Sunday, April 13, 2008

Levers, Gears, Pulleys ... and some Bailing Wire

Had I been drinking milk at 8:17 last Wednesday morning, I might have shot it out of my nose, and not for laughing, I promise. Admittedly, only a few other econo-financial dorks would have found the FT Lex column headline so ridiculous but it just summed up so concisely (as the "pink paper" is wont to do) our current financial crisis ... how we got here, what's wrong, and how the crazies running the asylum are trying to get out of their current mess by using the same tricks which got them into it.

The article started "CITI OFFLOADS $12BN LEVERAGED LOANS TO PRIVATE EQUITY FIRM TPG" or something to that effect.

First off: leveraged loans? C'mon people. What is that supposed to mean?

I can just picture it ... Pandit berating his CFO committee ... saying without saying that they better find a better way to cook the books this time around. They all know their last 3 quarters have looked like pig shit ... and they're hoping that they can put enough lipstick on the producer of it to avoid becoming bacon, themselves. When in doubt NY I-banking types always fall back on their oldest tricks, hoping for new results. Their actions are so predictable that I am convinced the following must be scrawled on bathroom walls all up and down the Street:

I-Banker's bag-o-tricks:

  • Clouding: Nobody can justify mega-million dollar Wall Street compensation for something as mundane as "buying something, waiting a little bit, and then auctioning it off, hopefully at a higher price." Let's face it, an IPO is just "putting your company on e-Bay." The only way you can justify charging 6% of the value of the company for this is to talk in circles so nobody can understand. It makes you sound smart for inventing something so complicated. Smart sells at a huge premium in the Wall Street job market. This takes many, many forms. Here are a few:
      • Arcane, fabricated (usually compound) terms ... leveraged loans, anyone?
      • Arcane, fabricated (usually shaky) math ... by bigshots. LTCM ring a bell?
      • Pretending to reduce risk through "hedges" (usually based on fallacious precepts) ... guess what - LTCM again.
      • Pretending to reduce risk through "collateralizing" (usually with a "Trust us - It's good!" asset)
      • Sleight-of-hand accounting
      • Bazillion-page prospectuseses
  • Making Sausage: Layering, Packaging, Blending, and Slicing. Just like baloney, the ingredients are magic and secret and most likely you really don't wanna know. As long as it tastes good, people don't bother to figure it out ... Your secret recipe is worth its weight in ... well, baloney I guess.
  • Offloading: It's scary to own something. That thing might spoil. That thing might go out of style. The value might go down. You might have to sell it at a low price in a pinch. I-bankers are afraid of commitment. Plus, it's just sitting there occupying your money; much more fun to have cash to play with. Much better to "manage" someone else's assets for a fee than actually taking the responsibility of managing your own. The fees you earn can't get taken away, even if you manage the asset right into the shitter. You can even sell your asset to someone and then borrow it back. And I love the irony as these i-bankers and brokers go pitch their wares: "well, I wouldn't own it ... but you TOTALLY should!"
  • Leveraging: This must be the oldest trick in the bag. No investor or i-bank likes sticking their neck out and actually making a bet with their own money. When in doubt, borrow to take risk. Even better - use the fail-safe "steroids for investments": borrow some money and dump it into your wimpy underperforming investment. Suddenly your measly 1% return on initial investment looks like 10%. As long as the interest you pay is less than the return you make, you look like Midas. See, i-bankers and other investors are measured based on "return." It's their job to figure out how to squeeze the most profit out of the least amount of money. Those who make the biggest returns get fat bonuses. The rest get canned.

Let me boil the CITI situation down for you: CITI loaned shaky companies money. The companies blew the dough and suddenly found themselves with liabilities exceeding their assets. Rather than just foreclose on the companies, CITI swooped in to save their initial investment using the ole leveraging trick. They joined with TPG, Apollo, and other private equity firms to loan the ailing companies more money, this time at elevated rates (since now the companies are considered "junk"). This is what they really mean when they resort to clouding by calling it a "leveraged loan" but don't tell 'em I told you. Of course, everyone got fees and probably a chunk of equity. CITI doesn't actually expect to get the money back 9 out of 10 times. Their plan is to package the leveraged loans (for another fee) and sell them off in little pieces (for yet another fee) aka making sausage and offloading. Unfortunately, nobody will buy this crap anymore, so CITI and the PEs resort to hot potato. Stay with me here. CITI gives the PEs new super-cheap loans (more leveraging). PEs use the money to buy (from CITI) the loans CITI made to them initially ... at above-market, yet helpfully below-book prices (more sausage and offloading). CITI's books are now much tidier. The mess is moved to the PEs books ... which are secret (clouding). CITI continues to mange the loans (hilariously, bankers prefer the term "service the loans") for a fee, meaning in accounting terms they've turned an ugly string of write-downs (=negative profits) into a nice stream of pure-profit fees. Those are the facts.

Now let me speculate: CITI also loaned TPG the money to pay a bunch of structuring fees on that cheap loan. CITI also sold TPG some insurance (in the form of credit or other derivatives). There was assuredly a buy-back clause saying if too many of the companies (remember them?) go belly-up, CITI will buy back the loan at a discount (note to TPG: you'll be in the courts for years if you try to exercise this). Finally, the kicker: to finance the whole thing CITI borrowed from the Federal Reserve discount window at rock-bottom rates by pledging questionable collateral. With that, the risk of the whole thing gets swallowed up in the big black hole of the Federal Government. Because of the prevailing "too big to fail" philosophy, not to mention the prevailing populist politics, the Fed would never actually try to collect on this loan should CITI stop paying.

What's in it for the PEs you might ask. If there's anyone in this mix you should not feel sorry for, it's them. They have their own bag of time-tested tricks ... Err ... well OK, they only have one trick, a doozy called "gearing" which is pretty much the same as leveraging. They have ownership in the struggling companies. They pump these companies up with as much debt as humanly possible in a game of corporate Jenga. They force the companies to use that money, not to invest in the future, but rather to artificially pump up revenues. The PEs extract as much in interest and fees as possible without totally bleeding the company out. Then they put thne lipsticked pig back on the market at an inflated price. They whip out fancy valuation math which takes the (new and inflated) growth rate of revenues and pretends this will continue into the future forever (the famout and ubiquitous "hockey stick" chart).

So, the end state is this:

  • The ailing companies now have debt FAR exceeding their assets. Should they ever make a profit, it would get swallowed up in either loan payments or "special dividends on preferred shares" to the PEs. One or two of them might turn into the next Google, but the other 90% will eventually go bankrupt or get gobbled up by the competition ... just AFTER the PEs have left the building.
  • The PEs have a huge new chunk of cash to play with from CITI. They have their talons ever deeper into their struggling companies. Water from a stone comes to mind.
  • CITI has a nice new performing loan on the books, backed by a cheap government loan so it looks profitable on the books. Plus, of course, fees everywhere.
  • The Fed has a no-recourse loan to CITI at a below-market rate. Thankfully, the Fed has no profit motive since the US taxpayers are ready and waiting to hand it some of our hard-earned tax payments.

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