Toomre Capital Markets LLC blogs

December 2008 Developments and Scandals

2008-12-26T11:59:44-05:00

During the past few weeks, Toomre Capital Markets LLC ("TCM") has been busy working on client engagements and hence has had limited time to comment upon important sentiment and capital market developments. Since the start of December 2008, there have been a number of significant developments. Several of these deserve further detailed commentary that hopeful will be forthcoming before the end of the year.

First, the United States Department Labor reported a very sharp decline of some 533,000 jobs for the November period as well as significant adjustments to the prior reports for the September and October periods. In total, some 830,000 more jobs were reported lost over the most recent three-month period for a total of 1,156,000. Ouch! On a percentage basis of the workforce, this is the worst report since the recession period at the start of the Reagan presidency in the 1980s. Other economic reports have subsequently confirmed that economic activity sharply dropped around the time of the Lehman Brothers bankruptcy on September 15th and continued through November.

The sharp drop-off in both business investment and consumer demand since the Lehman Brothers bankruptcy has led many businesses to reevaluate their staffing needs. On Wall Street, there have been a considerable number of "redundancy" decisions leading to layoffs of more than ten percent of staffs. Many speculate that there will be further layoffs after the start of the 2009 if underwriting volumes continue at such non-existent levels. After all, what good is an investment banker if there are no deals to complete or capital to raise? Equally as well, what good are large staffs of salesmen and traders if there is no capital to commit or investors/hedge funds with whom to buy and/or sell?

On Main Street, the relatively sudden and very steep contraction in demand is leading to mass layoffs and even questions about whether the American automobile industry might survive. Clearly, the job losses witnessed in the last few months will continue and the fourth-quarter GDP will be sharply negative. Many macabre discussion wonders whether the 4th quarter GDP decline will be five, six or even eight percent on an annualized basis. Not many are willing to definitively speculate about what the first quarter of 2009 might be.

The Federal Reserve has responded in a very proactive manner to the down-turn in economic activity. The Federal Reserve lowered the effective Fed Funds target to a range of zero to 0.25 percent and announced further expansions in its alphabet soup of various special lending programs. Its decision to start to purchase GNMA, FNMA and FHLM mortgage pass-through securities, Agency debentures and highly-rated ABS backed by consumer debt has started a contraction in credit spreads relative to Treasuries. With many portions of the Treasury yield curve now yielding around two percent or less, the Federal Reserve clearly is encouraging investors to take on more risk premium than simply buying Treasuries and hunkering down in a bunker-like mentality seeking safety and no worries.

In the past month, three significant scandals have become public. In late November, Democratic Illinois Governor Rod Blagojevich was arrested by federal authorities who alleged that he was engaged in a "political corruption crime spree" that included recorded conversations about he might personally profit from the "sale of US Senate seat" to replace President-elect Barack Obama. While many not from Illinois might dismiss such charges as part and parcel of Chicago-area machine politics, the crassness of the conversations disclosed in the criminal complaint suggests that "pay to play" was very much a part of that Governor's mode of operation. No doubt with the Governor's subsequent pledge to "fight, fight, fight" the public will be exposed to more details about this repugnant public official.

The second scandal that recently emerged concerned the fraudulent activities of one Marc S. Dreier, the sole equity partner of a major law firm called Dreier LLP. He was first arrested in Toronto where he apparently was impersonating a lawyer at a Canadian pension fund in an effort to sell fake promissory notes to a unit of Fortress Investment Group. After spending several days in Canadian jail, he was released and then arrested again by American authorities upon his return to the United States where he was charged with defrauding several other hedge funds by selling or attempting to sell fake promissory notes based upon commercial real estate. Subsequently, the scope of his fraud was alleged to have totaled approximately $380 million. Surely more details about this fraud too will emerge in the coming days as this Harvard-educated lawyer languishes in the "comfort" of federal government custody.

The third scandal concerns the fraudulent activities of one Bernie Madoff. This former chairman of NASDAQ apparently ran an "investment" division within his well-known market-making firm. Some investors had invested with him for more than thirty years and were rewarded with steady returns in the range of ten to twelve percent each year. On December 11th, he was arrested after he confessed to his two sons who held senior executive positions in the market-making side of the family firm that the whole investment side of the business was one large Ponzi scheme. By his own admission, Bernie Madoff apparently defrauded investors world-wide of approximately $50 billion. He since has been released to supervised home confinement as various investigators search through his firm and the various fund of hedge funds firms that fed monies to his fraudulent operations. This Madoff scandal is going to continue to be in the news for many weeks to come and Toomre Capital Markets LLC will expand its posts on this scandal shortly.

Combined the dismal economic statistics, the large number of layoffs (that also apparently have continued in December) and the three above scandals have led many investors to pull back even further from making significant investment decisions. Liquidity continues to be quite poor in the capital markets and is likely to remains so through the early months of 2009. There is considerable speculation that the hedge fund redemptions will continue at a high rate as a result of the Madoff scandal as many investors flee the opaqueness of these investment pools and their relatively poor absolute performance during 2008.

There also is considerable uncertainty about what the earnings potential of large companies might be during 2009. The net result is that at least through the first quarter of 2009, Toomre Capital Markets LLC expects business activity to continue to decline and returns from investment activity to be relatively flat if not negative. It appears that few seem willing to make significant investment decisions until the depth and breadth of the economic downturn that accelerated in September 2008 becomes more fully known. Hence, it probably remains a prudent decision to keep one's powder relatively dry and to continue to deleverage wherever possible. In the meantime, the above scandals (and others that are likely to emerge with proverbial receding of the economic tide) will dominate many of the coming news cycles. Reader comments and thoughts are welcome.

Pay Option ARMs Continue To Worsen

2008-12-06T21:32:33-05:00

Back in January 2008, Toomre Capital Markets LLC ("TCM") penned the post Option ARMs Spur New Worries. That post highlighted a number of other ticking credit bombs that were going to be effecting the Capital Markets in the coming months. Its chief focus was on the most toxic mortgage credit "bomb" of all: the Pay Option ARMs.

On Saturday December 6th 2008, The Los Angles Times and its writer E. Scott Reckard yet again return to this toxic subject in the article entitled Record 10% of U.S. Homeowners In Arrears Or Foreclosure. The subtitle of the article is "California, with 19% of new foreclosures in the third quarter, is a big contributor to the worsening picture." The prime culprit of this rise in the combined delinquency foreclosure rate are those Pay Option ARMs, given primarily to what were known as Prime borrowers and to a lesser extent to Sub-prime borrowers.

One might remember from the earlier TCM post: "Typically, these Pay Option ARMs present the mortgage borrowers with a choice every month during the first five years of the loan: pay the interest due and some of the principal; pay interest only, leaving the loan balance untouched; or pay less than the interest due, making the loan balance rise. Then, at the end of the five year option period, the loan is reset to fully pay-off with a fully indexed adjustable interest rate. Since many of the mortgage borrowers elect to pay less than the amount that will fully amortize the mortgage and the effect of fully indexing the interest rate from the typical more "teaser" initial rate, when Pay Option ARMs are reset, they almost always require a higher principal and interest ("P&I") payment than initially was required. Sometimes these reset P&I payments are as much as two or even three times what the borrower was originally paying on the mortgage each month. If the borrower elects only to pay interest only during the initial months and the balance rises above a set percentage of the original loan amount, the reset process can occur earlier as soon as three years."

Remember too Pay Option ARM loans often were granted on the basis of stated income, not proof of a borrower's income, giving rise to their nickname, "liar's loans." It has been said that "This is not a sub-prime crisis. This is a stated income crisis." In short, where Pay Options ARMs were most issued (Florida and California), evidence is accumulating that a significant portion of the spectacular rise in residential housing prices earlier this decade was driven by people who stated that they more financial income and assets than was truly the case.

From the above article, according to Jay Brinkmann, chief economist for the Mortgage Bankers Association, "California represents 13% of the loans in the country, but is recording 19% of all new foreclosures." One why might wonder why California is having so many more problems than other parts of the country. It is visible in the so-called "roll rate, which is defined as when one compares the number of newly delinquent loans in one quarter with the number of loans entering the foreclosure process in the subsequent quarter.

As Brinkman explained, That foreclosure "roll rate" was about 10% to 12% nationally in the 1990s and ran from 12% to 15% for most of this decade. The percentage is now 30% nationally but has reached 79% in California and 65% in Florida. "This is nothing like anything we've ever seen before," Brinkmann said. "We were shocked when we saw the California roll rates."

"Prime and subprime ARMs continue to have the highest share of foreclosures, and California and Florida have about 54% and 41% of the prime and subprime ARM foreclosure starts, respectively," Brinkmann said. "Until those two markets turn around, they will continue to drive the national numbers." The above figures are as of September 30th 2008. If the figures are correct, they indicate that almost four out of five California mortgages that were delinquent in the second quarter entered the foreclosure process during the third quarter.

And this was before the economy fell off the proverbial cliff around the start of the fourth quarter. The last three monthly employment reports have indicated that employment is falling sharply. No doubt the pull-back by both businesses and consumers will add to further employment pressure which in turn will lead to yet further residential house price reductions.

The real ticking credit bomb is that most of the Pay Option ARMs do not begin to reset until the latter portion of 2009. Combined with California residential real estate prices that are down as much as 40%, this quarterly report indicates that if a Pay Option ARM turns delinquent, it extremely likely in time to turn into a foreclosure which in turn will lead to realized losses for those who hold either the mortgage notes or the securities that are backed by those notes. Many of such securities are often referred to as Alt-A pass-throughs or ARMs. Many have also traded down very significantly in the secondary market. The very interesting issue will be "Have they become cheap enough yet to reflect the actual delinquencies and foreclosure losses that will occur among these homeowners who took out 'liar loans'?"

Citadel Investment Group To Try To Raise $500 Million

2008-12-06T10:18:46-05:00

The weekend edition of the Wall Street Journal on Saturday, December 6th contains a small article about how Citadel Investment Group Seeks to Raise $500 Million. The funds supposedly are going to be added to the $2 billion Citadel Tactical Trading fund, which is up more than 40% this year. This is a smaller fund to the much larger Kensington and Wellington funds and now includes Citadel's profitable market-making business.

The larger Kensington and Wellington funds have performed miserably this year. Supposedly they are down approximately 47% through the end of November 2008 and lost approximately 13% during the month of November alone. CEO Ken Griffin's plan apparently is to use the funds raised for the Citadel Tactical Trading fund to purchase approximately half of the combined equity portfolio from both of the larger multi-strategy funds.

According to the letter sent out from Citadel Investment Group about this limited offer, “Citadel Kensington and Citadel Wellington will experience reduction in the risk associated with their portfolios and enhanced liquidity from the transfer of a substantial portion of the Global Equities portfolio." Apparently, Citadel’s stock-picking team, with about 80 employees, has made money this year and will manage the equity positions of the Tactical Trading fund, the letter said.

Toomre Capital Markets LLC ("TCM") wonders though whether in this case Citadel Investment Group and Ken Griffin are talking out of both sides of their mouth. The two multi-strategy funds will be losing a substantial portion of the Global Equities portfolio, one that was supposedly profitable for 2008. Does that not mean that existing investors in the two funds will have more concentration in other strategies that contributed such miserable return numbers?

One also has to wonder whether any new investors in this "limited offer" might just be fodder for those investors, particularly institutions, who want their money back after such poor performance. Does anyone have any sense of how high the redemptions might go in Kensington and Wellington? Say the number is 30 percent. What more of their illiquid assets would need to be sold to meet the redemption requests? And perhaps equally as interesting, "With might be left in the portfolios, can this hedge fund manager make any substantial money until more normal conditions return to the debt capital markets?"

TCM suspects that market participants have not yet heard the last of damaging blows from illiquid investments, poor performance and high redemption requests. Perhaps Citadel Investment Group will survive this round. However, do not people want to do business with people they like and respect? The combination of being an arrogant prick and poor performance will be the death blow to many previously high flying hedge funds.

Vanity Fair: Profiles In Panic

2008-12-05T12:40:13-05:00

In the January 2009 issue of Vanity Fair, reporter Michael Shnayerson has penned another excellent article, this time entitled Profiles in Panic. This article goes into some detail about how the downturn that intensified in September is affecting the Wall Street types who were living high on the hog in a gilded era. That era is very definitely changing as many are just happy to still have a job and not be one of the more 100,000 world-wide in financial services that have been laid off. It is a well written article definitely worth reading in its entirety.

In the middle of the article, the narrative turned to the sudden bankruptcy of Lehman Brothers. Perhaps no man better represented the excesses and hubris of this gilded era than the former number two at Lehman Brothers, President and COO Joe Gregory. From the article,

If the gilded age has come to an end this fall, surely Lehman’s demise—with its bankruptcy filing on that Monday morning of September l5, 2008—was the tipping point. It panicked the money markets, froze global credit, and sent stock prices spiraling down.

Lehman’s 31st floor—where Fuld and his top executives worked—was by all accounts a quiet place, especially by midafternoon, one managing director recalls dryly. Among Fuld’s loyalists, no one was more loyal than his number two, chief operating officer Joe Gregory, whose story, even more than Fuld’s, seems emblematic of the age now past. If Tom Wolfe were writing a sequel to The Bonfire of the Vanities, Gregory would be his man.

Gregory, 56, was a legend at Lehman—less for his business exploits than for his lifestyle. He had several homes: a principal residence in Lloyd Harbor, on Long Island’s North Shore; an oceanfront McMansion in Bridgehampton; a ski home in Manchester, Vermont; an apartment at 610 Park Avenue; and reportedly a house in Pennsylvania. “He had a kid who went to a small school in Pennsylvania,” a former senior colleague recalls. “Joe didn’t like the hotel, so he bought [a] house in town. It was probably only $500,000, but he paid for it so that, on the maybe two trips a year he took there, he’d have a nice place to stay. And then he had it redecorated!” The colleague says he heard it on good authority that Gregory’s after-tax expenses approached $15 million per year. That, he heard, was exclusive of mortgages. (Gregory’s lawyer declined to comment on e-mails from Vanity Fair.)

Gregory came from a modest background, an ex-colleague recalls; at one time he had aspired to be a high-school history teacher. One summer while attending Long Island’s Hofstra University, though, he worked as an intern at Lehman and got hooked. Both he and Fuld joined the firm soon after college; as the two men rose in the ranks, they became close friends.

Like Fuld, Gregory started on the commercial-paper trading desk. By the 1980s he’d become a top executive in fixed income and was known as one of Lehman’s Huntington Mafia, because all four executives in it lived in or near that North Shore town and often commuted together. “It was said that the four of them decided the fate of the floor every day on their drives back and forth,” recalls one ex-colleague. “And you had to be in their good graces to survive on the fixed-income floor.”

Gregory’s rise was strongly linked to Fuld’s: loyalty was his strong suit. “Joe never had clients,” says a lawyer who worked with the firm. “So he wasn’t on 31 because he was a rainmaker. And he never really had a business he was responsible for. He was Fuld’s full-time loyal lieutenant. And Fuld did have a yes-man mentality, where if people didn’t agree with him they’d get shot. And Gregory was sort of the hatchet man, who fired them or tried to enforce rules.”

Gregory played the sidekick role well, two ex-colleagues suggest. The problem, says one, is that as president and chief operating officer, beginning in 2004, he came to oversee all departments, including the derivatives that would get so tricky. The commercial paper (i.e., short-term loans solicited by creditworthy companies and banks) he’d traded in his early days was lower-risk. “If you bought it wrong, you could hold the position,” one ex-colleague explains, “till it rolled off—30 or 60 days. So it would cost you a few basis points, that’s all.” The longer end of the market involved bonds you might get stuck with if the market changed. “I don’t know if Gregory knew how much risk he was taking,” the ex-colleague says. “The other thing, which Joe had never seen, was how a market could go highly illiquid. Joe had observed this but not lived it.”

Toomre Capital Markets LLC has previously written about the excesses of Joe Gregory in the post Possible Bankruptcy for Joe Gregory of Lehman Brothers. At the height of Lehman Brothers' stock price, Gregory was supposedly the second largest individual holder with holdings that were valued near $550 million. Likely he borrowed cash against those stock holdings and then used that cash to fund his extravagant lifestyle (such as famously purchasing a helicopter to commute to Manhattan from his homes on Long Island). The only problem was (like many Wall Street types from this gilded era) he likely never thought or even considered that the stock price could sink all the way to zero.

Lehman Brothers and Dick Fuld: Burning Down His House

2008-12-01T18:18:44-05:00

In the event that the reader has not seen the excellent New York magazine article Burning Down The House written by Steve Fishman about the last months of Lehman Brothers, go read it now. The sub-title is "Is Lehman CEO Dick Fuld the true villain in the collapse of Wall Street, or is he being sacrificed for the sins of his peers?"

Toomre Capital Markets LLC ("TCM") believes that this is one of the better articles that explains some of what went on behind the scenes that led to the collapse of the fourth largest investment bank in September 2008. Lars Toomre at one point worked with or reported to some of the principal characters of this story. Several reporters have contacted Lars for information and background information on these characters. However, other than sharing some recollections about Bart McDade with the Wall Street Journal, Lars has declined. Rather TCM has written a number of articles about Lehman Brothers (including the very popular post Possible Bankruptcy for Joe Gregory of Lehman Brothers). An index of the various Lehman Brothers articles can be found here.

This article starts out with a description of a luncheon meeting that Dick Fuld had in June 2008 with a number of investment bankers that was arranged by the head of investment banking head Hugh Skip McGee. Two days earlier the investment bank had announced its first quarterly loss in fourteen years. The loss of $2.8 billion caused the stock to plummet again, 21 percent in a couple of days. The message to Dick Fuld was simple: "The board of directors is going to be under pressure. … It has to deliver a head to the street." Supposedly Dick Fuld shot back (as his veins on his neck popped), "I've given you fourteen years of earnings. I have one bad quarter. This is how you respond?" Yet the next day he canned both the then CFO Erin Callan and his long-time crony and then COO and President Joe Gregory.

Three months after that luncheon, Lehman Brothers on September 15 "filed for bankruptcy, the largest in history and a devastating blow to an already fragile financial system. Fuld became a symbol of failure, the face of arrogant, blindered, massively overleveraged Wall Street. Fuld is blamed for betting the farm on the way up, then stubbornly refusing to recognize the company’s dire straits on the way down. A few weeks after the bankruptcy, Congress summoned him to Washington for a deeply humiliating inquisition." Subsequently, "three sets of prosecutors launched investigations of Fuld and Lehman, probing whether shareholders had been duped."

The article goes on to make the point that in some sense Dick Fuld also is a victim. Apparently Fuld has been having trouble sleeping as he repeatedly goes over and tries to decipher the "mystery", his description of the firm's sudden collapse. "Why didn’t the government save Lehman the way it saved so many others, Bear Stearns and AIG and, just last week, Citigroup? Fuld and his allies can’t help but blame Paulson, whom he’d trusted and, until the end, viewed as an ally and even a friend. Yet Paulson, for reasons Fuld doesn’t yet understand, participated in making him the scapegoat." However, apparently "Mostly, he sits and replays Lehman’s calamitous end. 'What could I have done differently?' he thinks. 'In certain conversations, what should I have said, what could I have done?' How, he wonders, did it all go so disastrously wrong?"

Toomre Capital Markets LLC might suggest that Dick Fuld made the critical mistake of trusting too much his protégé and the firm's Mr. Inside Joe Gregory. TCM has previously written about Joe Gregory's decision to remove Michael Gelband in the spring of 2007 as the global head of the fixed-income division in the post Initial Reflections on Demise of Lehman Brothers. Apparently, Gregory did not want to cut back on the fixed-income's risk profile and may in fact have wanted to expand the risk to use the resulting profits to further fund the firm's aggressive overseas expansion.

The article confirms

By the end of 2006, some at Lehman had begun to think that real estate was nearing the end of its run. Mike Gelband, who was responsible for commercial and residential real estate, had by then turned decidedly bearish.

“The world is changing,” Gelband told Fuld during his 2006 bonus review, according to a person familiar with Gelband’s thinking. “We have to rethink our business model.”

But given the importance of real estate to Lehman’s bottom line, that wasn’t what Fuld wanted to hear. Fuld had seen his share of cyclical downturns. “We’ve been through this before and always come out stronger,” was his attitude. “You’re too conservative,” Fuld told Gelband.

“We’ve been lifted by the rising tide,” Gelband insisted.

Fuld, though, wondered if the problem was with Gelband, not the market. “You don’t want to take risk,” he said—a deep insult in the trader’s vernacular.

At the beginning of March 2007, Gregory took Gelband to lunch in the company dining room. The two had never been close, an ominous sign at Lehman. “When you had no chemistry with Joe, your time was going to be limited,” says one person close to him. Complicating Gelband’s life, Gregory agreed with Fuld on the market’s direction. “If Dick was rosy, Joe was rosier,” said one insider.

At lunch, Gregory pointedly told Gelband, according to a person briefed on the conversation, “you’re not moving. Either you make a change or I’m going to.”

Gelband soon left, an event that for many insiders marked an early sign of the Lehman crisis. “It upset a lot of people when Mike was fired,” said one senior Lehman official. Gregory brought in one replacement, then another for Gelband, the last of whom, Andrew Morton, left in September.

None of Gelband’s successors had deep experience in real estate. And later, Alex Kirk, who’d worked under Gelband and shared his bearish views, confronted Gregory about the hires. “What are you doing [putting these people in critical jobs]? These people are not experts,” Kirk told Gregory, according to people who heard accounts of the conversation.

Gregory disagreed. “No, people need broad experience,” he said. “It’s the power of the machine. It’s not the individual.”

After Morton was hired, Gregory told Kirk, “You can stay if you want, but there’s no place for you.” He got the message and left in February 2008, the culmination of what was sometimes referred to as “a Joe-icide.”

Earlier in the article, Joe Gregory is quoted as saying "I was one of those people who didn’t want to disappoint Dick." And not disappointing Dick also had the sub-text of not pissing off the seemingly always affable Joe Gregory. From personal experience Lars Toomre can testify that Joe Gregory did not respond at all well to contrary or "not with the program" views. Part of the problem with the Lehman Brothers situation was that so many of the mid-level managers had little to no experience working professionally outside of the firm's insular environment. Hence, many drank the "Kool-aid" and operated over a period of time in a way that would not rock the boat (and hence piss off Joe Gregory or one his senior managers). In short, Lehman Brothers was very vulnerable if the "group think" (heavily influenced by those at the top) was different from market realities.

In some ways, Dick Fuld and his proxy Joe Gregory were so domineering and capricious in their use of power that they created an environment where honest communication from those below was stifled. When the environment began to change in late 2006, no doubt there were those below Joe Gregory who knew that "smart" or "influential" clients were beginning to either pull back or express doubts. As more and more clients began to change their views, smart traders no doubt would also know that the environment was changing. How that got communicated up the chain of command is the issue.

By all accounts, Dick Fuld was not good at walking the trading floor to gain a personal and first-hand sense from his troops of the current environment. Instead, most stories (including this one) describe Fuld as being highly insulated in his executive office space or working primarily with external parties as Mr. Outside. From the many descriptions, he primarily relied upon his Mr. Inside, Joe Gregory, and his management committee for a detailed sense of what was going on in the markets.

Another portion of the Lehman Brothers problem was that much of its profits came from historically less liquid portions of the capital markets. Since the 1980's, the mortgage sector has almost always been a significant portion of the firm's revenue and profits. Initially, Richie Isaacs made a boatload of money with Harold Zietland and John Finegold trading pass-throughs. [The decision to short $400mm in GNMA 11.5% into the first arbitrage CMO deal may not have been that desk's finest moment. The comment that "It never will sell" no doubt spurred on Ron "Jessie" Juster and Deanne Landress to prove that that first deal would be a success.]

At the same time, Stuart Dauman and Karen Zimmerman were getting various computer tapes run of whole loans available for sale from a range of savings and loans. In those days, longer term interest rates were in the range of 12% and many financial institutions were reluctant to sell such whole loan portfolios (with mortgages in the range of 3-10%) at prices such as 60% on the dollar. Occasionally, though, a financial institution would make the decision to sell and resulting profits could be significant. [Of course, buying a discount mortgage portfolio at a yield with a slower presumed prepayment rate and then selling it at the same yield (or better) at a slightly faster prepayment speed results in significant price differences (and profits).]

Subsequently, the CMO business (which Lars and Aldon were intimately involved with) began to make significant profits. Later, Wes Edens and his team began to make noticeable profits in the "project" area and what became known as private pass-through securities. Many of those early private MBS had adjustable rate coupon features. The terms of the underlying mortgages varied considerably and often made it difficult to create a uniform pass-through interest rate.

Those early private pass-through structures generally included both a subordinated class and an excess-interest class as well as the primary pass-through class. As Lars recalls, in those early days, the underlying whole loans could be purchased at a price roughly equivalent to where the primary class might be sold to ultimate investors. As a result, both the subordinated class and the excess-interest class could be retained at near minimal cost. Imagine having an investment cost of say $3 million that threw off cash proceeds of say $400,000 per month declining by say $10,000 each month. No matter how one might mark such a position, no doubt the net result would have been quite positive. The key was knowing where to sell the primary private pass-through class. Wes was very good in that respect.

Later on, Mark Walsh emerged. His formal title was the head of Lehman's Global Real Estate Group. According to the article, "'Mark Walsh [head of commercial real estate] financed a lot of the firm for a number of years,' says one person who was above him." Even their best years, Lars Toomre and Wes Edens were very significant to the over-all profits of the firm; however, they never "financed" the firm. One can only imagine what percentage of the revenues and profits Mark Walsh's area contributed to Lehman Brothers' quarterly results. Of course, though, one will never definitively know based upon the limited disclosure made in Lehman Brothers SEC filings. As an article in the New York Observer discloses

Mr. Walsh made big, headline-grabbing deals. His team underwrote Tishman Speyer’s $22.2 billion acquisition of the Archstone-Smith apartment portfolio--360 luxury apartment buildings in cities from Houston and Phoenix to Fairfax and New York. Mr. Walsh partnered with SunCal in the $110.2 million purchase of a 2.25-acre plot of land in Southern California. At the time, Forbes reported that SunCal had outbid Donald Trump for the parcel.

Mr. Walsh had, according to Eastern Consolidated’s Eric Michael Anton, risen to “the top of this country’s professional real estate pyramid.” He had also earned a reputation as one of the biggest risk-takers on Wall Street.

“When you contrast them to a Goldman or Morgan Stanley, it’s a very different way of doing business,” said one capital markets broker. “You talk to Morgan Stanley, they have $3 billion worth of [commercial mortgage-backed securities] exposure in the States. Lehman had $30 billion.”

AND MARK WALSH, AS a source close to Lehman put it, “held the keys to the kingdom.” By virtue of his skillful manuevering or by virtue of plain old happenstance--depends on whom you ask--Mr. Walsh, as one real estate financier who regularly worked with Lehman said, “had extraordinary authority to commit capital as he saw fit.”

“One of his signature products was high-risk, high-return bridge debt and equity financing for large acquisitions, such as Archstone,” continued the financier. “By quickly committing to fund required-debt and equity, Lehman was able to ‘bear hug’ deals with large profits as positions were securitized and longer-term equity capital was raised. The downside was large balance sheet positions when market conditions eroded and values dropped.”

“In Wall Street, Mark held an unusual position in that all the different aspects of real estate reported directly to him,” said one admirer, who has done billions of dollars worth of deals with Mr. Walsh. “In most other Wall Street firms, those responsibilities were divided among two or three other people. While it was working, Lehman was one of the best players out there. They were great as partners and great as lenders; they were very astute real estate people. And I think they really facilitated a lot of transactions in the market.”
Mr. Walsh declined to go on the record for this article. Even in good times, when his deals made headlines, his name never did, summoning scarcely anything but press releases on Lexis Nexis, or, for that matter, Google.

In these days of Internet overexposure, only one image of Mark Walsh exists online. It’s a head shot, his face reddish against a gray background, under a conservative cut of brownish hair, circular glasses framing blue eyes. He’s wearing a plain suit and tie. The photo is on the Web site of UCLA’s Ziman Center for Real Estate. Mr. Walsh, one of its founding members, helped raise its initial endowment.

The 48-year-old appears to think highly of real estate education. In 2005, he and his wife endowed the Fordham University Albert A. Walsh Chair for Real Estate, Land Use and Property Law, in honor of Mr. Walsh’s father, a prominent affordable housing advocate.

“Real estate law and related issues touch everyone’s life every day, particularly in New York City,” Mark Walsh said in a Fordham press release.

His words were prescient. The manipulation of the residential and commercial real estate markets--by investors, credit agencies, mortgage brokers and the lowly homeowner--have
led to the destruction of Wall Street as we know it. Lehman ended up having to write down a number of its assets, including the Archstone-Smith and Suncal deals. The 158-year-old bank ended up declaring bankruptcy two weeks ago. Barclays has since gobbled up most of its American assets. And now that Lehman’s fate appears settled, the blame-mongering can begin.

Some former Lehman employees and observers have come out of the woodwork and laid the blame for Lehman’s demise at Mr. Walsh’s feet, including, most recently, deposed CFO Erin Callan, who this week told Fortune magazine that “the commercial real estate portfolio really was the albatross of the firm.” Critics in the real estate industry have criticized Mr. Walsh and his boss, Richard Fuld, for what they describe as a concentration of too much power, too much autonomy, and too much risk-taking in too few hands.

“He’s very calculating and political and was able to ingratiate himself with Dick Fuld and had incredible autonomy and was able to do things in the firm that no one else was able to do,” said the source close to Lehman. “There were reportedly capital committees and processes under way that everyone else had to go through, and Walsh didn’t have to go through them.”

In the "old" days of the late 1980's, Lehman Brothers Commercial Paper Inc. ("LCPI") was quite a profitable commercial enterprise. That organization was led by Dick Fuld and what was known as the Huntington Mafia: Christopher Pettit, Tommy Tucker, Joe Gregory, and Steve Lessing. Supposedly these individuals used to commute into lower Manhattan via a collectively owned 750 BMW automobile. Given that their parking space beneath the American Express Tower was just a few feet away from that designated for Lars Toomre, sometimes there were observations of these LCPI executives before they had put on their "game faces". The difference between such unguarded "playing around" moments and their executive representations was quite stark. In retrospect, one might wonder what value there might be for "taking one" for the team… especially the Lehman Brothers team led by Dick Fuld and Joe Gregory..

UBS Poised To Name US Tax Dodgers

2008-11-28T00:05:00-05:00

On Friday November 28th from London, The Financial Times is reporting UBS Poised To Name US Tax Dodgers in an article written by Haig Simonian. At the shareholder meeting held the day before to approve the latest round of capital raising for UBS, "The 2,395 investors gathered in a dingy suburban hall and heard for the first time that the world's biggest wealth manager looked poised to bow to US pressure and release the names of an unspecified number of US customers who may have committed tax fraud in squirrelling away their assets."

One has to wonder whether the "limited number" of such cases that were announced to have been identified (among the roughly 19,000 US citizens who held offshore accounts with the bank's Geneva, Zurich and Lugano offices) were the result of shall one say "illegal" activities, such as proceeds from drug transactions, bribery or other criminal enterprise behavior. Certainly the public revelation that mod and drug traffickers were hiding their money with UBS will create a great political uproar in the United States.

Perhaps the Swiss government hopes by releasing only the names of such known individuals who clearly committed crimes under both United States and Swiss law, there will be less pressure to expose the names of the other American account holders. From the story, "Peter Kurer, UBS chairman, gave no details, and officials stressed that the decision to transmit names to foreign authorities remained a government matter." But in noting the discovery of tax fraud "under both US and Swiss law", Mr. Kurer added: "Contrary to the idea conjured up in public discussions, bank secrecy is not absolutely valid. It is not there to protect cases of tax fraud." However, these comments suggest that there soon may be a settlement with the US authorities in their long-running investigations into alleged tax evasion in Switzerland.

Toomre Capital Markets LLC ("TCM") previously has written about this on-going investigation in the posts NYT: Indictments Said to Be Possible in UBS Inquiry, Wealthy Americans Under Scrutiny in UBS Case and UBS Global Wealth Chairman Raoul Weil Indicted.

TCM applauds the efforts of American tax authorities to ensure that all Americans pay their appropriate income taxes as called for in the income tax statutes. Those who consciously and actively have sought to avoid declaring and paying their income taxes should and deserve to have the proverbial book thrown at them (as press reports suggest are in process with a number of simultaneous criminal and civil proceeding in parallel).

PIK Your Own Poison

2008-11-27T18:34:08-05:00

Toomre Capital Markets LLC (“TCM”) has been quite concerned about the future of mortgage finance in America. Back in July 2008, TCM created the post Fannie Mae, Freddie Mac and Future of Mortgage Finance. The key point of this post was the need for “the critical policy decision on the future of mortgage finance in the United States. TCM has highlighted this critical issue before. Until the late 1980s, the S&L's were the primary holders of mortgage debt. Commercial banks also have owned some mortgage debt (with significant capital haircuts). The relatively lower capital requirements and the ability to ‘turn’ the mortgage origination portfolios led to the rapid growth in securitization and the funding of mortgage debt through investors in the capital markets.”

Some four months later, the GSE’s have effectively been seized by the Federal government. Lehman Brothers has gone bankrupt. Merrill Lynch has agreed to be become part of Bank of America. And both Goldman Sachs and Morgan Stanley have become bank holding companies actively looking to attract deposits. As predicted in that July post, institutional investors have “gone on strike” against mortgage-backed securities (“MBS”). As a result, in the last week both residential and commercial mortgage backed securities have widened to extreme spreads against swap spreads. Those spreads narrowed considerably this week with the announcement that the Federal Reserve will be buying up to $100 billion in GSE debentures as well as $500 billion in agency pass-through securities.

Still, there is little discussion about the future of mortgage finance in America. In order for the American residential mortgage market to stabilize, there needs to be available financing for well-underwritten home mortgage loans. These purchases by the Federal Reserve are a temporary solution. There no longer is a savings and loan industry to provide the long-term holdings of MBS. The community and commercial banks are capital constrained and looking forward to greater losses on many types of loans as the credit crisis worsens becoming perhaps the worst recession since the Great Depression.

Part of the reason for the GSEs conservatorship was that it was deemed that their portfolios were too large for their capital bases, especially given projected future losses due to the decline in residential real estate prices. As mentioned above, the various traditional institutional investors who previously bought securitized MBS and their “sliced and diced derivates” such as CMOs, CDOs, and private pass-throughs are on a “buyer’s strike”. In many cases, these institutional investors also are trying to reduce their exposures to the mortgage sector.

Toomre Capital Markets LLC has long suspected that the securitization process will be key to answering this quandary about where longer-term mortgages should be financed in America. There is a critical problem that has been displayed in how that business was conducted prior to the current credit crisis. As a loan moved from the mortgage originator to the mortgage wholesaler to a warehouse facility to Wall Street and eventually on to institutional investors (blessed of course with a high-grade by one or more of the rating agencies), no one had a vested interest in the quality of the underlying mortgage loan. For several months now, it has been clearly understood that for the securitization process to restart, each part of the process will need to have some “skin in the game.”

On Wednesday, November 26th 2008, New York Times columnist Joe Nocera devoted his column entitled PIK Your Own Poison to a truly excellent article written by Emanuel Derman. This is one of the best “thought” articles that TCM has read about possibly to restart the securitization process. Interested readers, particularly those interested in the subject of mortgage finance and securitization, are urged to read this article in its entirety. The article starts

Emanuel Derman is a former physicist-turned-Goldman Sachs quant who helped create several widely-used options models in the late 1980s and early 1990s. He now runs the program in financial engineering at Columbia where he thinks and write and teaches about risk management issues, and is also a principal at Prisma Capital Partners. Recently, he sent me an article he had written about how we might begin to “recreate trust in the financial supply chain,” as he puts it. I asked him if he would share his article with Executive Suite’s readers. Happily he said yes.

“All that is solid melts into air, all that is holy is profaned, and man is at last compelled to face with sober senses, his real conditions of life, and his relations with his kind,” wrote Engels and Marx in The Communist Manifesto. They were describing what chemists call sublimation, the process by which a solid changes directly into a gas without passing through an intermediate liquid phase, an apt term for the past few months of evanescent financial values and firms.

This insubstantiality is not surprising — it’s modernity itself. Developed economies now revolve around service rather than solidity, and the growth of seemingly arcane financial securities personifies this trend. The assets of financial firms are predominantly people, and their product is service and ideas. Securities are not cars or iPods; they are things of the mind, about as unsolid as you can get, obligations or contingent promises created by people, once upon a time inscribed on pieces of paper and now, increasingly, encoded on magnetized bits of computer memory. Once invented, they can be replicated over and over again, cheaply.

One airy invention is the PIK (payment-in-kind) bond, a loan that pays its promised interest in additional bonds of the same kind, as opposed to solid cash. It sounds insubstantial, a barely disguised pyramid scheme in which you make your promised payments each time with further promises of payment, each at least as chancy as a subprime CDO. But think about the dollar: deposit it in the bank for a year and you get more dollars at the end. What is paper money but a PIK, an early derivatives contract? To trust it you have to trust the country that provide its value, and the same is true of payment in kind. Used wisely, maybe payment in kind can serve as hallmark of trust in the financial supply chain too.

Toomre Capital Markets LLC would like to thank Emanuel Darman for his contribution to the discussion about “how to recreate trust in the financial supply chain” and strongly urges readers to review this column in its entirety. Reader comments and thoughts are welcome.

Paul Volcker To Head Economic Recovery Advisory Board

2008-11-27T07:16:53-05:00

On Wednesday November 26th 2008, President-elect Barack Obama announced that former Federal Reserve Chairman Paul Volcker will head up the newly formed President’s Economic Recovery Advisory Board. This panel will be comprised of officials from a variety of business sectors outside of government and will be tasked with providing Mr. Obama independent advice for how to jumpstart the economy and stabilize the financial markets. This new board will be modeled on the Foreign Intelligence Advisory Board that gave President Dwight Eisenhower independent opinions on intelligence issues. Austan Goolsbee, another key Obama adviser, will serve as the economic board's staff director and chief economist, Obama also announced.

Mr. Obama called the 81-year-old Paul Volcker a voice that he knows well and trusts. "Paul has been by my side throughout this campaign, providing a deep understanding of financial markets, extensive experience managing economic crises and keen insight into the global nature of this particular crisis," Obama said at his Chicago news conference announcing the appointment. This was the President-elect's third news conference in as many days focused on trying to demonstrate to the American electorate that he is trying to do something about the current credit crisis.

Paul Volcker was appointed as the Federal Reserve Chairman in 1979 and served two terms ending in 1987 when he was succeeded by Alan Greenspan. Volcker is famous for throttling the economy to crush inflation in the 1980s at one point raising short-term interest rates as high as twenty percent. According to the Wikipedia (which at times has inaccurate information, particularly regarding controversial public figures),

Paul Adolph Volcker [born September 5, 1927 in Cape May, New Jersey] grew up in Teaneck, New Jersey, where he graduated from Teaneck High School, and his father was the township's first Municipal manager. Volcker's undergraduate education was at Princeton University; he graduated in 1949. He earned his M.A. in political economy from Harvard University in 1951 and then attended the London School of Economics from 1951 to 1952 as a Rotary Foundation Ambassadorial Fellow.

In 1952 he joined the staff of the Federal Reserve Bank of New York as a full-time economist. He left that position in 1957 to become a financial economist with the Chase Manhattan Bank. In 1962 he joined the U.S. Treasury Department as director of financial analysis, and in 1963 he became deputy under-secretary for monetary affairs. He returned to Chase Manhattan Bank as vice president and director of planning in 1965.

From 1969 to 1974 Mr. Volcker served as under-secretary of the Treasury for international monetary affairs. He played an important role in the decisions surrounding the U.S. decision to suspend gold convertibility in 1971, which resulted in the collapse of the Bretton Woods system. In general he acted as a moderating influence on policy, advocating the pursuit of an international solution to monetary problems. After leaving the U.S. Treasury, he became president of the Federal Reserve Bank of New York from 1975 to 1979, leaving to take up the chairmanship of the Federal Reserve in August 1979.

Paul Volcker, a Democrat, was appointed Chairman of the Federal Reserve in August 1979 by President Jimmy Carter and reappointed in 1983 by President Ronald Reagan. Volcker's Fed is widely credited with ending the United States' stagflation crisis of the 1970s by limiting the growth of the money supply, abandoning the previous policy of targeting interest rates. Inflation, which peaked at 13.5% in 1981, was successfully lowered to 3.2% by 1983. However, the change in policy contributed to the significant recession the U.S. economy experienced in the early 1980s, which included the highest unemployment levels since the Great Depression, and Volcker's Fed also elicited the strongest political attacks and most wide-spread protests in the history of the Federal Reserve (unlike any protests experienced since 1922), due to the effects of the high interest rates on the construction and farming sectors, culminating in indebted farmers driving their tractors onto C Street NW and blockading the Eccles Building.

Toomre Capital Markets LLC ("TCM") believes that this selection of Paul Volcker to head the new board focused on economic recovery is an excellent choice. Hopefully, President-elect Obama will listen to his advice and counsel as some very hard decisions need to be made to get the American and global economies growing again.

TCM was very impressed with Mr. Volcker's April 8th 2008 speech at The Economic Club of New York and wrote about it in the post Volcker Takes on Bernanke. He argued then that the Federal Reserve was doing the wrong job and not defending the dollar. Hence, he proposed that interest rates should be raised then, not lowered. Just imagine what would then have happened as the crises with the GSE's, Lehman Brothers and AIG emerged!! However, controversial though the thought might have been, it was very much "outside the box" thinking that will serve the incoming administration well.

History Often Repeats Itself

2008-11-26T22:34:45-05:00

Many people believe that history often repeats itself. Maybe the exact details are not the same, but the two time periods in question share many common characteristics. For example, many economists point to the parallels between the current economic crisis and the period of 1932-33 when President Hoover was in the tail end of his term and about to be succeeded by Franklin Roosevelt with his "New Deal" thoughts about change to get the economy functioning again. As a result of potential parallels between various points in time, some people study various historical events, people and time periods to gain a better understanding of how current events might be handled so as to prevent the mistakes of the past. The history of the financial markets is a case in point.

Economies have had periods of prosperity and contraction throughout all known history. Some of the contractions have been caused by excess supplies of some type of inventory; others have resulted from fears about the availability of credit or fears about the soundness of the banking system. Less frequently, the periods of contraction have been led by a complete collapse in the demand for products and services (like what appears to be happening during this credit crisis). Hence, it is often useful to have a better understanding of historical events and people.

Recently President-elect Barack Obama has been announcing the new members of this economic team, such as Timothy Geithner, Larry Summers and Paul Volcker. As a result, Toomre Capital Markets LLC ("TCM") has been reviewing just what did happen in the Korean crisis of 1997 (and which resulted in the in-coming Treasury Secretary Timothy Geithner rising to the attention of Robert Rubin and Larry Summers)? Or what were the forgotten details of Paul Volcker's "Saturday Night Massacre" in October of 1979 that inflicted large losses on many Wall Street houses as he suddenly raised short-term interest rates?

(As a side note, Lars Toomre recalls that in October 1979 Lehman Brothers was then long much commercial paper, the principal product it then traded in its small fixed-income division. Who was there on the commercial paper desk actively trading trying to minimize the losses? The disgraced CEO Dick Fuld was then head of the desk and one of his principal traders was Joe Gregory, the former COO of Lehman Brothers.)

In reading up on some of these historic events, Toomre Capital Markets LLC came across a previously unknown and truly excellent website with this type of information. That website is part of www.buyandhold.com called Educate Yourself. The truly excellent Wall Street History section can be found here. For those interested in gaining more perspective on Wall Street history, this site is highly recommended. History sure does seem to have a way of repeating itself.

Readers are welcome to leave their own recommendations in the comment section of this post.

After the Crash: How Software Models Doomed the Markets

2008-11-26T14:31:51-05:00

The above also is the title of a November 21st 2008 editorial by The Editors of Scientific American. The editorial's sub-title is "Overreliance on financial software crafted by physics and math PhDs helped to precipitate the Wall Street collapse". This editorial is well worth reading both today and in the months and years to come, as all parties consider the form and regulation of global financial markets after we get through the current credit crisis.

The editorial begins:

If Hollywood makes a movie about the worst financial crisis since the Great Depression, a basement room in a government building in Washington will serve as the setting for a key scene. There investment bankers from the largest institutions pleaded successfully with Securities and Exchange Commission (SEC) officials during a short meeting in 2004 to lift a rule specifying debt limits and capital reserves needed for a rainy day. This decision, a real event described in the New York Times, freed billions to invest in complex mortgage-backed securities and derivatives that helped to bring about the financial meltdown in September.

In the script, the next scene will be the one in which number-savvy specialists that Wall Street has come to know as quants consult with their superiors about implementing the regulatory change. These lapsed physicists and mathematical virtuosos were the ones who both invented these oblique securities and created software models that supposedly measured the risk a firm would incur by holding them in its portfolio. Without the formal requirement to maintain debt ceilings and capital reserves, the commission had freed these firms to police themselves using risk tools crafted by cadres of quants.

The staff at Toomre Capital Markets LLC has long admired this publication, partly since both Lars and Aldon started in technical fields before moving to Wall Street in the 1980s. Immediately before starting at Lehman Brothers, Lars Toomre was at M.I.T. and Aldon Hynes was at what then was one of the Mecca's of industry research, Bell Labs.

Where did we work in Lehman Brothers? We each started work in the mortgage department focusing on the very software that let Lehman Brothers and other investment banks slice and dice pools of assets into various classes (or tranches) of debt securities then known as Collateralized Mortgage Obligations ("CMOs") and now as Collateralized Debt Obligations ("CDOs"). We were two of the first quants hired by Lehman Brothers' fixed-income division working on some of the early software that this editorial targets!

The editorial continues:

The software models in question estimate the level of financial risk of a portfolio for a set period at a certain confidence level. As Benoit Mandelbrot, the fractal pioneer who is a longtime critic of mainstream financial theory, wrote in Scientific American in 1999, established modeling techniques presume falsely that radically large market shifts are unlikely and that all price changes are statistically independent; today’s fluctuations have nothing to do with tomorrow’s—and one bank’s portfolio is unrelated to the next’s. Here is where reality and rocket science diverge. Try Googling “financial meltdown,” “contagion” and “2008,” a search that reveals just how wrongheaded these assumptions were.

This modern-day tragedy could be framed not only as a major motion picture but also as a train wreck or plane crash. In aviation, controlled flight into terrain describes the actions of a pilot who, through inattention or incompetence, directs a well-functioning airplane into the side of a mountain. Wall Street’s version stems from the SEC’s decision to allow overreliance on risk software in the middle of a historic housing bubble. The heady environment permitted traders to enter overoptimistic assumptions and faulty data into their models, jiggering the software to avoid setting off alarm bells.

The causes of this fiasco are multifold—the Federal Reserve’s easy-money policy played a big role—but the rocket scientists and geeks also bear their share of the blame. After the crash, the quants and traders they serve need to accept the necessity for a total makeover. The government bailout has already left the U.S. Treasury and Federal Reserve with extraordinary powers. The regulators must ensure that the many lessons of this debacle are not forgotten by the institutions that trade these securities. One important take-home message: capital safety nets (now restored) should never be slashed again, even if a crisis is not looming.

For its part, the quant community needs to undertake a search for better models—perhaps seeking help from behavioral economics, which studies irrationality of investors’ decision making, and from virtual market tools that use “intelligent agents” to mimic more faithfully the ups and downs of the activities of buyers and sellers. These number wizards and their superiors need to study lessons that were never learned during previous market smashups involving intricate financial engineering: risk management models should serve only as aids not substitutes for the critical human factor. Like an airplane, financial models can never be allowed to fly solo.

Toomre Capital Markets LLC ("TCM") very much agrees that risk management models should serve only as aids and not as substitutes for the critical human factor called judgement. TCM has previously written about quants, notably including this post Businessweek: Math Will Rock Your World. All of these "new" mathematical models for both new businesses and finance might be right for all of the observable data. However, as quants themselves, both Lars and Aldon continually remind people, particularly non-technical types, that they need to know and understand the assumptions that went into the construction of that particular model.

Take, for instance, that original CMO model at Lehman Brothers. Over the years that "simple" cash flow model morphed from first being able to only handle sequential pay bonds into one that allowed for both fixed and floating rate collateral and debt structures, weird prioritization of both principal and interest cash flows, the inclusion of possible subordination and the possibility of reserve funds (either funded up-front or from the excess spread in the securitization during its first few years).

In the early years, one constant prepayment rate was used to value the resulting tranches. However, as dealers and investors gained a better understanding of homeowner behavior, the need for variable month-by-month gained importance. A later "improvement" demanded by leading market participants was prepayment forecast modeling which in turn was fed into yet another improvement, a model that calculated the Option Adjusted Spread ("OAS").

An OAS value attempts to express the spread over risk-free interest rates that would result if the "optionality" embedded in a security were either bought back or sold at the then current option prices in the open market. In the case of a mortgage pool, the security holder is generally short the option given to the homeowner to prepay the underlying mortgage at any time. And generally there is a fair amount of prepayment activity in all mortgage pools as families move for job reasons, split up, retire or relocate. OAS is a "short-cut" way of trying to estimate that prepayment risk.

Returning back to that original "simple" CMO model, one gains a small sense of the many assumptions that went into the calculation of the OAS value for a particular CMO tranche. Of course, the value generated by the Lehman Brothers model often varied, sometimes slightly and sometimes greatly, from those generated by those models developed and used by Goldman Sachs, Morgan Stanley et al.

Often the difference between these models was in one of the assumptions. One firm might use the three-month moving average of historical price data to determine its volatility estimate assumption. Another might use the 30-day average. However, the "average" institutional investor often did not want to dig into even this key assumption. Often an investment decision was made because the reported OAS value of bond A was higher than that generated by a different model on bond B.

Toomre Capital Markets LLC hopes this post reminds everyone that there are considerable dangers in rote reliance on the numbers produced by the computer. One needs to understand the assumptions that went into that particular model and understand where those assumptions are likely to break down. One also needs to use judgment that the model was coded as described and that "bad" data was not feed into the model or spreadsheet.