Bank of America’s 10K

Blog readers should understand that I am a backtrader – this means that I do more work on my investments after events are realized, in self-flagellation and punishment, than I do before I actually put the money to work.

There is one trade that is, for me, particularly haunting.  This is Countrywide Financial Group, CFC.  During the third week of August 2007, Countrywide’s stock was on its way to zero, and I was supposed to make about three or four million dollars from a monster short position that combined written calls, near at-the-money puts, long-dated out-of-the-money puts, and short stock.  Instead Bank of America invested $2billion in the company and CFC briefly hit 27 in after hours trading.  I was forced out of large parts of the position and ended up breaking even on the entire trade (which started in early summer) and losing a ton the week of the BofA investment.

Having gone through this experience, there are few things that incite me more than pictures of Ken Lewis’ face.  I truly believe him to be the dumbest man ever to head a major American corporation.

Bank of America has become, forever in my opinion, America’s bank.  BofA is the true zombie bank that will only survive with substantial government help.  It is a burden of the state — whether the government bares the burden by taking direct ownership or by giving invisible subsidies (Fed purchases, near zero Fed Funds) makes little difference.

There are two silent bombs on BofA’s books at the moment.  First, there are a lot of bad loans.  Loaning to American consumers and businesses at a couple of points above the risk-free rate was just never a very good business, and BofA was particularly bad at it.

Second, BofA faces contingent liability for fraud.  Yes, just when you thought that financial companies were off the hook for all types of fraud, the legal system has come in and said, “You know those sh*tty mortgage bonds you sold to pension funds?  We think there was something not quite right with those transactions and we want you to buy them back near par.”

From BofA’s 10k: “We have been, and expect to continue to be, required to repurchase loans and/or reimburse the GSEs and monoline bond insurance companies (monolines) for losses due to claims related to representations and warranties made in connection with mortgage-backed securities and other loans.”

In plain English, this would read, “for losses due to misrepresentations.”

Countywide was in the business of misrepresentations (hence my short position in 07.  At one point I thought the fraud would be revealed in a few weeks — now we’re four years on, and we’ve uncovered about half of it), and the courts – to everyone’s shock – are now saying that if you sell bonds to someone on fraudulent terms, you might have to buy them back.

When BofA sold a mortgage bond to a private entity who then insured the bond with  a monoline insurer like MBIA, MBIA would rely on BofA’s documentation about the loans.  BofA might note, for example, that 90% of the loans in a particular mortgage bond are “owner-occupied housing”.  This is relevant because owner-occupied housing is less likely to default than investment properties.  The courts are now taking the position that if MBIA can prove that, say, only 15% of the homes were “owner-occupied”, this is fraudulent conveyance of the bonds on the part of BofA and BofA can be forced to compensate MBIA for the losses incurred in insuring the bonds.

Now, in next part of the post, we’re going to dig into the gritty detail, much of which is quoted directly from the 10K.  This part can be safely avoided.  I wish I could convey to you, dear reader, what goes through my head as I read these things.  And I wish I could understand why – given what goes through my head – I continue to read these things.

From the 10K: “On December 31, 2010, we reached agreements with Freddie Mac (FHLMC) and Fannie Mae (FNMA), collectively the GSEs, where the Corporation paid $2.8 billion to resolve repurchase claims involving first-lien residential mortgage loans sold directly to the GSEs by entities related to legacy Countrywide (Countrywide). The agreement with FHLMC extinguishes all outstanding and potential mortgage repurchase and make-whole claims arising out of any alleged breaches of selling representations and warranties related to loans sold directly by legacy Countrywide to FHLMC through 2008, subject to certain exceptions we do not believe will be material. The agreement with FNMA substantially resolves the existing pipeline of repurchase and make-whole claims outstanding as of September 20, 2010 arising out of alleged breaches of selling representations and warranties related to loans sold directly by legacy Countrywide to FNMA. These agreements with the GSEs do not cover outstanding and potential mortgage repurchase and make-whole claims arising out of any alleged breaches of selling representations and warranties to legacy Bank of America first-lien residential mortgage loans sold directly to the GSEs, loans sold to the GSEs other than described above, loan servicing obligations, other contractual obligations or loans contained in private-label securitizations. In addition, we have other unresolved representation and warranty claims from the GSEs and certain monolines, and other non-GSE counterparties, and certain monolines have instituted litigation against us with respect…

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Should the Fed Continue Printing Money?

Last August Ben Bernanke unofficially announced QE2, known alternately as quantitative easing, seigniorage or laypeople as printing money. The idea behind this was to move to an easier monetary policy stance, and with real interest rates effectively at zero, this was the one monetary policy weapon left. In simple terms, printing money (should) and buying treasuries with this money would raise the expectations for inflation in the future and make investment and consumption more attractive today. This should then leads to GDP expansion and eventually employment creation.

Earlier this week, the President of the St. Louis Fed, James Bullard, gave a speech in which he said both that QE2 has been a success and that it will likely be winding down over the coming months.

“The natural debate now is whether to complete the program, or to taper off to a somewhat lower level of asset purchases. Quantitative easing has been an effective tool, even while the policy rate is near zero. The economic outlook has improved since the program was announced.”

As I have read around the blogosphere, most were against QE2 and would also for certain be against a QE3. The key arguments here were that the Fed is possible fueling an asset price bubble (in both equities and commodities) and that we risk runaway inflation in the long-term. In international relations, many developing countries have spoken strongly against QE2 for a couple of reasons, the main one being the Fed is exporting inflation and bubbles to them as capital flows into their markets; but one also cannot dismiss the fact that some countries (e.g. China) who hold large amounts of US treasuries are not too pleased about their assets being devalued.

I think all these arguments need to be considered and weighed against some of the benefits of QE2. Here are some of the points I think have not been highlighted enough:

1. Some inflation would be desirable, and the current inflation expectations are still not that high. Why would some inflation be desirable? Because it helps net debtors as the real value of their debt payments goes down over time. Since one key factor in increasing consumer spending will be reducing net indebtedness (and surely there is still some housing debt overhang in Middle America depressing consumer spending), then we should see some inflation as positive.

The key indicators of future inflation and inflation expectations all seem to be at reasonable levels. The most recent Cleveland Fed estimates of inflation expectations are only 1.8% (

2. The Yuan is still overvalued: The Big Mac index (totally scientific) says the Yuan is overvalued by 40%. Not surprisingly 50% of the US Trade Deficit is China. It appears that China has agreed to devalue the Yuan 25-30% over the next three years (, which should certainly help push the trade deficit back in the right direction for the US (and can potentially help create jobs). Further QE is basically a bargaining chip the US has that it can use to make China stick to this commitment of devaluation.

3. We may not be out of the woods yet: economic growth has picked up in the US, but just this morning the Q4 GDP growth estimates were revised down from 3.2% to 2.6%. Combined with unemployment still at nearly 10%, the economy may still be soft.

So should there be a QE3? I don’t think we can rule it out yet. We need to watch how GDP growth, unemployment, inflation and inflation expectations, the trade balance and the Yuan depreciation develop over the coming year.

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Ending Arab Regimes With Facebook Invites

I remember being at Harvard in the basement of Annenberg and watching the war in Iraq begin on FoxNews. It was right before Spring Break and I was sitting there with an Australian guy who I rowed with. This Aussie was particularly opinionated and wasted no time in sharing his opinion with me that that the war was idiotic and would just end in disaster. He was with his roommate Mark who I barely knew and would only meet once or twice after that. We watched the footage for a while and then left to get lunch.

In March of 2003, America began its quest to bring democracy to the Middle East and would over the next several years spend hundreds of billions of dollars to that effect. Since those first bombs went off in Baghdad, countless people have dedicated their careers and lost their lives trying to bring about this vision of a free and representative mode of governing in these countries that have forever been ruled by autocrats. This has largely been to no avail. It is hard to force democracy on people. They need to want it themselves.

Over the last two months, something changed. The entire Middle East has woken up to the idea of democracy. For the first time the masses were able to effectively organize and express their desire for it in a way they had not before. This turn away from autocracy was made possible not by the bombs I was watching on screen that March day in 2003. It was made possible by my Australian friend’s roommate. The unassuming awkward kid with a hoodie. He gave them the fire that let them burn their regimes down and he never even left his room to do so.

While America was spending billions of dollars trying to change the Middle East through shock and awe, that kid in the hoodie was with a team of other people quietly developing a website that would more than anything else effect the end politics of those countries we were so desperately trying to change by conventional means. They did it with barely any working capital and very minimal expenses. It would take a few years but over time we would all know the name of the website and the name of the kid in the hoodie.

What we probably don’t fully appreciate though are the wide ranging series of cause and effect that his actions have helped bring about. When the history of this period of unrest is written, it will be said that Mubarak and the other despots fell not because of international pressure but because some of their own people took 30 seconds to put together a Facebook invite and were able to organize themselves in ways never thought possible through this new tool. A tool that was created by a kid in a hoodie.


At the dawn of the new millennium A&E ran a special trying to identify the most influential people of the last millennium. For their number one pick, they didn’t choose Napoleon or Hitler or any of the famous political leaders and despots who conquered great territories and started wars. Neither did they pick the great artists like Shakespeare or Picasso who shaped the way we speak and perceive beauty. They picked a quiet man who died unknown in an obscure part of Germany. This man was not a religious figure although what he did would certainly affect world religions and lead to great upheaval. He was not a scientific figure although again his actions would have great effects on how that world developed.

His name was Johannes Guttenberg and he spent his life quietly laboring to develop a successful movable printing type. He successfully did it, although he never got the adulation he deserved in his life time. Neither did he make any money off of it. He died broke. No one even painted a picture of him until 100 years after the fact. Yet without Guttenberg, you have no printing press, and without the printing press, you have no Reformation and therefore no Enlightenment and no Industrial Revolution and everything that came after. Perhaps it would have all happened in due time but Guttenberg’s invention like Facebook helped dramatically speed up the process.

Who knows how Facebook will be viewed a hundred years from now. The fact of the matter is though that anonymous kid in Annenberg would change the Middle East in more profound ways than any of the bombs we were watching on television that day.  

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The Man Who Would Be King (If Obama Lets Him)

It has been said that without George W. Bush, Obama would not have been president. There is some truth to that. Had the Bush presidency not gone up in such spectacular flames and had the mood of the country not been so dire it is hard to imagine that Americans would have gravitated the way they did to the message of a young, single term African American Senator.

 A good portion of Obama’s appeal was that he was in many ways the opposite of Bush. Where as Bush was relatively short, Obama was relatively tall. Bush had a father, a famous one, Obama only met his twice. Bush went to schools that had scholarships named after his family, Obama was the one getting those scholarships. Bush had trouble speaking, Obama could always speak.  And then there is the obvious racial difference which underscored the entire campaign.

Democrats were smart in 2008. They knew that the country didn’t just want someone who was the political opposite of Bush but someone who was the opposite in every single way. They had learned from their mistake in 2004 in running John Kerry who was politically opposite from Bush but in every other way cut from the same patrician cloth.

American politics has always been like this. We tend to elect president’s who are not only political opposites of their predecessors but also the opposites in terms of personality and character. It is almost as if Presidents are not so much self-made as they are children begat by the previous President leaving office.

 Do you think a nice, well meaning naïve peanut farmer would have ever been elected President if Americans were not reeling from the Nixon Years and were yearning for someone who was distinctly outside the beltway? Nixon gave birth to Carter. After a few years of the nice but weak, slightly depressing Carter, we were ready for someone who could start carrying the country confidently again. Carter in turn begot Reagan. And so on.

The guys who are able to defeat the incumbent president or party do so because they represent not only an ideological turn but a turn in personality and character. Youthful, dynamic Clinton over stogy Bush I. Religious and moral Bush II over the too slick for his own good Clinton. I know Bush technically ran against Gore but he was really running against Clinton just as Obama was really running against Bush and not McCain.

Now, what does this mean for the 2012 cycle? It means that the Republicans if they are smart will find someone who is in every way the opposite of Obama. Being the incumbent, Obama will have all sorts of advantages going into the election. If they run someone who doesn’t represent a complete break from Obama, both in his or her approach to governing and his or her personality then Americans will go with what they know. Can we go through a process of elimination find the perfect candidate for this 2012 election cycle?

Obama’s experience is limited so the Republicans will need someone who has lots of government and private sector experience –eliminate Sarah Palin.

Obama is young, boyish so the Republicans will need someone who is older, more adult like –eliminate Tim Pawlenty, Bobby Jindal.

Obama is very telegenic and charismatic so the Republicans will need someone who seems more plainspoken and down to earth – eliminate Mitt Romney.

Obama is too over exposed and the media is too saturated with him so the Republicans will need someone who is relatively unknown and not trying to constantly grab face time – eliminate Mike Huckabee and eliminate Sarah Palin again.

So who are we left with after this process of elimination? Who is the anti-Obama? The answer is….

This guy…Mitch Daniels, the Governor of Indiana.

You’ve probably  never heard of him. Let me just give you a quick summary. Mitch Daniels is a short, quiet, not particularly charismatic, plain spoken down to earth Midwesterner who has loads of government and private sector experience and more than anyone else fully grasps the fiscal issues this country is faced with. Hearing him speak reminds you that adults still do exist in this country. He is already building some support and momentum going into this cycle. It still is unclear if he will run or not but a lot of smart people within the party would like him to.

More on Daniels at a later point. …

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$5 gas, coming to a pump near you

Back in the spring of 2008, oil prices hit the $80 range, climbing on a seemingly endless ascent from $15/barrel in 2002 (it’s hard to even imagine oil at $15/barrel now!). At the time, I was leading the energy demand research work at the McKinsey Global Institute and I started getting quite a few emails from partners around McKinsey who wanted to know if the oil price was ever going to stop going up. Had peak supply actually arrived? We decided to kick off a piece of research on short-term demand (paired with some work on supply) and how it would be affected by higher prices.

What we found may seem a bit obvious: like any other demand for any other good, oil demand reacts to price, at least in pockets. One major area of demand reaction is intuitive – people just reduce their demand for oil intensive goods, namely driving and flying. This reaction tends to happen more where the price signals are stronger. In Europe, gasoline and diesel have been highly taxed since the oil shocks of the 1970s, so the demand that’s left is a lot more resilient to price increases. If you are already paying 5 quid per gallon of petrol, 6 quid probably doesn’t seem like that different. Going from $2.50 to $4 per gallon in the US stings a lot more, because driving as an activity spans income levels. In 2008, the dollar was weakening in currency markets and oil (priced in dollars) and the dollar developed in inverse relationship, meaning that the countries that were really feeling the bulk of oil price increases where the US and any currency pegged to the dollar. Stated another way, the price for oil, which is sold in dollars, was not going up as much in other currencies. So the US was really going to feel this shock harder than other countries. (Indeed if you look at the reductions in driving in the US in 2007/08, this was actually happening). The other way that demand decreases is through a secondary income effect. Basically oil is more of a necessity than other goods and services, people can decrease demand to a certain extent, but they also have to spend more of their income on the necessary usage and reduce expenditures in other areas. Simply stated, US consumers needed to pay more money to oil exporting countries and spend less money on other goods. On an overall basis, higher oil prices dampen economic growth globally, and as a secondary effect this reduces oil demand and helps alleviate price pressure. Given that oil prices had been rising since 2002, many argued that this price reaction – both the direct price effect and indirect income impact – should have happened much earlier. But in fact, other income effects were helping support demand, namely the easy credit situation in the US. We concluded that the demand impact of high prices would come as soon as credit growth slowed down.

Our overall conclusion was that ~$150 a barrel oil over a period of 6-12 months, would create enough demand reaction to foment the price increases and probably reverse them temporarily (there was likely to be some overshooting in demand reduction). We never really got to find out if our analysis was right or not, because although oil did reach nearly $150/barrel that summer, as we all know in October 2008 something else brought oil prices back down to earth.

Our second conclusion from the study was perhaps a bit more frightening – that after the recession ended, oil demand was going to pick up its rate of growth again and that supply was not going to be able to keep up. We reached this conclusion through very careful bottom-up projection of all the components of oil demand, like the number of air trips in China, how many electric vehicles would be on the road in 2020 and how many refrigerators in India would get power from oil-based electricity plants. Based on this analysis, we published in 2009 that a supply/demand imbalance like we saw in 2008 was likely to happen again somewhere between 2012-2014, depending on how deep the recession was and thus how fast demand recovered. Demand is on a faster recovery pace than we had predicted even in our most optimistic scenario; according to the IEA’s statistics, 2010 oil demand jumped 2.8 million barrels per day, which was a huge jump (albeit following declines in demand due to the recession), and prices are quickly following suit. (

$100 a barrel, may seem expensive, especially when we are in the middle of the worst post-war recession. The current uptick in prices also rooted in the political turmoil in the middle East, and thus oil price may also subside in the short-term. But with demand on its current pace we shouldn’t think any relief we get is permanent. It looks like in the next year or two, we may get another real-world experiment to see if our theories about price elasticity of oil in the short-term were right.

If we were right, the US is in for a bugger of a time. One can easily imagine a double dip recession, with US consumers feeling twice the oil price pain due to a likely to be declining dollar (remember oil is priced in dollars) and our addiction to gasoline…

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