Spank the Banks

Is it irony that "Chess" is a term used in this article? From Bloomberg.com Investors Should Spank Banks for Betraying Trust: Mark Gilbert By Mark Gilbert November 14, 2007 Nov. 15 (Bloomberg) -- Exactly a year ago, I was summoned to ABN Amro Holding NV's London headquarters for a dressing-down. I had sinned by comparing the bank's glossy new derivatives, dubbed constant proportion debt obligations, to a Nigerian banking scam. The newfangled securities made bets on credit-default swaps, which are themselves a gamble on company creditworthiness. Steve Lobb, ABN's global head of structured credit, tried to convince me of the error of my skeptical ways with the help of a whiteboard and one of those wonderful diagrams of boxes and arrows showing money flowing from here to there. This week, Moody's Investors Service said it may cut the Aaa ratings on two of ABN's CPDOs, along with five CPDOs and one swap contract initiated by UBS AG and rated between Aaa and Aa3. Moody's cited ``the continued spread widening and spread volatility on the financial names underlying these CPDOs.'' One of the ABN CPDOs, called Chess III, went on sale in July priced at 100 percent of face value with that golden Aaa rating. This week, it was worth about 41.5 percent of face value, according to ABN prices. Put another way, the investors who bought the 100 million euros ($147 million) of notes lost 58.5 million euros in just four months. That beats any Nigerian scam. It turns out that anyone who trusted the CPDO creators -- and even the most sophisticated derivatives buyer has to place some faith in what the stress-testing models of the seller suggest about future valuations -- misplaced their faith. Confession Time The complexity of the securities market is mirrored in the opacity of how the banks explain their earnings to investors. Recent years were supposed to be a glorious period of disintermediation, with risks sliced, diced and transferred off balance sheets once the fees had been booked. Instead, the banks are trooping one by one into the confessional to admit to warehouses full of toxic waste that is deteriorating in value. You could pick up shares of Citigroup Inc. for as little as $31 each this week, a far cry from their January peak of $57 and about the same as you would have paid in March 2003. Never mind that Citigroup's total net earnings in the intervening period amounted to a staggering $90 billion; ``the stench of banks not coming clean with their subprime exposures in the first place,'' as the credit strategy team at Societe Generale SA described things in a report this week, has seared investor confidence in financial companies. So it should. `Anyone's Guess' Bank of America Corp. shares had their biggest one-day gain in five years this week, after Chief Financial Officer Joseph Price said at an investor conference that he has no idea whether a $3 billion writedown in the fourth quarter will square the accounts once and for all. That's right. The shares ROSE. Hey, at least $3 billion isn't the $8.4 billion bullet taken by Merrill Lynch & Co. last month, or the $11 billion Citigroup flagged on Nov. 4. ``Where valuations will be at the end of the year is anyone's guess,'' Price said. ``This is further complicated by the impact of ratings and the behavior of the owners of the most senior tranches of certain structures, which add to an already complex evaluation.'' In short, if the guy next door starts dumping all the top- rated nasties he owns into the market, and the rating companies continue to slash the creditworthiness of all the wriggly things hidden in the warehouse, writedowns might have to get bigger. Orphan Accounts Bank of America also said it might have to pony up as much as $600 million to bolster money-market funds that gave some of the cash they manage to structured investment vehicles. As some SIVs start to go bust, Legg Mason Inc., SEI Investments Co. and SunTrust Banks Inc. are also bailing out funds to ensure they can repay every dollar entrusted to them by widows and orphans. It isn't just money-market funds that have played fast and loose with the public's wealth. The state of Florida's money was invested in less-than-stellar asset-backed commercial paper, leaving taxpayers owning $2.2 billion of debt cut to junk status, or about 4 percent of the investments made by the Florida State Board of Administration. How many other local governments in the U.S. were similarly profligate with the contents of their coffers? Merrill published a full-page advertisement in the Financial Times this week, telling us ``Why Merrill Lynch Is Still Bullish on Merrill Lynch.'' Lots of positive, muscular statements are scattered across the page. Setbacks are something to be ``overcome,'' liquidity is ``strong,'' transactions are ``significant, innovative.'' The company's bull logo symbolizes ``pride, strength, integrity and optimism.'' Bearish on Bulls Hmm, I remember another full-page Merrill proclamation in the newspapers, on Sept. 25, 2001, in response to the terrorist attacks that destroyed the World Trade Center that month. ``We remain bullish on America,'' the bank said, urging investors to keep the faith and load up on stocks. A year later, the Nasdaq Composite Index had lost 20 percent of its value, the Standard & Poor's 500 Index was down 17 percent, while the Dow Jones Industrial Average had dropped 10 percent. Merrill itself fell 12 percent. Bullish on banks? Too many dark cupboards with too many potential skeletons, too many job cuts on the way and too much obscurity in earnings reports make that a leap of faith too far. (Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)