Waiting for the Fed, and Hoping

By FLOYD NORRIS

Published: September 14, 2007

That there is a financial crisis is clear. What is not so clear is whether the medicine in Dr. Ben Bernanke’s bag can do much good.

Next week, the Federal Reserve is expected to make the first cut of the Bernanke era in the federal funds rate. The Wall Street debate is over whether that cut will be just a quarter percentage point, or whether the Fed will show its determination to act by cutting the rate by twice that amount.

That the debate has gotten this far is evidence that the economy now seems much weaker than it did when Mr. Bernanke was testifying to Congress in July, just as the credit squeeze was getting under way. Then, he seemed to think there was no need for any cut at all, despite the crumbling housing market and the growing subprime problems.

A new poll of corporate chief financial officers, taken by Duke University and CFO Magazine, shows a surge in pessimism. Nearly a third of the financial bosses say their companies have been hurt by the credit market turmoil. And few see much benefit from Fed action. Nearly half think a cut of half a percentage point would not help their companies at all, and most of the rest see only a small benefit from such a move.

For many companies, the immediate credit issue is not price, but availability. Can they borrow enough money to get by?

The next part of the crisis may come from a company that is unable to borrow enough money to pay off maturing commercial paper. The Fed can help there, with gentle urging to banks not to be overly tight in their lending standards, and there is reason to hope that the immediate problem will pass with banks taking on a lot more loans.

But even if it does pass, there is the question of where companies will borrow in the future, whether to finance expansions or acquisitions, or just to raise capital if and when their business turns down. The credit markets were wide open just three months ago. Now they are all but shut to companies with speculative-grade ratings.

In the second quarter, the total volume of new junk bonds and leveraged loans averaged $88 billion a month. In August, the figure was $6.6 billion. That is a 93 percent decline.

“For the first time in years the loan market is all but gridlocked,” Standard & Poor’s said this week in its leveraged company commentary. “Demand has withered, forcing arrangers to put the massive calendar of underwritten deals on ice.”

That has happened, it may be noted, with virtually no defaults on corporate loans. But the majority of such loans were financed through securitizations, in which the risk was sliced and diced in ways that enabled most of the money to be put up by investors who bought securities rated AAA, the highest possible rating.

Sometimes those ratings were a bit off. Three weeks ago, one such security still had AAA ratings. But since then Moody’s has cut it twice, and it is now in the nether regions of junk, rated Caa2, with Moody’s warning it could go lower. It’s sort of like going from class valedictorian to remedial reading failure.

That fall is unusual, but instructive. The security in question, called a variable leveraged super senior certificate, was sure to be safe unless the market value of a bunch of AA-rated securities collapsed. Those securities are still rated AA, Moody’s tells me, but their market values have plunged.

“Liquidity in asset-backed markets has dried up,” Merwyn King, the governor of the Bank of England, told Parliament this week, and banks will have to return to their historic roles as financial intermediaries. “That process,” he added, “is likely to be temporary, but it may not be smooth.”

Eventually, perhaps, a safer and more cautious securitization market will develop. In the meantime, banks, and perhaps some institutional investors, will be called upon to finance corporate loans directly. Until some part of that happens, the credit squeeze is on.

Lowering the fed funds rate — the rate at which banks lend to one another — will not hurt. It will make it cheaper for high-quality borrowers to raise money, and some of that will filter down. But it will not address the issues that have caused credit to tighten.

Nor will it get us closer to learning just where prices will settle — whether for homes or companies — in an era when risky loans are no longer easy to come by. This week’s stock market euphoria at the prospect of Fed easing is likely to be temporary.

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So This Subprime Lender Walks Into an Audit...

By FLOYD NORRIS

Published: September 7, 2007

The auditor got cold feet, and the company may die.

It would no doubt be interesting to hear a tape of conversations last week between the senior management of NovaStar Financial, a subprime mortgage lender, and its auditors at Deloitte & Touche.

NovaStar, like many of its competitors, has seen its business model blow up this year. But in mid-July it got a lifesaving $48 million infusion of capital from two institutional investors, with a promise of $101 million more to come.

Now Deloitte has effectively revoked its audit of NovaStar — evidently without claiming that any number in the report was wrong — and the investors do not have to put up the cash.

Deloitte seems to have invoked a little-known auditing standard that says an auditor cannot allow a previously audited financial report to be cited by a company if there are subsequent events “of such a nature that disclosure of them is required to keep the financial statements from being misleading.”

Deloitte won’t talk, but by NovaStar’s account, the auditors’ qualms did not surface until last week, when Deloitte said it thought that the 2006 annual report should have more disclosures on business problems and that there were questions about the company’s ability to continue as a going concern. But even with those changes, Delolitte was not prepared to quickly recertify the financial statements.

Since the company had to make a filing with the Securities and Exchange Commission to get the additional money, and since it could not do that without Deloitte’s blessing, the additional money will not be coming.

NovaStar says it will soldier on, cutting costs and hoping to get by. Since the stock is still trading around $6 a share, it appears that some investors think it can do so. But at current prices, the company has a market capitalization far below the dividend it is supposed to declare later this month.

NovaStar holds a special place in the market not because of the problems it has encountered, which are similar to those of others in its business, but because of the long and bitter battle waged between investors who believed in the stock and those who did not.

Before Overstock.com, Nova-Star was the stock of focus for those who believed their stocks were being sabotaged by “naked short sellers” who drive a company’s share price down by selling shares they had not bought or borrowed.

It was NovaStar that Patrick Byrne, Overstock’s chief executive, pointed to when he began what he called his “jihad” against naked shorts. There is a suit pending by some NovaStar shareholders against major brokerage firms, charging that they aided naked shorting and thus cost the investors money.

At last report, NovaStar had 9.5 million shares outstanding, and a short position of 8.1 million shares, a very high proportion. Overstock, by contrast, has a short position equal to less than a quarter of the shares outstanding. (It also has confounded the shorts by rising sharply this year.)

In its prime, NovaStar appeared, to its fans anyway, to be a money machine. It was organized as a real estate investment trust, and it reported high taxable income that it paid out in dividends. The high yield attracted investors and made it easy to sell more shares, which it regularly did. Its shares were worth $1.8 billion.

Critics asserted NovaStar used questionable accounting to produce those profits as well as other dubious business practices. One of its current problems is a $46 million judgment won by a competitor who said NovaStar conspired to drive it out of business.

Accounting in the mortgage business is notoriously inexact. NovaStar, like many other companies, sold mortgages on terms that left it with some of the risk. Just how much profit it reported depended on a series of assumptions about those risks.

“If our actual experience differs materially from the assumptions that we use,” NovaStar said in the annual report that Deloitte is no longer willing to certify, “our future cash flows, our financial condition and our results of operations could be negatively affected.”

That warning was prescient. With mortgage defaults rising, it appears NovaStar paid dividends from ephemeral profits.

The REIT status that helped make NovaStar attractive is now its albatross. The company’s last estimate said it would have to pay $157 million more in dividends to satisfy tax rules that require REITs to pay out profits to shareholders. In July, it talked of paying the dividend with preferred stock rather than cash.

But that may be tricky. At current market prices, the entire company is worth far less than $100 million, so how can it give out preferred stock worth more than that?

The $48 million July investment in NovaStar, made by funds affiliated with the Jefferies Group and the MassMutual Corporation, seemed bold at the time. Now it seems foolish, providing for the purchase of preferred stock convertible to common at $28 a share.

The funds will not comment, but there is nothing — other than a fear of throwing good money after bad — to stop them from making a new investment, presumably on better terms. Perhaps significantly, Jefferies and MassMutual have not exercised their right to name two new NovaStar directors.

Had Deloitte not rebelled at the last moment, NovaStar would have the extra $101 million. Without it, the battle for survival will be that much harder.

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New Worries for Small Banks

By FLOYD NORRIS

Published: August 31, 2007

For America’s small banks, the changing financial landscape of the last decade meant that many opportunities were no longer available. The big national banks went after consumer lending and came to dominate the market for credit cards. Lending to big companies had long since migrated away from local banks.

What was left? Real estate. That included home mortgages, of course, but in that business there was more and more competition from independent mortgage brokers and from national companies that packaged the loans and sold them to investors. The banks’ share of such mortgage lending was still large, but it was declining.

Still, one part of the real estate picture remained dominated by local financial institutions: lending to local land developers. It was a market where local knowledge mattered.

A result has been a steady increase in commercial real estate loans, particularly loans secured by raw land that a developer plans to build on.

By the middle of this year, 15 percent of the assets of smaller financial institutions in the United States — defined as those with less than $1 billion in assets — were in construction loans, quadruple the proportion a few years ago.

Now, the banks that were most dependent on that strategy are being questioned by investors — in some cases to the irritation of bank executives who say they are being tarred by fallout from lending excesses in which they had no part.

“Everything about Colonial is speculation, and rumor and fear,” Robert E. Lowder, the chief executive of Colonial BancGroup, a bank holding company based in Montgomery, Ala., complained in a conference call this week.

Of Colonial’s $15.5 billion in loans, 42 percent are construction loans. Most are in Florida, where the real estate boom has faltered.

“Everybody’s down on Florida,” Mr. Lowder said. “Everybody thinks Florida is going to fall into the Gulf of Mexico. Trust me, Florida is still a great place to be.”

The chief executive of another bank heavy in construction loans, the Las Vegas-based Community Bancorp, was in New York this week assuring institutional investors that they should not worry. “We’re doing great,” the executive, Edward M. Jamison, said in an interview. “We see a lot of vitality in our markets.”

With home prices falling and mortgage delinquencies rising in many areas, banks now feel a need to prove their loans are safe. Mr. Jamison emphasized that his bank lent to commercial, not residential developments, principally strip malls. Mr. Lowder, whose bank does finance residential developments, said it had avoided speculative projects.

Few construction loans are behind in interest payments, but that fact may be less reassuring than it seems, since many such loans do not require payments until the project is completed.

Bank regulators are at least a little worried. The Federal Deposit Insurance Corporation keeps track of banks that are heavily dependent upon commercial real estate loans — either because construction loans are greater than the capital of the bank or because total commercial real estate loans, including mortgages on commercial properties, are at least three times the bank’s capital. By this June, 37 percent of all banks met one or both criteria, triple the figure of a decade ago.

Early last year, the regulators proposed new rules on such loans, but the watered-down policy that finally came out did little more than to warn that “rising commercial real estate loan concentrations may expose institutions to unanticipated earnings and capital volatility in the advent of adverse changes in commercial real estate markets.”

In the stock market, banks with such concentrations have done a little worse than other banks this year. Short-interest on those stocks is up sharply, a sign that hedge funds think banks will end up owning a lot of vacant real estate, having to pay taxes on land that brings in no income.

Mr. Jamison, the Las Vegas banker, scoffs at such a forecast.

“It would,” he told me, “be almost a perfect storm to have a meltdown in the real estate market.”

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Floyd Norris: Notions on High and Low Finance

With Markets Moving Wildly, Insight Suffers

By FLOYD NORRIS

Published: August 17, 2007

Twenty-first-century financial markets react with lightning speed to events halfway around the world. Investors in China can immediately see what happened in New York and make trades in London based on the news.

So why is the credit panic of 2007 being played out in slow motion?

One reason is that those involved have never seen anything like this before. Information may arrive instantly, but insight takes longer.

It seemed unlikely, if not absurd, that the American economy and credit system could be shaken because a few people with poor credit fell behind on their mortgages. Why should that slow consumer spending? Why should it affect companies that made mortgage loans only to people with good credit? Why should it bring a halt to the leveraged buyout boom?

Perhaps none of those things should happen. But fears that they may take place have sent the stock market on a wild ride over the last month, culminating yesterday with the Dow Jones industrial average falling more than 300 points before gaining nearly all of them back in the final hour of trading, amid speculation that the Federal Reserve would find a way to keep troubled financial companies from failing. Not long ago — four weeks, to be exact — Larry A. Goldstone, the president of Thornburg Mortgage, a real estate investment trust, was feeling good. He had seen the subprime mortgage disaster unfold, and believed it was good for his company.

“The current credit crisis is the market environment today,” he said in a conference call on July 20, as the stock rose above $27. “The liquidity issues in the marketplace are creating a very, very nice opportunity for us. This is not a big surprise to us.”

The way he saw it, the crisis was shaking out his competitors, the ones who had made those imprudent loans. With them gone, he could make more money.

Within days, he bought 10,000 shares. The chairman and chief executive, Garrett Thornburg, invested almost $13 million in company stock. Four other insiders, including the chief financial officer, were also buyers.

But last week, things got dicey. Thornburg Mortgage owned a lot of AAA-rated mortgage securities, and had borrowed up to 95 percent of their value. Now the lenders, suspecting the securities were worth less, wanted more cash. To get it, Thornburg had to sell securities, and few wanted to buy. Suddenly the commercial paper market, so willing to lend to Thornburg at small margins just weeks before, was not interested in lending even at much higher rates.

As for the share price, it went into a free fall on Tuesday, amid rumors that the company could not meet its obligation. Trading was halted with the stock under $8. On Tuesday night, it conceded it was having trouble raising money to finance mortgages. It said the dividend it had promised to pay on Wednesday would be delayed by a month.

But it insisted that it was not bankrupt. Even marking down the value of its assets to current market value, it said, it was worth $14.28 a share on Monday, down from $19.38 at the end of June.

That provided some reassurance, and since then the shares have climbed back above $12.

Thornburg has prospered until now with a fairly simple formula. Organized as a REIT, it paid big dividends representing all of its taxable income. It grew by issuing more shares, which it could sell at prices above its book value because individual investors valued the high yield. The shares wound up in a lot of retirement accounts, and the fact that people paid more than book value enabled the book value per share to grow.

The insiders profited hugely from that. The company gets away with not disclosing how much the bosses are paid because it is managed by a separate company owned by some of the bosses. That management company gets incentive fees based on the company’s total book value and profits, a formula that would seem familiar to a hedge fund manager. Effectively, the bosses get a cut every time the company sells new stock, and keep getting cuts from those sales every year.

Now Thornburg, like many other companies, needs a quick unfreezing of the credit markets. But even if they get it — if the Fed tells banks to rescue them with emergency loans — many may find that they cannot safely operate with such high leverage. And without the leverage, profits will be harder to make even if Thornburg can charge more for mortgage loans.

The unfortunate series of events that got us here — remember the proverb in which a kingdom is lost for want of a nail — began with a weakening housing market. That caused some mortgages to go into default, which raised questions about the value of mortgage securities and the credibility of the ratings that enabled the securities to be sold.

That led to the questioning of other types of loans that had been financed by selling packages of securities that were structures in similar ways to ones that had financed the mortgages. It became more difficult for companies to borrow. Now it seems to be spilling over to the real economy, with consumers getting nervous.

“We are going through a psychological event,” Mr. Goldstone said. “It has everybody in a panic. There is nothing fundamental here.”

He may be wrong about that last part. There may not have been a fundamental change in the health of his business, but such a change is taking place in the credit markets. There, buyers with available cash are few, and many of them are in no hurry to buy when so many need to sell.

It is sort of like a game of musical chairs in which the music stops and it turns out that all the chairs have vanished.

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Floyd Norris: Notions on High & Low Finance

August 2, 2007, 7:40 pm

To Catch a Falling Knife

Lone Star Funds, a private equity operation, prides itself on its ability to figure out when markets have overreacted and driven down prices to unreasonable levels. In June, it stepped in to buy Accredited Home Lenders, a troubled sub-prime mortgage lender. (Is that redundant?)

Today Accredited finally put out its delayed 2006 annual report. (It had to change auditors first, after the previous ones quit.) It includes this paragraph:

In connection with the challenges facing the non-prime lending industry, several of our competitors have recently stopped originating loans or sought protection under bankruptcy laws. Unless the values of our mortgage products cease their decline, and we are able to obtain new sources of liquidity and waivers and modification of the covenants in our credit facilities, we may suffer a similar fate.

Lone Star has not had anything to say, but Accredited’s stock fell to $5.31 a share, about a third of the price Lone Star has promised to pay

Of course, in this credit market, you can’t be sure that a private equity firm could fund such a takeover anyway.

In other mortgage bad news, IndyMac has told its employees “the private secondary market is not functioning” and it will be much more discerning in making loans in the future. And American Home Mortgage, whose problems came from mortgages that were not sub-prime, said it will close. In April, it sold shares to the public for $23 and change. Now they will be worthless. (In Friday’s Times, I look at the accounting games American Home played, and the evidence that some stock traders knew what was happening before the company disclosed its problems a week ago.)

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Floyd Norris: Notions on High & Low Finance

July 26, 2007, 9:02 am

Cox Chooses Sides

When Chris Cox became chairman of the Securities and Exchange Commission, he made it a priority to bring together a commission that had been bitterly divided under his predecessor, William Donaldson, who sometimes sided with the two Democrats on the commission in 3-2 votes. A series of unanimous votes followed as Mr. Cox appeared to have worked behind the scenes to bring about unanimity.

That all blew apart this week. The issue was whether companies can ever be forced to allow dissident candidates for director to appear on ballots sent out by companies. That was an issue that had bedeviled Mr. Donaldson, who first endorsed a very limited proposal and then backed away from it in the face of strong business opposition.

Mr. Cox would have let the issue lie, but the Second Circuit Court of Appeals ruled that the S.E.C.’s longstanding interpretation of current law was dubious. That meant that without S.E.C. action, it would be possible for companies in that circuit, which includes New York, to be forced to allow dissident candidates onto ballots. Shareholders would first have to amend bylaws to allow such dissidents, but the court said they could get such a bylaw amendment put before investors.

But the court also said that the S.E.C. could restore the status quo by just voting to agree with the old interpretation that shareholders could not force such a vote.

When the court ruling hit, Mr. Cox promised it would be settled immediately — only to find that there was no consensus available. So he stalled for a year.

This week he tried to stall again, proposing that the S.E.C. put out for comment two contradictory proposals. One would adopt the old rules, effectively banning dissident shareholder nominations. The second would allow them, but set a very high bar to adopting such a proposal. (It would take 5 percent of a company’s shares to get such a proposal before shareholders.)

His idea was that the S.E.C. would put out both ideas, and get more reaction.

But the two Republicans had other ideas. Late Tuesday night, they got the wording of one of the proposals changed, to say that it was the commission’s current interpretation of the rules. That, the Democrats say, was designed to end the debate by satisfying the court ruling and barring shareholder votes.

Mr. Cox went along at Wednesday’s meeting. We don’t yet have the wording of what was passed — the S.E.C. is notoriously slow about that — but it appears that if nothing happens, those who oppose shareholder nominees for director will have prevailed. The S.E.C. will take public comments, but they will not matter unless Mr. Cox is willing to push something through with the support of only Democrats.

Mr. Cox did his best to navigate a center course. But he was finally forced to choose sides, and he did.

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Floyd Norris: Notions on High & Low Finance

July 25, 2007, 11:43 am

Belatedly, the C.F.T.C. Acts

The latest enforcement action from the Commodity Futures Trading Commission shows just how aggressive that regulator is. Not very.

That is not, however, what the news release says. “This case demonstrates the commission’s ongoing vigilance to punish those who attempt to compromise the integrity of the futures markets,” said Walter Lukken, the commission’s acting chairman. “The C.F.T.C. continues in its unwavering determination to ensure that the futures markets operate in an open and competitive manner free from price distortions.”

The case is brought against Amaranth Advisors, the failed hedge fund, and its former head trader, Brian Hunter. It says that on two days in 2006 they set out to manipulate the settlement prices of natural gas futures on the New York Mercantile Exchange by engaging in heavy selling during the period when the settlement price would be set. Amaranth had over-the-counter positions whose value would rise if the settlement price was low.

Amaranth failed last September because of its gas trading. Regulators seem to have noticed something funny was going on when Amaranth was making the big trades that now are challenged, but their action was minimal. The NYMEX asked about the trading, but seems to have been satisfied by a letter the C.F.T.C. now says was full of lies. So now, months after the fund collapsed, the commission is seeking an injunction barring the defunct fund from any more violations of the commodities laws. That’ll teach ‘em.

“The C.F.T.C. stands ready to enforce the provisions of the Commodity Exchange Act against those who attempt to manipulate U.S. futures and commodity prices. The filing today sends an important message to market participants that such conduct will be met with appropriate sanctions.” That is the view of C.F.T.C. Commissioner Michael Dunn, according to the news release.

Or perhaps the important message is that the commision will act 10 months after your hedge fund suffers a spectacular collapse. Too bad there was no real investigation back when the trading was taking place.

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Floyd Norris: Notions on High & Low Finance

July 23, 2007, 10:27 am

Bye Bye Borrowing

The leveraged loan market seems to be in danger of seizing up — largely because the investors who buy the paper issued by Collateralized Debt Obligations — are suddenly unwilling to do so.

An early victim is Expedia.com, the travel service controlled by Barry Diller. It announced today that it is scaling back its share buyback. Now it will buy 25 million shares, about 8 percent of the outstanding shares. It was tendering for up to 116.7 million shares. The price will be $27.50 to $30.

The share price plunged $2.54 to $26.85 in early trading. That means the price will be at the bottom of the range, and the offering is likely to be oversubscribed.

“While we remain confident in Expedia’s long-term prospects and will continue to be net buyers of our shares, the terms available to us in the current debt market environment were simply unacceptable,” Mr. Diller said.

“The magnitude of today’s virtually default-free unraveling is without precedent in the 20-year history of the modern leveraged loan market,” Standard & Poor’s Leveraged Commentary and Data department said today.

It is not only the C.D.O. buyers who have fled. S.&P. says the hedge funds that were providing money to leveraged loans are now out of the market — or trying to sell what they have.

There are worse things than not being able to repurchase shares. We’ll see who gets left with paper from deals that began but could not be completed.

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Floyd Norris: Notions on High & Low Finance

July 20, 2007, 1:46 pm

A Bull Market Without Beer and Cholesterol?

The double will have to wait.

The stock market hit one milestone yesterday, 14,000 on the Dow.

And it came very close to another, a double off the Standard & Poor’s 500 low set in 2002. Then the index hit bottom at 776.76 on Oct. 9. Yesterday’s close of 1,553.08 was a gain of 99.94 percent from there. Given the market’s performance today, we will have to wait until another week to get that double.

A double in less than five years is not, by the way, all that impressive. It did take a little over five years to double after the 1990 low reached in the run-up to the (first) American war aganst Iraq. But it took only three years and four months to double off the 1982 low. And it took only three months and a day to double off the 1932 low.

Bloomberg has historical data for the entire time on 477 of the 500 stocks now in the S.&P. index. It reports that 296 of them have more than doubled, and 16 are up more than 1,000 percent. Only 17 of them are lower than they were then — of which, I am very sorry to say, three are in the newspaper industry. They are The New York Times Company, Tribune and Gannett. Other well-known losers include Wal-Mart, Pfizer and Anheuser-Busch. What kind of a bull market penalizes America’s biggest retailer and the makers of Budweiser and Lipitor?

The winner since that 2002 low is Akamai Technologies, which is up 6,945 percent from the 71 cents it fetched then. Akamai is an Internet company, and even with that performance it may have a few unhappy owners. From its closing high of $327.63 on the last day of 1999, it had fallen 99.8 percent by that October day. And even now it is trading for less than a sixth of its old high.

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