July 26, 2009

Goldman Sachs: Still Arrogant and Unrepentant

Last week Goldman Sachs (GS) reported record profits for the April through June 2009 quarter. Quite a difference for a firm that was nearly insolvent less than a year earlier. But thanks to the TARP and favorable borrowing terms from the Federal Reserve, Goldman was able to use taxpayers' funds primarily for the benefit of its shareholders and employees.

In announcing its stellar quarterly earnings of $3.44 billion or $4.93 per share, Goldman stated that it was setting aside $11.36 billion for an employee bonus pool, or $386,489 per employee. According to the Wall Street Journal, Goldman is on track to set aside $20 billion for the year or $700,000 per employee. Under any circumstances, such bonus compensation would be considered sensational. But given the actual circumstances under which its profits were "earned", the projected bonuses are reprehensible and unjustified.

The justification for such bonuses should reflect the risk/reward undertaken to achieve them. Unfortunately, that is far from the case in this instance. Rather, Goldman's apparent success is a function of a confluence of events which had very little to do with the adeptness of its management or employees.

As alluded to above, Goldman was in severe financial stress last Fall as the U.S. financial system was under assault. First, Bear Stearns effectively failed and was sold off to J.P. Morgan Chase (JPM) for $10 a share. Second, Lehman Bros. was forced into bankruptcy after the federal government decided not to bail it out. Third, other financial institutions nearly collapsed and were forced to sell for a fraction of their value only months earlier. Consider Washington Mutual, Merrill Lynch and Wachovia for example.

After the Lehman failure, the financial woes of the U.S. financial system worsened rapidly. The Government enacted the TARP to prevent a further avalanche and in the process created a bailout nation mentality, as least among the largest financial institutions.

A huge beneficiary of TARP funds was AIG. As of today, AIG has received approximately $180 billion of government funds and guarantees for other substantial obligations on its books depending on the ultimate value received for the vast inventory of credit-default swaps and related derivatives on its books.

Of the AIG TARP funds, Goldman received nearly $13 billion. Without those funds, Goldman would likely have suffered a significant loss on the counter-party liability due from AIG. Although Goldman claims that it was really never at risk and was substantially collateralized, Goldman showed no hesitancy in accepting the AIG TARP funds as opposed to enforcing its contractual rights. Clearly, if AIG had gone out of business, it is far from certain as to the nature and extent of AIG's total liabilities and of those particularly due to Goldman, and how such obligations would be treated vis-á-vis other creditors of AIG.

Aside from those funds, Goldman also received $10 billion of TARP funds directly. Of course, this was only after Goldman received nearly instantaneous approval to change its status from an investment bank not regulated by the Federal Reserve to a bank holding company that is. Without the change in status, Goldman would not have qualified for TARP funds and it would have had to raise additional capital from private sources.

In fact, before becoming eligible for TARP funds, Warren Buffett invested $5 billion in preferred stock of Goldman in exchange for a cumulative annualdividend of 10% and warrants to purchase 43,478,260 shares of common stock bearing a strike price of $115. In contrast, thanks to Henry Paulson, the then-Treasury Secretary and former CEO of Goldman, the U.S. government only negotiated to receive a cumulative annual dividend of 10% on its preferred stock investment and warrants to purchase only 12,205,045 million share of common stock with a strike price of $122.90. In effect, Buffett received twice the dividend rate of return on his equity investment to that of the government (even though the situation was more dire when the government invested the TARP funds) and 31,273,215 more warrants than the government at a strike price almost $8 lower. Clearly, the government's below-market equity investment terms were a benefit to Goldman, which would have had to pay at least the same terms to a private investor as received by Buffett (which, given the government's investment, would have equated the right to purchase almost 87 million shares at a strike of $115) and likely much more, given the severity of the situation when the government made its TARP investment as the likelihood of repayment was even less certain at that time.

Besides the TARP, as a result of Goldman becoming a bank holding company, it was given access to the Fed Discount Window, meaning that it could borrow billions of dollars from the Fed at rates as low as .10% and then deploy those funds. Now, the original intent of such borrowings was to enable "banks" to make loans to creditworthy borrowers to spur stagnating economic growth. Such borrowings were not intended as a mechanism for Goldman or other banks borrowing such funds to either purchase other government instruments bearing a higher rate of return or to fund a bank's proprietary trading operations.

But that is exactly what Goldman did. They didn't make a single commercial loan, nor did they accept a single customer deposit. They used the funds to make money on the spread between the almost non-existent cost of borrowing from the Fed and government-guaranteed rates on return on U.S. bond instruments (i.e., bonds issued to fund the Fed borrowings and other government obligations) and related instruments and derivatives. Net net, the government loaned money to Goldman so that Goldman could buy the bonds/instruments being sold to loan money to it and other financial institutions.

Goldman profited handsomely as a result of all of this government assistance, TARP and Fed borrowings. They were literally guaranteed a substantial profit merely by borrowing as much money as possible and then buying government-backed securities bearing a higher rate of interest. Additionally, Goldman took advantage of its nearly monopolistic bond trading operations. With the departure of Bearn Stearn and Lehman Bros. and with Merrill Lynch becoming a shadow of itself due to its acquisition by Bank of America (BAC), there were only two of the principal bond trading operations existing from at least five only months earlier, the other being Morgan Stanley (MS).

While there were other firms trading bonds, Goldman had and retained a significant competitive advantage due to the loss of three of its principal bond trading competitors.

As a result of all this, Goldman posted record earnings. Was that due to Goldman's talent? The skill of its management and its employees? Or did Goldman benefit from the TARP and easy Fed money and fewer competitors in the marketplace? To put it bluntly, Goldman did benefit mightily and for its management to now seek to compensate itself and its employees as if its skill and expertise alone were the only or primary reason for its success is arrogant and condescending.

Yet, that is what Goldman appears to be doing. Other than a perfunctory acknowledgment of thanks to the U.S. government for its assistance, Goldman apparently hasn't learned a thing, certainly not about humility or avoiding ostentatiousness. Consequently, the outrage from the public and Congress has been strong. And even President Obama has counseled against payment of out-sized bonuses by those firms that benefitted from the TARP and other government assistance now that they have returned to profitability due in no small part to U.S. financial assistance.

If Goldman and other banks do not take this advice to heart, it is quite likely that new legislation will attempt to rectify this compensation issue or at least to prevent it from occurring again in the future.

Disclosure: Long BAC and no other positions.

July 22, 2009

CIT Execs Should Resign

I don't know who is supposed to be happy about the CIT bondholder-led financing. Certainly, not the shareholders, unsecured creditors or the non-participating bondholders. Nor the customers of CIT who are likely going to have to find alternative sources of financing when CIT does file Chapter 11 and it will.

No, the only people who benefit from this "usurious" loan under "duress" are the participating bondholders (the "Passive-Aggressive Lenders" or "PA Lenders", for short).

And, perhaps, the Obama Administration which can now proclaim that capitalism finally exists and works in this country because it refused to provide TARP funds in addition to the $2.3 billion already provided.

Note: I use the appellation Passive-Aggressive Lenders because this is the same group of bondholders who has stood on the sidelines for the past several months, such as PIMCO, obviously waiting for a government-style bailout that wouldn't cost them a cent of principal. You know, the people like Bill Gross who presumably calls himself a capitalist even though he will gleefully promote government handouts or guarantees to serve his own agenda.

But when the government refused to play ball, the nice PA Lenders turned downright nasty and imposed "egregious terms" and what Sean Egan, president of Egan-Jones Rating Co., referred to as "Don Corleone Financing."

Let's consider the financing terms. A new lending facility of $2 billion initially. Fee for providing loan: 5% of principal amount or a quick $100 million. Interest payable at 10% over LIBOR, with a minimum LIBOR rate of 3%.

Therefore, the minimum interest charged will be 13% per annum. In exchange for the $2 billion, plus another $1 billion in less than a month (not sure if additional 5% fee applies to that sum as well, but why wouldn't it?), PA Lenders receive a security interest in previously unencumbered assets of CIT having a nominal value of at least five times the $3 billion loan amount.

Let's just say the PA Lenders received really, really good collateral coverage, or so it seems if the numbers bear any relationship to the truth. A good synopsis of the most relevant terms is set forth in a Bloomberg article entitled: CIT Rescue Group 'Ripped' Lender With 5% Fee, Collateral Demand.

Has anything been solved by CIT's new borrowing? Very little, if anything, as a bankruptcy filing is nearly inevitable. Why? Because CIT has lots of bad loans on its books and its good customers will probably jump ship as soon as they can find a more stable lender than CIT. In order words, CIT's business is kaput with or without a bankruptcy.

Who do we have to thank for this pitiful mess. Jeffrey Peak, CEO of CIT, and the Board of Wreckers, er ..., Board of Directors of CIT. By approving this financing deal, they committed one of the deadly sins of management (in addition to all their prior poor management decisions) ... believing that any alternative is better than a Chapter 11 which must be staved off at all costs no matter what. (Remember how GM sucked up TARP funds for months before it eventually had to file for bankruptcy anyway?)

While it's true that the date of bankruptcy has been temporarily delayed, the bond rating agencies and the FDIC, by their actions or inactions, don't seem convinced that CIT's problems have been adequately addressed by this pathetic stop-gap measure. On the other hand, CIT has now given up any negotiating power it may have had in a Chapter 11 with billions of dollars of unencumbered assets at stake. Hey, maybe a regular unsecured creditor/bondholder would have rather taken its chances with an unsecured claim equal in priority to the PA Lenders unsecured bondholder debt (the outstanding debt prior to the new $3 billion or secured debt).

Now, even though only the new financing is secured, the excessive fees and interest will surely more than compensate the PA Lenders for the new loan as well as a way to make back some money on the old stuff outstanding.

There was an interesting wrinkle along with the new financing. CIT has initiated an exchange offer to buy back $1 billion of bonds maturing in August for 82.5 cents on the dollar. So, while the PA Lenders loot the remaining unencumbered assets, unsecured bondholders who would have had a right to share in the proceeds of those assets until last weekend are being asked to compromise their claims.

Why should they unless shareholders are wiped out? Why should they now that the PA Lenders have extracted unreasonable loan terms from an insipid CIT? Frankly, I am surprised that the bondholders with upcoming maturities haven't filed an involuntary bankruptcy petition to stop this mismanagement of CIT's assets as they know for certain they are not going to be voluntarily paid in full.

In sum, the new financing was not commercially reasonable. It encumbered at least $15 billion or more of theretofore unencumbered assets. The fees (and there are many in addition to the initial financing fee) and interest rate on the new financing are unserviceable for any length of time. The CEO and the BOD have completely mismanaged the company to the brink of bankruptcy while begging for another government intervention as opposed to coming up with an intelligent strategy for restructuring the company months ago before it got to the brink or instituting an orderly wind-down of its assets with sufficient notice to its customers to find alternative sources of funding.

The CEO and BOD of CIT have exhibited an unforgivable level of incompetence. The only saving grace would be for the CEO to immediately resign or be terminated and then the last act of the BOD before resigning themselves would be to appoint a new CEO who knows how to liquidate a company that others have screwed up.

Disclosure: No position in CIT.

July 8, 2009

Unintended Consequences of TARP Mentality: California IOU's

It's hard not to get a bit disgusted by the lack of political will to resolve the California budget crisis within its own borders. It has been apparent for months that California tax revenues would be substantially lower than projected and that the budget would be impacted accordingly.

What did Governor Schwarzenegger and the California legislators do to prepare for and respond to this crisis? Nothing, nada, zilch. Instead of developing of plan to stem mounting costs, to issue municipal bonds to fund a portion of the shortfall and to temporarily increase tax revenues (with an automatic sunset), the bickering continued and the June 30 fiscal year ended without a budget in place for next fiscal year.

Since then, California has been operating in never-never land with no concrete plan yet on the table. But now that the state has bills to pay and no money to do so they've decided to issue paper IOU's to pay their liabilities bearing a 3.50% interest rate with an October 2, 2009 payment date. Problem is a paper IOU is of questionable value. Its value depends on whether California will ultimately get its act together and figure out a way to fund its obligations, something that is far from assured.

Bank of America set the tone for dealing with the IOU's which was quickly adopted by other California banks. BAC stated that it would accept them as cash equivalents but only through Thursday, July 10, 2009. Why not through October 2, 2009? Because BAC concluded that leaving the IOU's commitment open for several months would not exert the necessary pressure on the State of California to resolve its budget/fiscal problems.

Let's think about the irony of BAC's position. Just last year, Ken Lewis, CEO of BAC, entered into an ill-conceived and ill thought-out merger with Merrill Lynch. He basically decided to pay $50 billion for Merrill over a weekend without understanding the nature of potential losses and by paying a premium for a company whose stock price would have surely fallen to a fraction of the cost paid in just a couple days after Lewis acted. To add insult to injury, after he found out the extent of the Merrill losses, Lewis didn't even bother to tell BAC shareholders so that they could decide if the deal made sense. But that is not the point of this blog post.

I mention the BAC-Merrill deal only because at the same time as Lewis was galavanting around trying to satiate his ego as opposed to working on behalf of shareholders, BAC was also in a financial crisis exacerbated by the Merrill deal. In fact, BAC became one of the largest TARP recipients receiving a total of $45 billion of taxpayer funds.

But BAC was not alone as all of the large banks were required to take TARP funds whether they needed them or not, and most of them did. Stately more starkly, BAC and the other TARP financial institutions were bailed out by the U.S. government via the American taxpayer.

Fast forward. California doesn't solve its budget crisis and the longer it doesn't do so, the more call there is for some sort of bailout or assistance from the federal government. To date, the Obama Administration's, to its credit, has rejected those pleas due to the consequences of the dangerous precedent it would set, to wit: that virtually every other state would then also seek federal government assistance -- something this country cannot afford on top of the already trillions of dollars of debt racked up in the past year.

Having been turned down by the U.S., did California change its ways and get down to business?No, instead it continues to engage in a game of chicken with the American taxpayer, whether by design or sheer lack of leadership and discipline. Where does that leave us? Either the taxpayer bails out California or BAC and the other TARP banks in California will have to accept the IOU's past their current self-stated deadline of tomorrow. If the banks do stand firm on their threat, California will essentially be bankrupt from a liquidity perspective and hundreds of thousands of government employees will not receive paychecks and government services will grind to a halt in a matter of days.

On the other hand, if BAC and the other TARP banks do accept the IOU's for the next several months and the budget crisis in California is still not solved, we could have the unintended consequence of a TARP bank taking huge losses or write-downs on the IOU's they are then-holding. So either the TARP recipients bail out California indirectly (with implicit U.S. backing) or the U.S. government is likely going to end up bailing out California and a longer list of states that come calling thereafter.

Perhaps the most long-lasting problem with the TARP is that, even after TARP funds are repaid, there will not be an end to the mentality it created. It basically told irresponsible banks that they didn't have to pay the ultimate price of insolvency, even though they were insolvent, because they were "too big too fail". Now, the federal government is in the same position vís-a-vís California as it was with the TARP banks. Essentially, the question now becomes whether California is too big too fail and, if it is, the federal government will have no choice to come to its rescue. And so goes the TARP.

July 3, 2009

Signs Economic Recovery Not in Sight

Here is just a sampling of signs that the economic recovery is nowhere is sight:

California is issuing IOU's for billions of dollars of current obligations. State workers to be furloughed three days per month.

Unemployment rate hits 9.5%, with 467,000 jobs shed. Job losses accelerating from previous month with estimates for unemployment to exceed 10% up to 11%.

Automobile sales are still suffering despite massive incentives. Consequently, gross margins are being compressed. Sales without profits is not a recipe for long-term survival. Lear and other suppliers to file for bankruptcy relief as sales slow and margins disappear.

Once the current buyers of vehicles have bought at heavily discounted prices, sales will continue downward cycle as all who could afford and wanted to buy will have already done so.

People who are unemployed or who fear job loss are not going to buy cars or fund an economic recovery. This is a nonsensical fallacy.

The recent stock market rally is not based on improving fundamentals. It is based more on the herd mentality of Wall Street. The investment laggards must buy into the fool's rally to supposedly avoid falling further being competitors. Unfortunately for them, their clients are not going to participate in the recent rally; instead, they will suffer further losses as the market retreats.

The FDIC has already shut down more banks this year than last year in its entirety by a factor of two.

Home prices are still declining. The only increase in home sales relates to foreclosured properties or those in the midst of foreclosure.

Consumer credit is constricting at a rapid pace and banks reduce credit risk and the cost of that reduced credit is ballooning. Hardly the condition for a return to prior consumer buying habits.

The U.S. dollar is being continually devalued due to outrageous defecit spending. The value of the dollar versus other currencies will continue to decline if the profligate spending continues. It may already be too late to stave of a tidal wave of inflation once the world economic recovery returns in full force, two, three or more years from now. Don't expect an economic recovery until unemployment begins to decline for a substantial period of time and consumer credit eases.

China has already indicated its intention to rely less on the dollar as the sole global reserve currency. As that movement expands, borrowing costs for the U.S. will continue to rise.

The American taxpayers is being stressed to the max even before the cost of a new health care system and of environmental "cap" and "trade" are factored in.

Similar to California, state governments throughout the country are on the brink of collapse due to the failure to align actual current revenues with prior outdated prognostications of revenue. State legislators lack the political backbone to curtail spending even in the face of economic catastrophe AND just as every individual household must do when sources of income decline.

There are no "green shoots" of any lasting consequence. Whatever "green shoots" supposedly existed were manufactured by government manipulation of our capitalist system.

When the government no longer respects contracts or the rule of law that has governed business relationship from time immemorial (with few exceptions) in favor of general notions of the public good or socialist tendencies, we are not fomenting the conditions for economic recovery but just the opposite as entrepreneurs and businesses can not rely on the sanctity of their negotiated arrangements.