“Wall Street’s Next Big Trade…”
By Larry Doyle on January 4, 2009 at 7:45 AM in Current Affairs
Secretary of the Treasury Henry Paulson has become a household name over the course of 2008. Paulson has been roundly criticized for his mixed messages and inconsistent use of funds from the $700 billion TARP (Troubled Asset Repurchase Program).
While most of us have seen more of Henry than we would have ever cared, allow me to introduce you to another Paulson. John Paulson (no relation to Henry) is one of the most highly acclaimed and profitable hedge fund managers on Wall Street. While investment banks, hedge fund managers, and most asset managers were investing in and promoting sub-prime mortgages and the like, John Paulson was “going the other way.” In 2006, he started shorting sub-prime originators, the ABX (the CDS index that tracked the sub-prime market) and the investment banks that most heavily trafficked in this sector. He personally and the investors in his fund made tidy fortunes in the process.
The reason for my introducing you to John Paulson at this juncture is because he wants to enter the world of community banking. One may wonder why a titan from Wall Street would want to enter into the world of regional and community banking.
This past summer, the first large bank to fail was Indymac Bank located in Pasadena, CA. Since then there have been another 24 banks that have failed with another 200 on the FDIC “watch list.”
Enter John Paulson, along with J.C Flowers of private equity shop J.C Flowers and Co., and Steve Mnuchin from hedge fund Dune Capital. Paulson, Flowers, and Mnuchin are about to purchase Indymac. Flowers already took a controlling stake in a small community bank in Missouri. By the end of Friday, none other than George Soros and Michael Dell were also part of the consortium purchasing Indymac. With a group as high profile and diverse as this, do you think they are getting a fabulous deal?
What do these transactions give them? Well, what does any hedge fund or private equity shop want? Cheap funding, a strong backer that will absorb losses, a bigger balance sheet, and a source of cheap assets. Indymac Bank provides cheap funding from the consumer deposit base (savings and checking accounts paying very little and CDs paying 2-3%). Indymac Bank has a strong backer in the form of the U.S. government that will agree to underwrite a significant percentage of non-performing assets. This loss sharing technique was widely utilized in the S&L meltdown in the late ’80s and will very likely be used again. Indymac Bank has cheap assets currently on its books but also can utilize its balance sheet to buy more cheap assets as it lays off unwanted assets onto ………the U.S. government!!
What do these hedge fund and private equity fund managers bring to the equation? Capital and an expanded balance sheet, both of which are desperately needed by our banking system currently.
Why have banking regulators, the FDIC and the Office of the Comptroller of the Currency, been reluctant to engage these companies and others like them in the purchase of failed institutions? I mean, this is the essence of capitalism and risk taking, correct? Shouldn’t these purchases be promoted? Even our highly respected analyst Meredith Whitney has been recommending that federal funds be directed toward smaller regional and community banks. Won’t these transactions help accomplish that? Not necessarily!!
My concern, and it has been shared by the regulators to this point, is that these hedge fund and private equity managers will not promote the core mission of community lending at these banks.
Hedge fund managers and private equity investors are primarily focused on return on capital without the obligations of traditional banking. How do they most effectively achieve that? Cut expenses and overhead as aggressively as possible. In my estimation, they would just as soon have an online bank with little to no infrastructure. Utilize adverse selection in terms of assets at these banks that they will retain. Adverse selection is simply the process of cherry-picking the existing portfolio. The government will certainly end up with the dregs. Grow the portfolio not through lending but via the purchase of illiquid assets already in the marketplace which have expected returns higher than those on traditional lending.
Another concern is the potential conflict of interest in the bank activities versus the ongoing investment activities at the hedge fund and private equity fund. If there is ever a situation screaming out for aggressive regulatory oversight it is the entry of these buyers into the banking business.
Again, I am a strong and steady proponent of free and open markets in which private capital has an opportunity to take risk to generate returns. I welcome and applaud the government for the willingness to deal with “new money” but I hope that strong and demanding regulators are reviewing this operation regularly. We need to make sure these new buyers know how to “play nice in the local sandbox.”
Read more about this deal and how the rough and tumble world of hedge funds and private equity wants to “come to a town near you”….
SEE: WSJ article
I thought that it may also be helpful to provide a link which highlights all of the banks in our country. This list comes from the FDIC and ranks, in descending order, the risk embedded in these banks as measured by their troubled credits utilizing the Texas Ratio, which is determined as follows:
100 * ((non-performing assets - U.S. gtd loans) + other REO (real estate owned)) / (equity + loss reserves)
The 95 banks with a ratio higher than 100 are considered to be in very serious danger of collapse. Well worth a look!! Additionally those banks with very low ratios may be a great place to start for those looking to make equity investments.
I have to believe that Messrs. Paulson, Flowers, Mnuchin, Soros, and other hedge fund and private equity managers are already booking travel plans!!!
Trying to stay ahead of the curve for you here at NQ!!!
LD
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Some how I have the feeling that we need to: 1) have regulators enforce existing laws, 2) ensure that failure is a option, 3) in the event of failure, you are taken over by the government and your company is unwound and sold off, with clawback on the executives on all personal and funds held with others.
This is the model we are following with AIG. If we do not formally do something like this, trust will always be a issue and the restart of the market will be very slow.
I guess the good news is the banks pay the insurance for thier own regulation (FDIC). The other banks are complaining about increased premiums. However with guy’s like Soros the monitor model has to be stricter.
LD,
Good to read your posts first thing this morning. Can you speculate as to why someone like George Soros helps buy an election, either watches the crash of the markets (or participates in the calculated crash) and then wants to be involved in these smaller regional and community banks? My gut tells me there is something sinister going on. I for one would prefer that they didn’t get involved with the small banks in my area as according to the attached rating sheet, all the banks I deal with are rated at 20 or below.
MBC….
The private equity and hedge fund managers will only be involved in failed banks or those about to fail. If your banks are well capitalized and managed then you will not be seeing them.
Why would Soros, Paulson, et al want to get involved with these banks?
1. Low risk proposition…they are committing only $1.3bln to purchase an institution valued at $13+bln and they have a strong backer (the U.S. government) taking app 75% of future losses.
2. Taking an ownership stake in this institution gives them an “insiders look” at situations as they develop. That look/information is enormously beneficial to the management of their other businesses.
Honestly I am very skeptical that this group of owners will take a “community based” approach to the running of this institution. The regulator that will oversee this institution is the OTS (Office of Thrift Supervision). Given the expectation that dozens of other institutions will fail will the OTS have the manpower to properly manage this bank.
Remember, that the new owners of this bank are accountable to their investors as the previous shareholders in Indymac have been wiped out.
Soros is obviously a huge player on the global financial and political scenes. This token investment on his part is a very cheap opportunity for him to gain “insider status”. IMO, that is the real value to this investment for him and the others involved.
http://www.nytimes.com/2009/01/04/magazine/04risk-t.html?pagewanted=1&_r=2
Found this article at realclearpolitics, and for the first time I kind of understand how the over reliance on VaR as a measurement of risk contributed to the meltdown. What never made sense before, as someone with a limited and more general understanding of risk management, was why these firms never realized that a disaster was in the making. It seemed like the writing should have been on the wall when so many sub prime mortgages were written based on haphazard underwriting standards (garbage in, garbage out).
The article explains that data input into the risk management models generally covered only the past two decades and didn’t take into account unanticipated events or adequately measure liquidity risks in a crisis. (I see it as a management failure, where management put too much faith in mathematical measurements of risk, and never bothered to look out the window to see what was going on in the real world.)
Of course, it seems likely that certain players should have been able to see what was coming, and that some may have positioned themselves to use the upcoming crisis to their advantage.
Sammie,
Great link. this article is th elead article in this weekend’s New York Times Magazine.
Volumes have been written and will continue to be written on the theories and concepts at work here.
In my estimation, there are a few core issues that we will continually try to promote.
1. The quantitative models ALWAYS inaccurately gauge that during periods of extreme volatility, liquidity dries up because at the end of every trade is and always will eb another human being. How will that human being react and respond to extreme volatility in the economy and market. Will that human being provide liquidity to allow an investor to exit a position?
This scenario has played out over the last few years but we saw a fabulous preview of this back in 1998 when the wizards of Wall St. who managed Long Term Capital Management had a portfolio with 30+ % leverage.
What drives people to take such massive risks?
IMO, there are two factors at play.
1. ego…the feeling that these people are smarter and sharper than others in the market and that when trades go against them, their feeling is the market is wrong and they are never wrong.
2. compensation plans that are wildly askew in which those taking risk are incentivized to swing for the fences.
I have seen versions of this movie dozens of times from a fairly small scale to the current massive scale.
The script is almost always the same.
LD - do you have a handy reference as to what regualtes what and who are they accountable.
To start it off, I have not been able to see who FDIC reports to.
Other agencies as I see it are: The Federal Reserve, Treasury ( Office of the comptroller of the currency and Thrife Supervision) and the SEC. Also some how Agriculture covers Credit Default Swaps
This mish mash has to be streamlined. They have a funcitonal proposal as proposed by the Presidents Working Group. It is proposed to be run out of the Federal Reserve, but that makes me nervous as Greenspan really did not do a good job of keeping us out of trouble, especially the non regualtion of the mortgage underwriters like Country Wide, WsMu and Indy Mac.
This is realy a more indepth subject for another time, yet it is important.
Fiscal…
I do not have a handy reference guide but that is a great idea to add to my list of “things to do.”
I will offer, though, that it always struck me that the crowd on Wall St. was ALWAYS way out in front of the regulators in terms of market know how, embedded risks, and the like.
Clearly the regulators need to properly monitor the markets but in my estimation they need to hire people who are as far up the curve as those they are regulating. They should have an opportunity to hire some of these people given the consolidation on Wall Street.
I agree - you will never catch up with financial innovation and risk. Especially with diminishing budgets in the Bush Administration. Hence the final conclusion of failure and a orderly unwind. However there is a need to stop things like the mortgage underwriters like Country Wide, WaMu and Indymac. When these guy’s do not verify income and ability to pay, to sell a security as AAA is fraud. I do not hear about any of these loan officers being summoned to court etc.
I started to try to find who regulated who and found a lot of confusion. I will continue to persue it and send it to you when I get sometning.
I found this article today in the NYT which helps explain some of the regulator maze.
http://www.nytimes.com/reuters/2009/01/04/business/business-us-financial-regulation.html?pagewanted=print
This is some scary news. Thank you for sharing.
Thanks, LD for all you do.
My pleasure.
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Closed my last commercial bank account in 1996, and am delighted to be in my well-capitalized, local Credit Union.
Couldn’t help but noticing IndyMAC F.S.B. is at the bottom of your LewRockwell list. What does this mean, even though they are a failed institution, that they are a good investment?
Interested….
The fact that Indymac is now at the bottom is, IMO, a reflection that the institution has recognized the losses and wiped out shareholders equity.
It is now a private entity.
I see. My other observation is agreeing mixing banking with high-risk investment is troublesome. In the past the former was known for its conservative approach to investment, low yield-low risk (this is good) while the other was prone to gamble or high yield-high risk (this is also good). There’s a manipulation of this equation now, in having government assume the risk, which may be good for investors, but a raw deal for tax payers (this is not good).
Is this the Paulson of Paulson and Co, the firm Greenspan went to work for after he did such a terrific job of helping regulate? Indymac was a story that deserved more attention, it just got lost in the avalanche of stories.
Yes Annie, it is that Paulson. I do not disagree that this story deserves more attention which is the very reason why we are trying to highlight it right here at NQ !!
Sooo, while the most important central banker in the world was pretending he couldn’t foresee the downside to his policies, his associates were profiting from foreseeing the public cost of the Greenspan Fed. Greenspan goes to work for these lucky people who now profit from the wreckage the taxpayer is left to clean up, and the entire merry band of privatized finance and government goes on to profit more, taking risks that they do not actually take but pass on to the unsuspecting public.
I know Indymac had a holding company that was very interesting, and I couldn’t figure out if the holding company was completely removed from the risk of Indymac’s failure. Again, the issue is that those paid to take risk are not actually taking it. It seems to me that failure is passed on while only the profits are kept.
Annie…this deal is an indication as to how badly the banking system needs capital and how expensive that capital is.
We plan on trying to stay on top of and ahead of these stories here at NQ.
LD, as if I don’t have enough troubles…Just went through that exhausted list you posted of banks & ZOOWIE!! I have funds in two, a decent amount in one & a substantial amount in another. Forgot to jot down their Texas ratios but assets were pathetic (less than my CD in one of them)Please advise. Both say they’re FDIC
Just….exhale !!
In all seriousness, I posted that list for the simple reason that I believe more information is better than less.
In regard to the assets listed, please understand that those numbers are in thousands. For example if the assets shown are $20,000 that equates to $20 million (20,000,000).
Understand?
If you still have assets greater than those numbers, then I would say you have a “high class” problem.
Again, in all seriousness. Make sure that your assets are below the FDIC limit of $250k per account. I am assuming they are.
Go back and check the Texas Ratio. I would be most concerned with the ratio if I were an equity holder first and foremost. Then secondarily a creditor (as in you own bonds issued by the bank).
If you are a depositor below the FDIC insured limit…then you should be fine.
Breathe in…Breathe out.
Please let me know if you understand all of the above.
Hope this helps.
LD, inhale/exhale/inhale/exhale…. yes..you saw my message on the other thread…thank goodness the FDIC answered the phone today or I’d be camped out on the doorsteps of the bank(s) tomorrow morning. LOL. I’m no doubt the only one that actually freaked & thought 20,000 was a literal 20K…anyway I found out something of interest in my panic FDIC call: effective last Sept 28 “beneficiaries based on certain family relationships has been eliminated”, this refers to POD (pay on death) or TOD (transfer on death) revocable trust accounts. One may now use any person (they do not have to be relatives) or a non-profit. Apparently a lot of banks don’t know this or are choosing to not know this, as this adding of beneficiaries gives an additional 100K FDIC protection to an account. Almost sounds too good to be true. The agent I spoke with told me to have the bank call FDIC with me on the line & hear it themselves. Am I making sense?
Just…Awesome color !! Wow. I did not know that but thanks for sharing with our entire audience. That is truly significant.
All’s well that ends well !!
LD - great show tonight with KD
I still wonder - are any of these fraudulent loan originators going to jail? Even though the companies are out of business, is there any culpibility for the loan officers.
Very good pace and management of the material during the show
Thanks very much. Glad that you enjoy it as much listening as I do delivering.
I will inquire from KD as to whether he thinks any more loan officers may be culpable. I do know that some have been charged but certainly not nearly as many as deserved it. Over and above that the management of many of those companies should be charged.
I did find it very interesting that the owner of Ameriquest was a big Bush benefactor and ultimately the Ambassador to the Netherlands. Wow!!
If you’re looking for blame don’t let the comptroller of the currency off the hook, remember 3 or 4 States voted to try & stop the predatory level of subprime lending & he told them they had no authority
LD, I listened to your radio show & found it interesting but I want to go back to the lists of banks at LewRockwell.com Is that a list of troubled institutions? If so how did a branch of JPMorgan Chase get on that list? Also noticed LewRockwell is affilated with the mises school of economic thought. Do you adhere to the mises school of thought? Aren’t they big advocates of buying gold?
Just…
That is NOT a list of troubled banks. I read that list as being a comprehensive list of ALL banks in the country.
I will admit that I am not familiar with the Mises School of thought. I do appreciate your continuing to raise interesting points.
I still need to look into the BDI (Baltic Dry index).
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LD, please indulge me on this question: What is that silver thing with the gold glow on top that is being used as an icon on your Dollars & Sense site? At first I thought it was a Dodge Ram hood ornament, however on closer inspection couldn’t figure out what it is. I hope this isn’t going to be another question everyone knows the answer to but me. Thanks for putting up with me.
I am fairly certain that it is a piggy bank. Remember….there are no bad questions.