Financial Services Industry

At least a few venture capitalists seem to be crying in their cognac about the collapse of the IPO market for venture-backed firms. According to a study by the National Venture Capital Association, leaked first to the New York Times, not a single venture-backed company went public in the second quarter of this year. And just two went public in the first quarter.

In exchange for first dibs on the study, the Times lamented the study’s sorry conclusion, quoting Paul Kedrosky, who it describes as an investor and blogger. (Hey, what do you know, me too!). Kedrosky tells the paper: “Here’s an industry struggling in a big way to hang onto its investors, let alone find new ones. They’ve been hanging on by their fingernails.” The lack of a good way to cash out just makes things worse. “There is no venture industry if there is no IPO market,” Kedrosky says.

It’s a sorry state of affairs, one that would be sorrier if it were true. But it’s not. According to the NVCA’s own data, the volume of venture capital investments has been progressing at a steady clip since hitting a low in 2003. Since that year, VC investments increased from $19.7 billion to $30.5 billion. Based on the Q1 numbers, investments by VCs looks like they are holding up even as the IPO exit door is closing. And, after all, the soundness of the VC industry is based on the money it can raise and invest.

But won’t the number fall eventually if there is no prospect of an IPO? Actually, no. The IPO has always been just one way for VCs to cash out — albeit the most spectacular way. Companies can also be sold privately or merged in stock-for-stock deals. Or, and this is a novel thought, they can stay private and generate profits internally. All of these options are still available, even on a grand level, as Blackstone Group’s planned $3.2 billion sale of its plastic-containers business to Thomas Hicks’ buyout firm attests.

The most interesting thing about the Federal Reserve’s comments on the Bear Stearns bailout is how uninteresting they are.

According to the March 14 minutes: “Board members agreed that, given the fragile condition of the financial markets at the time, the prominent position of Bear Stearns in those markets, and the expected contagion that would result from the immediate failure of Bear Stearns, the best alternative available… ” was to help JP Morgan Chase buy its rival two blocks down the street.  Beyond that, the minutes cite “unusual and exigent circumstances.”

The reasoning is a tautology underscored by a cliche. Why exactly were the financial markets fragile and why would a Bear bust lead to a contagion? There is also nothing to indicate why the Fed thought that JP Morgan would need its help, as opposed to being able to secure financing in the market, fragile though it may be.  This is especially true since the Fed makes pains to point out that the loan would be “fully secured.”

I suppose that the minutes don’t unveil the high-level financial pontificating that was going on behind the scenes. But this is what they released, so presumably the Fed maestros thought it made them look good.  Where is the data? What’s the evidence?

It’s also possible to argue that the forecast contagion was arrested, so the Fed’s plan worked.  But it’s also possible Bear could have been bought (for a pittance) without the Fed’s intervention.

Two titans of plastic are being bit on the backside by charge cards of yesteryear.

First, MasterCard Worldwide agreed yesterday to pay $1.8 to rival American Express. The cash is part of a settlement of claims that Mastercard (along with Visa, which agreed to a $2.1 billion payment seven months back) tried to monopolize the charge card business, or at least make it harder for rivals to get in.

Meanwhile, the Wall Street Journal reports that General Electric is having trouble unloading its store-based credit card outfit, a business engaged in servicing charge cards issued by the likes of Wal-Mart, Lowe’s and Brooks Brothers. The reason: Possible buyers — banks already in the credit card biz — fear rising delinquencies and charge-offs.

The two stories are tied together by the boom in the number of cards issued in the late ’90s and since then. At that time, Visa and MasterCard imposed rules on their member banks, which restricted the banks’ abilities to issue cards served by rival networks such as Amex and Discover Financial Services. After a Justice Department lawsuit nixed the restrictive rules, Amex and Discover were able to cut more deals with banks.  The result is the number of credit cards issues boomed — which in turn accelerated the proliferation of credit card debt, the number of delinquent payments and the volume of personal bankruptcies.

With banks issuing plastic like candy, it raises the question of who needs a store-based credit card. The answer, of course, is no one. But stores issue them as part of a come-on to retail customers — typically along with a discount on a particular purchase. (The business GE is trying to unload services the cards issued by stores.) The cards are, therefore, attractive to consumers with marginal abilities to pay.

Not surprisingly, the non-payment rate on these cards is rising faster even than the rate on regular Visa (or Amex or Discover) cards. This being the case, possible buyers of GE’s business are thinking twice or walking away.

Investors willing to pay two percent in fees and 20 percent of the profits probably deserve whatever happens to them. After all, anyone who expects persistently outsized returns after paying costs like these is probably at least a little delusional. Such returns may happen for a while — especially thanks to leverage — but not for long. And hedge funds have long attracted charlatans and crooks. They also forgo the protections afforded — or so one hopes — of regulation of all kinds.

Or all kinds but one. The criminal charges against former Bear Stearns hedge-fund managers Ralph Cioffi and Matthew Tannin highlight the fact that even hedge fund chiefs aren’t allowed to lie to their investors, rich and “sophisticated” though they may be. The essence of securities fraud is that a manager tells investors one thing while believing another. There’s nothing new or fancy about the idea, which predates securities regulations and goes back to the common law.

Hedge funds, marketed to the elite few and accountable to almost no one, effectively “postdate” securities regulations. But the oldest rules of market fairness still apply. And fraud charges are more straightforward than obstruction of justice allegations, which are harder to prove.

The feds say the Bear Stearns duo misled investors about the health of two hedge funds that went belly up when the subprime mortgage crisis was still fairly new. If a series of e-mails between the two men show they knew one thing and told their investors another — that their rosy statements were not simply mistakes — that could lead to prison, even if their “victims” were hardly blameless themselves.

Image by Flickr user o2ma, CC 2.0

The tortured love affair between the ratings agencies and the bond insurers took another turn as Ambac Financial Group resolved to terminate its contract with Fitch Ratings. While Ambac is not the first insurer to give a rating agency the Heisman — not always successfully — its ability and willingness to do so puts the entire rating system in question.

There was a time when bond insurers loved the rating agencies. Indeed, if not for the ménage-a-trois between the raters, the insurers, and the issuers of mortgage-backed securities, the entire credit boom (now bust) would scarcely have been possible. The rating agencies scored bonds backed by dubious mortgages as entirely credit-worthy, sometimes on their own, and sometimes because the bonds were backed by the likes of Ambac and MBIA. Dubious credit turned to gold.

The more general conflict of interest where rating agencies “work with” investment banks before rating their issues — thereby allowing the banks to shop for the best rating — has already drawn the attention of the SEC.

Lately, though, the insurers have developed their own credit problems, leading the rating agencies to deny them triple-A status. Some have argued they are headed for bankruptcy. Now insurers like Ambac are saying that if they can’t get the best grade, they might as well drop the course. But if a company, whether an insurer or any other kind, can simply opt out of the system, exactly what value do the ratings have in the first place?

Scattered within Lehman Brothers’ disastrous quarterly results yesterday was the “good” news that it reduced is exposure to mortgage securities. Good news, of course, is a relative term when a bank loses $2.8 billion, which is more than it earned in the last three profitable quarters combined. But the bank boasted that it “reduced exposure to residential mortgages, commercial mortgages and real estate investments by an estimated 15-20% in each asset class” (PDF link). At the same time, it threw in some nouveau accounting that raises some red flags — as if Lehman needed any more.

When one takes a look at the absolute numbers, the news remains spooky.  As of the end of last quarter, Lehman said it held $4.3 billion in mortgage securities. If it reduced those holdings by 15 percent, it would still have $3.7 billion worth of the stuff on its books. But the drop in underlying real estate prices is actually accelerating. The last Case-Schiller index report from late May (PDF) recorded a 14.1 percent decline from the first quarter of 2007 to the first quarter of 2008 — the largest drop in the series’ 20-year history.

This being the case, Lehman’s reduced exposure might easily represent nothing more than a markdown of the bonds it holds as opposed to a successful sell-off. Also, the bank could easily be forced to take further write-downs on its still sizeable mortgage-security holdings — or run into other problems with its business.

For all its efforts to solve problems — and there has been some progress — Lehman is still leveraged to the hilt. Borrowing stands at 25 times the firm’s equity, although that’s down from a “gross leverage ratio” of 31.7 at the end of last quarter. In a wrinkle, however, Lehman highlighted the fact that its “net leverage ratio” — a less common measure than gross — fell to 12.5 from 15.4. Lehman says the net-ratio figure is more significant because it counts some “equity-like debt” as equity.

Any way you slice it, though, even with leverage at these reduced levels, the value of the firm’s assets don’t have to fall very far in order to completely wipe out Lehman’s equity.

To add to the confusion, Lehman hedged on exactly what it means by “net leverage.” The key passage, which it relegated to a footnote: “Net leverage as presented is not necessarily comparable to similarly-titled measures provided by other companies in the securities industry because of different methods of presentation.” Portfolio’s Jesse Eisinger looked into the accounting switch last March, when Lehman’s news was good, and still found the change “worrisome.”

So there’s plenty of reason to fear that Lehman remains overleveraged, whether on a gross or net basis. That’s true even though Lehman’s debt ratio is in line with its peers — everyone with that kind of leverage is walking a tightrope. Worse, according to a WSJ report on Lehman’s conference call, it doesn’t intend to reduce its debt ratios any further. But it does intend to sell new shares — to the tune of $6 billion. The sale will increase equity, providing a cushion just in case its assets fall further.

A rundown of recent financial sector news:

• Lehman Brothers needs capital, and some are saying it could be the next Bear Stearns; others think it’s the next Enron.
• Bear Stearns Merchant Banking goes independent. Or was it always?
• Rising credit card delinquencies and debt point to problems in the future for some creditors, but it’s probably a stretch to call it the next sub-prime.
• Banks may be required to put $5 trillion back on their balance sheets. Why weren’t these numbers reported in the first place?

On the books, Wachovia considered the recent firing of CEO G. Kennedy Thompson an “early retirement” — resulting in a $1,453,333 severance award and an accelerated vesting of $7,246,362 in restricted stock. But it actually could have been a far bigger payout for the departing CEO if Thompson hadn’t terminated his employment agreement with the bank three years prior.

All other Wachovia execs have an employment agreement entitling them to a pro-rated retirement bonus of either their current annual incentive or the highest incentive payout from the previous three years. If Thompson had such an agreement, his $6 million current annual incentive pro-rated for five months of service would come to $2.5 million, and that’s on top of any stock awards that would immediately vest.

But if Thompson had such an employment agreement and the bank considered his firing an actual firing (absurd!), he would’ve been entitled to severance pay of three times his current salary ($1,090,000) plus his biggest incentive payout from the past three years ($5,150,000 in 2006). On top of the $7,246,362 in stock awards, the total would come to $25,966,362.

So the bank may have saved $17 million in severance pay, but it’s probably not worth it, seeing as they have no succession plan in place with which to move forward. The bank now has its chairman, Lanty Smith, as interim CEO, and vice chairman and president Ben Jenkins as interim COO.

Hopefully the bank’s executive troubles won’t have an adverse effect on its customer service, as Wachovia recently took the top spot in the J.D. Power banking survey measuring customer satisfaction. For more on Wachovia, BNET’s own Corner Office blogger Peter Galuszka details the bank’s financial woes leading up to the CEO’s departure.