Slouching Towards Wall Street… Notes for the Week Ending Friday, 3 June 2011
Our cynical friends at ZeroHedge turned up the corner of the rug and found a suspicious looking pile. We enjoy ZH’s well-documented work, largely because they are often even more paranoid than we are — which makes us feel we may be missing something important. This week they wrote about real estate short sales, where a bank disposes of foreclosed properties for less than the balance on the mortgage. These deals all look pretty sketchy to us and frankly we’re not sure where the legitimate part of the transaction starts.
CNBC reporter Diana Olick broke a story last year, following up in 2011 after speaking with entrepreneur Jeremy Brandt, whose businesses include FastHomeOffer.com, which pairs distressed sellers with cash-ready buyers. Brandt describes a process that may have more effects than are being reported.
During the housing bubble, many borrowers ended up with two mortgages. Many had purchased properties they could not afford, and a second mortgage was wrapped around their first, providing the cash to make the initial down payment. Other homeowners started drawing on home equity lines. As the equity in their houses started to inflate, many took on piggy-back loans — secondary or even tertiary mortgages. When the carrion birds came home to roost, many of these borrowers found the value of their houses far below the balance due on their primary mortgage. Like Bialystock & Bloom in “The Producers,” they found themselves owing multiple times the value of their home, having borrowed more than 100% of what their house was now worth.
Banks were also in a bind. Facing diminished real estate values, they couldn’t just start foreclosing left and right. Banks are not in the real estate investment business, and owning large numbers of properties would be financially disastrous. And foreclosures would mean writing down their mortgage portfolios, which would mean a hit to the bank’s assets, and a ripple effect as every other bank with mortgages in the same geographical market would have to take a charge against their portfolio, even if they did not foreclose on properties.
Enter the short sale. Unlike foreclosures, short sales are negotiated, and the bank and the property’s owner must agree to the transaction. A bank loss mitigation department works with the homeowner, takes formal appraisals of the local market and the property, and assesses the current market price of the property. Once the price is agreed, the bank sells the property and pockets the proceeds. There’s one catch: all lenders must agree to the sale. When a homeowner has a first mortgage, a wrap second mortgage, and a piggy-back loan from a third institution, the secondary liens must be satisfied before the short sale can be effectuated. Since the primary bank is taking a loss, it has no incentive to ensure that second- and third-lien holders get anything at all. Lenders generally will kill the short sale if a second lien holder receives anything from the proceeds. But without any payout at all, the second lien-holder won’t approve the sale.
Brandt reported a large number of complaints and inquiries about second lien-holders requiring short sellers to make off-the-record cash payments to secure approval for the transaction.
Analytics firm Corelogic says lenders may have taken unnecessary losses in around 2% of short sales done in the first half of last year, and that total losses from suspicious transactions in the first half of 2010 amounted to $150 million. CoreLogic says losses from short sale fraud could hit $375 million this year. Among the rules of thumb used in identifying potentially suspicious transactions are “flipping” a property for a profit of 10% or more within the first month of buying it from the bank, or for 20% or more in less than 90 days, or at 40% or more after six months — indicators that the sale was pushed through at an unreasonably low price. Short sales are reportedly up 200% in the last two years, and continue to rise.
CoreLogic cautions that just because a transaction falls within these parameters, one should not assume it is fraudulent. There are investors with cash who will acquire a fixer-upper for possible resale. But CoreLogic perused hundreds of thousands of properties and found a number were re-sold the same day as the short sale. The report indicates that, while most of the short sales were legitimate, as much as 65% of short sales with subsequent resales subsequent be in some way fraudulent.
Why is this in the news today? One high-visibility short sale recently re-sold (for a profit of over 100%) was purchased by Sarah “Will She Or Won’t She?” Palin, whose 8,000 square foot house in North Scottsdale, AZ, was bought a year ago by a local real estate investor in a short sale from JP MorganChase in March, 2010, for $805,000. This year, Ms. Palin paid $1.75 million for the property.
We do not wish to imply — nor are we aware of any evidence — that either the buyer, or Ms. Palin has done anything improper. This appears to be a legitimate transaction by an investor who bought the property from the bank, and by Ms. Palin, who may find the desert bracing after the frozen tundra of her home state.
But this high-profile purchaser has brought the snoops swarming out of the woodwork and shone a new light on a practice that has created not merely opportunity, but clear incentive to commit fraud. A homeowner wishing to avoid foreclosure can not cooperate with a reasonable bank in a short sale unless he first obtains the approval of his second lien holder; the second lien holder can not receive any proceeds from the short sale. Are we missing something here? We think not.
Olick quotes Brandt, the short-sale entrepreneur, as saying the practice of demanding cash payments on the side is not limited to shady operators working out of boiler rooms. Already last year Brandt was hearing reports of representatives from Citi, JP MorganChase, and Bank of America demanding cash on the side to close short sales.
So this is not exactly a new story. But while Congress tries to steady its aim at Goldman Sachs, this practice is apparently going on unregulated, unpoliced, and unabashed. And there’s another question still unanswered. How do the banks account for these transactions?
Twelve states in the US are non-recourse states, meaning creditors must cancel an unpaid balance once a settlement is made. In all the rest — all 38 of them — creditors may seek restitution for unpaid balances. We think it likely that banks may not charge off these losses, but carry the difference between the cash proceeds of the short sale and the original mortgage as an asset. With the short sale process, the bank avoids foreclosure — which is less onerous for the borrower’s credit rating — the bank thus may not be required to take a charge for the unpaid portion. We recognize that we have a twisted view of our fellow human beings. Still, it’s worth looking into.
We would be interested to see the analysis on an institutional level of banks making short sale deals with homeowners in the thirty-eight recourse states. CoreLogic’s analysis indicates we may see some $375 million in losses tied to improper short sales. But if “proper” short sales are being effected, and the banks are figuring out ways to not charge off the difference as a loss, then the dollars lost to fraudulent short sale tricksters could pale by comparison to phantom equity in bank loan portfolios. We bet there’s still plenty of rot hidden under the tarp.
Meanwhile Sarah Palin has bought herself what looks like a beautiful new home. Does a potential carpetbagger need to travel so far to find a constituency? Maybe Palin noticed the Phoenix Coyotes, the local professional hockey team, and was intrigued by a winter sports team playing in a desert town. With Palin rolling her thunder into Scottsdale, what could be next? The Death Valley Iditarod?
Resolved: Either the Libyans are stupid, or they aren’t. Either Goldman is honest, or they’re not. Either Congress knows what it’s doing, or… oh, never mind.
Says the Wall Street Journal (31 May, “Libya’s Goldman Dalliance Ends In Losses, Acrimony”) in June of 2007 Libya “made a conscious decision to join the major leagues.” They made a big show of owning up to the Lockerbie bombing, paying reparations to the families of the victims, and abandoning their nuclear program. So far, so smart. Then they “approached 25 financial institutions, offering each of them a chance to manage at least $150 million.” Not so smart, says the Journal.
Among Libya’s investments was $1.3 billion worth of options, purchased in the first half of 2008, covering a basket of currencies, plus six major global financial and energy companies. If you are reading this Screed, you no doubt recall what transpired in the second half of 2008. Indeed, one truly unintended consequence of constant references to “The Crisis” has been to force people to remember events of three years ago, which is a lot farther back than a Wall Street banker’s memory generally can stretch. If a long memory is in fact the most radical idea in America, the Washington-Wall Street conspiracy is unwittingly laying the groundwork for its own demise. Three years’ recollected collective suffering now become the Silver Lining.
The Journal cites a Goldman internal document saying the Libyan investments were worth only $25.1 million by early 2010, but Libyan sovereign wealth managers were calling Goldman executives on their richly textured carpet as early as July 2008, accusing them of misrepresentation and unauthorized trading. Over the next two years, says the article, Goldman came up with six different proposals to get the $1.3 billion back into Libyan coffers.
So are the Libyans smart? Libya’s investment managers must know that money doesn’t care who owns it. A losing investment has no moral obligation to return a profit to its owner — and doesn’t it just happen all the time that, no sooner do you sell the dog that lost you 20% of your investment, than it shoots up 50% from the price at which you sold it? The Libyans should know that a stupid or incompetent investment made on their behalf by Goldman Sachs in no way guaranteed that same Goldman Sachs would be able to make it back.
Or perhaps the Libyans had more of an Old World view of investing. “We’re in this together” — meaning: I don’t invest to lose my money. And I sure don’t invest to lose Muammar Gaddafi’s money! To make good on these rather substantial losses, the Journal reports, “Goldman offered Libya the chance to become one of its biggest shareholders.”
Which brings us to our second question.
An investment firm doesn’t guarantee a customer against losses. Guarantees are prohibited in a brokerage relationship. This is the “agent” relationship at the heart of the idiotically mis-managed testimony given by “Fab” Fabrice Toure and his former Goldman bosses when they tried to explain to Congress that Goldman had no obligation to act in the interest of its client. Even CEO Blankfein thrust his Ballys in his maw in his singularly inarticulate efforts to describe the non-fiduciary nature of the broker-customer relationship. If this is the Best and the Brightest, we are in even deeper doo-doo than we thought — especially considering that one of these guys may be signing the dollar bill before the decade is out. Assuming there is still such a thing as a dollar.
It appears that Goldman may have tried to make up Libya’s loss without actually repaying them — which would possibly be unlawful — and reportedly offered Libya a discounted buy-in to the firm, asking $3.7 billion for $5 billion worth of preferred stock. (“Since we’re obviously so bad at what we do, maybe you should become our partner…”) The Libyans ultimately rejected this deal, leaving Warren Buffet to subsequently take nearly identical terms to those offered to the desert republic. The Libyans withdrew to lick their wounds, retrieving the convicted Lockerbie bomber in the process. Buffet’s deal sailed through the seas of corporate governance and Congress because Buffet is an American icon. No negatives are associated with his ownership of a significant stake in a major American financial institution. Unless you are a US taxpayer, in which case you underwrote Goldman’s paying back Buffett’s investment. And has anybody checked the personal trading records of Berkshire Hathaway employees around the time of the Goldman purchase?
It may be an optical illusion, or opaque reporting — perhaps the Journal has only sketchy information — but Goldman’s Libya offer looks murky. We wonder at the corporate governance process that brings the CEO and CFO of one of the world’s premier banks to offer a low-ball deal to a wealthy customer to make up for trading losses. Maybe this is principally a story about an investment firm agreeing to make whole a customer’s trading losses. But why this deal? Why Libya? Did Goldman offer to make up losses on the Abacus and Timberwolf deals? If Goldman simply wrote a $1.3 billion check to Libya, it would be admitting to those allegations of misrepresentation and unauthorized trading. Offering a block of discounted stock as an inducement, in a structure that required a 20-year payout, gives other preferred holders an automatic haircut. From Libya’s perspective, getting one’s money back over 20 years doesn’t feel like payback.
Meanwhile, Goldman nemesis journalist Matt Taibbi is no doubt sharpening his quill. His latest squid screed (Rolling Stone, 26 May) is titled “The People v. Goldman Sachs.” The lead-in line: “A Senate committee has laid out the evidence. Now the Justice Department should bring criminal charges.” But New York’s Attorney General beat them to it.
No details have come out about the subpoena issued by Cyrus Vance’s office this week, and there will certainly be hefty jousting before this matter is laid to rest. We note that Vance has pushed for changes to New York’s Martin Law, the law that gives the State’s prosecutors broad powers to subpoena any company doing business in New York. You will no doubt recall the aggressive use made of the Act by then-AG Eliot Spitzer, who used it to play Whack-A-Mole with Wall Street. (If you are in this industry, you will also recall the cheers that went up on trading desks when the news broke of then-Governor Spitzer’s sex scandal. We were on a trading floor where they literally sent out for champagne.)
Vance has said the penalties under the Act are in general too lenient, because they do not differentiate enough between offenses. Speaking to the NY Bar Association earlier this year, Vance pointed out that “a broker who fraudulently deprives one customer of $500 is subject to the same penalty as a high-level market manipulator who deprives the investing public of hundreds of millions of dollars.” Among reforms Vance sought to the Martin Act were lengthening of statutes of limitations, and increased in penalties, based on magnitude of the losses or damages caused.
We remain nonplussed at the Goldman executives’ inarticulate performance before the Levin Committee, and we wonder why lawyers did such a poor job of coaching them on what was sure to be a key Public Relations question: “Is it not your duty to act in your client’s best interest?” This time around Goldman may believe they have a home field advantage, considering that generations of senior Goldman executives made the transition to Washington, where they effectively wrote much of the legislation that governs the industry today. We think an all-out assault may be brewing. Congress has given the prosecutors the ammo, with the Levin report. AG Vance has fired the opening volley, but he is surely aware of how poorly Eliot Spitzer’s cases fared — and Giuliani’s, for that matter. We would not be surprised to see him press for the states’ Attorneys General to assemble seeking some kind of global settlement. Goldman hunter Taibbi says the abuses on Wall Street will never really stop until senior executives of firms go to jail — and not to Bernie Madoff country clubs, but to state prisons where they can be routinely beaten and abused by their cellmates. We are not sure what similar corrective might apply to state AGs.
Meanwhile, Goldman offered Libya a sweetheart deal to become a partner. Gaddafi and his money managers turned them down flat, and now they’re getting shelled within an inch of their lives by NATO. We remember rumors that Henry Kissinger told Israel to back off the encircled Egyptian Third Army in 1973, allegedly at the request of Salomon Bros’ oil traders. Israeli forces gained the upper hand after initial setbacks at the beginning of October. By 24 October, they had the Egyptian Third Army encircled — and the Arab Oil Embargo had been in effect for one week. Call us conspiracy theorists, but we bet there would be no push to bomb Libya if they were Lloyd Blankfein’s partners. Hey, Senator Levin and Attorney General Vance: look what happens to people who turn down the deal Goldman offers them.
Cole Porter’s deliciously multiple entendre-laden song from “Kiss Me Kate” describes what happens to sexual performance when the weather gets out of control. If Porter were alive today, he might plant similar verbal tricks in songs about global warming (“Baby, my ice cap’s melting too fast…”) Speaking of being victimized by the climate, global warming appears to be alive and well on Wall Street.
Investor Peter Theil says Wall Street mangled the valuation LinkedIn’s IPO (Financial Times, 31 May, “Wall Street Mispriced LinkedIn IPO, Says Prominent Tech Investor”) saying bluntly “the bankers screwed up.” FT says of this obviously mispriced deal, “banks did not understand the full potential” of LinkedIn. Why, even troglodytes like us knew this was a sector-defining transaction. The underwriters included Morgan Stanley, Bank of America Merrill Lynch, and JPMorgan Chase, old hands at the old game of mispricing public offerings. One economist quoted said deals are underpriced around 15% on average. This builds in a protective lift in the price of the stock, allowing the company and the bankers to keep what they made on the deal.
Observers recall the years of consistent underpricing during the internet boom in the late 1990’s that led to a regulatory case against super-star tech banker Frank Quattrone. But the case went nowhere, and Mr. Quattrone is back at work in Silicon Valley.
Internet companies are trading in a shadowy world of private exchanges. We would be delighted if the SEC would examine the pricing and distribution of the LinkedIn IPO. A company with this profile should not be underpriced by 100%, and a prompt and transparent regulatory review would help steady investors and make the marketplace look less threatening. We expect the SEC to do precisely nothing, partly on the notion that LikedIn is a big enough entity that they don’t need Washington’s help, partly because the SEC chants the mantra of the religion of Free Marketism, and certainly because the Agency already doesn’t know where its next meal is coming from, and they probably recognize that getting investment bankers angry won’t go down well in Congress (who, in contract, generally do know where their next meal is coming from — especially as long as the bankers can underprice the hottest deals.)
Meanwhile, with Congress dithering over whether the investors really need to be protected after all, Groupon announced its own IPO this week, which should do what the SEC can’t. We shall be fascinated to see how far Groupon’s bankers underprice this deal. Meanwhile, the SEC won’t look into single transactions, but wait to see whether there is a “pattern of behavior.” This is their excuse — the reality is that they lack both resources and imagination. As far as we are concerned, the LinkedIn deal is already a coincidence, so we’re not sure what they are waiting for.
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