate. 

The reversal of our short USD/JPY hedge was well-timed, as the announcement of the reissuance of U.S. Treasury samurai bonds to the Japanese marketplace has accelerated the upside momentum in USD/JPY. We have decreased the size of our short EM bias as commodity prices appear to have temporarily stabilized and we prefer to selectively express views through cross regional plays such as short EMEA/LatAm with underweights in HUF, PLN and overweights in CLP, BRL. 

We will continue to utilize low quantities of leverage and fewer numbers of intraday positions, as we anticipate the persistence of a high volatility marketplace into the end of Q1 2009.

Now of course it would be nice to understand how these guys do it - because they are good.  Very good.  Here are there monthly performance numbers.

 

Of course - as I do not understand the letter I can't vouch in any way for the validity of these results.  So I am not publishing their name on this blog.  But if anyone can explain this to me I would be very grateful...

POSTSCRIPTS:

1.  The FBI has arrested Rusciano - see this article.

2.  Folio Administrators has confirmed the relationship with Paradigm's international funds.  Here is the email:

Dear Mr. Hempton,

 

I can confirm that Folio Administrators Limited are the appointed fund administrator for Paradigm Global Fund.  Folio has been providing fund administration services to Paradigm's offshore funds since July 2004.

 

Please let me know if you require any further information.

 

Kind regards

 

William Harris

Director

 

Folio Administrators Limited

Folio House

James Walter Francis Drive

Road Town, Tortola

British Virgin Islands, VG1110

 

Tel: (284) 494-****

Fax: (284) 494-****

www.folioadmin.com

 

I have some concerns though and have further followed up.  In an Auguest 2005 document linked here they clearly say that Folio has been an administrator of their offshore fund for THREE YEARS.  That would bring the date to 2002 - whereas Folio Administrators confirm the date since 2004 only.   Here is the extract:

Again I will follow up.

Another shameless plug for the Cooler Mr Hempton

My cousin Nick's jazz band is going from stregth to strength.  

Here is the latest review of the Nick Hempton band:

http://www.allaboutjazz.com/php/article.php?id=32698