Swim with the sharks but risk being eaten alive

Private companies that lend their own money are generally very careful with their loan underwriting, and they know how to collect the money they lend. Most reputable finance companies use simple accounting procedures and have adequate loan reserves, and conservative financial leverage. These firms generally understand derivatives and don't rely on them to manufacture profits. They're not sharks.

This article is not about the private companies that use sound lending practices. It's about the many big financial players, the giant hedge funds, major money center banks, and Wall Street Investment banks. These are the "Big Boy Sharks" who created $2 trillion in subprime mortgages, using hubris and Gordon Gekko-style greed, and have recklessly used leverage and risk with other peoples' money to book corporate profits. A typical example of this is the over-levered Bear Stearns hedge funds investing in crappy mortgage securities that have now left many investors scratching their heads while they search for answers as to why their equity vanished overnight.

Are the codes of conduct being abused by the credit rating agencies when they effectively "sell their souls" to rate untested mortgage product in unproven financial structures? Should investors look askance at the mono-line bond insurance companies that are backing about $2 trillion dollars in asset-backed, mortgage-backed and other securities? How else could the Big Boys get away with it?

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To fully grasp the risk for the financial sector, it's important to understand how finance companies make money. For finance, the greatest profit engine of all time has been the ability to take advantage of a positively sloped yield curve. Long-term interest rates are usually significantly higher than short-term. If you borrow short and lend long, you can make an interest spread of two percent on the 10-year Treasury, with no credit risk at all. However, over the last year and a half, the yield curve has been flat or inverted and the Fed Funds rate of five and a quarter percent is actually above the 10-year Treasury yield of five percent! This means that the greatest profit engine for banks and finance is totally out of gas.

Another big profit engine for banks and finance is borrowing at a highly rated credit rating, and investing at a lower credit rating. The difference between the high rated cost of funds, and the lower rated investment yield, is called the "credit spread". For the past few years, credit spreads have set a new record for being the least profitable ever recorded! A flat yield curve and narrow credit spreads are usually a disaster for bank and finance company earnings. You would think that the right time for finance companies to be minting money is when the yield curve is steep and the credit spreads are wide, not now during times like these.

So, why are the Big Boys still reporting record profits? It's actually easy, with a combination of the following: 1) Taking on unprecedented risk by exploding up the size of the balance sheet; 2) Adding massive amounts of leverage, including hidden leverage through derivatives; 3) Robbing loan loss reserves; and 4) Playing accounting games that allow earnings to be booked today at the expense of losses tomorrow.

Included in the unprecedented risk category is when these same financial firms switch to the foreign carry trade. Big carry trade profits can be achieved by borrowing in a low interest rate foreign currency (such as the Yen). As long as the Yen declines in value, a fortune can be made borrowing below one percent interest, and investing in US financial assets yielding much more. However, this trade is placed and highly leveraged and if the Yen ever goes up against the dollar, the carry trade losses will make the subprime fiasco appear like a minor footnote in history.

On-balance-sheet leverage has also reached new heights. If a financial institution makes nothing on borrowing short and lending long (and credit spreads are cut in half just to keep profits the same), the firm will have to double its leverage, which means twice the risk! Even so, the Big Boys have exploded the size of their balance sheets and are funding massive positions in securities with short-term "repurchase agreements" in the money market. (Many of the securities funded are just like those in the subprime mortgage hedge funds where the security can't find a buyer who will make a bid in the market.) These securities have value recorded on the balance sheet because a trader or portfolio manager, with a fancy financial model, says they have value, not because the market says they do. These balance sheets are like sandwiches filled with hundreds of billions of dollars of "mystery meat". This over-leveraged and frequently rotting meat is something you really wouldn't want to eat. It smells.

Many lenders who have not adequately deducted loss reserves from earnings for credit losses have, instead, goosed their earnings by short-changing the loss reserves. These same lenders also continue to reward their executives by paying them large bonuses and allowing them to cash out their stock options. It's really all about booking a profit today, and telling you about the losses tomorrow.

In the derivatives world, credit derivatives are the new new thing. Very simply put, a credit derivative known as a Credit Default Swap or "CDS" is when the insured pays a premium (like any insurance policy) and if the credit goes belly up, the insurance pays off. Today, there are tens of trillions of dollars in notional credit derivatives, and all of the big players have become sharks with their use of these derivatives.

For financial institutions, CDSs are a way of making a credit bet (just like making a loan) without the inconvenience of putting any real money up or having to place the loan on the balance sheet, that would require equity. Indeed, there are now about 10 CDSs written for each and every corporate bond that actually exists! That means that 90 percent of the business is pure speculation because it is not hedged by someone who owns a bond or loan. Most of the CDS business is simply a way for the Big Boys to place big bets with no money down. Remember, if you own the stocks of big financial institutions, they are gambling with your money.

Why is all this Big Boy betting going on? Just like the accounting for subprime mortgages, the financial institution gets to value the instrument they created. Accounting for derivatives allows both the seller and buyer of the insurance to pretend that the financial institution isn't gambling at all, as both get to book a profit!

The seller of the credit default insurance can claim "I know the credit will never default; I can book the premium I collect as pure profit and don't need to book a loss reserve." At the same time, the buyer of the credit default insurance can claim "The credit will default within a few years so I can amortize my profit, net of the premium I paid, to my expected date of default."

The best analogy would be to picture watching a poker game and around the table are the biggest Wall Street Sharks. A lot of chips are on the table and depending on the accounting treatment used, each player would claim to have won the entire pot even though the last cards have yet to be dealt. The problem is, those cards will be dealt eventually and someone is going to have to book a loss. In this type of poker game, if you don't know who the patsy is, you're the patsy! A number of investors in some big subprime mortgage hedge funds just found this out.

The accounting treatment used in each credit default swap derivative is, unfortunately, not the same. For each and every derivative, each player gets to build their own fancy computer model and mark the value of their credit default swaps, or similar securities, to the model. Since the bonuses that the traders receive are based on what they show to be their profit, human nature and a combination of hubris and greed lead to massively over-optimistic and self-serving modeling, instead of an honest value "mark to market".

Think sausages. We all know they taste great yet we don't dare ask how they're made or what's in them. The major rating agencies and accounting firms have been the helpful and highly paid facilitators in the making of the sausage. Profits at the Big Boy houses look great, too, at the end of the quarter but if you saw how these profits were actually made, you might have reconsidered your investment. Don't count on the accountants or rating agencies to even take a look, until the Sharks have eaten and everyone sees the blood in the water.

For the past couple of years, 40 percent of profits in the S&P 500 have come from financing activities, and financial profits have a long way to fall just to get back to historical averages. Remember, the US economy has been driven by the financial system which has created an unprecedented level of debt. For those of you celebrating when the Dow edged up toward 14,000 and the S&P 500 hit a new record high, you may find the next celebration a long time coming. The recent stock market slide is caused primarily by worries over credit quality and excess leverage. The problems are just beginning.

The high level of risk in the financial sector is one major reason why I buy gold and silver. Remember, these precious metals have no accounting games attached to them. That gold coin in your hand won't go bust and suddenly vanish into thin air!

Written by Richard Benson and published in Benson's Economic and Market Trends 26/7/2006, www.sfgroup.org