Easy escape for Goldman

Goldman Sachs settled civil charges that it misled clients through selling mortgage securities designed by a hedge fund with SEC by paying $550M on Friday. Goldman admitted it made a mistake that they had not disclosed the hedge fund's role. This is the civil charges for Goldman. The criminal probe has not been concluded. Although the case has not been fully closed, it is an easy escape for Goldman.

Goldman's role in the 2008 crisis is far more than hedge fund designed mortgage. For example, its number two executive, Gary Cohn, was in a congress hearing to provide Goldman's role during the crisis. Only few still remember what the drama involving Bear Sterns and Lehman. Here are some snapshots.


Goldman was the first firm that novated Bear Sterns' trading partner in March 2008. The action triggered a series of rumors about Bear's situation. Novation is better explained by this example: Bear had a trade with a hedge fund Hayman. At the beginning Goldman wasn't involved. Then in March 2008, Hayman realized Bear's situation has deteriorated, so they asked Goldman to novate, that is, to take over their derivative trade, about $5M. When a novation is requested, usually that means the other side of the trade has liquidity problem. The request was escalated to Cohn. Besides political plays between Goldman and then Bear's executive, Goldman eventually didn't novate the request even though they sent an email to Hayman that they consented the novation. Goldman just delay the request and eventually killed the request. Later Goldman refused that they had agreed the novation.

Goldman was also the first firm disclosed publicly Bear's two hedge fund's liquidation problem mortgage back obligation. When one of Bear's hedge fund blew off in April 2007, Goldman marked (means they evaluated the fund's value) half compared to other firms. That was to say every one else marked the fund had 100 but Goldman only gave them 50. All the marks had to be averaged to tell what the current value of the fund was so that they could operate. This single mark down caused the previous great performed fund had a -19% drop. That is the start of Bear's problem because they decided to save the fund by putting $3.2B their own money. Cohn, again, was the one explained to the world why they marked down so much: Goldman's aggressive mark down was due to the detriment of the fund's income statement and those of some of their clients who would then have to account for Goldman's mark. He also protested that Goldman had profited a lot. He didn't say who the clients were. It turned out Goldman was right that the fund had liquidity problem. The bet of MBO's collapse is also right perfectly.

Although the settlement has been approved, the political conflict is not difficult to sense: a 3-2 vote on SEC with 2 Reps vote against the settlement (the Reps are against strong fraud charges). It reveals how powerful Goldman is, adding that Paulson was the Goldman CEO and then Secretary of Treasury, who ordered Lehman's bankruptcy. Goldman might face up to $1B charge. But now half of the price is really a steal. Goldman has bright future.

Efficient customer and inefficient markets

The Wall Street Journal reports that concert goers are more prudent when purchasing tickets. Compared to the previous generations, they delay the dates to buy tickets closer to closer to the concert date. That give them more time to look around the Internet to find better deals. That sounds a good news on the customer stand point so that they save more on concert expanding. But it certainly is not as good on the artist side: the concert sales has declined 17% compared one year ago. Artists are struggling to find ways to spike up the market.

The Perfect Market theory says market participants will find ways to excel in intrinsically inefficient markets. Although this theory has been challenged by many investor, it seems it works perfectly in this context. In this case, the incentive of having cheap tickets is high, may be the uncertain economical condition plays a role. However, as loud as the challengers sound, plenty of real life examples contradict:

For companies that still are struggling on revenue, according to the theory, they should streamline their management and push out more competent products. But that is not the case. Sluggish product development and chaotic management wasted lots of opportunities to make productivity efficient. To an extreme, external pressure either make or break some institutions. For those don't need to worry about revenue in near term, it is the same story. One news said that a university research on inserting a micro camera into a tube to detect inner organ got $1.5M funding from the government. Is it worth for such spending? When facing deadlines, companies usually would just double the man count, which caused more expenses.

In all, the theory just doesn't work: the markets can't adjust themselves, either they don't know how or don't want to. This free market theory is good for academic study but in real life, we need some management (hopefully qualified) to right the ship.

This is a mini snapshot of the view between Adam Smith vs. John Keynes

Home ownership and mortgage crisis

Freddie Mac and Fannie Mae are now off the big board. These two entities were the main power for many to realize their American Dream. Now they are gone after the mortgage crisis. We can't help to thoughts who caused whom, the crisis or the entities? A brief history of US home ownership policies may help to think. Nonetheless, it is not easy to answer.


In 1918, the government encouraged middle class home ownership by "Own Your Own Home" campaign. Home ownership or further, real estate investment, was considered a hedge against inflation. Home ownership rose from 40% in 1940s to 65% around 1990s, when a plateau was reached around 1960s. The peak was in mid 2004 with 69.4%. This is attributed to government-back mortgage plan. We should look at the trend more closely.
Prior to 1994, home ownership hovered around 64% constantly. After 1994, it started moving upward consistently.

When the first President Bush was in power, a bipartisan effort to increase home ownership was proposed to meet the goal of American Dream Downpayment Initiative. This initiative went into law officially in 1993 when President Clinton came to power. No administration would oppose such proposal. The law allowed to provide up $200M to support home ownership among low-income first-time home buyers by helping to pay closing costs and down payments. Such policies were attributable to pressure on the Department of Housing and Urban Development (HUD) to implement them.


Sooner or later, conservative lending rules gave ways to "creative" ones. Starting from 3% mortgage to 0% mortgage, more and more mortgage banks hurried to provide loans to low-income households and especially minorities. Adding to the tide, arguably, the change of the Community Reinvestment Act of 1977 also played a role, in which banks were rated based on how much lending they did in low-income neighborhoods. Good CRA's are important for banks to get approval from regulators to sign off mergers, expansion, and branch openings. Around the time, Fannie and Freddie were pushed to allow previously disqualified customers to be qualified for loans. Also, securitization of subprime loans was allowed since then.

To flow such pressure more efficiently, the first such securitization of subprime loans, about $385M, was underwritten in Oct 1997 by now defunct Bear Sterns and First Union Capital Markets (now became Wells Fargo). Freddie and its AAA rating guaranteed the payments on the securities. Suddenly, the risk of low-income households on mortgage shifted to investors because of this. The performance of these securities was so great: its return was about 7.5% compared to low interest rate from the Fed. Banks flurried into deals like that.


Let's see what statistics says about home ownership in big cities to see who actually can afford it. The data is from Federal Reserve Bank. For example, in San Diego, home ownership dropped to 55% from the peak of 63%. But households with positive equity in their homes were between 35% and 39%. A worse case is Las Vegas, where only 15% to 19% home owners have positive equity out of total 59% total owners. Such puffy data, not surprised, can be linked to high foreclosure rate in Las Vegas.

However, HUD denied the role of loosening lending roles along the path. It is really not a one-man show: see how many bankers got rich from CDO's and MBS's. What apparent is that the policies were skewed and the death of Fannie and Freddie. CRA's should be under review, for example, as a lesson learned from the crisis.

Storm awaiting Wells

Wells Fargo on Wednesday, July 8, 2010, announced plans to restructure its financial division and close 638 Wells Fargo Financial stores across the nation. Consequently, approximately 3,800 positions over the course of the next 12 months will be eliminated. According to Wells, these financial stores are not competitive with banking and mortgage network. Economically speaking, the restructuring will cost Wells Fargo approximately $185 million, $137 million of which will be recorded in the second quarter of 2010.

Wells Fargo, the third largest bank in the United States, has to do something to rein their size so that they can keep up with expectation. Services from Wells seem out of pace as they absorbed Wachovia. One customer shared his experience in their investment branch: he tried to talk to the manager about changing a yesterday's trade cost basis. The arrogant manager, after self-claimed he is highest rank on the decision, abruptly said, "no, I don't want to do that. You've caused too much trouble for me". The client immediately shifted his fund to another firm. Never heard of such experience before.

Indeed, Wells needs some fixing. Here is another story about their mortgage business, widely reported in media.

Wells was faced a foreclosure of Levitt & Sons LLC on seven stalled housing development in Georgia, Florida and South Carolina. Due to the dire housing condition, the builder claimed bankruptcy in 2007 and discontinued operation. Now it is under the process of liquidating. In order to save the $122M loans Wells had put in, they pursued an unusual route: Wells agreed to fund another $3M revolving line of credit to help finish building such amenities as clubhouses and sell some completed homes. They bet the 1,800 acres property in various stages of completion, would unlock more value and attract more buyers if the property is maintained and close to generating revenue. The result is Wells recouped roughly $65M, including individual homes, after deducting the costs for operations such as construction.

What to tell from the news in combined with the restructure and their services? Wells has more to do to clean up the bloating team. There must be many dark corners deemed to be enlightened. Some had questioned their ability to integrate Wachovia, besides infrastructure. Now it seems the easy part is gone and the hard part is coming.

Right judgement

Right judgement is critical to everything. In financial world, it will cost death and survival. Many times, individuals fully soaked in events can't make correct judgement because they're so embedded that keen judgement ability is lost. That is just our psychological fact. So the suggestion is that pull ourselves out of a situation and think outside the box.

Here is an example.

Right before Bear Sterns' fall, its credit deteriorated from $18B to $4B just in one day. Trading partners and lenders kept withdrawing from Bear Sterns. They couldn't open the door the next day because they didn't have operating capital anymore. So the executive team seek help from JPM and the Fed. Realized how much impact could be the financial system, the Fed and JPM decided to open a lending window to Bear Stern. In fact, it was the Fed who is lending, JPM is the agent because the Fed didn't want to involve in this deal directly. The announcement said Bear Stern could have up to 28-days of credit backdrop by JPM. Everyone in Bear's executive team was so enlightened that they claimed a victory. No one questioned the statement and situation because they're too tired to do so. Instead they just hoped this was over and used the 28-day window to solve the problem.

The traders in Bear Stern, however, right after they got the announcement, immediately said the firm was done, as opposed to what they're told by the executive. The market knew they're done too because if the Fed needed to be involved that meant the situation was really bad. Downgrades from all rating firms pushed down Bear's price by 50% the next day. When Bear's executives puzzled why the market reacted in this way, the Fed realized much of Bear's assets were toxic. So they won't allow Bear afloat in the system for 28 days but 2 days. They ordered Bear to find a buyer in 2 days. Bear's executives argued that they had 28 days. No, JPM said, "it is *up to* 28 days". No one paid attention to the deadly "up to". It is useless to discuss the book in such a short time.

The rest is well known: in 2 days, Bear sold itself for $2.

Bear had options to sell itself earlier with unknown price. But they didn't. They thought they might get $30 or $40. The ones who knew intuitively are the traders right out of their market senses.

Fund of funds

A fund of funds is one kind of hedge fund. This is why is named: a fund of funds selects and manages a diversified portfolio of funds so that it sells to wealthy individuals or institutions. A good analogy of fund of funds is the ETF concept: a manager picks a pool of stocks to form an ETF and sell to investors. Fund of funds are targeting to those whose don't manage complicated asset allocations themselves.

The selected funds in fund of funds portfolio can vary from different flavor, for example, growth versus value, long versus short, and many other more. Fund of funds employ sophisticated techniques to filter value by allocating asset among fund classes. Besides quantitative measures on funds, they also monitor whether their fund managers working with them are lagging behind and emotional drifts.

Fund of funds charges 1 to 1.5% of asset as management fee, in addition to that 1% of profit. Since fund of funds also needs to pay their funds 20% fee, the cost is significant on investor side. For example, if return before any fee is 20% a year, the funds need to take out 20% of the profit, that leave 16% net profit. Then there is a 1.5% of asset fee. This is translated to 14.5% net profit before fund of funds' fee. After all of these been taken care of, the effective return is 11.7%. Double fees are the big drag in return.

Also because of the double fee structure, fund of funds are working pretty aggressive to whip their funds work even harder. Not only their own performance but also funds' performance under them are under closely scrutiny. Fund of funds knows when to switch horse, especially a series of luck hit a manager, it is time to bail out and gear in to another who had lost in a row.

Even with such double fee structure, fund of funds can still recruit large institutions like pension funds. Because pension funds don't have the ability to manage funds themselves but they have to maintain stability and return in the long haul. Fund of funds meet these two basic requirements by having an analytical layer between pension funds and broad range hedge funds. It becomes more efficient. To some extent, fund of funds may be considered a substitution of fixed income products.