Monthly Archives: April 2008

Bloomberg is reporting that Standard and Poor’s has lowered its assumptions for how much money investors will recover after defaults of mortgage related collaterized debt obligations.  Many view this as a sign that S&P may be preparing to add to the record number of downgrades already present.

Mortgage-linked CDOs have been the biggest source of more than $320 billion of asset writedowns and credit losses since the beginning of last year.  These writedowns have come primarily from classes once rated AAA or Aaa. 

According to Brian James, a partner at Link Global Solutions, “further rating-agency action will cause banks who hold hte majority of AAA bonds to re-evaluate their strategy.  So far they have been more comfortable writing down their positions in hopes of better recoveries.”

A statement released this week from S&P announced that the most senior bonds from CDOs originally rated AAA should recover 60 percent of principal owed, while securities rated A or lower will get nothing.   

One possible outgrowth of these reductions could be an increase in a secondary market where holders are forced to entertain the bid side of the market. 

According to S&P, their structured-finance ratings only reflect the odds that investors will receive timely interest payments and the return of their principal by the debt’s maturity date. 

Ben Stein (yes, that Ben Stein from Ferris Bueller’s Day Off notoriety) penned an insightful piece in Sunday’s New York Times.  Mr. Stein, a frequent contributor to the Times, asks “how on earth did the credit crisis on Wall Street become such a catastrophe?”  Many investors are wondering the same thing.

 The NY Times Article, Wall Street, Run Amok, ponders a number of questions. Namely, weren’t fail-safe devices in place to guard against risk?  Weren’t government watchdogs supposed to be keeping an eye on things?  What about the policing role rating agencies?  Why are we in this mess?

In search of answers, Mr. Stein points the reader to a speech given on April 8th by David Einhorn.  Mr. Einhorn, who runs the successful hedge fund Greenlight Capital, stated that those who run big investment banks have an incentive to maximize assets and leverage themselves into trouble because their compensation is a function of how much debt they can pile on. 

Mr. Stein simplifies this position as follows: “If they (the investment banks) can use relatively low-interest debt to generate slightly higher returns, the firms earn more revenue and executive pay increases.”  Problems therefore arise concerning what type of assets are acquired with the debt.  

The most troubling aspect of Mr. Einhorn’s speech is his observation that the S.E.C. allowed brokerage firms to set their own valuations on assets and liabilities that were by their nature difficult to value.  The result, in essence, was that the hens were allowed to guard the hen house.

This Wall Street culture, and limited examination from regulators, has created an interesting paradox.  It is the old “heads I win, tails you lose” analogy.  If Wall Street’s big bets pay off, it is the firms and their executives who reap the benefit.  However, when things go south (as they did with the recent subprime debacle), it is individual investors and taxpayers who are left to pick up the pieces.

Mr. Stein’s conclusion is that the inmates are running the asylum.  I cannot disagree. 

Investors of some student-loan auction-rate securities are seeing unprecendented returns (and not in a good way).  Bloomberg is reporting that more than $9 billion of auction-rate bonds sold by student-loan agencies have trapped investors in debt that is not paying any interest.

Over the past few months, many auctions in these bonds have failed.  These failures have triggered certain provisions in the bond offering documents that limit the interest that agencies must pay.  The result, loans with no returns.

According to Bloomberg, the bonds are paying zero interest because of a formula designed to ensure that borrowers don’t pay more interest on their debt than they receive from their student-loan clients.  These provisions became effective after the auctions began to freeze and rates initially climbed to over 10%.

The collapse of the auction-rate market in February left many bond issuers, student-loan issuers included, unable to raise additional capital.  According to Thomson Reuters, no new municipal bonds backed by student loans were sold in the first quarter of this year, the first time this has occurred in almost 40 years.

One need only look at the daily headlines to see new victims of Wall Street’s creative subprime financing.  The fallout from the subprime crisis continues.    

Today’s Wall Street Journal reports that while the freeze in the auction-rate securities market struck many individual investors and their financial advisors as a surprise, Wall Street firms that marketed one type of auction security scrambled to prevent auction failures several months before the market collapsed.

Ian Salisbury writes that UBS AG, Citigroup Inc. and Bank of America requested at the end of last year that several student-loan authorities issue waivers that would make these securities easier to sell.

What this says is that Wall Street firms were aware of the potential for auction failures months before the failures began.  The question then becomes what were these firms telling their brokerage clients about risk during this time.

Investors were sold auction-rate securities as liquid, cash equivalents.  Once the auctions began failing, the market for these securities froze and investors have been left holding their investments ever since.     

While the firms highlighted in the WSJ piece refused comment, it is likely that they  will have to answer questions soon as investors who suffered losses start litigating their claims.

On April 18, 2008 Morgan Asset Management, Inc., the investment advisor for RMK Advantage Income Fund, Inc., RMK High Income Fund, Inc., RMK Multi-Sector High Income Fund, Inc. and RMK Strategic Income Fund, Inc., entered into an agreement with Hyperion Brookfield Asset Management, Inc. under which Hyperion became the new investment advisor for the Funds.  In addition, it was announced that Hyperion would also become the advisor of three Regions Morgan Keegan open-end funds, the Select Short Term Bond Fund, the Select Intermediate Bond Fund and the Select High Income Fund.

These Morgan Keegan funds have seen dramatic declines in value over the past year.  Many investors have suffered significant losses due to the funds’ over-exposure to subprime investments. 

It remains to be seen how these funds (and their performance) will be effected by the change in investment advisor.  For many investors, this change has come many months too late.   

New York Attorney General Andrew Cuomo has launched an investigation into auction rate securities.  Just last week, the Attorney General’s office issued subpoenas to 18 Wall Street institutions.  It has been reported that more subpoenas are expected. 

The investigation is looking into the way these securities were marketed and sold to both municipalities for financing and to individuals as investments.  As has been reported by a number of media outlets, the auction rate securities markets have been largely frozen since February.  The lack of liquidity in a product sold as a cash alternative has raised red flags with regulators.  

In addition to the NY Attorney General, a task force of other state securities regulators has been created to investigate the actions of Wall Street firms relative to the auction rate market.    

In SmartMoney’s May 2008 issue, James B. Stewart writes an insightful article regarding auction rate preferred shares (ARPS).  Mr. Stewart calls on Wall Street to “do the right thing” and redeem investors positions.

ARPS are shares in closed-end mutual funds that own various kinds of triple A-rated bonds.  These shares were sold as “cash equivalents” to investors concerned with liquidity and preservation of capital.  Brokers told investors that these investments offered little or no risk because rates were set at regualr auctions, often every seven days.  However, due to the ongoing credit crisis, these auctions began failing in February.

At that time, Goldman Sachs and Citigroup stopped bidding in these auctions.  Other Wall Street firms soon followed suit.  The result was an evaporation of liquidity.

Now thousands of investors in the $330 billion auction rate securities market are left holding investments that were sold as safe, cash equivalents.  Three months into this crisis and many auctions remain frozen.

Mr. Stewart asks that Wall Street step up and take care of its customers.  But to date, Wall Street has refused to do so.  Many firms have offered their valued clients loans to cover any liquidity concerns, but none are redeeming these shares at par.  As Mr. Stewart points out, there is somehting wrong with the way Wall Street has chosen to handle this issue.

Clearly brokerage firms did not appropriately represent these products.  Although historically ARPS have performed similar to money markets, they are not money markets.  There are risks with auction rate securities (as many investors have now become aware).  Wall Street knew these risks existed. 

Should these auctions remain frozen and Wall Street not step up and redeem investors’ shares, the only recourse for aggreived investors will be filing claims for their losses.  If past actions of Wall Street are any indication, it appears that many investors will have no choice but file claims to recover their funds.  Funds that were supposed to be safe and liquid.  

Quoting Mr. Stewart, leave it to Wall Street to “turn a plain-vanilla product into a nightmare for investors.”          

The Wall Street Journal is reporting that Merrill Lynch & Co. is expecting to announce $6 billion to $8 billion in new write-downs this week.  This would bring Merrill’s total write-downs since October to more than $30 billion.

The write-downs have been caused (largely) by the subprime, CDO and credit crisisses.  But what is most interesting about the latest WSJ piece is that it appears Merrill was continuing to create new mortgage securities well after the risks of such securities were known.

It can be argued that Merrill was so taken by the large profits being generated by the creation of these new securities that even after it had become common knowledge that the risks of these products were greater than anticapated, Merrill did not relent in packaging and selling these securities to investors.  Now the SEC is investigating whether Merrill should have told investors earlier about the failing mortgage business.

The average individual investor can learn quite a bit from this story.  Namely, Wall Street and its brokerage residents often work in a vacuum.  They are all too frequently blinded by short-sided profit motives.  How else can one explain why Merrill Lynch kept digging itself into a subprime hole well after the hole began flooding?