Don't waste a good spy exchange

I grew up in the latter part of the cold war and despite our modern day challenges we are far better off with the nuclear armed and ideology fueled terror that pervaded the post war era well behind us. But the cold war had its allure for an Australian boy often bored by the banality of summer barbecues, afternoon teas and dull middle-of-the range local politics. The cold war was the great war of my youth and it had its own strange allure. I feasted on a diet of Le Carre where stoic and very clever little men from the Circus fought an endless twilight war of attrition against their bleak opponents from Moscow Central. I lapped up the gradual leakage of information on the compromising of western intelligence agencies by soviet moles, and was surprised by the subsequent revelations that MI6 and the CIA were at least their equals.

My spies weren't James Bonds. They were non-descript George Smileys. They shuffled in the shadows and plotted against the Soviets whilst mostly fearing betrayal from their closest colleagues. And the imagery was strangely compelling. Their work was done under grey skies and in dank offices. Bitterly cold middle European cities were most often their battle ground, so that dark heavy coats was their attire of choice. Their boots would clash on frosted cobbled streets as they shuffled out for a drop off. Everything was very serious. It was the raw, cutting edge of the battle of ideas.

But Reagan and Gorby put an end to all of that - and Le Carre was never as good again.

So now we are on the cusp of a likely spy exchange - with the 10 Russian sleepers to be exchanged for western agents who have been buried, along with non compliant oligarchs, somewhere in Putin's modern day gulag. The US and Russian agencies quite sensibly could simply put the spies on a plane and be done with it - but that would be an aweful waste of a good spy exchange. There is a theatre to these things that must be upheld. I know the Anna Chapman fans probably have other ideas - but I miss the Le Carre style of cold war chic. Here is one last chance to see an exchange done as it should be: people as puppets, all victims to realpolitik.

A cursory Google Earthing of North Eastern Estonia suggests that the bridge from Narva to Ivangorod could work very well. The exchange needs to be conducted at dawn and the spies brought to each side in military lorries or dark limousines. The dress code is sombre, bleak and ill fitting. Cigarettes should be provided for each spy so, as they are released, they can trudge across the bridge and share a smoke and a wry exchange with their counter part. As the last exchange is made the sun will rise and, modern day traffic can re-enter the bridge and the cold war can once again slip into the past.

The Confidence Game: a commentary on the Ackman-MBIA book

A correction to this post re the Australian infrastructure projects is at the end...


The Confidence Game – the book about Bill Ackman’s pursuit of MBIA is a good book – but this post is not a review – rather a commentary ex-post on the whole bond-insurer thing.
For those that do not know financial insurers were a handful of AAA rated companies who guaranteed financial products (mostly municipal and quasi government debt and structured finance) and – through their guarantee – imparted their AAA rating. All of the financial insurers got into some trouble and a few have failed. MBIA somehow soldiers on – Ambac has been split by its insurance regulator. These companies were ground zero of the crisis.

But I will start at the beginning and with an example which is more than a decade old – but which I think explains both the use of and failure of financial guarantors for structured finance.

Imagine a furniture shop which sells furniture both for cash and on store-generated credit. About half the sales are store generated credit and they are known as an easy place to get a loan. Nonetheless the shop has real customers as well – and those customers buy furniture either for cash or on credit cards supplied by third parties. [For those with a keen sense of retailing history I am not thinking of Sears.]
Anyway these loans perform sort-of-ok. The spreads are wide (more than 20 percent) but losses are about 10 percent. The loans are pooled and securitized – and – for the sake of argument – assume a piece of paper is sold entitled to the first 50 percent of the cash flow from the pool of loans. It is pretty hard to see how these loans can fail so badly the senior strip fails to pay. 

If even 45 percent of the loans actually pay over the term of the loans (assume two years) then – you will receive back 45 percent plus 20 percent spreads on those loans over two years. That is more than enough to ensure a senior tranche will repay in full. In fact – with a few years of payment history (showing the loans to be good) I would have happily rated a really senior tranche (with 50 percent protection) as AAA.

Ok – but there are things that can go wrong. And – to be really AAA you would need to cover them.

For example – the servicer of the loans can simply fall apart through incompetence or bad management of financial misadventure. So you would – to ensure a AAA rating – want to be allowed to change the servicer. And the deals I saw generally did this.
And – because I am a passive investor I would want someone with some skin in the game to be allowed to change the servicer – so it is useful to have a senior party – perhaps a guarantor – who has both the skill and incentive to change the servicer.

So far this is pretty good – and it is very hard to see why this should not be rated AAA. Indeed if I look at it now – and even knowing what happened – I find it difficult to imagine this defaulting to the AAA level. Sure it would fail in a total collapse of the US economy with unemployment rates above 50 percent everywhere. And I doubt the loans would survive a nuclear war and subsequent nuclear winter. But it is really pretty hard to imagine them defaulting.

But I am cheating. This is a real deal – and whilst nobody was ever criminally prosecuted I have a fair guess what happened. (Civil cases were still running last I looked which was years ago…)

What I think happened was that the furniture retailer made up customers – simply made them up. The people did not exist. The names in the loan files did not correspond to real people at real addresses. Instead the shop “sold” the furniture on credit to imaginary customers and then sold the imaginary loans to Wall Street for real cash. The furniture was then put back on the floor – maintaining the illusion of real furniture shops with real people walking around them.
The securitization trusts had to get bigger and bigger each year – with more fake loans made to make interest and principal payments on old fake loans. When they had grown too large the entire Ponzi came crashing down.
What you saw when you looked at the books was a fast growing furniture shop. When you looked at the shop you saw – well – a shop with real furniture, real staff – a real business.
But what was really there was an elaborate fraud.
The money – hundreds of million – supplied by Wall Street – was never recovered.
Losses in the securitization trusts rapidly went above 60 percent – indeed far above 60 percent.

You see it now – this deal really was super safe provided there was not mass fraud. And mass fraud makes something that looks really quite straightforward spectacularly different from appearance.
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Flash forward to March 2000 – the height of the tech bubble – and Bob Genader – later to be CEO of Ambac but then the CEO of the Ambac/MBIA joint venture in international financial guarantee was travelling through Sydney. He was underwriting some part of yet another Macquarie deal and he dropped by my old shop for an investor relations meeting. The stock – like many financial stocks – was in the sewer then (memory says it was under $30 which looks great compared to today’s price of about $1 but lousy compared to the $90 plus it traded at later.) This was the first “real company meeting” I had done for my new shop. I started in the business about a month earlier.
Genader chatted with us for about 90 minutes while we puzzled over a business that was 150 plus times levered and never seemed to lose any money. I had done some research for this chat and already knew about MBIA’s AHERF transaction (more on that later) but I was not familiar at all with other parts of the business (for instance I simply did not understand the guaranteed investment contract business which was to cause Ambac so much grief later on).

About ten minutes of the conversation revolved around the above furniture store and the defaulted AAA securities. Genader noted with a smile that no bond insurer covered this paper and observed it must be fraud. He then said something which has stayed with me ever since – he said that Ambac and MBIA really provided financial fraud insurance. As he described deal-after-deal I had the same impression – I could not see how they could fail – but deal-after-deal could fail the same way – through mass fraud. If the security (say loans or road tunnels or tax liens or whatever) did not exist then the loans would fail.

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As I looked a little closer there were clusters of deals which could cause major problems without fraud. For instance there were many loans secured by future landing fees at large airports. None of these loans were individually enough to cause Ambac or MBIA problems – but collectively they could be nasty. For instance just imagine if terrorists worked out a truly non-detectable way to blow up commercial planes and did it on a regular basis. They could make all commercial flight grind to a halt and hence turn all of the airport deals bad simultaneously. This would make the whole of Ambac or MBIA precarious simply because there were too many airport deals. Risk concentration and leverage meant that even remote possibilities had to be considered to make the judgment Ambac or MBIA were sound. There were just too many out-there things that could go wrong…

I don’t think any of the airport deals have failed – and some that I thought were questionable are still adequately covered.

Still – I think it was – and remains true that the main thing underwritten by Ambac and MBIA was fraud protection. No fraud meant the deals were OK. Fraud meant that the deals could fail spectacularly. Fraud produced spectacular and highly unexpected losses.

The only underwriting standard that made sense was “zero loss” because any loss 150 times levered could kill you. And the only way to ensure zero loss was to insure only things that could never possibly default and to insure that those deals contained no fraud.

In the furniture store case that would have been easy – get a hold of the loan file and physically check a random 100 loans. Check that the people really exist – check the sources of payments – check the phone numbers. If anyone had done the fraud would have been caught. Stopping fraud is – at least in the case of Ambac and MBIA – what due diligence was (or at least should have been) all about.

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Flash back a few years to the 1990s and Sydney’s Eastern Distributor. The ED is part of my life – I drive through it regularly to go to the Northern side of Sydney Harbor (colloquially known as “the Dark Side”). The toll is outrageous.

The ED however required about half a billion dollars of finance. Like all Macquarie deals of the time it required what was then (and is now) a high level of leverage. [This deal was only modestly levered by the standards of 2006.]

This finance was not going to come from Australia as the Australian banks had already had their fill of Macquarie. It had to come from the bond market. There is however only a thinly developed bond market in Sydney. So Macquarie went global.

The only problem was that nobody in the global markets had any idea as to whether the Eastern Distributor was a good deal. If you had asked the what the base traffic level in Southern Cross Drive was they would not have had a clue…

Enter Ambac/MBIA. They could take a piece in the middle of the capital structure. They insured a mid-ranking piece – of about 70 million (and these numbers are from the deep recesses of my memory) about 200 million of debt senior to them and 230 million junior to them.

If the deal with the government was real and the traffic levels on Southern Cross Drive were not faked this piece of debt was money good. It was not going to default – and the risk to Ambac/MBIA was very nearly zero so – by rights Ambac/MBIA should have not been paid much for accepting the risk.

However Ambac/MBIA got paid really well – and they got paid well for a reason. By putting their guarantee (AAA) on an intermediate piece of debt every piece of debt senior to them in the structure was considered (justifiably) by the market to be AAA and the debt that was junior to them was also probably sound. The Ambac/MBIA joint venture – by putting their name to the deal – vouched for the entire deal – and hence improved the pricing of the entire deal. And so they got paid on the entire deal but only insured about 15 percent of it.

I remember working out the ROEs at the Ambac/MBIA leverage levels and assuming high costs – and the ROEs were in the 30s. This was a lovely business – one of the best financial businesses I have ever seen – a Warren Buffett quality business (and it came as no surprise to me that Buffett at various stages had owned some Ambac and MBIA)…

The JV however did have check that there was no fraud. That did not mean they needed to duplicate six months of traffic surveys on Southern Cross Drive – but maybe just five times half an hour check – randomly chosen – to see if the traffic volumes were as presumed in the model were accurate and had not just been “made up”. And I gather Genader made sure that check was done. The JV was being well paid for ensuring that there was no fraud before it provided a minimal amount of almost zero risk insurance.

A rating agency could come and tell you the debt was AAA – but the JV was much better than a rating agency. It was a rating agency run by people who looked competent and were risking real money – their own money – on the deal. It was a rating agency that was putting its money where its mouth was. That didn’t mean that they would never get it wrong – but in this case all that was required not to “get it wrong” was to check that there was no fraud – and that was an easy check…

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Now you see what the features of the “good deal” was. Firstly it was “small” – in this context meaning a $70 million exposure, not a $500 million exposure. Secondly it was a little exotic – and hence by Ambac or MBIA putting their name to it they could convince people that it was money-good. Thirdly people were not buying the deal purely on the rating – they were buying it a little because the JV had warranted part of the deal. Ambac and MBIA’s name improved the pricing of the whole deal – the whole $500 million – and because of that they got a stupendously good ROE for safe projects.

Finally the real risk to this type of deal was “fraud” rather than ordinary credit. Credit risk you “manage” – which is a euphemism for “accept”. Fraud risk however you avoid – and you avoid it by doing due diligence. Due diligence in this case is not hard – but you have to do it – and that means you need a modicum of competence – even if all that involves is sitting a staff member by the highway with a VCR so she can count cars for half an hour on five occasions and hence check the model.

Put this way you can see why Ambac and MBIA deserved to exist – and what good business for them looked like. You can also see why it makes sense to insure things that don’t ever need to be insured because they are “safe”. In reality what they were insuring was a single thing – they were insuring the deals that they insured were not fraudulent. And fraud was not a risk that was accepted and hence subject to cycles – it was a risk that could be avoided altogether through due diligence.

My biggest gripe with the MBIA book is that it does not come to grips with what a “good MBIA” might look like – and what the real reason for MBIA existing might be.

Its only when you put it in that context you see the opposite case – and why eventually MBIA and Ambac really collapsed.

You also see that there is again a case for a new Ambac or a new MBIA – but I will get to that at the end.

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Crank the clock forward a couple of years. We had invested $60 million in Ambac and had it double. We had invested a smaller amount in MBIA for a much smaller profit – and we had sold both positions because a few deals were making us mildly uncomfortable. Ambac rose fast just after we sold it and so smug feelings were short lived. (Both positions collapsed much later proving – yet again – that I would prefer be lucky than smart…)

More importantly Bob Genader had been made CEO of Ambac. That was no surprise – the international business had been astoundingly profitable – and the guy who made the money got the job. I spoke many other times Bob Genader usually about individual deals which I did not like. I never traded the stock again until quite late in the collapse and I will be the first to admit I was surprised at how nasty it turned out. I was aware of individual dodgy deals led by a Conseco securitization but I was surprised just how bad the book was and I was unaware of the so-called “CDO Squared” deals that were spectacularly bad. I had a long standing $10 bet with Genader on the Conseco deal – I thought it would lose money – Genader thought not. It was a bet in good fun…

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The MBIA book starts with a meeting that Ackman had with Jay Brown – the CEO of MBIA. I too had a meeting with Jay Brown and several of his staff. I was not as well prepared as Ackman – and I was less inclined to be sceptical. That said there was a strange discussion about AHERF which alerted me that all was not quite as it seems – though I only got the full import of the discussion a few years later.
AHERF was a hospital with bonds insured by MBIA that defaulted in the late 1990s. The cost (unimportant the story) was about $200 million. Rather than taking the charge however MBIA agreed to a perverse deal with their reinsurers by which the reinsurers would absorb the charge and recover the money over many years (twenty?) by charging higher premiums in the future. This spread the loss forward rather than taking the charge when the loss was made. The account fakery has a name – it was “finite reinsurance” – the same sort of deal that later caused the AIG-Berkshire problems and landed several General Re staff in prison. It was the sort of deal which induced Jim Chanos to short AIG.
It was legal accounting legerdemain – and was an indication that not all was well…

I asked Jay Brown about it – and there were two things he said. Firstly he said that AHERF was not really a credit loss – it was fraud. The second thing he said was that the finite insurance was set up before he arrived – and if he had been CEO they would not have done it. The second statement is – I think – actively misleading – but I did not recognize that until later. The first statement – that AHERF was fraud and not reflective of MBIA’s skill as an underwriter however had me in stitches.

I reported Jay Brown’s statement to Bob Genader who raised his glass to Jay Brown – laughed and reminded me again that what they really underwrote was fraud. Brown dismissing AHERF because it was fraud was in effect admitting his company’s failure. Fraud was always the risk with deals that were otherwise so safe they did not need to be insured.

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It was the second statement however that should have made me question Jay Brown further. Jay Brown said that if he had been CEO they would not have buried the AHERF loss with finite insurance. This simply does not fit with Jay Brown’s career. Jay made his reputation and fortune with an insurance company called Crum & Forster which had considerable asbestos exposures. It got sold for a good price in part because the buyers did not understand that it was larded with finite reinsurance. Jay Brown told me with a straight face that he wouldn’t have done it – when – alas – doing that stuff was precisely what he built his career on. Alas that realization came only a few years later.

There were plenty of other instances in the book where Jay Brown’s pronouncements were not to be taken at face value. One stood out – when he was telling the world about the virtues of short-sellers in financial markets whilst getting Eliot Spitzer to investigate short-sellers in his own stock.

But funnily none of what Jay Brown said in the book upsets me as much as when he misled me. As an investor all you need to know whether he is actively misleading but somehow it feels different when it is personal. It takes a certain pathology to look someone in the eye and to tell them what they want to hear rather than the nuanced truth. It is style that makes great salesmen (and Jay Brown is a great salesman). It is also – and unfortunately - surprisingly common amongst the senior executives of Wall Street firms possibly because they got there in part by being great salesmen.

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Crank the clock forward a few more years and the nature of Ambac and MBIA’s business has changed. Firstly the idea that a toll road in Australia was “exotic” became almost quaint. People were securitizing almost anything and borrowing against the most bizarre assets. When David Bowie securitized his music royalties that was novel. There were however clear and identifiable cash flows and you could see how the finance was going to be repaid. Later – if you looked hard enough – there were plenty of deals where repayment looked problematic.

The international finance business model of Ambac/MBIA in the 1990s – going around the world and giving deals the “good housekeeping seal of approval” had died. Once the JV could guarantee a $70 million piece a toll road in Australia and improve the pricing for the whole $500 million – and thus – through its “good housekeeping seal” it could add value to the whole deal. By 2004 people would buy the toll road debt because Moodys or Standard and Poor rated the deal AAA. Almost nobody cared about rating agency conflict of interest (they were paid to provide the rating). Nobody I knew would have cared that Ambac or MBIA did old-fashioned due-diligence on deals – and ex-post it is clear that they didn’t get their fingers too gritty that way any more either. Standing by the road with a VCR counting cars – well that was passé… as I guess was checking that the taxi driver on the mortgage application did or did not earn 250K per annum.

So rather than doing $70 million deals for relatively large fees Ambac did $500 million deals for smaller fees. MBIA did the same. And they had a few difficulties – notably the Channel Tunnel – but the deal that always caught my eye was the Conseco manufactured housing securitization done by Ambac.
This was a distinctly worse business. They were just selling guarantees they were no longer selling their “good housekeeping seal of approval” and hence improving the pricing of the rest of the capital structure.

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But something more insidious happened – which was that Ambac and MBIA stopped checking too rigorously for fraud. They must have done some checking because a careful examination shows that many Ambac securitization deals perform better than their non-insured counterparts. But they must have also turned a blind eye in some instances.

Here is a chart from a presentation by Ambac in 2008 for the net cumulative loss for their worst 12 second lien mortgage securitizations. Almost all their second lien losses came from these deals.


Two deals in particular stand out like sore-thumbs – which are a Bears Stearns deal and a First Franklin deal. First Franklin was owned by Merrill Lynch. These deals had 80 percent loss rates. To get that you need to have more than 80 percent of the loans default because the loans have (small) recoveries and also make some spread. Maybe 85 percent default will do it.

Now it is pretty hard to imagine how you could “randomly” choose 1000 loans and find 850 defaults. In fact I am not sure you could “randomly” do this. Instead you needed a process by which all the bad loans came to you. It probably requires fraud by someone – be it the companies or hundreds of mortgage brokers and thousands of borrowers.

Knowing what Ambac and MBIA really underwrite – which is not credit but fraud – I think you can guess that fraud was a likely cause. But the fraud was really widespread – these loans have loss rates 20 plus times as bad as Freddie Mac. And the non-guaranteed securitizations – the ones with no fraud check at all – were – on average – far worse than the guaranteed ones.

What really did Ambac and MBIA in is a haze of fraudulent loan origination and fraudulent accounting to hide the problems and fraudulent servicing of the loans and – well – just the ways of Wall Street in a bubble. Ambac and MBIA both failed because they forgot what they really underwrote which was fraud protection. Instead earnest people in their ivory towers (Armonk and the Southern Tip of Manhattan) did mathematical models of loss probability rather than combing though loan files and checking the individuals. The end game of mathematical modeling was CDO squared deals – where the individuals were lost two or even three deep in securitization structures and so there was no way that you were understanding just how corrupt the underlying foundations were.

What was really needed to check the Eastern Distributor was not based on a fraud is easy to state. The main thing was a staff member with a VCR by the side of the road for 4 times half an hour counting cars. What was really needed to underwrite mortgage based securitizations was someone who was someone who would randomly check 100 loans in the loan file making sure taxi-drivers did not self-report their income at $200K per annum. Alas the discipline that saw someone standing by the road counting cars was long-gone. Instead you had management accusing short sellers of fraud rather than management checking whether the loans that they insured were fraudulent.


Ackman’s MBIA short thesis

Bill Ackman’s short on MBIA was a short with an ever-changing thesis. What he saw was a highly levered company – often 140 times or more levered – doing things that were not quite straight. His original observation was the AHERF transaction – something I understood from my first look at MBIA in year 2000. Then he saw one I did not know about – a securitisation of tax liens over properties in Philadelphia. More accurately this was a securitisation of uncollectable tax liens from crack houses and the demolished houses of the dead. The transaction however was rated AAA with MBIA’s guarantee. Moreover MBIA unambiguously knew fraud was going on – firstly there was a tape of a meeting of senior executives in which the truth was on open display – and then there was the name of the transaction – which translated (badly) from the Latin as “black hole”.

The ex-post explanation is (a) these companies underwrote fraud only – as the deals had to be too safe to fail without fraud, (b) they – or at least MBIA – were committing some fraud – some of which was restated, (c) they were turning a blind-eye to fraud, (d) eventually they would be overwhelmed by fraud – in this case fraudulent mortgages – and they would die.

Ackman saw only part of this on the way – but he saw enough of it to simply obsess him. He knew everything that was public to be known about these companies – and he found a lot of bodies and guessed that there would be many more. But he was obsessive from 2002. The companies (MBIA and Ambac as well as the other bond insurers) were not insolvent in 2002 – they were only exhibiting the behaviour that would make them insolvent in the end. His starting position on the companies was almost certainly overstated – they were not insolvent – and – if they retreated to the right business model which was underwriting things that could only fail if they were fraudulent and checking for fraud – then they would have been fine. However the companies themselves reacted to the messenger by accusing him of stock fraud and then – by their own behaviour – dooming themselves to oblivion and irrelevance.*


A plea for new bond insurers

Any decent observer knows the rating agency model is completely riddled with conflicts. Moreover the rating agencies don’t get their fingers dirty – and often explicitly say that they do not check for fraud. I have never heard of a rating agency analyst counting cars for an expressway project. And I have never heard of them going through a loan file and checking 100 random mortgages.
But that is what this is – it is a gritty business. Mathematical models dreamed up by people like me in ivory towers would never have seen the furniture store above for what it was – and never saw the epidemic of truly hopeless loans given out last cycle.

There really are loans that so safe that they can be written with a zero-loss standard and levered 150 times – but they are only that safe if you have removed the possibility of fraud – and you can only really do that by getting your fingers dirty. You cannot do that with a mathematical model.

I am really hoping that one day a new Ambac and MBIA arise – ones that understand their mission – which is to be a rating agency that gets their fingers dirty doing actual due diligence and who have incentives aligned with the bond market. What I want is for the bond insurers to have the vision that Genader once gave me (and promptly forgot). They want to do smaller deals (10-15 percent of outstanding) but improve the pricing on the whole deal. They want to do this with a “good house keeping seal of approval” but not one dreamt up by the public relations firm – but one earned on the ground through loan files and counting cars. I want them to insure only things that can’t fail provided they involve no fraud – and I want them to check that there is no fraud. Because human nature being what it is – we can be assured that the financial markets will one day be infested by waves of fraudulently obtained loans – and if a bond insurer forgets that they go to zero.

One of the downsides of deregulation is “desupervision”. And desupervision is an open invite to scammers, opportunists and the gullible to borrow money they can’t or won’t repay. It is an invite to financial crisis.

Bond insurers at their best are “private supervision of financial markets”. At their worst they are “ground zero for crisis”. And the difference between being a good financial insurer and a bad one? About a decade.

John

*The malefactor company criticising short sellers (“shooting the messenger”) and then doubling up on their ill-deeds is a staple of my trade. Ackman and MBIA provide yet another example.

And now some notes:

1. The Conseco deal was a securitization of all of Conseco’s best manufactured home loans. Ambac insured the whole deal and I suspect the losses will wind up at zero. That looks smart – Ambac got paid well for the deal and took much less risk than it appears. But it is in fact stupid. The Conseco deals done immediately after that deal were truly utterly atrocious. They had a double-dose of bad loans in them. However they sold well because Ambac had vouched for Conseco’s credit worthiness at least at the AAA level. (For the record some of those wound up at Fannie Mae.)
Anyway what Ambac did was sell a bit of their reputation off for money. When what you are really selling is “a good housekeeping seal of approval” that is beyond dumb. It was the behavior in the Conseco deal which made me sell Ambac – not because I thought they would lose money (if they lost money Genader never made good on his $10 bet). It was because they would lose reputation and that would ultimately mean they had to compete with all the other lowlife in financial markets and not make money through adding their seal of approval.
In retrospect Genader should have been fired for the Conseco deal and the cultural shift that it represented. But I did not see it that clearly at the time – and I had too much respect for the man following the super-competent deals he had done as CEO of the JV.

2. Mary Buffett’s book on Warren notes that every Christmas Warren used to give his relatives a $10 thousand share certificate. It was a gift to the limit of the gift duty – but it was also a stock tip – and that stock tip was usually rather good. She has a list of those in the back of her otherwise bad book. Many – notably Fannie Mae, Freddie Mac, Citigroup, Ambac and MBIA have fallen on hard times. Berkshire/Buffett owned all of those at some stage and none at the end. These were all once good businesses – and they all drifted. The drift happened over a decade or more – you had plenty of time to notice. I noticed the drift at Ambac and got out. But I did not notice how far the drift had gone – and was very surprised at the end. I did not expect Ambac under Genader to get into anything like this much trouble.

3. Bob Genader stopped answering my emails. I would still like another drink and a chat if you are out there…

4. I collect super-smart people as friends. Ackman clearly fits the bill… if he wants to send me an email I would appreciate it.


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Correction: I have my infrastructure project with the middle bit insured wrong. MBIA/AMBAC never insured the Eastern Distributor and it took the middle piece of NO Australian infrastructure project.
The company used to take middle pieces - but stopped doing it because the mantra was "we want the control rights". The control rights are important - the right to take over the project if certain tests are not met. That would allow the company to correct (say) for a bad servicer.
As to Australian infrastructure projects - only one loss was taken - which was the Lane Cove Tunnel. Traffic projections were wrong - probably a wave of people taking real traffic data and making assumptions in their interest (the investment bankers for instance are not paid unless a deal was done.)
Sorry to my readers for the error.




John

Astarra weekend edition: Lockhart Road

David Morisset is the nom-de-plume of David Andrews – a former director of Astarra Capital – later Trio Capital – the responsible entity for the Astarra funds.  The Morisset persona is a self-published poet and a worthwhile writer.  He writes a blog which deserves more attention.

However as an independent director of a financial institution he has a problem – under his nose it seems about 170 million has simply gone missing.  With respect to one fund (the Astarra Strategic Fund or ASF) the judge said:

there are strong reasons to believe that a substantial part of the funds of AFS were invested fraudulently and have been lost;

It is unlikely those were lost to David Andrews or David Morisset.  Instead he was just a director when it happened.

When you hear me sing in the corridor you would (justifiably) suggest I do not give up my day job.  But seeing how well Morisset writes and his problems as a financial director I suggest that he is much better at the weekend job.  Award winning even.

And below is a riff he wrote about a fictional funds management organization.  The resemblance to Astarra is surprisingly strong… 

The Sydney Morning Herald notes that this “cracking yarn” is suddenly missing from Morisset’s blog – which is a pity.  Like many things written by Morisset it deserves more attention.

To ensure that I have reprinted it below.

 

 

John

PS.  For Michael Mascasero in the fiction substitute Matthew Littauer who was murdered in Roppongi in mafia style circumstances…

WEDNESDAY, MARCH 17, 2010

LOCKHART ROAD

The following is an excerpt from the opening pages of David Morriset's crime fiction novel set against the background of Australia's trillion dollar superannuation industry.


Michael Macasero had apparently found out the hard way that the noise and traffic on Wanchai’s Lockhart Road in the early morning hours was ample cover for discretely committing murder in a rubbish-strewn alley. Two Chinese garbage men, who had shaken with fear at their discovery, had found the blood-soaked body. Overworked but politically sensitive police had come up with an inconclusive finding on the death. Macasero was, they had surmised, just another American who got into trouble in the red light district and could not find a way out of it with all his vital arteries intact. The police reports had skirted around the demonstrably obvious facts that the weapons used and the nature of the wounds suggested Triad connections.

None of the Hong Kong law enforcement agencies had seemed inclined to give the matter any more thought until years later when the Australian Federal Police raised some questions at the instigation of investment regulators puzzled by apparent irregularities in a Sydney-based superannuation fund. Even then the Hong Kong authorities had been artfully unhelpful and the Australians appeared to give up and go away to solve less complicated problems – or at least that is what they did at first.

Macasero had been proud of his reputation as an investment guru in the baffling field of hedge funds and he had claimed the equivalent of US$100 million under management. Still in his thirties when he was killed, he had set up supposedly sophisticated vehicles in various tax shelters to provide services for his clients in Hong Kong and was expanding into Australia. He knew very little about the great southern land but he had been attracted by its various governments spruiking the notion of Sydney as a major financial centre. His young English colleague, Joel Rogers, had an Australian mother and he had already set up a small Sydney office. Rogers was ready to move there permanently as soon as Macasero made the call.

Like many Filipino Americans Macasero was the product of a family that had escaped people power with a fortune assembled during the Marcos years and had then relocated everything but its money to the land of the free. An only child, he attended college at UCLA and then set off for New York to learn about hedge funds. Tiring of the compliance obligations of working for Wall Street firms, he was seduced by a job offer from a charismatic English investment banker who was looking for a hedge fund specialist to exploit new business opportunities in Hong Kong.

By this time Macasero was unencumbered by any unbreakable links to his adopted country. His parents had died and left him with ample financial resources, which his father had cannily spread around the Caymans, the British Virgin Islands, and several other similar havens of the rich and secretive. There was even a large balance in a Swiss bank account that gave Mr Macasero senior some evident respectability when he wanted to source political donations. Where the fortune came from was not clear to Michael but he was grateful for it and determined to preserve it as a first priority and add to it as a matter of urgency before he retired to enjoy the rest of his life. Inheriting his father’s entrepreneurial gifts and distaste for traditional ways of doing things, the hedge fund industry was a natural fit. It was mysterious, gently regulated and seemingly irresistible to high net worth customers and ill-governed institutions. Returns were driven not by the overall market trend but by the wits of the investment manager. Some would say it was all a matter of luck, but Michael Macasero described himself as skilful without any embarrassment.

Rodney Hawker was more than twenty years older than Michael Macasero when they met by chance at an investment seminar in the Pierre Hotel in a huge function room overlooking the yellow taxis of Fifth Avenue and the tree-lined borders of Central Park. When the conversation switched to hedge funds and the opportunities for new business they presented, Hawker mentioned his interest in prospecting the money men of Hong Kong as a first foray into the vast wealth management sector that was ready to be born in China. Macasero was all ears. They walked over to Trattoria del ’Arte on Seventh Avenue and, while they sampled the restaurant’s paper thin pizza and home-made pasta coated with subtle sauces, Hawker talked Macasero into coming with him to Hong Kong later that month. Macasero severed his Wall Street ties, sub-let his apartment and hopped on a plane without a second thought.

To the eyes and ears of a young American, Hawker epitomised suave English manners and style. His navy pin-striped suit was expertly tailored, but a little crumpled, his sky-blue and white check shirt did not quite match his Ferragamo tie of tiny red golf clubs on a grey background, but his voice was full of rounded vowels and seemed to come from the depths of his throat where it seemed a double bass had lodged. A more urbane observer might have noticed the traces of cockney in his accent – traces that became more pronounced as he drank his favourite scotch.

Hawker was a self-made man of the most determined sort because he had reinvented himself several times over. Now well into his fifties he could look back on stints as a junior civil servant in the sprawling administrative divisions of the Foreign and Commonwealth Office, a commercial banker for Barclays at a time the bank was struggling to come to grips with the fallout from deregulation, several roles as researcher and stock-picker with small funds management groups that ended when his employers were gobbled up by bigger players, and a time as a freelance investment consultant, which was proving to be hard going to such an extent that his financial reserves were starting to diminish at a rather alarming rate. Convinced that he was finished in England, he decided to try Hong Kong.

Within six weeks of his arrival, Hawker had set up a tiny office on the fringes of the Island’s financial district near where it merged into the night life of Wanchai and then he had acquired an apartment in a nondescript building just off Nathan Road in Kowloon. He had also hired Bo, a young Filipina, as combination concubine, housemaid and procurer of alternative sexual services when he felt the need for variety or multiple partners. A veteran of two disastrous marriages, Hawker made it clear from the outset that he offered Bo sexual experimentation, a steady income that allowed her to meet the needs of her extended family in Manila’s slums, a comfortable place to sleep, ample food to eat, and a much more secure life than she had as one of the city’s unfortunate bar girls. The fact that Bo was almost thirty and losing her ability to pull customers on a regular basis meant that she was easily persuaded and, indeed, she was actually grateful for the chance to be exploited on such a generous basis.

Setting about the task of networking amongst the expatriate community and finding his way around Hong Kong’s financial labyrinth was second nature to Hawker. He had a glib tongue and his resume was edited in such a way that it looked both impressive and authentic. However, running an office and the administrative chores that went with it were a bore. When it was time to buy information technology items like computers, software and printers, Hawker was quick to surrender to the obvious. He was a twentieth century man with enough in the way of people skills to sell himself and his services to people like him. But when it came to dealing with twenty-first century office infrastructure and its suppliers, he was lost in a jumble of words, symbols and business practices that were indecipherable. So he did what any sensible twentieth century man would do – he placed an advertisement for an assistant with a superior IT skill set and an interest in starting a career in the investment industry on the bottom rung of a very high ladder.

Most of the respondents knew almost as little about IT as Hawker but one of them was different. Joel Rogers had only been in Hong Kong for a few days and he just wanted a start. Hawker offered him the job and he commenced work immediately after the interview, during which Rogers had babbled on about hedge funds and the dearth of them in Hong Kong.

Rogers was more than capable. He had graduated from the University of the West of England in business studies. While students came from all over England to study at what used to be the Bristol Polytechnic, Rogers was almost a native. He was raised in Portishead on England’s dreary west coast in a house on Blaggard Street, so named, according to regional folklore, because of its former associations with smugglers and pirates. Unfortunately his west country accent and the origins of his qualifications did not play well in the City of London and all he could manage after six years of trying was a series of low-paid but extremely stressful dealing desk jobs. One day he found himself gazing out of a Canary Wharf skyscraper window and looking east. Like many others before him, sensing failure in London, he decided to give it a go in Hong Kong.

After three months, Rogers formed the view that Hawker was a bit of a pain-in-the-neck. He delegated only the most menial tasks and left his assistant almost office-bound. However, new business opportunities were abounding. Very soon, Rogers expected, he would be managing money in a hands-on way that would have still been light years away in London. Hawker, unfortunately, had other ideas. He flew to New York, ostensibly to attend a hedge funds conference, but, in reality, his main aim was to find a fund manager. He found one in Macasero.

When Macasero landed in Hong Kong and set himself up in Hawker’s office suite in a corner offering a view over Wanchai, Rogers was disappointed at first. However, that soon changed. Macasero knew what he was doing and started taking care of all the details that were beyond Hawker and unknown to Rogers. More importantly, he adopted the role of mentor to Rogers in a collegiate fashion that reflected the small age difference between the two of them. Rogers was learning business development from Hawker and money management from Macasero so he was happy.

Within three weeks of Macasero’s arrival, the firm had adopted the catchy name of Triadica Securities and was about to launch its flagship fund, labelled, rather pretentiously, as the Masterwork Macro Fund. The word "triadica" was the name of flower common in Southeast Asia, chosen by Macasero for sentimental reasons and because it seemed to refer to the firm’s founding by three theoretically equal partners. Lack of awareness that there were other organisations in Hong Kong who might find the company’s name interesting was evidence of Macasero’s naïveté and a testimony to the entire group’s ignorance.

Sonray Capital – another Australian broker failure

Sonray Capital failed a couple of days ago and the clients are likely to incur nasty losses.  Strangely I first found out about this from US news sources.  Only three weeks ago I wrote a letter to a blog reader who knew someone who worked at Sonray expressing my doubts about the organization.

For my global audience I should specify that Sonray commanded four-fifths of five-eights of not very much of the market.  In no way is the failure of this broker a reflection of the economy.  It is a failure – as if another one was needed – of Australian broker-dealer rules – or more precisely the lack of broker dealer rules.

The United States has strict rules which segregate client assets from broker assets.  The broker can’t use client assets to fund their own business and there are limits on the extent to which client assets can be rehypothecated.  In the UK those limits are thinner – and in Australia non-existent.  That means that if you pledge your securities to a broker (for a margin loan or even as collateral against a bill as low as $100) you can lose the lot in the event of a broker failure because the broker can repledge them to cover their own borrowings.

When Lehman failed the US broker-dealer sailed through unharmed.  The UK broker dealer failed causing huge client losses and a huge panic.  I blogged about that here and here. 

Opes Prime was smaller than Lehman London but the characters were just as unsavory.  I blogged about that here. 

I have no problem with a broker-dealer using their own capital to run their business or to trade.  I have a big problem with a broker dealer using their client capital to run their business.  I suggested a fix to the Australian Government in a submission to the Cooper review – but alas this has disappeared into the do-nothing basket. 

How long is it that Australia needs to hold itself up as a place where you can come, open a broker dealer, fund it with client money – and – in at least one case disappear with client money before the Australian Government will do something?

 

 

John

 

PS.  There is a reflexive no-government-regulation thing amongst some of my readers.  But the question here is not whether we should allow brokers such as Goldman to speculate.  The question is whether we should allow them to speculate for their own profit with the clients’ money.  Lehman US speculated itself into oblivion but it did not do it with client money and the clients of the broker dealer were made whole.  Lehman UK speculated with client money speculating their clients into oblivion.  In the Sonray case the clients were mostly retail.

Normal adjustment mechanisms – part five in the Edward Hugh tribute series…

Australia is a commodity sensitive economy.  Greece is tourism sensitive.  Tourism is almost as big in Greece as mining is in Australia. 

But unlike Greece Australia has a really effective adjustment mechanism to a decline in demand for its product.  When metals prices/demand falls the Australian dollar falls.

One way to think about it is that when metal prices halve (a surprisingly common occurrence) then Australian export labor just is not as productive (in the sense that it earns less USD or hard currency per hour of work– not in terms of metal output).  We could solve this problem by paying everyone less (which involves the changing of many internal prices with complex and hard-won contract terms) or by simply changing a single variable – the price of the Australian dollar.  It is much easier for the market to adjust a single variable (the currency) than to adjust many (everyone’s wages) and so – more-or-less – that is what happens – the market takes the easiest available adjustment route.  The wages on the mine tend to fall – but slowly – relative to other wages.  The AUD reacts quite quickly – and as it falls everyone is paid less in USD terms. 

The adjustment really is simple – don’t change everyone’s wage, change the exchange rate.  Suddenly Australian labor can (again) produce commodities profitably… 

America is a large country with many sub-economies on different cycles but with a common currency.  If terms of trade move against Texas (as happened in the mid 1980s when the oil price collapsed) you can’t have the Texas Dollar fall because there is no Texas dollar.  Houston – we have a problem…

There is a solution too – but it is not as neat as the Australian solution.  The Australian solution to a recession in the mining belt is to allow the currency to devalue – the American solution to (say) a recession in Houston is for people to move out of Houston. 

America has an amazingly mobile population – with almost all of the world’s busiest airports inside the US.  Almost nobody seems to live in the town in which they are born.  It is OK for Las Vegas to have a tourism based economy, Los Angeles to be based on entertainment and aerospace and Florida to be retirement because people in the US move when one part of the economy is struggling.   In Australia – a country very similar to the US – internal migration is much less noticeable. 

Alas Europe has neither much internal migration nor any ability for say the Greek or Spanish Euro to devalue against the German Euro.   I exaggerate a little – a cursory look at the racial mix of Spain over the past 15 years will tell you that immigrants to the Euro Zone settled in Spain in large numbers – and presumably they won’t be doing that any more.  But I do not see too many Spanish living in Munich. 

And so Club Med is left with its nuclear-solution to adjustment which is internal deflation to give adjustment.  What Greece needs right now is a flurry of German tourists spending big on retsina and hotels – and it needs to be able to tax that spending.  Alas Greece is expensive now – and whilst a devaluing Euro will make my “ruins tour” cheaper it won’t make it any cheaper for Germans to visit.  What will make it cheaper is lower Greek wages achieved through lots and lots of unpleasant austerity…

Alas I think it is worse than that

As observed the Australian solution to a local slump is to allow the dollar to devalue.  This makes Australian industry more competitive and hence provides the solution to the problem. 

There is one more consideration – Australia – like “Club Med” countries has a lot of external debt.  Indeed Australia has a massive amount of external debt – we are far more (privately) indebted than any of the so-called “PIGS”.   But fortunately (for Australia) that debt is denominated in Australian dollars.  If the Australian dollar devalues that debt devalues with it and it is no more difficult to repay.  If the debt were denominated in (say) US dollars then as the Australian dollar devalued the amount that would need to be repaid would go up and up and up at least when measured against Australian physical output.  If you devalue the debt simply becomes too big. 

It is the core of the Australian miracle that Australia is a small open economy with a floating currency allowed to borrow in that currency.

There is a reason why we are allowed to borrow in that currency – which is that the Chinese (with some justification) see Australian dollars as a claim on all of those minerals (and a history of 100 years of not-too-bad government).

Now Greece and Spain et-al do not borrow in their local currency – they borrow in Euro.  And if they had converted their local economy back to Drachma or Peseta those currencies would devalue against the Euro making their debt unreasonably large measured against Greek or Spanish output.  Private debt denominated in a foreign currency where it is just manageable prior to currency devaluation becomes entirely unmanageable once the currency loses a third of its value.

But the currency is pegged and whilst it remains pegged the nominal value of the debt – measured in Peseta or Drachma cannot increase….  But we know what the adjustment mechanism is – it is internal deflation.  Prices will fall in Spain and the rest of the PIGS – they are already falling in Spain.  And whilst this is a necessary part of the adjustment it has a side effect of increasing the effective amount that needs to be repaid vis say Spanish wages – just as surely as it would if Australia had borrowed in US dollars and the Aussie dollar devalued. 

Essentially club-med is in the position of a country with a floating currency too indebted in foreign currency when their currency collapses.  Except that it is worse – because the crisis will get drawn out -

Internal devaluation – the only adjustment mechanism Club Med has – will drive up the value of that debt measured against Club Med output just as surely as external devaluation drove up the value of Thai US Dollar denominated debt from the perspective of the Thai.

Even with internal devaluation there is alas no real equilibrium.  This is just a pug-ugly situation.

 

 

 

John

Post script: one reader reminds me that there is one remaining Finnish bank – but it has almost no cross-border business – and the general point – that Scandinavia got rid of currency union on a banking crisis and today only Finland with a small domestically owned banking sector is uses the Euro.

Weekend edition: he is not sick he is fully sick sick

No stock implications – just a fabulous YouTube rap.  Christiaan Van Vuuren is locked up in quarantine in Sydney with a really nasty strain of multi-drug-resistant tuberculosis.  He connects with the world with his rap videos…

 

And now that he is lonely he needs a quarantine girl…

 

I could leave singing about TB there – but much less cheery though utterly astounding is Van Morrison’s TB Sheets…  not much video – just get the headphones…

Stress tests and sovereign solvency – part IV in the Edward Hugh tribute series

The Scandinavian banking crisis was solved in the following manner

(a).  The banks were guaranteed

(b).  Someone independent of the banks was invited in to reassess bank capital.

(c).  The banks were then told how much capital they had to raise.  They had a fixed period of time to raise it.

(d).  If they could raise it – well and good – and they kept operating.  If they could not the Government injected capital cancelling existing equity as it went and where it could ultimately wind up with 100 percent ownership.  They were not afraid of the “n-word” (ie nationalisation).

The American solution worked almost identically except for step (d).  In America

(a).  The government told us that there would be “no more Lehmans” and they kept telling us and giving banks access to additional funds until we all knew the banks were effectively guaranteed,

(b).  They had a “stress test” to assess how much capital to raise.

(c).  The banks were told how much capital to raise and given a time.  They raised it in common equity.

(d).  If the banks could not raise the capital the government injected capital as common shares until they had enough.  Note that the US process could not wind up with 100 percent ownership of a bank – and the “n-word” was not used.  If the US had run on the Scandianvian formula Citigroup would be entirely government property. 

That said – the end solution in America and Scandinavia were remarkably similar – it was just that the language around them was different.  The “n-word” – which Americans are scared of and Scandinavians are not was the key difference.

This solution works provided you have sovereign solvency.  A sovereign can do this if it can print money (I will go into mechanics later) but cannot do it on a gold-standard or Euro standard.  The Scandinavians needed to de-peg their currency from Europe to achieve their solution and to this day there is a Swedish, Norwegian and Danish Kroner.  Finland alone took up the Euro – but Finland has no large domestically owned banks. 

The solution will work in Europe too provided the currency of the PIGS is separated from the Euro.  It will not work otherwise because step (a) above – the Government guarantee of the banks – is not possible.

Mr Geithner is encouraging Europe to run stress tests – because they worked so well in America.  That is fine – but it is only fine if you also run sovereign stress tests.  A guarantee is a necessary part of this solution – and that guarantee means that the real stress is on the sovereign not on the bank.

Scandinavia found that out.  The classic Norges Bank book on the crisis makes it absolutely clear that delinking the currency was the key to the solution.  And so it will be again.  The stress tests done in a vacuum mean nothing.

 

 

 

John