Archive for the ‘Hedge Funds’ Category

A tax increase on private equity and hedge fund executives

From the Financial Times:

A tax increase on private equity and hedge fund executives was passed by the House of Representatives on Friday as part of a package to fund middle class tax relief, but faces a likely veto by President George W. Bush.

The $50bn (€34bn, £23.89bn) tax increase was approved by a vote of 216-193 with all Republicans voting against the package and threatening to block the legislation in the Senate.

The passage of the bill is a setback for the private equity and hedge fund industries and makes it more likely that executives will in time see their tax rate doubled, depending on how Democrats fare in election campaigns next year.

The revenue raised has been earmarked to pay for relief for more than 23m middle-class families who would otherwise be caught by the alternative minimum tax.

The AMT is an archaic levy that was originally designed to catch 200 wealthy families that paid little or no tax, but has expanded stealthily because it was not indexed for inflation.

For a start, I don’t see that a tax increase on executives of specific industries should fairly face a tax increase – why not, say, oil or weapons industries? Their products are actively harming people. Of course this is not the case: the Financial Times is just doing a bad job. The tax is on carried interest, that thing executives of these industries use as income, call capital gains, and scam a lower tax rate on. Rather than fix the problem, the government has decided just to tax the problem (it’s an Austrian kind of day, all told). The tax also does apply to any other industry – whose executives are pulling this scam on the American people.

Second, how archaic must the Alternative Minimum Tax be, if it was designed to catch 200 households but is going to catch 23 million households, now? Call me an idealist, but those numbers tell me of a government that hasn’t been doing its job.

Third, of course – why in God’s name does a government with a budget the size of this one need any new taxes to pay for things? I think carried interest is a scam, as I said, but it should be fixed for that reason – not because the government is too chicken to, say, stop handing over money in tens of billions to the Pentagon.

Finally, the story’s punchline was Secretary Paulson demonstrating, as is his wont, the difference between an elected official, an appointed official and – particularly these days – a competent official:

Treasury secretary Henry Paulson called on the Senate simply to extend tax relief but “not raise other taxes”.

Priceless. They say he’s in charge of the economy, you know.

The Heavily Indebted Poor Countries initiative vs. vulture funds

The Guardian today has a wonderful article dissecting the – typically ass-ish – behaviour of vulture funds towards the world’s poorest countries.

Vulture funds buy up sovereign debt issued by poor countries at a fraction of its face value, then sue the countries in courts – usually in London, New York or Paris – for their full face value plus interest.

Donegal International, an offshore vulture fund, burst into the spotlight this year when it won an award for $15m from impoverished Zambia in the UK High Court. Donegal paid $3m for some old Zambian debt, then sued for $55m, although the London judge reduced the award to $15m.

But that was the tip of the iceberg. A paper prepared for the IMF/World Bank meetings this week shows there are now $1.8bn of lawsuits against poor countries where people typically live on less than $1 a day. Eight cases were launched in the past year – five against Nicaragua, two against Cameroon and one against Ethiopia. But the report warns the figures are far from complete and the real totals could be higher still.

It shows that of the 24 countries that have received debt cancellation under the Heavily Indebted Poor Countries initiative, 11 have been targeted for legal action by private creditors. And they have already seen awards in courts of just under $1bn – money that could have been spent on schools and hospitals.

Always an interesting debate – I am a smash-the-IMF-er type, generally (by way of full disclosure). The arguments for personal (even sovereign) responsibility don’t hold for me. Distressed debt, wether it belongs to shitty countries or shitty incomes/mortgages from sub-prime suckers, should be – somehow – protected. Not exploited.

Exploitation of distressed debt perpetuates, as the poverty trap never could, poverty. In our communities, in our so-called ‘global village’, etc., the principle of ‘catch-up’ will never work in practice while funds circle the globe poleaxing poor countries at every turn.

An enjoyable article to read. Also, the wikipedia entry for vulture funds contains a bundle of worthwhile references.

This is not to suggest there is ‘a’ solution – it is attitudinal. For example:

Gordon Brown has criticised vulture funds and called for international action to ensure that they cannot thrive. He wants the World Bank to help poor countries eliminate their commercial debts and creditors to establish a legal fund to help countries defend themselves. “We are determined to limit the damage done by such funds,” he says.

Can he honestly do this, without altering his own government’s alterna-function as international arms broker? I don’t think so. Well may we say, in our paternalism, that these countries could spend this money on health and education. They may just as easily spend it on the lifestyle of Charles Taylor – in which case our government would be just as happy to arrange trade shows.

How bad loans in the US infected the world

Today’s Guardian is all about credit crunching. I recommend the Business G24 .pdf version, if you’re about to take a train or bus somewhere.

I got to read the real version, live!


On this train:


The reason for the interest: the Guardian put in a great graphic on the infectiousness of the US housing bubble:

Bad Loans pic_guardian

Jim Kunstler has no sympathy for Wall Street

Which is fine, because neither do I. While I watched Jim Cramer absolutely lose it on CNBC last week, my only thought was, “you stupid crybaby prat.”

Jim Kunstler’s post yesterday dealt with this, and more! It’s a very good one, even by Clusterfuck Nation standards. If that doesn’t tempt you, it contains the likes of this quote:

A lot of catered crab tidbits and mini-quiches must have gone uneaten out along the dunes as weeping men in blazers realized that “marked to market” had come to mean the same thing as “holding a bundle of shit.”

It’s like my frank acknowledgement that a lot of the over-leveraged home loan borrowing was done by households that just don’t make enough money to own a home. The financial troubles currently assailing us came about thanks to people like Cramer’s buddies who were happy to bury anyone trying to make more money that you sustainably can in their game. It is blowing up in their faces, and I just don’t see why we should be sympathetic to them, or let them have more easy credit to try to double down (just long enough to get out and leave you and your neighbours with the tanking stocks, by the way).

Nor can Bernanke lower interest rates just for them. Everyone else is raising interest and – as we’ve heard time and time again – the United States needs to a borrow millions every day. Not Wall Street. America. I think Bernanke is slow when it comes to this ‘core’ inflation deal, but he’s not a moron.

Anyway. Jim Kunstler did a wonderful job.

Bush fails to calm battered stock markets

To think I’d just said the economy was boring! This, by the by, is my favourite of the stories making up the pictures.

The White House last night made a concerted attempt to inject fresh confidence into the world’s battered stock markets as share prices suffered a new day of falls on fears that a credit crunch will end an era of cheap funding for corporate takeovers.

With Wall Street down 100 points in early trading after Thursday’s 311-point plunge, Mr Bush and his treasury secretary, Hank Paulson, downplayed fears of contagion from the crisis-ridden real estate market and claimed that the US economy was strong.

Are they out of their fucking minds? For a start, nobody with actual money at risk is subsequently stupid enough to believe either (i) the canard about sub-prime mortgages being contained (will Greenspan please bend Bernanke over his knee and give him a good hiding?), or (ii) that the Bush administration can manage anything, ever. Hell, while a good economy and two odds-on favourite wars go to utter shit around them, they’re busy cooking up arms deals with the Saudis (nothing at all to do, I’m sure, with the weird sale-price they got on Saudi Aramco oil, a week or two back).

You’ll note that deal sells advance US weapony to “Saudi Arabia, other Arab allies of the United States and to Israel”. Thanks for all the hard work on peace in the Middle East and keeping down the proliferation of weapons, you bastards. It also includes “allies of the United States” such as Egypt – whose relative lack of those freedoms and democracy we’re exporting Bush and Rice themselves have criticised, repeatedly. At least now we’ve given them the weapons with which to fight back.

So here’s a tip for the White House: you guys don’t seem to have any sense of shame or, say, reality. But when everything from equity deals to hedge-fund-speculated commodities to housing to the risk profile of banks is tipping over, it’s best not to go on television, spewing pure fantasy and generally appearing like desperate, shrieking incompetents are at the helm of the ship of state. That might work with Fox News and CNN, but you’ll find the Stock Exchanges of the world are populated by intelligent people, not shills and hacks. This isn’t MSNBC’s bloody Trader Talk; it’s the actual traders.

So that was interesting. Meanwhile, more and more, writers are pondering aloud about Big Ones (market crashes, not Aerosmith albums). I never particularly gave this credence, given the differences (the biggest being that the Big One was a crash in value – actual value – rather than what had been occurring here), but those differences aren’t so stark anymore:

  • According to Moody’s, 2.5 million first mortgages will default this year. Delinquencies should peak in the summer of 2008 at 3.6% of all outstanding mortgage debt, up from 2.9% in the first three months of 2007, and it won’t get better until 2009. That’s driven by sub-prime and Adjustable Rate Mortgages, and it will most certainly affect everything from auto sales to garden hoses to curtains.
  • New and Existing homes drift forever (and sometimes sharply) downwards – meaning the stocks of building companies are taking a hit. Shares of major homebuilders plunged to the lowest in almost four years after D.R. Horton Inc. and Beazer Homes USA Inc. reported losses totalling $US1.47 billion on lower sales and huge write downs of unsold land and houses.
  • As bond sales go awry, and as lenders of money are unable, increasingly, to sell that debt on as bonds, banks are stuck with bonds and other debt that nobody wants, increasingly junk-rated and likely to vanish anyway. Shares for Deutsche Bank and Citigroup, among others, fell 5% and 4% respectively yesterday.
  • Oil is, ultimately, down (I’m not eating my hat yet – or is it crow?) a couple of cents, as hedge funds drop their investments in them. So is gold, copper, nicel, etc. (Australians: this will effect immediately the value of the commodities boom, not to mention the Australian Dollar, which is already down).
  • Sadly, even things like the Wesfarmers purchase of Coles Group, which I loved, are in great danger. Wesfarmers, you will recall, was doing it old school – straight cash and share offer. Well, their share price is off the cliff. Meanwhile they’re the only buyer, though – the other bids were from Private Equity, who ultimately couldn’t find a loan-bridge-er to back their play. So Coles Group can look forward to their value tanking, too.
  • If the US sneezes? Euro is down, AUD and others are down. Our All-Ords (Australia’s Dow Jones, if you will) lost ground, while Asia had it’s worst week in a year, as the S&P 500 has its worst in 5 years. Canada’s week was the worst in 6 years. Bloomberg tips US stocks to fall 10%, based on options trading.

There are two things at work: one is Bloomberg’s Housing Recession, which is properly heading for being an Actual Recession; the other is the capital markets, or credit crunch (a term that, for some reason, I really do not like). Capital drying up means more and more Private Equity deals are falling through – meaning that, if these aren’t likely to come through, or even come up, shares that are declining will continue to decline, because the expectation of an Equity buy-out won’t exist (and this has been fairly key in keep the paper value of a lot of firms buoyant – like Coles Group). Every story, lately, talks about risk aversion being nearly at its lowest – and it probably isn’t finished.

So, what? Nothing, really. Returning to Moody’s, their Moody’s In the News is a telling list indeed:

Moody’s in the news

Stocks down, currencies tied to the US down, housing down, etc. The only ‘up’ news came from the government – meaning it was a pitch, not a story.

In some good news, the US economy did go a little ahead of predictions, based on exports (that low US dollar), commercial and government spending. Commercial contruction, though, won’t last. The durable goods numbers are down, when aircraft, cars and trucks are removed, indicating that commercial investment is down. Government spending can only last while government borrowing can last – i.e. not forever. Exports might hold, though. Remember that old Macroeconomics equation:

Aggregate Demand = Consumption + Investment + Government Expenditure + Net Exports

Aggregate Demand also is Aggregate Expenditure and Incomes.

Consumption is already falling, thanks to the housing problem; Investment looks like it is declining, and ought to anyway, as consumption catches up and the credit problem fills out. That leaves Exports, at the mercy of the US dollar (which can’t be allowed to decline too far, because you need it for your borrowing – a complication that has upward pressure on US interest rates, which will hurt the economy further), and Government Expenditure, which (i) is already too large, relative to income, and (ii) is yet, to me, to be undertaken at all competently by the Bush administration, who seem never to have taken a Macroeconomics class in their collective lives.

Gets messy, doesn’t it? And what picture are these thousand words (no, I did not count them) worth?

Dow Jones:


S&P 500:

S&P 500

Which may as well be the FTSE100, the EUROFIRST 300, the NIKKEI, the ALL-ORDS. Take your pick.

CNN indices

A stroll through the S&P Goldman-Sachs Commodities Indices will give you the same losses or volatility in returns on cocoa, coffee, corn, gold, industrial metals, you name it. It’s a long list.

The Big Picture blog is also looking specifically at how – relevant to the rose-tinted press conferences being given – the US economy has lagged the world by a good long way for a good long while, now (we use the terms “Bush Boom” with not a little irony. Or sarcasm, it kind of depends on the tone).

What happens in private equity stays in private

This is a relatively link-free post, sorry. I’m waiting for a break in the rain to bolt to the laundry. Or to do the laundry, whichever is the common usage in your country.

Movement on both sides of the Atlantic. In yesterday’s Financial Times, the leading opinion piece discussed taxation (or effective lack thereof) of many private equity gains.

The fair way to tax private equity

The United States, even in its present mood of economic discontent, is less given than most countries to outbursts of animosity against the working rich. But strength of feeling on the subject is driven by the fact that the tax treatment of these managers, as compared to the treatment of other very highly paid individuals, really is anomalous. Take the anger and disgust away, and disinterested considerations of efficiency and fairness urgently demand a change.

To tax carried interest as ordinary income when granted would require an options-based valuation, which is not straightforward. Another complicated remedy would be to treat carried interest as an interest-free loan from the fund’s investors, and then collect tax in two parts: on the interest forgone, taxed as ordinary income, and on the subsequent capital gain, taxed at the lower rate required by current law. The simplest approach, and most likely the best, would be to set the question of deferral aside, and tax carried interest as ordinary income on realisation. To emphasise, this would not be to single out private equity or hedge fund managers as deserving of a new or specially punitive regime. It is a matter of even-handedly applying the logic of the present code.

For another day are bigger questions of whether it ever makes sense to tax capital gains at a lower rate than ordinary income (the policy that gave rise to this problem in the first place) and, in the American case, whether the tax system as a whole should be made more progressive. The case for reform on both points is strong, in fact. But the carried interest anomaly can be dealt with promptly, and should be.

They get to use ‘fair’, since it’s an opinion piece – although the suggestion to treat carried interest, which is basically income, as income, counts as fair in my book. Sorry, Dave.

The key, amongst the rough, is that private equity should not be taxed punatively for the money it makes. That Equity chiefs can admit to paying less tax than their cleaners is certainly an indication that something needs repairing, but the fact that some such chiefs are taking home more than USD1bn in salaries should not make them special targets. Just properly-targeted targets. Heh.

This is a legitimate issue, though, for once. It is not merely a straw-man employed by Wall Street Journal wankers to insist we’re all commies. Talk of a Private Equity Tax Rate is, unfortunately, being heard (whether it is being heard in earnest, or is from inception that straw man, I do not know. Frankly, either is a needless waste of time). Private Equity should not face a specific higher tax rate. Income should be properly identified, and taxed appropriate to society’s wishes. As long as the income is earned legally, its source should not warrant special attention. I’d sooner see New York City slumlords taxed to hell and gone before Private Equity, anyway.

In the UK, meanwhile, which is closer to actual action, little action, in fact, has resulted from all those entertaining committee meetings (i.e., the meetings were entertaining. They were meetings of the Treasury Select Committee on Private Equity, not the Entertainment Committee, or anything. Come on, that was hilarious). From – where else – the Guardian:

Private equity firms yesterday escaped the threat of tighter regulation and demands for closer scrutiny of pay and fees after a review rejected imposing public company-style rules on the industry.

In a consultation document, Sir David proposed a code of conduct that he said would greatly increase the supply of information to employees, customers and other stakeholders of the firms private equity acquired.

The code should be voluntary, he said, though he hoped some 200 large private equity buyout firms based in London would adopt it. He expects to produce a final report in October ahead of a review by the Treasury of allegations that private equity firms have been abusing tax rules to enrich their senior executives and investors. A further review of the industry will be completed by the Treasury select committee in the autumn.

Unions are not happy:

Unions said they were disappointed with Sir David’s report and it would fail to alleviate the fears of workers at private equity-owned companies. The GMB and other unions have accused private equity firms of profiteering at the expense of workers and the taxpayer through unfair tax breaks, asset-stripping techniques and anti-labour practices.

The TUC’s general secretary, Brendan Barber, said: “It will do little to reassure the staff of private equity takeover targets that the quest for short-term returns will not continue to threaten their jobs, pensions and working conditions.”

Personally, I don’t see that Public Company Rules would have done much to protect workers anyway, but this a game, and whatever keeps one’s opponent on their back foot would be welcomed. The secrecy surrounding the industry – who’s in, who’s making money and how much, the little details about financing and leveraged buy-outs that would land football clubs in a lower division, for example, is an issue that I had hoped the committee would manage. At the moment they have kicked this one for touch (Americans: they ‘punted’).

A later review, mentioned in the article, keeps the fire somewhat lit, but I won’t hold my breath. I would say that Private Equity can call this one a win. Moreso if it means greater room to maneouvre with the US Congress, when it comes time over this side (assuming Congress ever gets anything done again).

Looking the code of conduct over, it is essentially the equivalent of what is required of public companies, but it isn’t required. Just politely suggested. Mind you, given Private Equity’s fascination with not being villainised, they ought to, and most likely will, go in for at least some of the recommendations.

This, by the by, did not touch on the matter of tax paid on income earned via carried interest. So legislation shutting that opportunity down is probably – should be – on the cards, both in the UK and the US. And anywhere else it is employed.

Private equity to pay higher price for done deals

Keeping with the costs of doing the business of Private Equity. You will recall I mentioned the Wesfarmers’ buy-out of Coles Group (the reassuringly old-fashioned one). I commented at the time that two other groups, headlining Blackstone and the Carlyle Group, had failed to find lenders for their bids for the Coles Group. Well:

Private equity firms can now be in no doubt that they are going to have to pay more to fund the debt for buy-out deals they have already sealed.

This week alone has seen two of the biggest deals on either side of the Atlantic – buy-outs of Alliance Boots and Chrysler – forced to increase the premium, or interest rates, on loans they are trying to sell. Bankers in a flurry other deals have had to act likewise.

This means it is going to cost the US carmaker, which is being bought from DaimlerChrysler by Cerberus, the private equity group, an extra $20m annually to service this debt, plus whatever it has to give away in discounts, which could be another $20m up front.

On the same day it also emerged something similar was going on at Alliance Boots, the record UK leveraged buy-out, which is seeking some £9bn worth of loans from investors.

The changes are likely to cost anywhere between an extra £15m and £31m annually, according to investors’ expectations, plus some more in terms of fees.

However, it is not yet certain that even this will be enough to get the buyers in. One London-based investor said he thought the Boots loan had little chance of getting the commitments it wants from investors by a tentative deadline on Friday.

It goes on to other deals, similarly afflicted (it’s worth the read). Couple that with the news that financial offerings are becoming less popular with ordinary investors (another ripple in the pond from that sub-prime skipping stone), and a picture forms, thank you Mr. Squiggle (Brits: think Rolf Harris. Americans, I don’t know. I’ll ask my wife), of a market that is coming to remember that debt has risk attached.

If only the re-awakening would extend to casinos and bloody pokies (Brits: fruit machines. Americans: slot machines), I’d be ecstatic. Not just regular ecstatic. Just-been-told-Joss-Whedon-got-the-cast-back-together-for-5-more-seasons-of-Firefly ecstatic. And if you don’t get that reference, you’re God’s problem.

Bear Stearns’ coffee spoons laid out

A reference to a previous post. I probably should have noticed this earlier in the day, but I’ve been watching DragonBall Z and painting on the wall in the kitchen.

The losses, properly counted, of Bear Stearns’ (with apologies to Lynne Truss) funds? Immense:

Bear Stearns on Tuesday told investors in two stricken hedge funds managed by the bank that one fund had lost all its value and the other had about nine cents remaining for every dollar invested following bad bets on the US subprime mortgage market.

The two funds at one point had more than $20bn in investments, much of it using borrowed money.

The funny thing about this, to me, is a neat story I did spot this morning, in the Financial Times, insisting that the market was fine (no, it is not some financial-analyst cousin of The Lunatic Bill Kristol).

Bear Stearns the company did not suffer too heavily for the worse-than-expected results:

bear stearns

If you look at the 3-month trend, you’ll see it’s mostly the same – small rallies interrupting a continued slide.

I loved also the news of whose head came off:

Warren Spector, co- president, is widely viewed as a possible successor to James Cayne, who is 73. However, Mr Spector was ultimately responsible for the subprime funds.

I like the idea that, in this game of pass-the-Frankendebt, one guy can be called ‘ultimately responsible’. “First publicy burned”, sure.

Ethical investing

I spotted a story related to this many days back, now, in the Financial Times. It pertained to the performance of so-called ethical funds (interested? Check out Ethical Corporation, a pretty decent news magazine following ethical corporations/investing).

From the Financial Times:

Large ethical companies consistently outperform the market, according to a survey of corporate social responsibility by Goldman Sachs, the investment bank.

The study found that companies on an ethical list compiled by Goldman outperformed the MSCI World Index by an average of 25 per cent, with 72 per cent of companies outperforming their sector peers.

Most existing ethical indices, such as the Dow Jones Sustainability Index and FTSE4Good, have underperformed the stock market average since 2000. Goldman claims this occurs because the indices are based on ethical environmental, social and governance (ESG) factors in isolation.

The GS Sustain focus list instead identifies ESG measures relevant to specific sectors, such as energy or pharmaceuticals, and combines them with other indicators of performance.

Honestly, FTSE4Good? Who came up with that?

In any event, good news – kind of. There’s still, at this point in time, some space between public and actual committments, not to mention intentions, actions and results. It’s still better, to be sure, than a story about how shit the returns are on ethical investments. The story ends:

However, the survey reveals a big gap between good intentions and corporate practice. While three-quarters of chief executives said ESG issues should be embedded into company strategy and operations, only 50 per cent thought their company did so.

And half of those are probably wrong, anyway. As luck would have it, though, the scope to make money off this is expanding – and legitimately, rather than just taking berks ‘going green’ for a quick ride. Today’s Telegraph has an article about some recent work that found no link between polluting and making profits (the idea within us all is that it’s cheaper to pollute; seems this might not be the case, after all):

There is no link between companies’ pollution levels and profitability, which should push fund managers to opt for greener companies, according to a study.

Trucost, which monitors environmental output, said it found for a second year running that the worst polluters were not necessarily the best in their sector.

The absence of a link should encourage fund managers to opt for environmentally friendly companies because of the increasing likelihood that governments will impose financial penalties on heavy generators of carbon, Trucost said.

If you’re a potentially ethical investor, give Trucost’s website a looking-over, also. Ethical Corporation, also, has a very good article encouraging you.

Purely in terms of opportunity, consider this: oil prices are increasing, but the costs of finding increasingly less oil are also increasing (I don’t read the Oil Drum for nothing). No sooner will alternatives, however small, be found, than the value of those endeavours will fall, and with (probably, to my mind) little in the way of salvage to be had.

Meanwhile, everything from biofuels to photo-voltaic cells in vespas are attracting capital – whether they’ll pan out or not. Will bloody oil shale be likely to pay off even close to as highly, or reliably? The likes of Fidelity Investments and Climate Change Capital are pushing climate change as the moving markets – and why wouldn’t they be?

“There are five major market trends that we believe will develop over the next five years that will be a result in climate change,” said Mark Woodall, chief executive of Climate Change Capital – an investment banking group specialising in opportunities created by a low carbon economy.

He highlighted these as:

  • Consolidation of existing segments such as wind power
  • Growth of commodities such as biofuel
  • The identification of the low-cost countries that will mass produce these technologies
  • Stop-gap technologies that may not be the ultimate solution but will be in demand in the short to medium term, and
  • Adaptation technologies, which will help us live in a world altered by climate change.

In the first four months of 2007, ethical funds sales rose 83 per cent compared with the same time period in 2006, figures from Fidelity Funds Network reveal. If this trend continues sales for 2007 are set to double those of last year.

Read through that zerocarbonbritain report, about which I wrote yesterday, and consider where the money is to be made: getting in before these green-cottage industries take off, or investing in a machine that makes Russia nicer about sharing their oil.

Excellent story in the Guardian about sub-prime lending, CDOs, etc.

Travelling out to Bethlehem, today. The upside is that I get to sit and read the Guardian (with internet I feel guilty spending the money on the International edition); downside is no internet. Also the Guardian today was predictably full of Alistair bloody Cambell and his diaries.

Redeemingly, the paper carried some worthwhile stories, including this one:

Many repackaged the mortgage debt and sold it to other institutions as part of complex financial instruments. Banks pool the debts they buy, grade them according to their risk profile, and package them as so-called collateralised debt obligations (CDOs) to sell on to other banks and institutions. The problem is that these instruments are traded between banks which gives them a value, but no official market. Their value is based on a model contrived by the investment banks who sell them. Until one of the banks begins selling these CDOs in the open market no one really knows what they are worth. If banks are forced to sell their CDO holdings or mark down their value, it could result in a wholesale re-pricing across the sector, leaving some institutions with a large hole in their finances.

“It’s back to game theory. It is in everyone’s interests to sell, but the danger is that you spark a collapse that means you lose more on the debt you retain than the debt you sell. The alternative is to sit on it and hope for better times. It’s almost a conspiracy of silence. But no one can think of a better idea,” said one analyst.

Last week the US investment bank Goldman Sachs gave some indication of how the value of these instruments can change when it began a revaluation of its portfolio of mortgage-backed debt securities. Goldman cut the value by almost 30%, wiping $1.5bn (£750m) off the value of its assets.

Regulators in the US are ignoring the problem, say critics, because they also realise that adopting a hard line and forcing a market price on these packages of debt, will flush out catastrophic losses. The increased use of CDOs, often referred to as debt derivatives, created a web of holdings by banks which bought and sold from each other. To the US central bank the web was so wide it spread the risk and allowed banks to extend lending to poorer households.

It means that many banks now harbour debt portfolios that are difficult to value and which could turn out to be worth a lot less than expected.

To the banks it is not just a paper money problem; many of the empty homes they have repossessed are now sitting directly on their books. There are districts in Orange County, across Florida and many other parts of the US where they own hundreds of homes. Congress is beginning to ask if keeping these homes empty is the best policy. Shouldn’t they be sold and families move in? If that happened, the very real losses on selling homes would again leave large holes in the banks’ accounts. Worse, it might cause a collapse in confidence in the housing market, with all the implications that flow from falling prices and negative equity.

This latter mention of the empty houses is a great one. Banks, if and as they repossess houses, have two options (not including burning them down for the insurance money, renting them for use as props in monster truck derbies, or such things): keep the house, and keep the mortgage on their books as the asset value of that house, or sell the house, and determine the true value of that asset. In a housing market characterised more and more by distressed sales and falling prices, odds are the banks’ balance sheets do not accurately reflect the market value of their assets – but we never need to find out, as long as the market is never asked to value the house.

This is precisely the problem with CDOs, CMOs, etc., which also are not traded on a market. When Merril Lynch planned on taking Bear Stearns’ bonds built on these assets – all the way down to the sub-prime mortgages that made up the riskiest slice of the CDOs – a market, and a market value, would slowly have come about. Odds were that value would be significantly less than the value posted on balance sheets, both in Bear Stearns’ two funds, as well as hedge funds all over the land. Hence the conspiracy of silence, with periodic sensible behaviour such as the write-down at Goldman Sachs

Very relevantly – and this we do not hear often at all, and certainly not often enough:

Some critics say the Federal Reserve and Alan Greenspan, its former chief, take a good part of the blame. In a series of speeches he encouraged innovation in the credit markets that would allow banks to price the risk of lending to low-income households and those with poor credit histories. As late as 2005 he was making speeches encouraging banks to develop this market.

Assessing risk in microfinance – could it possibly be worse than normal finance, these days?

Very interesting story in the Financial Times, just spotted. At a time when microfinance is growing rapidly (and doing wonders), it is apparently constrained by a lack of transparent assessability of risk.

…some experts say there are obstacles preventing the microfinance sector from reaching its full potential, including the absence of a global framework that mainstream investors can use to assess properly the risks associated with the sector.

Activity in the microfinance sector has been growing in the last few years and has involved increasingly complex deals. Last month, for instance, the first publicly rated microfinance collateralised debt obligation – which pools together packages of bonds – raised more than $100m. The deal was rated by S&P and completed by BlueOrchard, which specialises in the management of microfinance investment funds, and Morgan Stanley.

S&P expects to rate an additional two to three microfinance CDO transactions and around 25 MFIs in the coming months, with CDO issuance levels potentially reaching $500m by the end of 2007. As the existing microfinance institutions become adept at handling new inflows of funding, and more MFIs enter the market, securitisation volumes could reach between $1bn and $3bn annually over the next decade, the agency says.

You know, those number might need re-doing. I don’t know how potentially risky debt from developing countries will fare in a market that can’t sell CDOs from the US.

The amount of U.S. high-grade, structured finance CDOs that are being offered to investors has plunged to $3 billion, from $20 billion a month ago, JPMorgan said in a report dated yesterday.

(I got that story via Calculated Risk) Yes, I expect BlueOrchard to be less risk and yield-happy than Bear Sterns or the ordinary hedge fund world, but we’re talking about basically the same thing. The way things are heading, I think microfinance is better off without. Anyone investing in CDOs – or investing in debt at all – is probably getting quite jumpy just now.

Also, via the Big Picture, a story from the Bloomberg markets magazine about the over-exposure of pension funds to CDOs. I’ve intimated before that I consider any exposure by pension funds to risky debt to be too much, but they’re being sold the riskiest of the risky debt – are they just plain stupid? More likely they realise that they’re dealing not only with Other People’s Money, but other people 40 years from now. Not likely to promote proper risk assessment. Which is kind of where we came in…