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What Lurks on the Books of Banks

Thu, 3 Dec 2009 17:00:08 -0500

By Theo Francis and Jessica Silver-Greenberg

At first glance, banks seem to be recovering nicely from the financial crisis. But investors cheered by optimistic earnings reports could soon face a painful surprise.

Many banks appear to be postponing inevitable losses on home-equity loans and commercial mortgages. Others face new trouble in consumer banking, especially credit cards. "Banks know they've got big holes on their balance sheets," says Paul Miller, an analyst for FBR Capital Markets.

The hopeful news is that overall bank industry earnings tripled, to $2.8 billion in the third quarter, compared with the disastrous three-month period a year earlier. But plenty of pitfalls remain, and more grief is certain if the economy takes a turn for the worse.

Consider home-equity lines of credit. During the real estate boom, many homeowners borrowed against the value of their dwellings to pay down credit-card balances, buy new cars, or even cover down payments on the very houses that anchored the loans. With property values down sharply in most markets, a lot of those loans now look shaky. Already, payments on $21 billion in credit lines are past due.

The full extent of the problem hasn't shown up yet on the books of some banks. Lenders generally don't write down questionable home-equity loans until after a borrower has stopped making payments. So far, just 2.94% of home-equity loans have defaulted, vs. 5.96% of traditional mortgages, according to real estate data company First American CoreLogic. Industry analysts predict the percentage of home-equity defaults will rise significantly.

When home-equity loans sour, the damage to banks tends to be greater than losses on traditional first mortgages. That's because home-equity lenders stand in line behind first-mortgage lenders when a foreclosure occurs. The bank holding the first mortgage has claim to the underlying property and often sells it to recoup some money. Home-equity lenders must fight for any remaining scraps. Recovery rates on home-equity lines that have gone bad averaged about 40% during the boom; mortgage-servicer Clayton Holdings says the figure now hovers near zero.

Many banks are reluctant to write down the value of their home-equity loans because that could force them to raise more capital, further denting profits. Problems with home-equity lines and other residential loans in Florida alone could shrink financial reserves at Atlanta-based SunTrust Bank by $745 million to nearly $1 billion over the next several quarters, ultimately hurting profits, according to Gradient Analytics, a research firm that serves hedge funds and other investors. SunTrust declined to comment.

Home-equity loans aren't the only weak spot in consumer lending. ...

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These Men Could Kill SarbOx

Thu, 19 Nov 2009 17:00:36 -0500

By Theo Francis

From the marbled corridors of Congress to the tony salons of Georgetown, liberal lawmakers are abuzz with ideas on how to rein in U.S. corporations. Yet over in the courts, two conservative lawyers are mounting a serious challenge to a law, enacted earlier in the decade, that imposed tough restrictions on American businesses. A ruling in their favor could deal a serious blow to the pro-regulatory movement in Washington.

Michael A. Carvin and Noel J. Francisco, partners at the giant law firm Jones Day, are taking on the Sarbanes-Oxley Act of 2002, the controversial anti-fraud legislation passed after the last big wave of corporate scandals. The two are representing Brad Beckstead, the head of a small auditing firm in Henderson, Nev., who is suing the Public Company Accounting Oversight Board, the panel created by SarbOx to make sure auditors are doing their jobs. Beckstead says the PCAOB picked apart his business in a grueling 2004 audit. "I became the poster boy for what not to do when auditing small companies," he says. The cost of complying with the rules was so great, he claims, that he had to abandon his auditing practice.

On Dec. 7 the U.S. Supreme Court will hear oral arguments in the case, known as Free Enterprise Fund and Beckstead and Watts v. PCAOB and United States of America. A finding for Beckstead could reopen the entire Sarbanes-Oxley Act. Some board defenders fear a victory for Beckstead could even shake the foundations of established bodies such as the Federal Reserve. "The implications are potentially far-reaching," says Gillian Metzger, a Columbia law professor who is supporting the PCAOB board in filings with the high court.

For Carvin, 53, and Francisco, 40, this is no ordinary case. While the two have staked out a nice business for Jones Day cutting through regulatory tangles on behalf of blue-chip companies such as Electronic Data Systems (HPQ) (EDS) and R.J. Reynolds Tobacco (RAI), they're litigating Beckstead for free. They were attracted to the case not only for its potential to bring in new corporate clients but also because it fits their political agenda. "If you believe [in] limiting government, you're much more zealous," says Francisco.

Yet that passion hasn't alienated them from Democrats among Jones Day's 2,400 lawyers worldwide. One partner who voted for Obama says he enjoys jousting with the pair over politics. "Francisco has a beautiful mind," he says. "So does Mike."

CONSERVATIVE CONSORTIUM

Carvin and Francisco are important players in what Hillary Clinton might call the vast right-wing conspiracy. They belong to an informal yet powerful web of conservative judges, lawyers, and veterans of the Ronald Reagan and George W. Bush Administrations that has been decades in the making. Even liberals admire the group's reach. "Although I disagree with these people to the core, I have a lot of respect for the way they went about cementing not just their beliefs, but the network of people who shared their beliefs," says Stephen Vladeck, an American University professor of constitutional law.

Both Carvin and Francisco boast impeccable conservative credentials, including big roles in Bush's successful challenge to Florida's Presidential vote in 2000. ...

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Wall Street Plays Hardball

Wed, 18 Nov 2009 20:10:45 -0500

By Theo Francis, Ben Levisohn, Christopher Palmeri and Jessica Silver-Greenberg

Detroit Mayor Dave Bing is struggling to save his city from fiscal calamity. Unemployment is at a record 28% and rising, while home prices have plunged 39% since 2007. The 66-year-old Bing, a former NBA all-star with the Detroit Pistons who took office 10 months ago, faces a $300 million budget deficit—and few ways to make up the difference.

Against that bleak backdrop, Wall Street is squeezing one of America's weakest cities for every penny it can. A few years ago, Detroit struck a derivatives deal with UBS (UBS) and other banks that allowed it to save more than $2 million a year in interest on $800 million worth of bonds. But the fine print carried a potentially devastating condition. If the city's credit rating dropped, the banks could opt out of the deal and demand a sizable breakup fee. That's precisely what happened in January: After years of fiscal trouble, Detroit saw its credit rating slashed to junk. Suddenly the sputtering Motor City was on the hook for a $400 million tab.

During late-night strategy sessions, Joseph L. Harris, Detroit's then-chief financial officer, scoured the budget for spare dollars, going so far as to cut expenditures on water and electricity. "I figured the [utility] wouldn't turn out our lights," says Harris. But there wasn't enough cash, and in June the city set up a payment plan with the banks.

Now Detroit must use the revenues from its three casinos—MGM Grand Detroit (MGM), Greektown Casino, and MotorCity Casino—to cover a $4.2 million monthly payment to the banks before a single cent can go to schools, transportation, and other critical services. "The economic crisis has forced us to move quickly and redefine what services a city can and should provide," says Bing. "While we face a tough road ahead, I believe we're on the right path." UBS declined to comment.

Detroit isn't suffering alone. Across the nation, local governments and related public entities, already reeling from the recession, face another fiscal crisis: billions of dollars in fees owed to UBS, Goldman Sachs (GS), and other financial giants on investment deals gone wrong.

Charm Offensive

The seeds of this looming disaster were sown during the credit boom, when Wall Street targeted cities big and small with risky financial products that promised to save them money or boost returns. Investment bankers sold exotic derivatives designed to help municipalities cut borrowing costs. Banks and insurance companies constructed complicated tax deals that allowed public utilities, transit authorities, and other nonprofit organizations to extract cash immediately from their long-term assets. Private equity firms, pointing to stellar historical gains, persuaded big public pension funds to plow billions of dollars into high-cost investments at the peak of the market. Many of the transactions shared a striking similarity: provisions that protected the banks from big losses and left the customers on the hook for huge payouts.

Now, as many of those deals sour, Wall Street is ramping up its efforts to collect from Main Street. "The banks stuffed customers with [questionable investments] and then extorted money from the customers to get rid of them," says Christopher Whalen, managing director at research firm Institutional Risk Analytics. The New Jersey Transportation Trust Fund Authority, for instance, must pay nearly $1 million a month at least until December 2011 to Goldman Sachs on derivatives deals tied to municipal debt—even though the state retired the debt last year. The Chicago Transit Authority (CTA), having entered into complex arrangements to lease its equipment to outside investors and then lease it back, could face termination fees of $30 million. The investors could collect penalties because American International Group (AIG), which backed the arrangement, has seen its credit rating tumble. "These [sorts of deals] are potentially huge liabilities," says Stanford Law School's Joseph Bankman. "Investors aren't going to be settling for chump change." Goldman Sachs declined to comment.

The financial struggles of America's cities and towns stand in stark contrast to Wall Street ...

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Blog: Fed & Treasury Pitch Pay Rules, But Will They Work?

Thu, 22 Oct 2009 09:19:43 -0400

Posted by: Theo Francis

Call it pay day in Washington: The Federal Reserve and Treasury made a splash by unveiling sweeping compensation rules, mostly for executives at banks and other financial companies.

The Fed’s proposals are broad — reaching every bank, with special attention for the biggest, and potentially touching every facet of the pay structure. The Treasury’s rules only apply to the seven companies that have gotten extraordinary taxpayer aid — including AIG, Bank of America, GM and Chrysler — but dig deep into the minutiae of compensation for as many as 175 executives and top earners at those firms.

But both efforts, while ambitious, illustrate what may prove to be the key shortcomings of their approaches: The Fed’s guidelines count on the agency to succeed where it failed before, and the Treasury’s dictates fall back on some of the old assumptions about pay and performance that lay behind pre-crisis compensation practices.

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The SEC's Tough New Offensive on Insider Trading

Wed, 21 Oct 2009 08:56:57 -0400

By Roben Farzad and Theo Francis

Insider-trading scandals have been a fact of market life since the Dutch were hawking East India Tea. And the high-stakes bust on Oct. 16 of Raj Rajaratnam, the billionaire founder of hedge fund Galleon Management, for allegedly trafficking in ill-gotten information includes the usual array of investment analysts, corporate executives, and clock-punching interlopers.

But the Securities & Exchange Commission's recent action against Galleon evinces a new offensive against the notoriously difficult-to-prosecute crime. Armed with informants, wiretaps, and intricate software tools, the federal agency—still smarting after missing the Bernard Madoff Ponzi scheme—is signaling a bolder stance on insider trading. "It would be wise for investment advisers and corporate executives to closely look at [the Galleon] case and consider what lessons can be learned and applied to their own operations," SEC enforcement chief Robert Khuzami said in a press conference.

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The FDIC's Gift to Banks

Wed, 30 Sep 2009 09:08:17 -0400

By Theo Francis

The Federal Deposit Insurance Corp. isn't the only beneficiary of a plan to refill its coffers. The proposal, which the banking regulator announced on Sept. 29, also offers an intriguing way for financial firms to boost their capital and raise their profits.

Under the proposal, banks would prepay three years' worth of insurance fees, or roughly $45 billion. The money will help the agency dodge a cash crunch as it deals with a record number of failing institutions. So far 50 banks have been taken over by the agency in the third quarter, vs. a year ago. If the plan goes through, the banks would pay the cash up front but take the hit to earnings over several years. Banks that don't have the means to pay could seek an exemption.

It's a bit of financial legerdemain. Under accounting rules, banks record prepayments as if they had used the cash to buy an asset—in this case, FDIC insurance. Different types of assets have different capital requirements depending on their risk. The FDIC argues these assets are backed by the government, and the banks shouldn't have to hold any capital against them. If they did have to come up with additional capital to cover these assets, banks might balk at paying their insurance ahead of schedule. "The FDIC's guaranteeing it, and the federal government is guaranteeing the FDIC," says John F. Bovenzi, until May the agency's chief operating officer and currently a partner at industry consultancy Oliver Wyman Financial Services. "It looks like a creative way to deal with a difficult situation."

Plumper Bank Cushions

Here's where it gets interesting for the banks. Deep within the proposal, the agency calls for similar treatment for other assets backed by the FDIC, for the sake of consistency. Those assets include the roughly $300 billion worth of special, FDIC-guaranteed bonds issued since the financial crisis kicked into high gear late last year. Right now the bonds are considered akin to high-quality debt, and the banks have to hold $1.6 million of capital for each $100 million of the bonds they own. The shift means banks would no longer have to set aside money to cover potential losses on FDIC-backed securities. The result: Some banks' cushion of capital would look plumper practically overnight.

A similar change could add to profits. ...
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No Big Fix for Global Finance

Wed, 9 Sep 2009 19:36:16 -0400

By Theo Francis and Peter Coy

World leaders are talking bravely about fixing the global financial system. As the Group of Twenty heads toward an important summit in Pittsburgh on Sept. 24-25, they are vowing to bang out a regulatory structure that will keep rich, careless bankers from once again driving their firms to ruin and then getting bailed out by taxpayers. Finance ministers and central bankers who met in London earlier this month reported "substantial progress in delivering our ambitious plan."

But their plan is far less ambitious than what some voices were advocating as recently as last spring. Bank lobbyists have fought back hard, and recent improvements in the global economy and financial markets have robbed momentum from the reformers. What's more, truly ensuring change on a global scale would probably require a single international regulator with power to intervene in local affairs. Yet there is little appetite for that among the G-20, which includes the major industrialized countries as well as China, Brazil, and other developing powers.

The likely result? A package of worthy but lukewarm reforms that leave the global financial system—and taxpayers—exposed to another costly bust some years down the road. "We're not going to have a revolution," says Edwin M. Truman, a senior fellow at the Peterson Institute for International Economics who advised Treasury Secretary Timothy Geithner before G-20 meetings last spring. "The question is to what extent you're going to have, over the next year, a substantial evolution."

International and U.S. proposals on the table target the hot topics: increasing capital requirements, corralling the "shadow banking system" of nonbank lenders, and otherwise trying to ensure that risk doesn't balloon out of control. But in most cases they rely on the kinds of tools that failed the last time around, when supervisors proved less than vigilant, turf squabbles impeded regulation, and fears of foreign competition led governments to yield to industry demands for a lighter touch.
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Private Equity Waits Out the Feds

Thu, 3 Sep 2009 17:00:01 -0400

By Peter Carbonara and Theo Francis

The U.S. is making it tough for private equity firms to buy ailing banks. In late August the Federal Deposit Insurance Corp. imposed stricter rules for acquisitions, the latest move in a long game of chess between the banking regulator and the buyout giants. But analysts say the FDIC may back down. The number of troubled banks is rising, and the regulator's pot of money is dwindling.

For months private equity players such as Carlyle Group, Blackstone Group (BX), and KKR have been salivating over bad banks. That's because the FDIC has agreed to eat the bulk of the losses in most deals, leaving buyers with huge potential for profits. The FDIC says these "loss-sharing" pacts ultimately save taxpayers money, in part because it's costlier for the U.S. to take over the banks outright. For buyout players, the deals "are like licenses to print money," says a banking lawyer.

Despite the ready pool of capital, private equity has accounted for only a handful of such purchases. The most recent was in May, when Carlyle and a group of other investors bought Florida's failed BankUnited Financial (BKUNQ) for $900 million. Instead, established banks have bought most of the failed institutions from the FDIC, snapping up dozens since the start of 2009.

DIFFERENT STANDARDS

Dealmakers say the government is the biggest roadblock for private equity. Under the new FDIC rules, a bank acquired by private investors will have to keep an extra cushion of capital to protect against losses, roughly 10% of assets in the first three years of ownership. The buyout industry calls the requirement unfair. In similar situations, bank holding companies typically set aside capital that amounts to 8% of assets. "We're being held to a different set of rules," says a deal-maker at a large private equity firm.

The changes are less stringent than initially proposed, and FDIC Chairman Sheila C. Bair told BusinessWeek they are justified. ...

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Old Banks, New Lending Tricks

Wed, 5 Aug 2009 03:22:51 -0400

By Jessica Silver-Greenberg, Theo Francis and Ben Levisohn

That didn't take long. The economy hasn't yet recovered from the implosion of risky investments that led to the worst recession in decades—and already some of the world's biggest banks are peddling a new generation of dicey products to corporations, consumers, and investors.

In recent months such big banks as Bank of America (BAC), Citigroup (C), and JPMorgan Chase (JPM) have rolled out newfangled corporate credit lines tied to complicated and volatile derivatives. Others, including Wells Fargo (WFC) and Fifth Third (FITB), are offering payday-loan programs aimed at cash-strapped consumers. Still others are marketing new, potentially risky "structured notes" to small investors.
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Washington's Lobbyists Change Their Tactics

Wed, 29 Jul 2009 11:13:46 -0400

By Theo Francis and Steve LeVine

Despite the rhetoric of the past 18 months, few in the nation's capital really believed the Beltway lobbyist would disappear overnight just because a new President vowed to change business-as-usual in Washington and Congress heightened scrutiny. Yes, lobbyists now must heed stringent new disclosure rules; the gift-giving and golf outings have largely vanished. But the influence game rolls on in Obama's Washington.

That isn't to say, of course, that nothing has changed. The Democrats have set in motion a landslide of potentially transformative legislation: an overhaul of the U.S. health-care system; a sweeping energy and climate-change bill; new regulations to rein in the financial markets; and more. "There are a lot of challenges for business," says Steve Elmendorf, a longtime aide to former House Democratic Leader Dick Gephardt who now runs his own lobbying firm. "When there are challenges, they hire help."

With so much legislation and so many new rules, many K Streeters are adjusting their playbooks. One lobbyist says that where a client once hired two firms—one Republican, one Democrat—it now may hire five, including specialists for each house of Congress and at least one big-picture strategist. Twitter, Facebook, and sophisticated Web sites have become de rigueur tools of influence. And lobbyists are looking to cooperate more often with lawmakers—or at least appear to be doing so—rather than simply training their guns on bills they deem hostile.

At a time when lobbying is under assault, the most effective practitioner is sometimes someone who technically isn't a lobbyist.

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