Agora Financial’s Rude Awakening

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New Orleans, Louisiana

• What the banks and politicians don’t want you to know about the
  credit crisis,
• The Merrill Lynch writeoffs: Just the beginning,
• $285.7 trillion in paper worries, here comes Energy & Scarcity and
  plenty more…

Eric Fry, reporting from the New Orleans Investment Conference…

I’ve got a question: Why is Citigroup trying to end-run the post-Enron
accounting standards of the Financial Accounting Standards Board (FASB)? And
I’ve got a second question; why is the Treasury Secretary leading the end-
run? Surely the intentions of Citi and the Secretary are not criminal, but
neither are their intentions guided by a devout fiduciary sensibility. In
other words, these guys are hiding stuff…and that’s not very helpful.

According to directives from FASB, Citigroup should be reporting losses from
the SIVs it controls, as if the losses belonged directly to Citigroup. In
accounting language, that’s called consolidating.

[For a detailed examination of this topic, please read the brilliant column
by Jonathan Weil: Citigroup SIV Accounting Looks Tough to Defend]

“In its 2006 annual report,” Weil’s column relates, “Citigroup classified its
SIVs as ‘variable-interest entities,’ or VIEs. That means they are covered
under a 2003 set of rules by the Financial Accounting Standards Board called
FASB Interpretation No. 46(R), as well as a related 2005 FASB paper on
‘implicit variable interests.’ Under the rules, if a company is obligated to
absorb a majority of a VIE’s expected losses, it is deemed the entity’s
‘primary beneficiary’ and must consolidate the entity on its balance sheet.

Such obligations can be ‘explicit or implicit.’ VIEs used to be called
special-purpose entities. The FASB issued FIN 46(R) in response to their
abuses by Enron Corp.”

In other words, Citi and Treasury seem eager to replicate – or at least to
mimic – the precise Enron-style accounting abuses that FASB’s FIN 46 (R)
seeks to prevent. Why, we wonder, is the nation’s Treasury Secretary
conspiring with the nation’s largest banks to skirt post-Enron accounting
standards? Probably because the credit crisis is much larger and much more
serious than any financial or political leader wishes to admit.

“So,” Weil concludes, “the proposed cure for Citigroup’s off-balance-sheet
SIVs is more off-balance-sheet accounting. There’s no surer sign that
Citigroup is worried about its potential SIV losses.”

In other words, the crisis ain’t over. The credit conflagration that Wall
Street’s professional cheerleaders declared “contained” just a couple weeks
ago has breached all the firebreaks.

“Is the credit crisis contained? Yes.” Jim Grant joked during a presentation
here at the New Orleans Investment Conference, “The credit crisis is
contained…to planet earth.”

In the North American portion of planet earth, Merrill Lynch just disclosed a
massive $7.9 billion writedown of impaired mortgage-backed securities (MBS) –
a figure that swelled $3.4 billion from the $4.5 billion write-down Merrill
had forecast just 19 days earlier. (Apparently, the marketplace is “evolving”
rapidly). Merrill’s massive write-down is an alarming data point, both for
what it is…and for what it is not. It IS a great big number – equal to
nearly one fifth of Merrill’s book value. However, it is certainly NOT the
last massive MBS-related write-down by a major brokerage firm or bank.

As the credit conflagration spreads, it will claim innumerable victims,
consume incalculable wealth and – thanks to the Fed’s proclivity to fight
fire with credit – singe the dollar’s value and prestige.

Remember, paper is highly combustible. “Money – for what passes of money – is
a short sale,” James Grant declares in the latest issue of Grant’s Interest
Rate Observer.

We agree.

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SIV-Positive
By Eric J. Fry

A-B-C-P may be the four most influential letters in today’s financial
environment.

The fate of those four letters over the next few weeks will determine the
fate of the U.S. stock market and the U.S. dollar. The wellbeing of the
entire U.S. economy might also hang in the balance. At least that’s our
guess…and that’s the reason we will be closely watching A-B-C-P over the
coming weeks.

These four letters stand for asset-backed commercial paper. “Commercial
paper” – or CP - refers to short-term corporate debt. Specifically, unsecured
short-term promissory notes issued by corporations with maturities that
typically range from 30 to 270 days. Asset-backed CP is that which is
collateralized by an asset-backed entity – i.e. an entity that owns assets
like mortgages or credit-card receivables.

The ABCP market is struggling mightily at the moment. Almost no one will
provide financing to an asset-backed entity, especially not an asset-backed
entity like a “structured investment vehicle” (SIV) that is full of mortgage-
backed securities (MBS).

In a perfect world, SIVs borrow short-term money in the commercial paper
market, then invest the proceeds in debt instruments like mortgages, credit
card receivables and collateralized debt obligations (CDOs). But as we
observed in the September 24 edition of the Rude Awakening, “The borrowing
part of this formula has dried up completely. The asset-backed issuers of
commercial paper cannot find any lenders to finance their toxic cocktails of
lousy mortgages and ‘new math.’”

Since almost all the investors who comprise the free market refuse to
purchase ABCP, the Federal Reserve has stepped into the breach. In other
words, the Fed is now financing the very same stuff that the world’s private
investors refuse to finance. What more do you need to know about the gravity
of America’s credit crisis?

The ABCP market has nearly ceased functioning. In early August, ABCP
outstanding totaled nearly $1.2 trillion – representing about half of the
entire CP market. Since then, however, ABCP outstanding has tumbled by $279
billion, while the other half of the CP market has remained exactly the same.
In other words, traditional corporate borrowers like IBM may still tap the CP
market, but not asset-backed entities.

This harsh reality becomes even more alarming when one considers that a
complete CP cycle is 270 days…which means that the SIVs who effortlessly
obtained 270-day commercial paper commitments last April, May or June have
not yet attempted to roll over their CP in the now-hostile environment.

In all, another $894 billion of ABCP will mature over the next six or seven
months. Who will provide that funding?…Maybe the same nameless “top tier”
institution (the Fed is our guess) that just provided an $80 billion credit
line to Citigroup. Already, the Federal Reserve appears to have absorbed
about $25 billion in MBS securities via “temporary” repurchase agreements.
(We realize that this stuff is as boring as heck, but that’s also why it
escapes scrutiny…and why it may be so important to investors, especially,
dollar-based investors).

Repurchase Agreements, “repos” are also called Sale and Repurchase
Agreements. Under these agreements, the seller (usually a bank) sells
securities to a buyer (usually the Federal Reserve) for cash. But the seller
(bank) agrees to re-purchase the securities from the buyer (Fed) at a later
date. Typically the banks use Treasury bonds or Agency bonds as repo
collateral. Lately, however, mortgage-backed securities (MBS) have become the
collateral of choice.

In the early part of this year, the Fed rarely “repoed” an MBS. Weeks would
pass between MBS repos. But as springtime arrived, MBS repos started popping
up like so many daffodils. Just a few at first, then a few more, then
eventually enough to absorb a money center bank’s entire short-term
liabilities…for example.

As the nearby chart clearly shows, the rolling 2-week total of “temporary”
MBS repos soared from about zero in June to a whole bunch in August…and the
repos are on the rise again, despite the “recovering” credit markets.

The Fed’s newfound interest in MBS contrasts sharply with the utter
disinterest of free market investors. The disinterest of real-world investors
comes as no surprise. It is an open secret among many hedge fund managers
that the institutional holders of mortgage-backed securities and derivatives
have not even come close to marking their assets to market. It is also an
open secret that two critical pieces of knowledge remain utterly unknown: How
big is the total MBS risk? Who’s holding the risk?

Until these questions receive credible (and quantifiable) answers, no one
will provide financing to AB entities, except the Fed.

Could the Fed conjure up $1 trillion worth of AB financing between now and
President’s Day, 2008? Maybe, but probably not without also conjuring up a
dollar crisis, or a bond market crisis…or both at once. The only viable
path toward recovery and normalcy requires a legitimate mark-to-market. But
marking MBS and CDOs to real-world prices might clip tens of billions of
dollars from bank balance sheets…and might kick a few dozen millionaire-
bankers to the curb.

Unfortunately, because the millionaire-bankers still control the flow of
information – and still hold meetings with the Treasury Secretary to concoct
shell games – the “fantasy pricing” regime remains in effect. Merrill’s $8
billion write-down was at least a good start because it broke new ground: it
acknowledged impairment of AAA-rated securities - “a level of detail that
other banks have so far failed to give,” analysts from the Royal Bank of
Scotland politely observed.

To begin to illustrate the magnitude of the crisis, let’s examine the
unfolding SIV meltdown. According to professional estimates, 36 SIVs
worldwide deploy about $400 billion in capital. According to unofficial
“whisper” estimates, these 36 SIVs have leveraged their capital to about $2
trillion worth of actual exposure. [If the number is less than $2 trillion,
we'd love to hear about it. But the SIV operators are conspicuously mum on
the topic. In fact, the SIV operators ain't sayin' nuthin' about nuthin'.]

And even when they do say something, they don’t say anything useful. Late
last week, Citigroup claimed to have “secured funding through year end for
the $80 billion in structured investment vehicles it manages…” But of
course, the giant bank neglected to disclose the source of this
astronomically large credit line. There aren’t too many lending institutions
with $80 billion to toss around. In fact, there’s only one we know of, and
it’s run by a guy named Ben Bernanke.

Citi also announced that its SIVs had succeeded in selling “many billions of
dollars” of short-term CP to “top-tier name institutions.” Again, we wonder,
what’s the big secret? Why not just tell us which “top-tier institution” is
in a position to purchase “many billions of dollars” of SIV CP? Why not just
tell us…unless that top-tier institution is also the one run by Ben
Bernanke? We are also struck by the coincidence that $80 billion happens to
be the exact sum that the Citi-led syndicate of banks is supposed to be
providing to the Super SIV.

Maybe we’re way off base here, but we’re not way off base in fearing non-
disclosure. Any investor with more than two days of investment experience
should know that non-disclosure is never good news.

Meanwhile, the SIVs that can’t secure financing from the U.S. Federal Reserve
must liquidate their portfolios at “fire-sale” prices (i.e. real-world
prices), or default on their debts…or both at the same time.

One week ago, the $6.6 billion Cheyne Finance Plc became the first SIV to
default on its CP. A couple European SIVs are in the process of liquidating
their $15 billion portfolios. We predict others will follow in their
footsteps. According to the Financial Times, “More than $42 billion of assets
in SIVs…are facing limits on their operations.” But that still means about
$300 billion of SIV assets are struggling for survival. And they will likely
continue to struggle, not merely because they cannot access funding, but also
because their assets are deteriorating.

Just read the newspaper.

The housing bust is triggering a deepening mortgage bust, which is triggering
a deepening MBS bust. And the evidence is everywhere. Last week, S&P
downgraded $23 billion worth of mortgage-backed securities that had been
issued less than 9 months ago! 1,713 different securities in all; and each
one from the class of 2007. Meanwhile, the housing market is trending from
bad to worse. As the nearby chart clearly shows, home sales and home
inventories are both heading in the wrong direction. The inventory of unsold
homes nationwide totals more than 10 months worth of sales – a 23-year high.

Enter the $80 billion Citi-Paulson “Frankenfund” – the Master Liquidity
Enhancement Conduit, or MLEC – to finance the stuff no one else will touch.

We are skeptical of this rescue attempt, as noted in the October 17 edition
of the Rude Awakening, “Bail-Out Nation.” The MLEC advances the cause of
obfuscation, while preventing the price discovery that would enable the ABCP
market to recover, and bring an end to the crisis.

Just yesterday, Former Chairman of the SEC, Arthur Levitt, described the
Citi-Paulson MLEC scheme as “problematic.”

“Transparency is the issue,” said Levitt. “These [MBS] products are opaque.
And our mechanism for overseeing the products, for regulating the process is
virtually non-existent.”

Translation: Its time to clear the fogged mirror, not fog it up some more.
The crisis will continue deepening until the market-improvers at Treasury and
the Federal Reserve abandon their price-support schemes. The crisis will
deepen until MBS securities fall to the real-world prices that will attract
real-world investors.

The ABCP market will probably provide an early clue as to when that moment
has arrived.

So make sure you know your ABCPs.

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Rude Endnote: As we go to print with this morning’s issue, news is coming
over the wire of “a major breach of corporate protocol,” on the part of,
Stanley O’Neil, CEO of beleaguered Merrill Lynch.

The breach came when Mr. O’Neil apparently met with Wachovia senior
executives to propose the possibility of a merger between the two. Mr. O’Neil
neglected to notify the board of his decision to do so, further increasing
tensions in the already strained relationship between the two.

It’s not clear what this will spell for both Mr. O’Neil and Merrill at this
early stage…but it certainly doesn’t look good. We’ll keep you posted.

In the meantime, keep a look out for all the news in today’s issue of the 5-
Minute Forecast, due out shortly.

Cheers,

Joel Bowman
Rude Awakening