Archive Page 2

Merrill’s Internal Controls Worked

The WSJ has issued a retraction on their story around the supposed deal by Merrill to move risky assets off balance sheet to hedge funds while guaranteeing a return.

In its correction on Monday, The Journal said that the deal didn’t go through. “Merrill didn’t complete the deal after the firm’s finance department determined it didn’t meet proper accounting criteria,” the paper said in its correction. “In addition, Merrill says it has accounted properly for all its transactions with hedge funds.”

Note the phrasing “didn’t meet proper accounting criteria.”  Translate, someone on the trading side thought it was a good enough idea to get the accountants to look at it.

WiMax, Why Care?

The demise of the agreement between Clearwire and Sprint may appear, on the surface, to be irrelevant to the financial services industry as does the debate around net neutrality and Google’s Android effort. Actually, all are quite important to when a new set of innovations will arrive.

First a brief detour into the land of mobile payments. Let’s look at two of the leading contenders in this space in the US, Firethorn and Obopay. Grossly over-simplifying, Firethorn is making its bet on the carrier side. They are providing the tools for Verizon, ATT and the rest to monetize the channel by managing the application. Obopay is lining up on the handset side, with their on-phone app written in BREW for Qualcomm handsets. Each of these approaches makes good sense for a startup. Find a powerful incumbent and spin up operations.

In contrast, the promise of WiMax and Android is the ability to put any device on the end of the pipe and connect it to any service. This model is independent of what the carriers or the incumbent handset manufacturers want. The demise of the Clearwire deal with Sprint means that a true 3G / 4G network with open access is that much further away. No pipe. No new apps. And the rest of the world just gets that much further ahead of us.

Market Pain

A phenomenally painful day in the financial sector where Chinese comments on diversifying out of the dollar, investigations by New York’s State’s Attorney General that include WaMu, speculation regarding Morgan Stanley write-downs (later announced after the market close) and oil price volatility combined to push stocks sharply lower.
WaMu Stock Chart

Prosper’s Regulatory Innovation, Considerations and Implications

In my earlier post on Prosper’s planned resale market, I identified four key aspects of the proposed approach outlined in the prospectus. In this post, I’ll dig into each and explore both the considerations and implications. Before doing that, a disclaimer. I’m not a lawyer, so approach my comments accordingly. Also this post as well as my previous posts on Prosper are not in any way investment recommendations.

Many individual issuers. At the cost of being redundant to my previous post, here is the description from the prospectus for how the process will work for creating debt on Prosper:

The Notes are promissory notes representing three-to-five year, unsecured, fully amortizing credit obligations of individual borrowers. If and when a borrower listing placed on the [Prosper auction] Platform is matched with a bid in, or multiple bids totaling, the amount of a requested borrower loan, Prosper makes the loan to the borrower and evidences the borrower’s obligation by separate Notes in the amount of each individual’s winning bid. Each Note is thereafter sold and assigned by Prosper to each respective winning bidder…Prosper has no obligation for payment of principal of or interest or other charges on the Notes.

Through this mechanism, any investor (institutional, accredited or retail) will be able to buy and sell the debt of a single person on an exchange within the existing regulatory framework.

Today when an investor buys debt it’s typically against the credit of an entire enterprise (say Ford) or a pool of loans that are diversified to diminish risk (think securitization). In the first case, an investor can make a judgment about how strong the company’s business is and the likelihood of default (usually with the help of credit ratings from Moody’s and S&P). In the second case, diversification reduces the impact of any single borrower defaulting. Even with the subprime meltdown something like 80% of residential mortgage backed securities remain classified as having a low probability of default (e.g. strong investment grade rating).

In both of these cases there is an intermediary – the investment bank – sitting between the issuer and the initial buyer of that debt. That is the primary market. After the debt has been purchased by the first investors it then trades in what is called the secondary market. So Prosper is proposing to facilitate both the primary and secondary markets using registered notes without securing the debt themselves. This is a very elegant approach.

Now for the implications. Think again of Ford. They help millions of customers to finance the purchase of their cars. The Prosper mechanism creates a way for an individual to issue registered debt to finance their car instead. This potentially makes every person a micro-issuer of their own debt. Obviously this is similar to the initial innovation of Prosper’s peer-to-peer finance model, but it goes much further in its flexibility. In fact, this mechanism also creates a means for doing micro-securitization.

Differing terms and face amounts. In a typical shelf registration statement for debt, a company files a maximum offering amount and a description of the proposed security. The company can then issue debt from the shelf registration statement from time to time with key aspects varying such as length of term, interest rate and face amount.

At a surface level, Prosper is creating a kind of shelf registration statement. They are registering $500 million which they intend to sell from time-to-time. However, they cannot actually create a true shelf registration now because they do not yet meet certain SEC requirements. That’s why they have filed an S-1. This is typically called a debt IPO. Needless to say, it’s quite unusual for a tech company to do this kind of offering. It’s also unusual to try to create a shelf registration statement on form S-1 because the issuer has an obligation to keep the registration up-to-date for material changes. That’s a little different here because the material information for this debt does not relate to Prosper, but to the individuals for whom Prosper has issued debt. More on that below.

So Prosper is creating a pool of debt out of which they can establish specific notes that match all of the individual pieces sold in a given auction to the various lenders. That process will recur thousands of times before the pool is exhausted. The risk is that there are so many unique pieces of debt that the notes remain very thinly traded. That’s why micro-securitization could be more attractive.

No apparent reporting requirements. Now for a potential road bump. While Prosper will be obligated to continue to update their financial information as a public reporting company (which creates some interesting IPO dynamics and opportunities) Prosper will not be updating the borrower’s credit data, in particular credit score. This seems problematic. It means that a new buyer of the notes will only see what was provided when the loan was initially issued even though the credit quality of the person could have improved or declined since the start of the loan. For instance, the person may have defaulted or become delinquent on their other debts in the interim, which might be reflected in their credit score. That would remain unknown to the new buyer if the borrower is still current on their Prosper debt. From the selling lender’s perspective, if the person’s credit has improved then they may accept a lower offer than they should on the note.

Not updating the information seems contrary to the spirit of ongoing reporting for a registered security. No doubt it is expensive to rerun credit scores frequently, but Prosper is charging 1% on the trade, so it seems they should absorb the cost as part of facilitating the market. The downside of this for the borrower is that running their credit score can negatively affect it, especially if done frequently. That obviously adds complexity.

Reasonable transaction cost. Prosper charges 1% or 2% of the total loan amount (depending on credit quality) to facilitate any given auction. There is also a 1% servicing fee per annum. Given that Prosper is facilitating the registration of sub-$200 notes, which in aggregate make up the total loan to a given borrower, this is amazingly reasonable. For debt resale, Prosper intends to also charge 1% for the resale market. With the face amount of the notes typically in the $50 to $150 range, paying $0.50 to $1.50 also feels reasonable. Having transaction fees at this level is obviously fundamental to creating a workable exchange.

In concluding, Prosper has proposed something new for the capital markets. If the SEC approves the structure, it could prove to be the leading edge in a new approach to syndicating debt, even if it’s not part of a peer-to-peer process like Prosper.

Merrill Lynch, More Problems

The situation is looking even more grave for Merrill Lynch.  The WSJ (subscription) is reporting:

Merrill Lynch & Co., in a bid to slash its exposure to risky mortgage-backed securities, has engaged in deals with hedge funds that may have been designed to delay the day of reckoning on losses, people close to the situation said.

The transactions are among the issues likely to be examined by the Securities and Exchange Commission. The SEC is looking into how the Wall Street firm has been valuing, or “marking,” its mortgage securities and how it has disclosed its positions to investors, a person familiar with the probe said. Regulators are scrutinizing whether Merrill knew its mortgage-related problem was bigger than what it indicated to investors throughout the summer.

In one deal, a hedge fund bought $1 billion in commercial paper issued by a Merrill-related entity containing mortgages, a person close to the situation said. In exchange, the hedge fund had the right to sell back the commercial paper to Merrill itself after one year for a guaranteed minimum return, this person said.

What makes this all the more amazing is that Merrill Lynch appears to have participated in a similar scheme (in reverse) with Enron where Enron sold barges in Nigeria to Merrill Lynch and agreed to repurchase those barges at a later date for a fixed price that guaranteed a return.  Merrill paid substantial fines in connection with the barge transaction. In that case Enron was trying to inflate earnings.  In this case, if the article is accurate, Merrill was trying to hide losses.  Several Merrill bankers were convicted over the barge deal though those convictions are under appeal.

The Current Challenges of Marking-to-Market

For an excellent article on the problem of marking-to-market complex (and not so complex) securities in the current market see this WSJ article (subscription) from October 12. It provides some great insight into the massive change in write downs at Merrill Lynch, which I discussed in this post.

The article also reveals that

Some financial firms have sought in recent weeks to avoid write-downs by selling mortgage positions to hedge funds, with an agreement that allows the hedge fund to sell them back after a set period. A hedge-fund trader says his firm recently bought $1 billion of risky subprime mortgage loans from Bear Stearns with a one-year pact, known as a “mandatory auction call,” under which Bear agrees to participate in an auction for the loans that will provide the hedge fund with a minimum rate of return, according to a person familiar with the situation. “They didn’t want the mortgages on their books,” the hedge-fund manager says.

Such financial arrangements typically are considered proper if there’s an economic purpose to the trade and if risk is taken on by both parties. Legal problems could arise if such trades are part of an attempt to conceal a company’s financial picture, regulators say.

After the off-balance sheet scandals of recent years, it’s hard to believe that this type of trade has returned so soon.

Prosper’s Brilliant Regulatory Innovation

On Tuesday Prosper filed with the SEC to create a mechanism that will provide a secondary market for trading loans originated through its marketplace. This addresses an important limitation of the current system – the ability of lenders to sell loans they’ve purchased. It also represents a brilliant innovation in U.S. securities markets if approved by the SEC.

Unlike eBay where an item is bought and delivered with no ongoing relationship between buyer and seller (ignoring disputes!), Prosper creates a long-term arrangement between the borrower and their many lenders. While a borrower can repay their loan at any time and terminate the agreement, lenders have been locked in.

So how does the creation of  non-recourse notes enable a secondary market? According to the prospectus filed by Prosper:

The Notes are promissory notes representing three-to-five year, unsecured, fully amortizing credit obligations of individual borrowers. If and when a borrower listing placed on the [Prosper auction] Platform is matched with a bid in, or multiple bids totaling, the amount of a requested borrower loan, Prosper makes the loan to the borrower and evidences the borrower’s obligation by separate Notes in the amount of each individual’s winning bid. Each Note is thereafter sold and assigned by Prosper to each respective winning bidder…

Prior to the date of this prospectus, there has been no trading market for the Notes. As soon as practicable after the offering of the Notes covered by this prospectus commences, Prosper intends to establish a secondary trading market online auction platform, or the Resale Platform, on which the Notes may be resold after three months following the date that they are acquired from Prosper by the winning bidders.

There is a major regulatory innovation here. Prosper is  facilitating the sale of registered debt by individuals. In the equity market context it is commonplace for individuals to register their shares in a given stock for resale. Importantly, this is for a single stock trading at a single price. Here, Prosper is effecting the registration of many, many different pieces of debt:

  • with different terms and face amounts
  • from many individual issuers
  • with no apparent reporting requirements
  • at a reasonable transaction cost.

Undoubtedly the SEC will appreciate the magnitude of this innovation. The question is whether the examiner and the more senior folks at the SEC will play along or force substantial changes to the structure, including ones that effectively kill it.

Tuesday’s filing reflects the impressive innovative drive of Prosper, especially in the regulatory arena. My concern remains that the underlying premise of the platform with its current focus on medium term consumer debt may not be working. See my earlier post – Prosper, Strangely Flat.