A different type of financial insecurity–cyberattacks

There’s been much attention paid to an article in this month’s issue of The Atlantic that looks at financial insecurity in the US: “The Secret Shame of Middle-Class Americans.” It’s both a great and terrifying read.

This morning, Reuters reported on a different type of security concern:

SWIFT, the global financial network that banks use to transfer billions of dollars every day, warned its customers on Monday that it was aware of “a number of recent cyber incidents” where attackers had sent fraudulent messages over its system.

The disclosure came as law enforcement authorities in Bangladesh and elsewhere investigated the February cyber theft of $81 million from the Bangladesh central bank account at the New York Federal Reserve Bank. SWIFT has acknowledged that the scheme involved altering SWIFT software on Bangladesh Bank’s computers to hide evidence of fraudulent transfers.

How confident are we in the safety of the money we do have?

Reforming Two Decisions That Led To The Recession

While many decisions made over a number of decades created the circumstances that led to the worst recession since the Great Depression, certain government actions were particularly devastating to the US and world economies. Embodied in the Gramm-Leach-Bliley Act (also known as the Financial Services Modernization Act of 1999), the law made two important changes to the securities regulations enacted in response to the Great Depression.

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It’s TARP Repayment Week!

Today, both Citigroup and Wells Fargo announced plans to repay their TARP funds. Their announcement comes shortly after Bank of America announced its plans to exit the bailout program. Apparently, December is the month for those banks remaining in the program to make their way out.

Could this move have anything to do with the approaching year-end?

Considering that all three have fiscal years ending December 31, 2009, the move is hardly surprising.123 By repaying their TARP funds during this fiscal year, all three can start 2010 free of government encumbrances on executive compensation and the additional oversight that came with the Troubled Asset Relief Program (which, by the way, never relieved [government speak for buying assets from the banks] any troubled assets, but instead infused capital into the banks to prevent their collapse).

IFRS Confusion Abounds

In the past few years, much has been made of the plans to merge the accounting standards used in the US with those used by much of the rest of the developed world. In 2002, the US standards setter and the international standards bodies agreed to a framework for convergence of US generally accepted accounting principles (US GAAP) with the International Financial Reporting System (IFRS) in a document known as the Norwalk Agreement.1 Since then, the US and international bodies (known, respectively, as the Financial Accounting Standards Board, or FASB, and the International Accounting Standards Board, or IASB) have worked to align their respective standards so that, eventually, developed nations will have a homogenous accounting system. One particular point of difficulty in this effort, however, has been the issue of fair value accounting. The economic recession that began in 2007 further complicated convergence efforts as attention was drawn away from reconciliation efforts and focused on both placing blame and reforming the practices that caused the crisis. Then, with the election of President Barack Obama, the entire convergence movement was threatened when the newly-appointed chairwoman of the Securities and Exchange Commission announced that she would not “feel bound”2 by the convergence roadmap established by her predecessor.

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As Venture Capital Funding Slows, Three Investors Provide Tips for Securing Financing

According to the latest PricewaterhouseCoopers/National Venture Capital Association MoneyTree report, venture capital (VC) investments in the first half of 2009 are 55% lower than the same period in 2008, falling from $15.2 billion to $6.8 billion. To be sure, $6.8 billion is still a substantial sum of money, but the decrease in funding from venture capital firms means increased competition for every dollar in an financial environment that is already unfriendly to new investments. As banks have reduced or eliminated companies’ credit lines and are unwilling to provide other forms of financing, entrepreneurs are now forced to look for more-creative ways to fund their operations. Venture capital funding, where investors provide financing to begin operations, support ongoing growth, and foster development of new ideas, is an increasingly appealing option for small businesses impacted by the recession. Whereas entrepreneurs may have previously resisted relinquishing any amount of control over their companies (see below) in exchange for operating capital, some organizations now find that they have no other choice if they are to survive.

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What About Ford?

Today, General Motors and Chrysler announced plans to advance money to their dealers to cover payments related to the government’s “Cash for Clunkers” program. Ford made no such announcement. In fact, Ford Motor Credit specifically stated that it is not modifying its relationship with Ford dealerships.

Could this be a sign that the sole US auto maker that was not bailed out by the government is running short of cash? As you might remember, Ford only avoided the need for government rescue because it mortgaged most of the company back in 2006.

Spoofed Email Causes Stir At SEC

This morning’s Wall Street Journal has an interesting, albeit breif, article about a spoof email which purported to be sent by an SEC enforcement attorney. The email was critical of the SEC Chairwoman Mary Shapiro and Inspector General David Kotz, particularly as it related to Mr. Kotz’s recent reports regarding the SEC’s performance prior to the economic downturn and its stock-trading scandal involving enforcement attorneys. The situation is a bit strange, but it only reinforces the President’s point about US cybersecurity. The article is available here.

Bank of America tries the Citigroup approach

Between Ken Lewis’ recent purchases and his comments during today’s press conference with Merrill Lynch Chairman & CEO John Thain, it appears to me that he is trying to build a financial institution in the same fashion that Sandy Weill did at Citigroup. During his opening remarks, Mr. Lewis mentioned building the “premier financial institution in the world,” language that reminds me of Mr. Weil. The size of the bank would speak to this tendency. Having added mortgages and private wealth management by way of Countrywide and U.S. Trust, respectively, Bank of America is simply plugging the holes at this point. LaSalle is further evidence, filling one of the largest holes in the bank’s branch network. For Mr. Lewis, his about-face on investment banking makes this purchase that much more curious. The quality of Merrill Lynch’s operations certainly sets this purchase apart because of the value it adds to B of A, apparently relieving the banks concerns regarding investment banking; the many other aspects of Merrill’s operations also make the purchase an attractive addition to B of A’s portfolio.

I was also happy to hear that B of A is committed to retaining the Merrill name and operations. With the number of ongoing integrations, Mr. Lewis doesn’t expect to begin the Merrill systems integration process until 2010 anyway.

Changing the Window Dressing

Yesterday’s announcement that the Treasury Department has blessed covered bonds for use in the mortgage market made me wonder if Wall Street and the government have learned anything from the credit crisis gripping the national economy. There are two distinct differences between the collateralized debt obligations (CDOs) that got us into trouble in recent years and the covered bonds as announced yesterday by Treasury Secretary Hank Paulson. First, rather than removing the securitized assets from the seller’s balance sheet, the assets remain in the issuer’s control, providing purchasers recourse against those assets. The second difference involves the types of mortgages that can be securitized in a covered bond. So-called “stated income” or Alt-A mortgages, as well as the notorious subprime mortgage, cannot be included in a covered mortgage bond. Beyond these two differences, CDOs and covered bonds are essentially identical.

The idea with a covered bond is that since the assets stay on the issuers’ balance sheets, they are less likely to take risks with the securitized assets. Additionally, the purchaser of these bonds has recourse against specific balance sheet items, a feature intended to limit the default risk associated with mortgage-backed securities. Unfortunately, these debt instruments are still based on residential mortgages, an area of the US economy showing substantial weakness in the foreseeable future.

While intended to provide more liquidity to the mortgage market, covered bonds still rely too heavily on the CDO model. It seems unlikely to me that the minor differences noted above will instill enough confidence in the market for these instruments to have any impact on mortgage availability.

My other concern with covered bonds regards insurance. Bond insurers, having suffered greatly over the past year, are not in a strong position to offer insurance on covered bonds. Given that covered bonds provide recourse, the utility of bond insurance is further reduced. Additionally, I, for one, see little value in the insurance offered by major insurers.

Ultimately, the success of these securities will depend directly on the quality of the underlying mortgages and the health of the US economy, both of which are quite uncertain now and in the near term.

The Problem With Being “Too Big To Fail”

“Too big to fail” is a nifty bit of rhetoric swirling around Washington right now regarding Fannie Mae and Freddie Mac. Yes, the government-sponsored mortgage giants do play a crucial role in the US housing market, funding or guaranteeing more than half of all mortgages. Clearly, a failure at either institution would be catastrophic for the domestic housing market, but their size is also a hindrance to their purpose. To understand this, one must realize where these two behemoths came from.

Created in 1938 as part of Franklin D. Roosevelt’s New Deal, the Federal National Mortgage Association, or Fannie Mae, was established to facilitate home ownership in America following the Great Depression. At the time, mortgage funding was unreliable and expensive, preventing many Americans from buying their own homes. The creation of Fannie Mae provided the funding necessary to lower barriers to home ownership. For nearly 30 years, Fannie Mae dominated the secondary mortgage market, buying home loans from other banks in order to free up those funds for new mortgages. Throughout this period, Fannie Mae was part of the federal government, representing a substantial burden on the federal budget and a barrier to entry for competition. In 1968, in response to these concerns, Fannie Mae was rechartered as a government-sponsored, publicly-traded entity. At the same time, Congress created the Federal Home Loan Mortgage Corporation, or Freddie Mac, to provide competition for the newly-independent Fannie Mae. The federal government hoped that by placing both companies in the private sector, competition would be created in the secondary mortgage market.

Over the next 40 years, Fannie and Freddie grew into their roles in the mortgage market. By 2008, the companies together guaranteed more than $5 trillion in mortgages, representing more than half of the market. It is because of their size that everyone from Treasury Secretary Henry Paulson to Senator Chris Dodd (D-CT, Banking Committee Chair) insists their failure must be prevented. While I understand how important their role is in the mortgage market, I do not think it is imperative that they continue in their current form.

Monopoly and competition are rarely complementary concepts. This is especially true in the case of Fannie Mae and Freddie Mac. While the later was originally intended to compete with the former, nowadays there is little difference between them. Rarely is one mentioned in the news without the other accompanying it. Because of their size and near homogeneity, increased regulation will have no impact on competition in the secondary market. Instead, both should be broken up into smaller entities. Doing so will allow them to operate as they were intended, competing with each other for a share of the mortgage market. In the following clip from Bloomberg Television’s Morning Call, Marc Faber, editor and publisher of “The Gloom, Boom, and Doom Report” makes his argument for the breakup of Fannie Mae and Freddie Mac.

As Mr. Faber pointed out at the end of this clip, the federal government has stepped in before to break up a monopoly, namely in the cases of Standard Oil and AT&T. Competition was created when those two behemoths of their industry were split up. The same should be done with Fannie and Freddie.

The “baby Maes” which would result from a breakup of Fannie Mae and Freddie Mac would need to retain many of the characteristics of their parents in order for them to be successful. Government sponsorship is important as it reassures investors and carries with it an implied guarantee, thereby allowing more investors to purchase securities issued by the companies. By placing more companies in the secondary market, a breakup would foster competition, thereby lowering borrowing costs for would-be homeowners. Splitting up the entities also reduces the risk assumed by the government should one of the entities falter. Current plans to bolster Fannie Mae and Freddie Mac could cost taxpayers as much as $25 billion if either failed, according to the Congressional Budget Office. By breaking the companies up, the failure of one would not damage the entire mortgage system, and the cost to taxpayers would be reduced significantly.