Commentary - Valuation, Attestation, and Litigation Location: New York Author: IRA Staff Date: Wednesday, December 26, 2007 "When the music's over When the music's over Turn out the lights Turn out the lights" Jim Morrison The Doors A very safe and happy holiday to one and all. Last summer, around the time that Countrywide Financial (NASDAQ:CFC) CEO Angelo Mozillo was on CNBC telling the Money Honey about going back "in the bank," the music stopped in the game of musical chairs that was the market for complex structured assets. Bids evaporated and, now six months later, value is likewise disappearing from balance sheets public and private. We reckon less than half the $1 trillion in subprime structured assets has surfaced so far in the markdown process. And that figure is dwarfed by the outstanding short positions in corporate credit default swaps ("CDS"). Hold that thought... In this final issue of The IRA for 2007, we look back at some of the year's events with an eye on the future and also share some comments from readers we've received in the past several weeks. Notable was this stark assessment in reaction to our previous missive ('Subprime: We Have Nothing to Fear But Forebearance'), from a reader with decades of experience working in and around the corporate restructuring market: "Amen, brother. The solution according to the central bankers is to ignite rampant inflation by supplying credit where credit isn't needed. I fear we're in a real pickle. This central bank led bank bailout is scary. They seem to know something the banks haven't as yet said publicly... I doubt your advice will be followed until there is a panic that trips the stops and shuts down trading several days in a row on the U.S. markets. While we're closed, we'll watch the markets abroad collapse until they too shut. It'll be the equivalent of the 1930's bank holiday, albeit on a global scale." Hopefully it won't come to that, but only if the politicians in Washington allow the private markets to work. Unfortunately, the leaders of the US Treasury and the Fed, and their counterparts in Europe, seem more concerned about avoiding asset write downs for those unfortunately long than allowing the financial markets to clear. Eliminate doubts about counterparty solvency and the subprime "problem" goes away, eliminating the need for 350 billion Euro open market operations. On Bloomberg radio last week, Alan Meltzer of Carnegie Mellon University in Pittsburgh accused the Fed of "giving in" to political pressure from Wall Street and the Bush Administration. He asked about the "motivation" of Feb Chairman Ben Bernanke and others in Washington who apparently want to help large investors avoid taking losses on subprime assets. "The solution to this problem is to take the losses," Meltzer opined, who adds that with unemployment below 5%, "this is not a crisis. The Fed is being pushed into doing things that it has every reason to know lead down the wrong path... The Fed can't do anything about what is going to happen next quarter, but they can do a lot about what happens a year or two from now." Speaking of scary, the New York Times metro section did a story about the impact on the local economy of mounting subprime foreclosures, kind of trickle down in reverse. The way in which the Times editors are focusing on the subprime story, both the Washington and local angles, makes us wonder if the real estate market meltdown won't become the issue in the 2008 election. Maybe we'll even learn what Treasury Secretary Hank Paulson and Chairman Bernanke talk about during those private meetings. All politics is local, after all, and when the local economy is slumping and your neighbors are losing their homes, this has a way of making voters more cautious on the issues and more conservative in terms of personal choices -- like spending money. Losses to public pension funds also inspire aspiring politicians to conduct witch hunts to punish the guilty and enact new laws to ensure that these terrible things never happen again. Thus our three themes for 2008: valuation, attestation and litigation. Back to the overhang from $500 billion in subprime paper and trillions in CDS. We're impressed by the fact that Citigroup (NYSE:C) has finally come round to the reality that the SIVs really must be brought back "on balance sheet," this despite repeated statements to the contrary made to investors. No doubt this decision was encouraged by C's auditors and lawyers, who must sign off on the company's annual report in a few weeks. Paulson, Bernanke and SEC Chairman Christopher Cox need to make clear that all other holders of moribund structured assets must follow suit. The SEC has indicated that fund sponsors like C must in future disclose same, thus the off balance sheet shell game is effectively over for this generation of banksters. Hopefully the process of moving from "mark to model" to markdown will cause state and federal regulators to reconsider whether banks and public funds should deal in assets which, by design, cannot be traded on exchanges and for which there is no information. More generally, the search is on for a new business model for banks that is not dependent upon the fat commission income from a continuous flow of unregistered structured debt. The boom in corporate debt issuance since the summer will not make up for the lost fees from the death of structured finance. But that said, the increasingly subprime US economy needs creative financing methods. We have no doubt that the structured asset market will return in a new form. The average probability of default for US consumers and businesses is well north of 1,000 basis points or below investment grade, so there is money to be made. If the largest banks deal with the asset valuation issue and the related need to raise capital, most of these organizations can survive the coming year. The answer to that question for particular institutions, as we said last year, depends upon the height of the oncoming credit default wave. Our view is that if 2007 was about market risk, 2008 will be the year if credit risk. Moody's (NYSE:MCO) predicts that corporate debt defaults will rise from one percent in 2007 to five percent by the end of 2008, a change which implies that the US economy is going to crater large and that corporate credit spreads must widen further from current levels. As dealers mark down inventories of structured assets, the same process must occur for the clients of the dealers, or at least one would think. Thus if 2007 was the year of the dealer losses, 2008 may be the year when losses to funds of all types are especially prominent. After all, the only difference between a hedge fund and a SIV is that one vehicle pretends to be at arms length from its sponsoring broker, while the other does not even bother to pretend. In both cases, the sponsor dealer financing the assets via margin loans effectively sets the "fair value." One of the key drivers of the markdown process are auditors, internal and external, who a preparing to certify the financial statements of thousands of funds, dealers and banks. In almost every case, the audit professional has clients who have spent the past six months trying to avoid massive losses on structured assets of all sorts and now are asking audit firms to certify their financial statements. Whether you are auditing a public company or a private hedge fund, the risk of litigation is enormous and the value of potential claims extend far beyond whatever professional fees are involved. Last but not least comes litigation, a possibility we described in considerable detail over the past year. MCO has already been hit by a number of claims due to the subprime debacle and we expect to see more, both against MCO and the S&P unit of McGraw Hill (NYSE:MHP). More important, the advisory role played by the major ratings firms in creating the $1 trillion in structured subprime assets may create some huge liabilities for these lightly capitalized, heavily leveraged firms. For an interesting discussion of the possible liability of the ratings agencies in securities fraud claims, take a look at the article published on Bloomberg last month by David Grais and Kostas Katsiris, "Not the World's Shortest Editorial". There are several things which worry us as 2007 ends. First, as further losses are taken by funds and other counterparties on subprime assets and derivatives, the possibility of a loss to the sponsoring broker or bank becomes increasingly likely. Again, remember that the relationship between a hedge fund and a dealer, and a SIV and a dealer, are not that different. In both cases, the dealer really owns the assets and the risk. Second, we remind one and all that among the tricks of the hedge fund trade in recent years was to write credit default protection on everything from corporate default swaps to subprime CDOs. As long as their was no apparent risk, the premium income seemed as free money, just like banks thought that lending was a zero cost activity. But hedge funds are not insurance companies and have neither permanent capital nor reserves, preferring instead to treat premiums on selling derivative put options as regular income. Third, the failure to perform on a derivative obligation by a hedge fund that causes a loss to a bank could seriously damage what remains of market confidence. Part of the "markdown" process which must occur is valuing the derivative guarantees made on subprime assets or corporate debt when spreads were tight vs. where the spreads are trading today. Now that defaults on subprime collateral as well as corporate names are starting to rise, hedge funds with commitments to offset these defaults are in a trap. Widened spreads make it uneconomic to sell the obligation to offset defaults, but as calls to perform come in from counterparties, these same funds must begin to consume profits and then that tiny bit of client capital that is available. Whereas 2007 was the year of imploding structured assets, 2008 could be the year of hedge funds decimated by losses on cash positions as well as unfunded credit default insurance obligations. Then you can "turn out the lights." 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