SHE’S 94

With the happy gene, it seems.


Not only have we gone too slowly and too meekly to flesh out Dodd, Frank – the financial reform bill that the Republicans fought and now seek to emasculate – there’s a new bill close to enactment that, at least as I read Floyd Norris in the Times, endangers investors even further.  Three Democratic senators are trying to improve it, as you’ll read.  And I actually love the notion of “crowd-funding,” even if it’s prone to abuse, so exempting some of that from most securities regulation, up to reasonable limits, doesn’t bother me.  But the rest?  Read this piece.


Herewith a telling excerpt from Janet Tavakoli’s 2003 Collateralized Debt Obligations & Structured Finance (reiterated five years later in its second edition).

“If you guessed that the credit derivatives ‘professionals’ in this incident were from Goldman Sachs,” Janet now writes, “you were correct.  Goldman has a long history of, inadvertently or otherwise, trying to pull a fast one.  BTW, to the best of my knowledge, only one of the fellows still works at Goldman; he’s a partner in the NY office.  But I can assure you the nice kids at Goldman have been playing these games a long time.”

One well-known, well-respected, American investment bank asked … if the bank I worked for would intermediate a credit default swap transaction.  Requests for intermediation are common.  Many banks need an OECD bank counterparty for regulatory capital purposes.  If the structure is right, the intermediation fee can allow the intermediary bank to earn a reasonable return on the minimal capital required, and all parties are satisfied.

The investment bank sent over their documentation.  It was a paltry two-page document, whereas monolines will send a small booklet and make their lawyers available to discuss language details.  When I looked at the document, I realized that the transaction was unsuitable.  The following diagram shows the gist of the proposal, without embarrassing those who should be.

The investment bank assured me they would give me proper credit default swap documentation incorporating whatever language I wanted.  If a credit event occurred, the bank would look to the SPE to make payment under the terms of the credit default swap, and I could design the terms.

I declined.

The investment bank invited me to a meeting at their offices. Four tailored Armani suits or better appeared at the meeting.  If life were a fashion war, the investment bankers would be winning. They were confident and took victory postures.  They attempted to persuade me to do the transaction.  I continued to decline.  I could sense their building frustration.  They couldn’t understand why they weren’t getting my agreement.  After all, they were taller, they were louder, and they were in the majority.

So what was the problem?

I picked up a cookie – the meeting didn’t have to be a total loss – and explained.  I didn’t want to play their shell game.  The problem was that my counterparty for the credit default swap protection would have been the SPE, a shell corporation.  The only asset of the SPE was an insurance contract.  The SPE would only receive a credit default payment after the insurance company determined its actual recovery after taking the matter through bankruptcy proceedings.  The SPE had no way of assuring timely payment under the terms of the credit default swap confirmation.

The transformer wasn’t even worth the price of the child’s toy of the same name for the purpose they were suggesting.  Sure, the SPE would have ultimately got paid and the bank would ultimately have received payment, but that wasn’t the point.  The point was that the SPE did not have the resources to perform under the terms of its transaction with the bank.  It could not pay on a timely basis, no matter how cleverly crafted the credit default swap confirmation.  If a credit event occurred, the bank would have to fund the credit default payment to the ultimate protection buyer until the SPE finally received its payment from the insurance company.  The investment bank only offered the usual credit default swap intermediation fee, but the bank had additional risk beyond the credit default swap agreement.

It’s possible that the well-dressed guys weren’t aware of this until I pointed it out.  The implications of that are ugly enough.  But if they were aware, the implications are even uglier.


After last week’s update, one of you offered this:

M.: “I own a considerable number of these.  My firm owns or manages capital that owns roughly 8% of them.  I paid close to what you paid for the great majority of them.  The company needs to do something to address the overhang the warrants are putting on the stock.  Above 12, the shares outstanding go up from 50 million to 90 million.  ROIC trades at a discounted REIT multiple, in part because of this overhang.  The recent equity offering the company did to finance new acquisitions was a step in the wrong direction.  An exchange of stock for warrants to raise capital to grow, and take the warrants out, makes more sense.  I think management gets this now, but they have misled me on this topic in the past.  There is also a difference between the price that management wants to pay in stock for the warrants and the price warrant holders like me want.  The Barron’s piece you linked to was good, but it missed this dynamic, and I thought I would point it out.  Also, keep in mind: when the stock gets close to 12, it makes sense for some warrant holders that are option oriented to hedge by shorting ROIC stock; the delta of the warrants goes higher, and they can make profits selling stock at 12 and covering at 11.50, without a lot of risk that stock goes higher.  This is also capping the stock some. IMHO, these will work out great if management ever takes some action to address the overhang.  But we have had quite a REIT rally already and multiples are not low.  And it is hard for the stock, and thus the warrants, to get to fair value if the overhang is not managed down.”

Tomorrow: Free Masterpieces and Your 17-Minute Feedback


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