The Rescue Bond is Back!

In the early 1990’s I was managing the Capital Markets desk of a Canadian Broker/Dealer in Tokyo Japan. In the wake of the “Triple Yazu” – precipitous drops in Stocks, Bonds and the Yen – Japanese banks and investors were groaning under the weight of balance sheets laden with securities that were underwater and incapable of supplying enough future income to avert catastrophe.

With the active encouragement of the authorities there, a variety of sleight of hand transactions and accounting treatments were employed to allow many of these organisations to forestall disaster – for a time. Chief among these was the “Rescue Bond”. The idea was simple: an approach is made to a Japanese institution who is underwater on some bonds, Say their portfolio is worth 80 per cent of par, carries a coupon of 5.00% and has an average life of 3.5 years. The pitch was to buy the portfolio at par and to provide a teaser coupon that would allow large interest accrual gains to be reported in the first 2-3 years- say 9.00%. Unfortunately you do not get something for nothing. The security would be long dated – typically 10 Years and the coupon structure would decline to a negligible level after year 2, say 1-2%. The economics of the restructured bond were in fact inferior to the original portfolio….How are investment bankers otherwise expected to earn their bonuses? There were other tricks that relied on the fact that most Japanese investing institutions actively manipulated their books and did not mark-to-market that allowed the merry go round of value destruction to continue twirling without getting the economy and loss making institutions anywhere but dizzyingly bankrupt. It took 10 years – The Lost Decade – before the Japanese economy regained a semblance of health.

It is therefore frightening to see similar accounting tricks and subterfuges now being employed by US banks and investors in a similarly vain attempt to forestall the day of reckoning.. With the SEC and other watchdogs actively looking the other way, many institutions are pre-determining the losses that can reasonably be reported rather than adhering to the mark-to-market discipline. Nouriel Roubeni of the Stern School of Business reports that:

“….folks dealing with the toxic/illiquid assets come up with totally ad hoc assumptions to make sure that such illiquid assets are valued consistently with the decided-in-advance amount of write-downs and losses. This is not earnings smoothing; this is active manipulation and falsification of financial results aimed at creating even more obfuscation of the true state of financial institutions. This obfuscation is actively abetted by the SEC, the Fed and all other regulators that are now in forbearance crisis management stage where the objective is to avoid at any cost anything that may trigger a financial meltdown. Thus, most of these earnings reports are not worth the paper they are written off. This earnings manipulation occurs in a variety of ways. First, ad hoc assumptions still used to value and write down level 2 and level 3 assets. Second, banks are leaving aside less reserves for loan losses that are much less than necessary; they do that by using ad hoc assumptions about future losses on mortgages, credit cards, auto loans, student loans, home equity loans and other commercial real estate loans and industrial and commercial loans. Reserves for loan losses have been sharply lagging actual and expected losses, thus padding earnings as decided by the financial institutions’ managers. Third, there is disposal of illiquid and toxic assets in ways that misleadingly reduces the amount of actual write-downs. An example is as follows: suppose a bank wants to dump illiquid MBS or leveraged loans that are worth – mark to market – 70 cents on the dollar rather than 100 cents on the dollar. Then, instead of selling these at a price of 70 and showing a 30% write-down these are sold to hedge funds and other investors to a price closer to par – and thus showing in the balance sheet a smaller write-down – by providing a subsidy to the buyer of the security: so a hedge fund will buy such toxic securities at 80 or 90 cents and receive a loan to finance the transaction at an interest well below the borrowing costs for the funds. Thus, write-downs are then shown smaller than the true underlying loss on the asset and the bank finances that fudged transaction with earning less revenues than otherwise on its credit portfolio. This is an accounting scam- bordering on the criminal – that auditors and regulators are abetting on a regular basis. “

This and other facts which we will discuss in subsequent posts convince us that the crisis is far from over. In fact we are not even near the end of the beginning. More likely we are standing on the verge of what will likely be the largest incidence of bankruptcies in the financial services sector in history. Expect a massive wave of restructuring and consolidation. Recovery Partners first provided this outlook in an address to the World Hedge Fund Summit about two years ago.

Our obvious conclusion is that the recent rally in financial shares is a head fake. Don’t get sucked in.

Posted in Bankruptcy, Bond Market, Restructuring, Sub-Prime, USA | No Comments »

You heard it here first

While we generally do not like to boast, we will point out that at Recovery Partners we have been informing our clients, colleagues and friends since 2006 that the credit cycle is turning. For some quarters now, the credit markets have provided unmistakable signals that the party is over  and that additional, significant, stresses clearly lie ahead.  

We note that a market report from the Bridgewater Associates was leaked over the weekend that estimates losses from the credit crunch at US1.6 Trn. That is a far bigger number that the USD 1.2 Trn. estimated by Goldmans only two months ago. It is also more than three times the amount of losses announced by banks and brokers to date. As far as we can tell this number does not include the destruction of shareholder wealth caused by tumbling sharemarket and real estate prices. The relevant questions are: (1) If the estimate is in the ballpark, have the markets already discounted this, and if not, are they prepared for the red ink when the wounded and dying financial sector firms begin to own up to the scale of their losses? And (2), whither the economy in the face of such unprecedented negative wealth effects?

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Posted in Bankruptcy, Bond Market, Crisis, Loan Losses, USA | No Comments »