Toomre Capital Markets LLC

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Lars Toomre's blog

Value Proposition of Cloud Computing

As Gartner senior analyst Ben Pring has said, cloud computing has "become the phrase du jour." The problem, though, as with its predecessor Web 2.0, everyone seems to have a different definition of just what cloud computing exactly means.

Many would agree that "the cloud" is a familiar metaphor for the Internet. However, when "the cloud" is joined with the term "computing", the combined meaning becomes even larger and murkier. Some analysts and vendors define cloud computing narrowly as an updated version of utility computing: basically virtual servers available over the Internet. Others go very broad, arguing anything you consume outside the firewall is "in the cloud," including conventional outsourcing. With such ambiguity, no doubt there is considerable confusion just what the value proposition of cloud computing might be.

The value of cloud computing becomes more clear when one focuses only what IT always needs: a way to increase capacity or add capabilities on the fly without investing in new infrastructure, training new personnel, or licensing new software. This focus helps one understand that cloud computing is really an aggregated way of referring to "Software as a Service" ("SaaS"), utility computing, web services in the cloud, incremental storage services (outside the firewall), and Internet integration.

To the extent that financial organizations are able to effectively and securely integrate these external services outside their firewalls (and tightly controlled internal environments), they will be able to take advantage of near ubiquitous and commodity-priced technology. In time, cloud computing is highly likely to force financial institutions to reexamine their "buy vis-à-vis build" decisions and force them to reconsider just what portion of the value proposition they truly need to control internally.

Toomre Capital Markets LLC ("TCM") welcomes the reader's comments and thoughts.

Ted Janulis, Head of Mortgage Capital, Leaves Lehman Brothers

On Thursday August 21st 2008, Bloomberg News is reporting that Lehman's Janulis, McKinney Leave as Mortgages Shrink. As the article explains, Ted Janulis most recently headed up Lehman Brother's mortgage capital division where more than 2,500 people have been fired since the credit crunch began. Rich McKinney, who headed securitized products in the Americas since the resignation of his predecessor David Sherr at the end of 2007 to start his own hedge fund (supposedly closely aligned with Lehman Brothers), has also resigned to join another firm. The article indicates what remains of the mortgage capital division will be folded into the fixed-income division.

Ted joined Lehman Brothers in 1985 and came to work on my CMO and ABS Trading Desk. I well remember Ted working with Kevin McDermott and I as we were almost overwhelmed by the sharp decline in interest rates during 1986. After that, for a while Ted traded CMOs with short-average lives before gravitating to the sales and marketing of the CMO and REMIC residual classes. In those days, the sale of the highly illiquid residual class was the key to completing a new issue arbitrage transaction. With Lehman Brothers' introduction of floating-rate CMO bond classes, Ted took on the challenge of selling what came to be known as humped-backed residuals that were highly sensitive to both LIBOR and mortgage prepayment rates.

Thoughts on Near-Term Future of Capital Markets Technology

Recently, one of the clients of Toomre Capital Markets LLC ("TCM") asked, in light of the on-going credit crunch, what trends TCM foresaw would be important in the forthcoming year(s) for capital markets technology. Our response was rather downbeat and pessimistic, particularly for those companies focused on leading-edge technology. This also was not the message that the client necessarily wanted to hear.

Our basic view is that the credit crunch will take at least another year to work its way through the financial system. As a result, a number of financial firms will be fighting for their survival and there will be limited budget for new technologies and/or big strategic projects. Hence, most new technology investments will be small and incremental in nature with proven risk/reward trade-offs. This environment for capital markets technology is likely to continue at least until senior management and investors begin to reach a consensus about what the new business model for investment and global banks will be and what revenue streams will result.

Toomre Capital Markets LLC would be happy to discuss our perspective on this subject in a more private setting. If you would like to learn more, please contact TCM for more information.

Lehman Brothers - Fannie Mae Pairs Trade and a Cup of Coffee

Toomre Capital Markets LLC ("TCM") is an active consultancy in the areas of structured finance, risk management and financial engineering. As a result, we have many conversations with numerous people across the spectrum of clients, prospects, former associates and other industry contacts. In the past several months, many of these conversations have touched upon Lehman Brothers, especially given Lars Toomre's personal history of working there and back in the 1980's running that firm's very influential ABS and mortgage derivatives trading business(es).

Given that that specific business area in the fixed-income markets is at the heart of the current credit crunch in the Capital Markets, many have asked more privately just what Lars has been thinking about the on-going market developments. Lars has specifically made a point (until now) on refusing to comment publically about Lehman Brothers and the recent sacking of his former boss, Joe Gregory, who until recently was the President of Lehman Brothers.

On Friday July 11th 2008, yet another contact queried what Lars thought about the on-going melt-down in financial equity securities, particularly those currently in the news such as Fannie Mae, Freddie Mac, Citigroup, Washington Mutual, Wachovia, Lehman Brothers, Merrill Lynch and Morgan Stanley. We talked through the various plus and minuses of these potential investments. This contact, who runs a multi-billion dollar portfolio on a leveraged basis, then asked Lars to put on his theoretical trading hat and suggest some specific trades. Lars demurred.

Fannie Mae, Freddie Mac and Future of Mortgage Finance

Toomre Capital Markets LLC ("TCM") has been quite busy during the past few weeks on client work ahead of the summer vacation period. As a result, there has been limited time to update this blog. Today's news of the Treasury Department's defense of the struggling GSE's known as Fannie Mae and Freddie Mac though deserves some comment.

That both of these GSE's need to be supported in at least an oral sense is more than a ripple in the Capital Markets pond. It is much more like a major wave. Just what the final cost to tax payers will be remains to be seen. TCM suspects that the final bill will not be known until well after residential home prices stabilize and even begin to appreciate again. No doubt, though, the costs will be significant.

Lost in all of the GSE consternation is the lack of discussion about 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.

Lehman Brothers Pre-Announces $2.8 Billion Loss

On the morning of Monday June 9th 2008, Lehman Brothers pre-announced their second quarter earnings report and gave limited details on their capital raise efforts. [A link to the press release can be found here.] The numbers are larger than what Toomre Capital Markets LLC ("TCM") wrote about last night in the post Lehman Brothers Said to Lose $2 Billion Plus in Second Quarter. Lehman Brothers now expects to lose $2.8 billion for the period ended May 31st 2008 as well as raising close to $6 billion through a combined common stock and preferred offering.

Partly as a result of this announcement, Moody's Investors Service has put the ratings of Lehman Brothers under review for a likely downgrade. Lehman Brothers will be conducting a 10 AM conference call to discuss further this press release. From the press release, it appears that the fixed-income division had a net loss of approximately $5 billion, which is much larger than the losses that Lehman Brothers has announced in prior quarters.

Lehman Brothers in the past months has pledged to increase its transparency regarding its financial transparency. It certainly will be quite interesting to learn more about where these losses came from. Toomre Capital Markets LLC will post more about this company later in the day as further information becomes available.

Lehman Brothers Said to Lose $2 Billion Plus in Second Quarter

Late on Sunday June 8th 2008, The Wall Street Journal is reporting Lehman Set To Raise $5 Billion Amid Losses. Supposedly the equity offering will be placed primarily with United States institutional investors, including the State of New Jersey Division of Investment. What is most interesting about the article though is that Lehman Brothers' second quarter loss is expected to exceed $2 billion, much more than the market consensus of a $300 million. Such a number, if true, makes it highly likely that the Lehman Brothers common stock will likely open down again on Monday morning. Such a decline tied both to a bigger than expected quarterly loss as well as the dilution from a secondary stock offering will make it much more difficult to price a big common stock offering.

Toomre Capital Markets LLC ("TCM") hopes that Lehman Brothers can succeed in placing the $5 billion in equity. While it will be highly dilutive to existing shareholders, such a capital raise should ensure that Lehman Brothers will be able to continue as an on-going entity, particularly in the fixed-income markets where their credit rating is critically important both for funding needs and the derivatives businesses. One might remember that a significant portion of the common equity currently is owned by the employees of Lehman Brothers who have seen the value of their holdings decline by close to fifty percent since the start of the year. Those employees might well be asking how Lehman Brothers allowed itself to get so off-sides to own some $80 billion odd in mortgages securities at the start of this credit crunch.

Timothy Geithner: We Can Reduce Risk in the Financial System

Toomre Capital Markets LLC ("TCM") is a fan of New York Federal Reserve Bank President Timothy Geithner (as demonstrated by the post Timothy Geithner: "Illigitimum non Carborundum"). On Sunday June 8th 2008, Mr. Geithner penned a commentary piece in The Financial Times that calls for global banks and investment banks whose health is crucial to the global financial system should operate under a unified regulatory framework with "appropriate requirements for capital and liquidity". Entitled We can reduce risk in the financial system, this article is must reading for those struggling with the question of what will be the value of investment banking franchises in the post-Bear Stearns environment. The commentary reads as follows:

Bradley Birkenfeld Hearing Canceled

Late on Thursday June 5th, Reuters ran a story indicating that the June 9th court hearing for Bradley Birkenfeld, the former UBS private banker who is expected to plead guilty to tax conspiracy charges, has now been canceled. The cancelation apparently was requested by United States prosecutors and no new date has been set.

Toomre Capital Markets LLC ("TCM") has previously written on the Bradley Birkenfeld case here. TCM wonders whether this delay indicates that United States prosecutors have entered into settlement discussions with UBS that no doubt will lead to the release of the customer list of wealthy Americans who used the services of the UBS private banking division. Certainly, if that were the case, prosecutors would not want Mr. Birkenfeld publicly naming names until a settlement with UBS was completed and further investigations were at least started. TCM will be keenly watching for developments in this and associated cases over the coming weeks.

Why Own Lehman Brothers?

CNBC Television personality Jim Cramer penned an article on Thursday, June 5th 2008 entitled Why Own Lehman? In that article he said that No, he did not think that Lehman Brothers was going under. "It's got a great franchise with a good cash position, reduced leverage, much better management than Bear [Stearns] and a buyback that's kicking in that wouldn't if things were as bad as the bears make it out to be." The questioner then apparently asked if Cramer would buy the Lehman Brothers stock. Cramer said, "Why the heck would I do that? To catch a 2- or 3-point rally? There is no earnings power at Lehman."

Toomre Capital Markets LLC ("TCM") normally approaches such pronouncements from television pundits with a healthy dose of skepticism. However in this case, Jim Cramer is right on. The article continues:

I explained that some stocks are neither longs nor shorts -- that, to me, is Lehman. There's no reason to short it, because I don't think it is going under but many are betting that way, and there is no reason to go long it, because the place is set up for a period of big fees from fixed-income products, from structured products, but clients have at last figured out that they will lose their jobs if they keep buying this nonsense.

And that's really the rub. These places have oodles of high-priced salespeople, tons of them, and they are all being paid fortunes to sell products that don't work. They sell broken vacuum cleaners with no warranties.

It is that stark.

I know that anyone in brokerage is always reluctant to admit that structured products really have no value or are too risky, that they're just a way to figure out how to take a little extra per million -- a fraction, but they do add up. But that's what happened to a lot of these great firms that got fixed-income-heavy. There isn't enough money to be made selling regular commodity fixed-income products, so you have to talk people into buying things they shouldn't that they don't understand.

That game is over. But the people are still there, as is the overhead. Without this stuff, I don't know how you make a lot of money at an investment firm, particularly when you have decided to shrink your balance sheet and make fewer loans. Some can get away with it: Bank of America BAC, for instance, because it has a deposit base (same reason Wachovia WB is worth something, but I don't want to own it, either), doesn't need to rely on structured products to make some money.

LEH? I just don't see how they can deliver $5-6 earnings power anymore. Worse, I can't even figure out what they could earn in this environment. The franchise isn't too dicey, just the earnings estimates.

Jim Cramer puts much more bluntly what Toomre Capital Markets LLC has been struggling with as illustrated by the post Value of the Investment Banking Franchises?? Just what can these investment banking franchises earn in the post credit-crunch environment where there is limited demand for structured finance, mortgage securities, and complex derivatives and where they must operate with sharply decreased leverage and more limited proprietary trading operations? The regulatory changes that are going to be forthcoming as a result of the credit crunch are as of yet unknown. However, surely there will be increased capital charges under Basel II for what are classified as "trading positions."

Wealthy Americans Under Scrutiny in UBS Case

For publication on Friday, June 6th 2008, The New York Times has produced an article by Lynnley Browning entitled Wealthy Americans Under Scrutiny in UBS Case. This article details some of the concerns that wealthy American clients of UBS are having much agitation ahead of the expected guilty plea on Monday, June 9th 2008 of former-UBS private banker Bradley Birkenfeld to conspiring to helping a former American client, Igor Olenicoff, avoid paying taxes on some $200 million held in undeclared UBS accounts. Previous Toomre Capital Markets LLC ("TCM") posts on Bradley Birkenfeld and UBS can be found at this tag link.

The noteworthy fact that this article reveals "Under pressure from the authorities, UBS is considering whether to divulge the names of up to 20,000 of its well-heeled American clients, according to people close to the inquiry, a step that would have once been unthinkable to Swiss bankers, whose traditions of secrecy date to the Middle Ages. Federal investigators believe some of the clients may have used offshore accounts at UBS to hide as much as $20 billion in assets from the Internal Revenue Service. Doing so may have enabled these people to dodge at least $300 million in federal taxes on income from those assets, according to a government official connected with the investigation." [emphasis added]

If UBS were to reveal such a large list of wealthy Americans, there no doubt will be phenomenal anger directed against UBS and its CEO Marcel Rohner, who also just happens to be the head of the private banking arm when this supposed "wink and a nod" tax-avoidance activity supposedly occurred. Surely there will be considerable press coverage of this "tax scandal". There also no doubt will be considerable questioning by other UBS private banking clients about just what the value of supposed Swiss banking privacy truly is. This surely is to lead to some withdrawals and a likely decline in the UBS franchise value.

On the other hand, UBS could elect to fight the United States Justice Department. Of course, there likely then would be criminal charges against the institution itself to fight and the possible loss of United States banking and securities licenses. What the franchise value might be under such a scenario is anybody's guess. However, it is likely to be less than today's closing stock price. Would you want to own a deeply flawed investment banking franchise coupled with a disgraced private bank?

Toomre Capital Markets LLC suspects that this story is going to pick up a life of its own in coming days. With the American electorate entering the Presidential campaign season that is keenly focused on the economy and general tax policies, TCM strongly suspects that these rich Americans are about to be vilified as part of the contentious political season. UBS no doubt is going to receive plenty of bad publicity.

Lehman Brothers Declines Again

During the first two trading days of June 2008, the common shares of Lehman Brothers have declined by 8.10% and 9.52% respectively. In pre-trading on Wednesday, June 3rd 2008, those shares are off another 2.50%. Clearly, the short attack on Lehman Brothers and concerns about the credit crunch are back!!

As Toomre Capital Markets LLC ("TCM") has written previously in the posts Value of the Investment Banking Franchises?? And Lehman Brothers Weighs Raising Equity Capital, TCM has been questioning what the on-going value of investment banking franchises will be in the post-credit crunch operating environment. That questioning assumes that one is able to work from "good" balance sheet data, which in the case of Lehman Brothers is being sharply called into question.

Lehman Brothers Weighs Raising Equity Capital

On Monday June 2nd 2008, Toomre Capital Markets LLC ("TCM") questioned just where is value with the global investment banking franchises in the post Value of the Investment Banking Franchsises?? The intent was to follow that post up with some of the details that is leading TCM to think that the Capital Markets are likely to be buffeted by further credit crunch turbulence.

However, on Tuesday June 3rd 2008, market participants woke to the news from The Wall Street Journal that Losses Push Lehman To Weigh Raising New Capital. As the article explains, the investment banking franchise known as Lehman Brothers apparently is "considering raising billions of dollars in fresh capital to help shore up its balance sheet, according to people familiar with the matter." This would be the first issuance of common stock by Lehman Brothers since it went public from American Express back in 1994. The cause of the stock issuance is what appears to be Lehman Brothers' first quarterly loss since it went public. The formal earnings announcement for Lehman Brothers is expected during the week of June 16th along with those from Goldman Sachs and Morgan Stanley.

This capital raise will be coming on top of six billion in capital Lehman Brothers raised during the past year including $4 billion in preferred stock raised after the forced sale of Bear Stearns to JPMorgan. The forthcoming earning report is expected to "show some fresh difficulties. The firm is saddled with billions of dollars in hard-to-sell commercial real-estate assets and leveraged loans and is expected to face further write-downs on these portfolios. That has led the firm to consider raising additional capital. Wall Street firms including Merrill Lynch and Morgan Stanley have also raised billions of dollars as losses from the mortgage meltdown have mounted."

The article concludes with information that Lehman Brothers was hurt by ineffective hedges. Specifically,

Value of the Investment Banking Franchsises??

Toomre Capital Markets LLC ("TCM") has been rather quiet in recent weeks about the investment banks and the on-going credit crunch started by sub-prime mortgages and the bursting of the real estate bubble. While some in the industry (like Dick Fuld, CEO of Lehman Brothers, and John Mack, CEO of Morgan Stanley) have suggested that the credit crunch is closer to the end, Lars Toomre and Toomre Capital Markets LLC have subscribed to the view that the collapse of Bear Stearns was just the nasty end to front edge of a massive credit deleveraging hurricane.

In the time since the Federal Reserve helped to broker the sale of Bear Stearns to JP Morgan (with some $29 billion dollars of potential assistance) on March 17th, the capital markets have stabilized. Credit default spreads have narrowed from extreme wide spreads. The equity markets rallied from the March lows. Also, in many fixed-income product sectors, spreads to risk-free securities have significantly narrowed from oversold conditions. In short, the massive oversold (or biased) positions in the Capital Markets have had time to return to more stable conditions.

Or at least that was the case until the last ten days or so when slowly conditions have started to deteriorate again. Are these deteriorating conditions indications of another wave of the credit hurricane about to hit the Capital Markets? Time will tell. TCM suspects that market participants are about to learn that various financial firms did not perform well during the second quarter and that there will be further asset write-downs in various portfolios where liquidity has been sharply curtailed due to the credit crunch. Such news will be no great surprise.

Amidst the turbulence of the various news reports about layoffs, resignations and common stock declines, TCM has begun to wonder just where is there value in the major investment banks [Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers] and their universal bank counterparts [Barclays, UBS, Deutsche Bank, and Credit Suisse]. What are these franchises really worth in a world of sharply reduced liquidity and where new regulations on risk and capital are likely to be imposed? Assuming that these institutions go back to the "old days" of client flow trading, aren't each of these franchises worth significantly less than their current market values? Reader comments and thoughts are welcome.

Wachovia Ken Thompson is Out As CEO

Toomre Capital Markets LLC ("TCM") previously has written about the perils of Pay Option ARMs in the post Option ARMs Spur New Worries and the troubles of one of its largest portfolio holders Wachovia in the post 'Moment of truth' for Wachovia. Now comes the news on the morning of Monday June 2nd 2008 that Wachovia's CEO Ken Thompson is "retiring" immediately at the request of the bank's Board of Directors. Lanty Smith, the current Chairman of the Board of Directors will be taking over as interim CEO and Ben Jenkins, currently vice chairman and president of the general bank, will serve as interim chief operating officer.

According to the press release, "No single precipitating event caused the board to reach this decision, but a series of previously disclosed disappointments and setbacks cumulatively have negatively impacted the company and its performance." One has to wonder though whether buying a large California thrift with an investment portfolio concentrated in negative amortization ARMs at the absolute top of the housing market had anything to do with his firing?

Or perhaps the recent regulatory sanctions had more of an effect than outsiders fully appreciate? Certainly having to settle charges about money laundering and needing to deal with possible collusion charges in the submission of municipal bond reinvestment hedges suggest that the bank did not have strong internal controls. Coupled with the recent OCC actions about its use of customer data with tele-marketing firms, one has to wonder what changed in approximately the last month since Ken Thompson was stripped of the Chairman role? Reader comments and thoughts are welcome.