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New York's Insurance Department has issued a Circular (NY Circular Letter No. 2008-19) titled "Best Practices for Financial Guaranty Insurers." It is the first salvo in the state's campaign to regulate credit default swaps (CDS) by classifying them as insurance. Circular 2008-19 replaces a general counsel opinion from 2000 (NY General Counsel Opinion June 16, 2000).
New York's intentions are further illuminated by a press release from Governor Paterson and the testimony of NY Insurance Superintendent Eric Dinallo before the Senate Agriculture Committee. Dinallo focuses on CDS written on other people's securities. He calls such agreements, "a directional bet on a company's credit worthiness," or, as my boss Mark put it, "me buying insurance on your life."
He lays blame for the rise of these products on the Commodity Futures Modernization Act of 2000 (PL 106-554) which exempted many derivatives from state "bucket shop" laws (7 USCA 16(e)(2)). As Dinallo points out, most states outlawed derivatives in the early 20th Century. New York's anti-bucket shop law (of 1909!), for instance, forbids agreements that are, "settled ... upon the basis of the public market quotations of or prices made on any ... exchange or market upon which such commodities or securities are dealt ... without intending a bona fide purchase or sale of the same," (NY GEN BUS § 351).
In an 8-K filed on the 24th, PNC Finanical Services Corp. (PNC) announced that it would acquire National City Corp. (NCC). The money for the acquisition (dubbed a "take-under" because the price is below NCC's market cap) comes from the Treasury bailout fund. PNC will sell eight billion dollars in securities to Treasury. So, Treasury buys PNC and PNC uses the money to buy NCC. Apparently, NCC applied for TARP money and was turned down. As Business Law Prof observed someone in Treasury is reorganizing the Ohio banking industry.
So far the agreements aren't public, but Treasury has posted a term sheet on its website. Through TARP Treasury is buying preferred shares - they are senior to common and pay 5% return for 5 years and 9% thereafter. They also carry a veto on dividends.
Every morning, I see stories like this one describing how trading in "stock index futures," predicts the movement of the market. But what, exactly, is a stock index future and how does it predict what the market will do?
A stock index future is a futures contract tied to a stock index. I know, that doesn't help very much, does it?
A futures contract is an agreement to buy something in the future at a price set now. For example: imagine that last year you made an agreement with your local gas station - you agreed that in one year you would buy 100 gallons of gas for $3.00 per gallon. You have, essentially, made a bet that gas will cost more than $3.00 when it comes time to settle up.
An index is a mechanism for measuring price fluctuations of the market as a whole. An equity index, like the S&P 500, tracks the performance of a hypothetical portfolio of stocks. The portfolio is composed of the stock of 500 large companies. For more on the S&P 500 click here.
In 1982, the Chicago Mercantile Exchange debuted a futures contract designed to track the price of the S&P 500. They work like this: you sign a contract to buy a basket of stocks resembling the S&P 500 at today's price. The amount you'll pay is arrived at by multiplying today's S&P 500 index number by 250 (it comes out to nearly $400,000 per unit). But, you don't wait until the end of the contract to find out if you're ahead or behind. The CME adjusts the contract price every morning based on closing price of the S&P 500 from the day before. If today's close is higher than yesterday's close, they put money in your account. If the price goes down, they subtract. This goes on until the end of the contract.
This is how we get to stock index futures as a predictor of tomorrow's market. Daily resetting, coupled with the fact that the contracts can be traded make them a way to gamble on whether today's closing price will be above or below yesterday's. For instance, if you think the market will end down compared to yesterday you might try to unload your index futures before the CME debits your account.
For those who don't have time to read the whole thing:
40 SRLR 1681 - "Sources," tell BNA that the SEC is considering creating regulatory "circuit breakers," (sorry about all the quotes and parentheticals) that would stop short sellers from collapsing vulnerable companies.
40 SRLR 1677 - A guide to the notable parts of the just-made-public SEC Enforcement Manual.
40 SRLR 1689 - How law firms are planning to capitalize on TARP.
Chuck Nathan, via the Harvard Corporate Governance Blog, on the state of takeover defense law.
Marty Lipton, via the Reuters Deal Zone blog, on the sorry state of things.
A couple of weeks ago, the Financial Accounting Standars Board (FASB) issued Staff Position 157-3. 157-3 interprets and clarifies Statement on Financial Accounting Standards number 157. 157, titled Fair Value Measurements, tells auditors how to value assets. 157-3 adds further guidance about valuing assets that aren't readily salable. 157-3 comes in the wake of a joint SEC-FASB clarification of 157 issued at the end of last month.
Immediately upon the release of 157-3, the American Bankers Association (ABA) wrote a letter to the SEC asking them to ignore 157-3. The ABA's complaint is that 157-3 uses unreliable bargain sale prices to value assets.
A few days later, the Center for Audit Quality wrote a letter to the SEC protesting strongly against calls, "to suspend fair value accounting."
I was just reading the transcript of the 10/06 hearing on Lehman Bros. before the House Committee on Oversight and Government Reform (2008 WL 4458226) and it got me thinking, again about borrowed money. According to Luigi Zingales, a professor at the U Chicago Graduate Business School, Lehman had borrowed 30 times more money than it had on hand. Thus (math ahead!) a 3.3% decline in the value of the stuff purchased with that borrowed money would wipe out Lehman's cash reserve.
Okay, how about an example - you have $100. On the strength of that $100, a bank loans you $3,000. With the $3,000 you buy shares of Google. The Google shares cost $30 each so you buy 100. If Google goes down to $29, you lose your $100. If it goes down to $28, you lose $200.
Zingales also points out that most of Lehman's borrowing was short-term. So, that $3,000 you borrowed from the bank is due in a week. You don't have the luxury of selling when Google is up. You're going to have to sell those shares at the end of the week, no matter what the price is.
A couple of days ago, a librarian in California posted a question on pll-sis about tracking corporate exposure to losses and litigation from auction rate securties (ARS). I have a couple of suggestions for accomplishing this with West resources.
Public companies with proportionately large ARS exposure would have to disclose this risk in the Risk Factors section of their 10-K. I used the 10-K search function on Westlaw Business and narrowed my search to item 1A - Risk Factors. Then, I used the free text search to look for "auction rate." I found more than 200 companies that specified their auction rate securities portfolio as a potential risk.
To find lawsuits I used Westlaw. Trial filings from ARS-related suits are included in the FC-FILINGS database (financial crisis, trial filings). I searched "auction rate" /30 "auction rate" and found 51 filings from ongoing ARS lawsuits.
To track developments going forward, both of these searches can be saved as Alerts.
Yesterday, I was talking to my father-in-law, a retired corporate lawyer and strong contender for smartest-guy-I-know honors, and I mentioned that I was thinking about writing something about CDOs (collateralized debt obligations). "What's that again?" he asked, "I hate that kind of jargon. It just makes my mind go blank." I made a couple of jokes about the redundancy of CDO - aren't debts obligations?
But the more I thought about it, the more it seemed that this lack of clarity might not be entirely unintentional. Words like "collateralized" gave a gloss of stability to investments that were anything but.
The entities that issued CDOs were special purpose vehicles like those discussed in this post, except instead of buying mortgages, they bought mortgage-backed securities issued by other SPVs. At the big housing-bubble banquet, the CDOs were the dog under the table. By the time the people at the table started to feel hungry, the dog was dead.
One of the things I learned from the SEC Office of Inspector General report on Bear Stearns is that way back in 1990, Congress gave the SEC the authority to police the risks taken by broker-dealers. The power was granted by the Market Reform Act of 1990 (PL 101-432).
In response, the SEC's Division of Trading and Markets promulgated rules 17h-1T and 17h-2T (57 FR 32159-01). The capital "T" stands for temporary. These rules, adopted in September of 1992 and fully effective at the end of the year, were never revisited and never made permanent. The OIG Report is very critical of Trading and Markets' decision to never finalize 17h-1T and 2T. The temporary rules require broker-dealers to file form 17-H, Risk Assessment Report for Brokers and Dealers.
I tried to find a filed form 17-H, but discovered that they are confidential (it was in the rule, but I didn't read carefully enough). So, I asked my friends at Westlaw Business to start a FOIA request to see if they could lay hands on a couple. Did you know that WB did FOIA requests? If I manage to get one, I imagine I'll still need someone to translate it for me.
In other Bear Stearns report news, Race to the Bottom has a post about the wealth of information about the SEC investigative process the report contains.
The Speculative Debauch iMix is now available on the iTunes Music Store (not an endorsement of the iTunes Music Store). This link will open iTunes to the iMix (IF you have iTunes and IF you aren't using IE). Here's the playlist:
Rags to Riches: Tony Bennett
WORK.REST.PLAY.DIE: Sub Hum Ans
Mo Money Mo Problems: The Notorious B.I.G.
Misfortune, Bad Weather and Debt: Tiger! Tiger!
Everything is Borrowed: The Streets
A Bad Debt Follows You: The Go-Betweens
Dead Presidents II: Jay-Z
Eat the Rich: Motorhead
Hallelujah, I'm a Bum!: Al Jolson
Brother, Can You Spare a Dime?: Bing Crosby
(Let's Go) Slumming on Park Avenue: Ella Fitzgerald
No Depression (In Heaven): The Carter Family
DPA Blues: Hasil Adkins
Happy Days Are Here Again!: Tiny Tim
In my class on securities enforcement, I spend some time talking about the secretiveness of the SEC investigatory process. I'm going to have to change those slides. A few days ago, the SEC made its Enforcement Manual public. The Corporate Counsel opined that this isn't just the SEC making an existing document public, this is something new.
Morgan Lewis has a nice memo on the "new" Manual.
The Corporate Counsel blog has put together a one-stop post with all the new guidance implementing the executive compensation provisions of EESA (PL 110-343, 122 Stat. 3765).
Yesterday, New York State Attorney General Andrew Cuomo sent a letter to AIG. Cuomo is annoyed that at the same time AIG was asking to be bailed out by the federal government it was sending its executives to England to hunt partridges on the company jet (and how they got on the company jet ...). Cuomo tells AIG to recover the money, or he will.
His purported weapon is section 274 of the NY Debtor and Creditor law. Briefly, s. 274 says that a conveyance is a fraud on creditors if it (1) is made without fair consideration and (2) left the transferor without sufficient capital. There are similar provisions in most state laws, the Uniform Fraudulent Transfers Act and the federal bankruptcy code. For a good treatment see FLETCHER-CYC s. 7412 and 7405 and NY Jur 2d Creditors Rights s. 363.
Presumably, Cuomo is brandishing 274 instead of the Martin Act (NY BCL s. 352c and 353) because the Martin Act requires proof of fraud. Under 274, the determination is made without regard to actual intent. Even with that lowered threshold, Business Law Prof calls it "a stretch."
On October 9th, Wachovia (WB) filed an 8-K announcing its merger with Wells Fargo. A number of merger-related agreements were attached. Exhibit 2.1 is the merger agreement, exhibit 2.2 is a share exchange agreement and exhibit 4.1 is a modification of Wachovia's poison pill.
Can we talk about the old days? Back in the old days, when a bank wrote a mortgage, the bank took a risk. If you didn't make your payments, the bank had to contend with the expensive process of taking your house and reselling it at auction. To avoid that result, the bank did its best to determine your ability and willingness to pay it back.
No longer. Our new world, created by Fannie Mae and apotheosized by Lehman Brothers and Bear Stearns, is a place where consequences become wholly untethered from actions. The risk formerly carried by your mortgage bank is titrated into a kind of default-risk toxic sludge and sold to AIG.
This then, is a brief explanation of how the geniuses on Wall Street unglued the risk from mortgage banking. First, investment banks bought the mortgage portfolios of mortgage banks. Then, the investment banks organized special-purpose corporations (SPVs) and sold the mortgages to them. With the mortgages, the SPVs also acquired the associated default risk.
The SPVs were created as mortgage-backed security conduits (for more on mortgage-backed securities see this post). The SPV-issued securities were multi-tiered, with some tiers backed by riskier mortgages than others. The securities backed by the most stable mortgages were sold to the public. The worst went back to the investment bank; the default risk that started with the mortgage bank was distilled and acquired by the investment bank.
To protect itself from these risky securities, the investment bank bought default insurance. Because this insurance swapped default risk for insurance premiums, it was called a credit default swap. Who was the largest insurer? AIG. Thus, the default risk that originated when you borrowed money to buy a house was shifted onto the policyholders of AIG, and finally, to the taxpayers.
Since I'm in recappin' mode, here are a couple items of interest from this week's BNA Securities Regulation Law Report (BNA-SRLR on Westlaw):
PEQUOT
BNA has obtained a copy of an internal SEC report about the insider trading investigation of Pequot Capital (40 SRLR 1634). For more about the Pequot investigation and about Gary Aguirre, the whistle blower lawyer who brought the whole thing to light, see this article in San Diego Magazine and this article on the WSJ blog.
CREDIT DEFAULT SWAPS
On page 1633, BNA reports on the SEC's call for Congress to regulate the credit default swaps market. The article also outlines the present state of CDS regulation (40 SRLR 1633).
Just added to the Westlaw front page is a clearinghouse for financial crisis-related documents. There's a notable tilt toward litigation. Here's today's crop:
Financial Crisis Resources:
President Bush Signs Bailout Law, PL 110-343.
Standing room only at Lehman Brothers bankruptcy hearing. Read the transcript: 2008 WL 4378192.
Citigroup files $60B suit against Wells Fargo, Wachovia: 2008 WL 4457346.
Wachovia files suit in Federal Court: 2008 WL 4456335.
Ousted Fannie Mae executives face shareholder securities fraud suit accusing them of hiding the company's subprime losses. Read the Andrews article 14 No. 10 ANSLRR 3 and the complaint 2008 WL 4153695.
For an immediate look at the legal, governmental, and economic ramifications of the government's takeover of Freddie Mac and Fannie Mae, see 2008 Aspatore Special Rep. 19
Available today, for free, on the Westlaw Busines website: Bailout 101
In yesterday's SEC Currents there was a story about the role played by the Resolution Trust Corporation in developing the asset securitization methods that investment banks have recently used to blow themselves up.
I thought this as good an opening as any to talk about asset securitization and about the Resolution Trust Corporation.
WHAT IS ASSET SECURITIZATION?
Asset securitization allows a business (called the "originator") to turn a steady trickle of cash into a great, huge whack of cash. The steady trickle is generally some kind of loan receivable like credit card or mortgage payments.
Let's imagine our originator is a bank with a portfolio of residential mortgages.
1. The bank organizes a new company called a special purpose vehicle (SPV).
2. The SPV buys all the bank's residential mortgages.
3. Then, the SPV sells securities (called asset-backed securities - ABS) on the public market.
The bank gets cash and relieves itself of the burden of policing mortgages or getting clobbered if borrowers default. The risk associated with the mortgages shifts to the SPV's shareholders.
Stop, I hear you cry - who in their right mind would buy these ABS? Good question! Not so many people it turns out, so originators developed ways to enhance the appeal of ABS. Some of the methods included:
* A guaranty by the originator
* Third party letters of credit
* Several tranches
The tranches enhancement segregates risk from gain - some tranches bear all potential losses and some get all the gain. Thus, the risk is shifted from the bank to the holders of only one tranche. And what poor unfortunates buy these all-risk securities? The originators, of course.
For a very nice treatment of the origin of ABS see: Culver, The Dawning of Securitization, Probate & Property, March/April 1994 (8-APR PROBPROP 34).
WHAT WAS THE RTC's ROLE?
Mortgage-back securities were invented by Ginny Mae and Fannie Mae in the 1970's. Ginny and Fannie pooled and sold only residential mortgages (in the example above, imagine the bank selling its mortgages to Fannie and Fannie organzing the SPV).
The Resolution Trust Corporation (RTC) came on the scene in 1989 to clean up after the collapse of many savings and loan banks in the late 1980's. RTC, created by the Financial Institutions Reform and Recovery Enforcement Act of 1989 (FIRREA, PL 101-54), was supposed to buy the assets of the failed S&Ls and resell them in hopes of making a little money for taxpayers.
RTC ended up owning a large portfolio of commerical mortgages. Because of the complexity involved, no one had attempted to package commerical mortgages as ABS. Realzing that the alternative of disposing of the mortgages individually would be even more difficult, RTC developed methods for packaging commercial mortgages as ABS.
To see an example of an RTC ABS deal see the S-11 filed by Lehman Structured Securities on 8/12/1996. The securties being sold are called Commerical Mortgage Pass-Through Certificates Series 1996-1. For something more recent, try Bear Stearns Alt-A Trust, 424B5, 2/01/06.
NEXT: Risk
As I mentioned in a previous post, the SEC has cancelled its Consolidated Supervised Entity program now that all the CSEs have gone bust, or elsewhere. Let the post-mortem begin. Please see this post on the Corporate Counsel blog about how the SEC edited the publicly-released version of a report to Congress.
To arrive at the numbers needed to express the capital adequacy ratios required by lenders and regulators, a company must put a dollar value on every asset it holds.
If you're using mark-to-market valuation you assign value based on what someone would pay for an asset now. Assets without a ready market must be valued using more obscure methods* (see this post and this post for more about valuation models).
Our hypothetical company has large holdings of an asset for which no market exists. So, it uses projections and mathematical models to assign value to these assets.
NEXT: Asset securitization
* This uncertainty is one reason some advocate book-value accounting over mark-to-market. Book-value = the price you paid - depreciation. So, the collapse of the market for your asset is irrelevant.
Sadly, were he living today, bank robber Willie Sutton would have to rethink his characterization of banks as, "where the money is." In the last twelve months, sovereign wealth funds (SWFs) have rescued (or tried to rescue) UBS, Morgan Stanley, Citigroup and Merrill Lynch.
Using the M&A-DEALS database on Westlaw you can track the activities of SWFs. To search for SWF deals use the "buyer description" field like so: BD("sovereign wealth fund"). A search run today generated 250 hits. The data in M&A-DEALS comes from Thomson Reuters' SDC Platinum product.
For more background on SWFs have a look at this report from Price Waterhouse Coopers and this one from The Council on Foreign Relations.
Westlaw Business has recently published a number of articles illuminating aspects of the Emergency Economic Stabilzation Act of 2008 (PL 110-343, 122 Stat. 3765) - including:
Say on pay
Rules for asset managers and
Disclosure requirements for banks
For a more general treatment, the Harvard Law School Corporate Governance Blog has posted memos from Davis Polk and Gibson Dunn.
This morning Goldman Sachs Group (GS) filed its third quarter 10-Q. Attached to it as exhibit 10.1 is the Securities Purchase Agreement between Goldman and Berkshire Hathaway Inc.
See this post for the location of other crash-related agreements.
This post, and others that will (hopefully) follow, grew out of my conversations with my boss, Mark Schwartz. Mark and I have been talking through the crash to establish for ourselves what went wrong. Hopefully, our discussions will be useful to others.
In April, I heard Larry Summers on the radio. He opined that all financial crisises have two things in common, "greed and leverage." Since greed is pretty straightforward, I'm going to start by talking about leverage. Put simply, leverage is a measure of how much borrowed money a business is using. It is generally expressed as a ratio: a highly leveraged business has a lot of debt in comparison to equity.
There are regulatory constraints on how leveraged banks and investment banks can be. Government regulators use leverage and other ratios to measure the financial stability of regulated entities. These "capital adequacy" requirements are designed to ensure (in the case of the Fed) that a bank can continue to do business, or (in the case of the SEC) that a broker-dealer can repay all its debts.
Any entity loaning money will also look at the borrower's leverage ratio as a measure of the likelihood that the loan will be repaid.
Imagine a hypothetical company wishing to borrow money - it's lender asks for financial statements and a number of financial ratios. To do the math necessary to arrive at these ratios, every asset must be given a value, and that's where things get complicated ... NEXT: Valuation
Things are rather gloomy these days. As a tonic (warning?) I offer a few terrifying facts about the last giant crash. For more information, have a look at the timelines from NPR's Marketplace and The American Experience.
* The speculative run that preceeded the crash started in 1922. Between 1922 and 1929 the Dow quadrupled in value, from 100 to 381 points.
* The crash, apparently, was triggered by an economist named Roger Babson who said, " ... sooner or later, a crash is coming, and it may be terrific."
* The crash started in October of 1929, but the Dow kept going down until 1932. By the time it hit bottom, it had lost 89% of its value.
* The stock market crash led to bank runs which caused hundreds of banks to fail.
* The Hoover adminstration didn't enact a rescue plan until 1932 (The Glass RFC Recovery Act, 47 Stat. 5)
* It took over 25 years for the Dow to get back to 381. People who bought stock in 1929 didn't get ahead until 1954.
Are you cheered up yet?
As I mentioned in an earlier post, there has been discussion about the role of the valuation rules of FAS 157 in the gruesome fate of many of our financial institutions. Even Newt Gingrich (via Forbes) has weighed in.
Section 132 of the bailout bill passed by the Senate and the House (2007 CONG US HR 1424, 10/1/08 engrossed amendment) would allow the SEC to suspend FAS 157. Section 133 of the bill would require the SEC to produce a report analyzing the role of FAS 157 in bank failures.
Today, Thomson Reuters released its 3rd quarter, 2008 Global M&A Legal Advisory Review. This report, along with a wide range of legal and financial league tables including:
* Debt & Equity
* M&A
* Global Loans
* Project Finance
* Municipals
* Private Equity,
may be found at Thomson Reuters' new league tables site.
Today Bank of America and Merrill Lynch filed an S-4 joint proxy statement. To help you navigate the recent deluge of filings, here's a recap of other major crash-related documents filed thus far:
Washington Mutual, Inc (WAHUQ)
9/30, Bankruptcy Court, District of Delaware
* Voluntary petition for bankruptcy, file # 08-12229
American International Group & The Federal Reserve (AIG)
9/26, 8-K:
* Credit Agreement (ex 99.1)
* Guarantee and Pledge Agreement (ex 99.2)
Bear Stearns & JP Morgan Chase (JPM)
4/11, S-4
* Joint proxy statement and prospectus
* Agreement and plan of merger (Appendix A)
Lehman Brothers
9/15, Southern District of New York, Bankruptcy Court
* Voluntary Petition for Bankruptcy, file # 1:08-BK-13555
Merrill Lynch & Bank of America (MER, BAC)
10/2, S-4
* Joint proxy statement and prospectus
* Agreement and Plan of Merger (Appendix A)
