October 26, 2007
Banks' Exposure to Subprime Mortgage Woes
Floyd Norris today in the New York Times (at C1) asks the question that has long troubled me. Why are banks so heavily exposed to the problems of defaults on sub prime mortgages? We are told that originators of sub prime mortgages, banks and brokers, offload the obligations to independent legal entities (SIVs or SPVs) and collect fees. The SIVs fund their purchase with sales of securities (some rely on asset-backed commercial paper, other rely on tranches of debt (CDOs)). If the sub prime market dries up banks will suffer a loss of origination fees, but we now learn that they are suffering losses on the defaults themselves. How can this be? Wall Street investment bank income is based on fees, not investments, is it not? Apparently banks found a way to accept exposure to sub prime mortgages in a variety of ways -- through internally run investment (hedge) funds, thorough guarantees to and swaps with SIVs ("security enhancement devices") and through ownership of some of the securitization vehicles (conduits). All the devices are racking up huge losses and many of the losses are difficult to value. Their primary solution -- a new super SIV run by all the banks that will buy paper from the struggling SIVs -- will postpone accurate valuations and exacerbate our problems.
O'Neal at Merrill: Authority to Negotiate?
CEO Stanley O'Neal of Merrill Lynch is in hot water because, among other things, he approached Wachovia about a merger without informing his board of directors of his intentions. At issue is whether this is a breach of his legal duties to the board. I my view it is not, with a very important caveat. Initiating merger discussions does not itself require board authorization. When a CEO attempts to sign a confidentiality agreement on behalf of his company, however, he may not be authorized to do so without an express resolution of the board -- it is a close question. The board must, however, sign any deal negotiated by the CEO. Of this there can be no doubt. And when the CEO leaves his board out of the loop in the negotiations, this decision to sign may be viewed by courts as a fait accompli rather than an independent business decision, well-informed and deliberated. This is the rub. The court may not respect the boards decision to sign. Whether a CEO negotiates without board notification is best practice is another matter.