GBE - Can It Survive?
Grubb & Ellis' stock is less than a buck. I am not sure of the endgame here, but it does not look promising.

Royal Bank of Scotland
I read yesterday (and can't find the link this morning) that the Royal Bank of Scotland (RBS) has debt to equity of 50:1. This should put to rest any questions on why there is a banking crisis (and why the Bank of England is bailing out RBS).

The Credit Problem
I have said on this blog before that bankers are lemmings. Before the credit crisis bankers could not make loans fast enough. No credit was rejected when loans were backed by the false security of securitization and bogus credit ratings. Now in the credit crisis, no credit is strong enough. Here is a New York Times article that encapsulates the warped mind of bankers. Bankers are foreclosing on developers with excellent payment histories when these developers could not raise more collateral, not because they missed a payment. Bankers set the rules and then changed them in the middle of the game. This short-sighted, lemming mentality is making the financial problem worse and hurting the economy.

Collapsing (Big) Box
Circuit City is liquidating and closing all its remaining stores. This comes on the news of Goody's Family Clothing's decision to eliminate all its 287 stores. And before these recent announcements Linens & Things filed Chapter 11 and closed all its stores in 2008, Mervyns closed all its remaining stores by the end of 2008, and Office Depot plans to close more than 120 stores in 2009. And these are just a few from a quick Google search. This wave of liquidations is going to leave some big holes in many shopping centers.

There is a large amount of irony in this situation. Banks were eager to lend money to private equity firms that leveraged up the retailers (and in turn took out large amounts of compensation while stripping value). Banks also eagerly lent money to real estate buyers that liked the big box retailers. So, the retailers had too much debt that could not be supported in a slowing economy and had to close, and the real estate owners can't make debt payments because tenants are closing. Banks are losers on both ends. It makes it easier to understand why Citigroup and Bank of America are getting federal bailouts and their stocks are trading at levels that question whether they can continue in business.

Madoff's Oil and Gas Company- Six (Two) Degrees of Separation
Here is an article from Bloomberg. Bernie Madoff's two sons and niece started an oil and gas exploration company in 2007, Madoff Energy, LLC. I can't find anymore information on the energy company, but this seems like the type of firm that would raise capital through independent broker / dealers. When this scandal first came out it seemed limited in nature. But the more news that's revealed the narrower the degrees of separation to other financial firms. Through Tremont, Madoff's second largest feeder fund, the degree of separation is one or two for many independent broker / dealers. Tremont had widely distributed funds-of-funds, and it was owned by insurance giant MassMutal that also owns OppenheimerFunds. If Madoff Energy raised money through independent broker / dealers, the exposure will grow. This story just keeps getting interesting while the degrees of separation get smaller.

Commercial Mortgage Defaults
Here is a scary article. Commercial mortgages defaults are soaring. Default rates, currently at 1.2%, are expected to hit 3% by the end of 2009. Here is a quote:

But evidence is emerging that the commercial-property market -- which runs from apartment and office buildings to shopping malls and warehouses -- had some of the same excesses as the housing segment. An unusually high number of the underlying CMBS loans that are going bad were made and securitized in the past three years. That is a sign that investors overpaid greatly for those properties and that underwriting standards were loose. In many cases banks lent money based on future income assumptions rather than current cash flows, experts say.

Here is the chart from the article highlighting the defaults:


The article makes some good points. But it does not put the current defaults into a historical perspective. The chart above would be better if it went back to 2000. According to a research report from Deutsche Bank (that may have sourced part of the article), defaults in 2002, 2003 and 2004 approached 2%, nearly double today's rate. As quoted above, the article stated that many CMBS loans securitized over the past three years are in trouble, but the Deutsche Bank report showed this happening over other time periods as well.

The chart for multifamily looks the worst. But I suspect that this default rate is not due to traditional apartment transactions, but apartments that were bought by condo converters who paid over market price with expectations of selling units as condos. With a housing market in the tank, no cash flow due to empty units that were converted and not sold, or worse stuck in the middle of the conversion process, the multifamily default rate is not surprising. The Deutsche Bank report detailed one portfolio that had four converter loans and all were in default or past due.

Compelling Read
Before I forget, here is a link to an article written by Michael Lewis in Portfolio magazine. It is a long article, but worth reading. It has a fascinating profile of the few money managers and analysts who foresaw and acted on the financial disaster of the past year and a half. One money manager, Steve Eisman, bet against as many subprime-backed securities as he could.

Here are a few quotes:

But the scarcity of truly crappy subprime-mortgage bonds no longer mattered. The big Wall Street firms had just made it possible to short even the tiniest and most obscure subprime-mortgage-backed bond by creating, in effect, a market of side bets. Instead of shorting the actual BBB bond, you could now enter into an agreement for a credit-default swap with Deutsche Bank or Goldman Sachs. It cost money to make this side bet, but nothing like what it cost to short the stocks, and the upside was far greater.

The arrangement bore the same relation to actual finance as fantasy football bears to the N.F.L. Eisman was perplexed in particular about why Wall Street firms would be coming to him and asking him to sell short. “What Lippman did, to his credit, was he came around several times to me and said, ‘Short this market,’ ” Eisman says. “In my entire life, I never saw a sell-side guy come in and say, ‘Short my market.’”

And this:

The funny thing, looking back on it, is how long it took for even someone who predicted the disaster to grasp its root causes. They were learning about this on the fly, shorting the bonds and then trying to figure out what they had done. Eisman knew subprime lenders could be scumbags. What he underestimated was the total unabashed complicity of the upper class of American capitalism. For instance, he knew that the big Wall Street investment banks took huge piles of loans that in and of themselves might be rated BBB, threw them into a trust, carved the trust into tranches, and wound up with 60 percent of the new total being rated AAA.

But he couldn’t figure out exactly how the rating agencies justified turning BBB loans into AAA-rated bonds. “I didn’t understand how they were turning all this garbage into gold,” he says. He brought some of the bond people from Goldman Sachs, Lehman Brothers, and UBS over for a visit. “We always asked the same question,” says Eisman. “Where are the rating agencies in all of this? And I’d always get the same reaction. It was a smirk.” He called Standard & Poor’s and asked what would happen to default rates if real estate prices fell. The man at S&P couldn’t say; its model for home prices had no ability to accept a negative number. “They were just assuming home prices would keep going up,” Eisman says. [Read a letter to the editor from Standard & Poor's rebutting this point.]

My favorite anecdote about Eisman:

Eisman, Daniel, and Moses then flew out to Las Vegas for an even bigger subprime conference. By now, Eisman knew everything he needed to know about the quality of the loans being made. He still didn’t fully understand how the apparatus worked, but he knew that Wall Street had built a doomsday machine. He was at once opportunistic and outraged.

Their first stop was a speech given by the C.E.O. of Option One, the mortgage originator owned by H&R Block. When the guy got to the part of his speech about Option One’s subprime-loan portfolio, he claimed to be expecting a modest default rate of 5 percent. Eisman raised his hand. Moses and Daniel sank into their chairs. “It wasn’t a Q&A,” says Moses. “The guy was giving a speech. He sees Steve’s hand and says, ‘Yes?’”

Would you say that 5 percent is a probability or a possibility?” Eisman asked.

A probability, said the C.E.O., and he continued his speech.

Eisman had his hand up in the air again, waving it around. Oh, no, Moses thought. “The one thing Steve always says,” Daniel explains, “is you must assume they are lying to you. They will always lie to you.” Moses and Daniel both knew what Eisman thought of these subprime lenders but didn’t see the need for him to express it here in this manner. For Eisman wasn’t raising his hand to ask a question. He had his thumb and index finger in a big circle. He was using his fingers to speak on his behalf. Zero! they said.

“Yes?” the C.E.O. said, obviously irritated. “Is that another question?”

“No,” said Eisman. “It’s a zero. There is zero probability that your default rate will be 5 percent.” The losses on subprime loans would be much, much greater. Before the guy could reply, Eisman’s cell phone rang. Instead of shutting it off, Eisman reached into his pocket and answered it. “Excuse me,” he said, standing up. “But I need to take this call.” And with that, he walked out.

Lewis concludes by putting a large part of the blame on investment banks that went from private partnerships to public companies over the past twenty years:

No investment bank owned by its employees would have levered itself 35 to 1 or bought and held $50 billion in mezzanine C.D.O.’s. I doubt any partnership would have sought to game the rating agencies or leap into bed with loan sharks or even allow mezzanine C.D.O.’s to be sold to its customers. The hoped-for short-term gain would not have justified the long-term hit.

Happy New Year!

AIG Part Three - Why Didn't Spitzer Step in Sooner?
If Eliot Spitzer had stepped in sooner and investigated credit default swaps, maybe the folly of these securities would have been more apparent and the old AIG and old Wall Street would still be in business. I am being facetious, of course. Here is the last article in the Washington Posts's excellent three-part series on AIG.

Eliot Spitzer did not cause AIG's demise and Hank Greenberg could not have saved AIG. It was too overexposed in a business it improperly modeled. AIG thought it was collecting fees for billions of dollars of insurance (credit default swaps) it never expected to need to honor. The counter parties to these swaps thought they could underwrite any type of security and buy an insurance product to unload the risk. This scenario played out all across Wall Street. Myopia reigned and lead to complaceny that left most firms unprepared for the crush of the Credit Crisis. Situations where companies make outrageous profits while thinking they're not incurring risk, do not last forever. Hopefully, the Quants that developed all the failed models will go back to academia or to software engineering firms and Wall Street will revert to the traditional risk models and old fashioned credit analysis.