Monday, 25 January 2021 18:15

A Most Powerful Invention Comes to Life: Zero Trust Peer-to-Peer Value Transfer

This is a video that I published over 7 years ago. I find it be quite prescient.

This is an extended appearance that I made on CNBC on the same topic. Remember, this was 7 years ago (click graphic below)...

Fast forward to today, we have built functional product which utilizes the invention, and more importantly, a patent has been granted and registered - with reach into nearly half of the G20. Now, we move forward to implementing what I believe to be one of the most powerful technological inventions of modern time (then again, please realize that I am biased). Let's walk through what it is that I invented, and how it fits into today's world.

First, a few definitions....

“Zero Trust” is a situation where there is no or very little trust needed between parties in order for them to safely transact
"Value transfer" is a process of transferring rights (e.g., ownership, control, etc.) of objects of economic value among parties (e.g., gold, goods, services, responsibilities, securities, commodities, real assets).
“Cryptocurrency”, for the purposes of this discussion, is a cryptographically secured account of value that works in conjunction with a blockchain. Examples are Bitcoin, Ethereum, Chinese Digital yuan and Binance BNB

Overview of the Reggie Middleton ZeroTrust Concept

Market efficiency tends to increase—and therefore transaction costs tend to decrease—in proportion to the degree that transacting parties trust each other. However, rent extraction tends to increase—and therefore trust decreases—in proportion to market size1. Economic rent is any payment to an owner or producer in excess of the costs needed to bring what is being purchased into production.Efficient and productive participation in larger markets therefore requires mitigating trust issues, but that comes at a cost. That cost can often be reduced by economies of scale, but even today, there is substantial overhead from buffering against risks introduced by counterparties, intermediaries, post-delivery payment failures, guarantor failures, escrow, etc. 1 Rose, David C. The Moral Foundation of Economic Behavior. New York: Oxford UP, 2011. Print.

Since the mid 1990s, there has been an explosion of commercial activity where parties previously unknown to each other agree to transact using the internet as the fundamental communication medium, sometimes even across international borders. Establishing and maintaining trust between those parties has played a central role, and various crude solutions based on traditional, but inefficient and high friction methods have been attempted (e.g., electronic exchanges with expensive fees that step in as the counterparty, “online” escrow and dispute resolution using third parties, various reputation systems, third party guarantors, etc.).

Among those markets where unknown and untrusted individuals interact are those which trade financial instruments (e.g., stocks, bonds, options, futures, swaps, currency exposure, etc.). With the advent of financial engineering, individuals and businesses have been able to leverage computing in financial trading, including automating the process of entering and exiting trades based on programmable conditions or algorithms. However, even with the explosion of the use of technology in this space, such technology is overwhelmingly layered on top of legacy centralized markets. Nearly all impose relatively large costs to conduct trades with untrusted counterparties. Some very high-volume exchanges sell the ability for “high value” (i.e., high-paying) customers to cut in line ahead of less savvy or less well equipped investors. Some have questioned the fairness of this practice.

Further, the cost of contract enforcement in international trade can be prohibitive, and success might be very difficult to predict. In addition, a seller may wish to receive one currency, and a buyer may wish to send another. The value of one currency denominated in another can be volatile. Historically, one way that remote parties have mitigated risk is to engage the assistance of trusted intermediaries. One such mechanism is a letter of credit (L/C). L/Cs are appropriate where a seller does not know whether to trust a buyer wishing to place a large order, but does trust a bank where the buyer has established a line of credit. The buyer and bank agree that the bank will release funds from that line of credit to the seller when the seller meets certain conditions (most often transmitting evidence of shipment to the bank before a certain date). The bank provides the promise (L/C) to the seller, and the seller and buyer agree on the remaining terms of the transaction. However, payment often happens at a later date than the agreement, and exchange rates could vary between the time that the agreement was struck and the time payment is received. Only the largest of institutions have the resources necessary to properly hedge against exchange rate volatility. Additionally, the fees charged by banks for L/Cs and currency exchanges are substantial. Perversely, a high degree of trust must also be placed in the intermediary institution(s), who effectively acts as self-interested document examiners who may or may not independently verify the veracity of said documents before releasing the funds, perhaps leaving much of the risk of mistake, forgery, or fraud on the shoulders of the seller. As such, L/Cs are typically not well-suited for consumer transactions, or where transactions involve currencies whose values may vary wildly in relation to each other.

Decentralized digital currencies (or so-called “cryptocurrencies”)—technologies that promise tightly-controlled asset creation coupled with the ability to transfer control or ownership of those assets computationally when rigorously-defined criteria are met, with little-or-no dependency on third party intermediaries, and with very low transaction costs compared to traditional mechanisms—are relatively new creatures. The Bitcoin protocol and progeny (Ethereum, Litecoin, etc.) are one such class of technologies that have recently enjoyed meteoric rises in popularity (and valuation).

SUMMARY OF THE INVENTION

The invention pertains to systems and methods enabling parties with little trust or no trust in each other to enter into and enforce agreements conditioned on input from or participation of a third party, over arbitrary distances, without special technical knowledge of the underlying transfer mechanism(s), optionally affording participation of third-party mediators, substitution of transferors and transferees, term substitution, revision, or reformation, etc. Such exchanges can occur reliably without involving costly third-party intermediaries who traditionally may otherwise be required, and without traditional exposure to counterparty risk.

This patented invention description explores example embodiments enabling two forms of value transfer: arbitrary swaps and L/Cs. Arbitrary swaps and L/Cs are useful as illustrative examples because traditionally the two are very different animals. However, the invention allows for their expression and enforcement in remarkably similar terms. As one skilled in the art will appreciate, the invention can be applied to many other forms of value transfer as well.

In one example, Party A believes that bitcoins (BTC) will rise in notional terms when valued in New Zealand dollars (NZD) over the next few weeks. Party B believes the opposite is true, that BTC will fall when valued in NZD over a similar timeframe. Neither parties are aware of each other, but each wants to place a small bet in accordance with their respective beliefs. One embodiment of the invention allows those parties to discover each other, collaborate with each other to agree on concrete terms, propose transactions reflecting their agreement, and finally enforce that agreement without traditional, costly measures.
In another example, Party A is a merchant who wishes to allow her customers to trade their BTC for her services. However, she would rather receive US dollars (USD) because she is concerned about the volatility of BTC. Party A is not concerned about whether BTC will rise or fall when valued in USD. Periodically (e.g., once per day, hour, etc., or even once per transaction where she receives BTC), she can offer to sell exposure to BTC valued in USD in proportion to the BTC she receives from her customers. In other words, she swaps her exposure to BTC in exchange for exposure to USD. Party B has fewer BTC and more USD than he wants, and desires increased exposure to BTC valued in USD. One embodiment of the invention allows Party B to find and exchange—or “swap”—exposures with Party A, allowing Party A to accept BTC in exchange for her goods or services knowing that she will be compensated by Party B if her BTC lose value against USD, in exchange for Party B being able to keep any upside if BTC gains in value against USD. Another embodiment seeks out these swaps automatically upon detection of Party A's ownership of additional BTC.
Combinations are possible. For example, Party A accepts Australian dollars (AUD), but prefers USD, and wants to hedge against volatility of AUD in USD. One embodiment of the invention allows Party A to swap exposure to USD in BTC with Party B, and simultaneously swap exposure to BTC in AUD with Party C over a similar time period, thereby synthesizing a hedge against AUD in USD. The invention is not limited such that Party B and Party C are distinct parties (they could be the same), nor is it limited such that such that Party A must conduct two separate trades. In addition, various embodiments of the invention allow the parties to perform these types of transactions without maintaining currency deposits or making currency purchases or exchanges.
In yet another example, Party A wishes to purchase goods from Party B. The parties do not know each other well. Party B wants assurances of availability of funds from Party A, but Party A does not want to release those funds to Party B (or an assignee) until Party B has demonstrated proof of shipment (or met some other condition).
In one embodiment comprising a swap, a first device called a “client” and a second client participate in a series of transactions where assets from a first party and assets from a second party are committed until a combination of two (of a total of three) of the first party, the second party, and an facilitator release them in accordance with a calculation by the facilitator based on observation of external state, such as the relative value of certain financial, commodity or real property instruments, at a specific time.
- This is basically a swap without a middleman or credit risk/counterparty risk exposure since the participants (clients) hold the assets in their possession at all times unless committed to the blockchain where the blockchain itself then becomes the counterparty. Until the blockchain has been hacked or in some fashion critically malfunctions, the credit/counterparty risk has been drastically reduced and approaches that of zero, hence the need for due diligence and vetting of your counterparty approaches zero as well as the need to vet and trust the authoritative third party who may hold and escrow funds, i.e. exchanges, brokers, banks. Thus, we now have Zero Trust Contracts and agreements. Swaps can take many forms and themselves can become many things.
In another embodiment comprising a L/C, a first client and a second client participate in a series of transactions where assets from a first party are committed until either the first client or a facilitator releases them based on observation of external state, such as verification of delivery to a shipper or an address. The L/C as implemented by the invention, remedies multiple maladies in the traditional application of the L/C.
In a further embodiment, the assets may be refunded if no such observation can be made by an expiration timestamp.
In yet another embodiment, the commitment of assets may be extended pending a settlement facilitated by a mediator.

A quick Google search for letters of credit and swaps yields…

Note: The net economic exposure of swaps is roughly 1/10th or less of this figure, but for the purposes of this invention’s discussion, fees would be charged on notional amounts, not netted amounts.

$6.6 trillion daily times a 360 day year is approximately $2,376,000,000,000,000, to view this as an annualized number.

These are but two of what is possibly hundreds of permutations to be achieved by those skilled in the art, who can take the invention and use it to replicate nearly any transaction of value in a fashion that eliminates counterparty and credit risk, to wit (as per simple Google searches):

With the advent of faster block and settlement times and more efficient consensus systems, the speed and usability of this invention combined with the simplicity of user-friendly interfaces that allow those unskilled and unfamiliar in the art can transform finance, commerce and any transaction of value to an extent that far exceeds the transformation witnessed by the popularization of the Internet pre-ecommerce days.

This invention seeks to claim that transformation as its addressable space, and this space is monumental and set to grow exponentially larger, to wit:

Op-ed: A new global arms race in digital finance is heating up

www.cnbc.com › 2021/01/21 › op-ed-a-new-global-arms...

4 days ago — Much like the space race, development of central bank digital currencies will influence ... Specifically, this latest phase of progress has its sights set on a massive ...

What Are the Main Goals for Central Banks in 2021?

internationalbanker.com › Banking

Jan 4, 2021 — It has been an unusually eventful year for central banks all over the world in ... see the introduction of the first major central bank digital currency (CBDC) in 2021. ... pushing collectively for the development of the international monetary system

2021 the year for central bank issued digital currencies ...

www.cityam.com › 2021-the-year-for-central-bank-issu...

Jan 4, 2021 — 2021 the year for central bank issued digital currencies? ... China is well ahead in this journey, having planned for a Central Bank Digital Currency (“CBDC”) ... to a blockchain that is controlled by the rules built into the algorithm that powers it.

Turkish central bank announces surprise digital currency pilot ...

coingeek.com › turkish-central-bank-announces-surpris...

Jan 2, 2021 — ... new digital currency in 2021, after the country's central bank announced it had ... Turkey is now at a more advanced stage of development than other countries ...

Bank of France settles $2.4M fund in central bank digital ...

cointelegraph.com › news › bank-of-france-settles-2-4...

6 days ago — The Bank of France has successfully wrapped up a $2.4 million CBDC pilot, which saw ... The Bank of France successfully piloted a central bank digital currency — or ... “From a technological point of view, the experiment required the development ... underway at the Bank of France, with some expected to run until mid-2021.

China's CBDC 'Dress Rehearsal' Sets Stage for Other Central ...

www.pymnts.com › B2B

Jan 4, 2021 — Notably, the digital currency offered by China's central bank does not carry ... Fed and seven central banks have put forth a framework for CBDC development ... the central banks' approaches may differ, but 2021 may show marked progress ...

Swedish Bankers Face Identity Crisis Over Digital Currency ...

www.usnews.com › News › Technology News

Jan 5, 2021 — For a graphic on Central bank digital currencies across the world: ... advisor for the Swedish Bankers Association is concerned that the Riksbank has not made it ...

Venezuela to have 100% digital monetary system - FXStreet

www.fxstreet.com › analysis › venezuela-to-have-100-...

Jan 4, 2021 — To facilitate the entry of the digital currency, the country began demanding Petro in the form of payment in the country's oil-related transactions, which turned ...

BRIEF DESCRIPTION OF THE DRAWINGS

FIG. 1 depicts a typical embodiment for practicing the invention, especially for use with or comprising a transfer mechanism such as a decentralized digital currency, where the clients, transfer mechanism, facilitator, and data source are distinct participants connected by a computer network.

Published in Latest Analysis

Thursday, 19 November 2009 00:00

Let's Have a Conversation About Brand Names, Finance and Investing

Yesterday, I commented on Goldman's CMBS offering through the government's leverage program known as TALF. I was very nice and diplomatic, yet despite such I still received what I would consider, inappropriate feedback. Okay, let's take the politically correct gloves off - they never fit me anyway. This deal probably flew because Goldman Sachs underwrote it. Goldman thrives off of brand name value primarily, other than that nothing really sets them apart. Contrary to mainstream media inspired belief, they are not better than everybody else at everything. I posit, they are probably not better at anybody else at anything other than marketing and lobbying which allows them the perception of being better than everybody else and the protection from the government to get away with things other banks can't (or are afraid to try). I want to delve further into that CMBS deal I outlined yesterday (so be sure to read through this, particularly if you're with an insurance company), but before I do let me try to dispel the Goldman myth once and for all...

Goldman is a bank, just like everybody else. They hire the same people who went to the same schools, taught by the same teachers to use the same models to do the same things as the other big banks. When Goldman hires a banker with experience, where do you think they hire them from? When Goldman loses a banker, where do you think they lose them to?

Think about it:

Financial shares slumped, their stock fell - just like everybody else.
The market turned on big broker/dealers, they had to run for government protection - just like everybody else.
The market recovered, their shares recovered - just like everybody else.
Goldman pays the vast majority of its net revenue out as compensation, not dividends! I haven't checked, but I would wager that they probably paid more than their outstanding market cap as bonuses since going public. What does this mean? It means that you are much better off working at Goldman than you are as a client or as a shareholder. Keep that in mind as we review the CMBS offering from an anecdotal perspective later on in this post.

From Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street:

Their stock is fraught with risk that the sell side never bothers to analyze, which is why they are considered superstars when they have good quarters. Adjust for risk, and Goldman actually underperforms - see "Who is the Newest Riskiest Bank on the Street?" where I break it down in detail, showing Goldman as the leader in leverage, cost of capital and VaR as compared to the decrease in Risk Adjusted Return. I addressed similar points in the previous year in Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street.

Goldman Sachs Equity Guidance Would Have Made You a Fortune on Lehman!

I have outran their equity analysts and asset management arm on practically every stock I covered and I have a skeleton staff. Now, to be honest, I am devoid of the massive conflicts of interests that run through that company, but that is the point! To this day, we still have institutions that buy financial widgets because Goldman told them to, regardless of the fitness or viability of said widget.

For those with short term, or worse yet, media induced brand name fever, let's rehash "Is Lehman really a lemming in disguise?" (Thursday, 21 February 2008) and Is this the Breaking of the Bear?. Then peruse Lehman rumors may be more founded than some may have us believe Tuesday, 01 April 2008 (be sure to read through the comments, its like deja vu, all over again!), Lehman stock, rumors and anti-rumors that support the rumors Friday, 28 March 2008 and Funny CLO business at Lehman Friday, 04 April 2008

The esteemed Goldman Sachs did not agree with my thesis on Lehman. Reference the following graph, and click it if you need to enlarge. Notice the tone, and ultimately the outright indication of a fall in the posts from February through April 2008, and cross reference with the rather rosy and optimistic guidance from the esteemed Goldman (Sachs) boys during the same time period, then... Oh yeah, Lehman filed for bankruptcy!!!

Does anybody think that Lehman was a "one off" occurrence? Well download Blog vs. Broker Analysis - supplementary material and you will be able to track the performance of all of the big banks and broker recommendations for the year 2008 for the companies that I covered on my blog. I can save you the time it takes to read it and just tell you that it ain't all its cracked up to be. Again, I inquire as to why these companies' clients do not wise up?

Now, back to that CMBS Offering

Pray tell, educate me as to where Goldman's clients actually think they get all of their money from? Let's take that latest CMBS offering that they hawked Monday. In Reggie Middleton Personally Contragulates Goldman, but Questions How Much More Can Be Pulled Off, I blogged about the 4% (unlevered yield) Goldman was able to get for their underwriting clients (Developers Diversified Realty, a REIT that came up in another blog post of interest - "Here's a Big Company Bailout by the Taxpayer That Even the Taxpayer's Missed!"). This was actually a big win for DDR for they got access to 4% money at a time when commercial real estate is in the crapper. It was also a big win for Goldman, for they moved a big CRE/CMBS deal through a government leverage plan when such deals really haven't moved much. Was it a good deal for the institutions that Goldman peddled the securities to, though? Yet, I query further, who does Goldman really work for? To whom do they have a fiduciary duty? Is that duty to their bankers, traders, and analysts to get the biggest fees, commissions, and spreads possible? Quite possibly, since they are on track to announce record bonuses. I don't see clients putting out press releases touting record returns from dealing with Goldman! Is that duty to the share holder? Well, it doesn't look like it from a risk adjusted return perspective (see "Who is the Newest Riskiest Bank on the Street?"). Is that duty to DDR to get them the lowest rate possible? Quite possibly, for 4% is pretty damn good, and they lowered the rate due to being oversubscribed (high demand). But wait a minute, If their fiduciary duty is to DDR (or themselves), then they can't have a fiduciary duty to the insurance companies and asset managers who they are pitching these CMBS to, can they? Buyers should want a higher yield to compensate for the risk, no? The Wall Street Journal reported that this was a low risk deal. Really!!!??? Let's look deeper into that assertion from an anecdotal perspective, shall we?

In the WSJ.com article, it was stated the collateral (the mall properties) was conservative because they were occupied by discount chains where shoppers flock during hard times. Then they go on to contradict themselves by saying that occupancy is in a material downtrend:

The deal reflects the high bar the Fed has set for loans eligible for TALF financing. The 28 shopping centers in 19 states securing the bonds have stable cash flow because they often are occupied by discount retailers that tend to attract business even in a recession. For instance, one of the properties is Hamilton Marketplace, near Princeton, N.J., a 957,000-square-foot property whose tenants include Wal-Mart Stores, Lowe's, BJ's Wholesale Club and supermarket ShopRite. According to Fitch Ratings, the property has maintained an average occupancy of 96.7% since 2006 and is 95.1% occupied.

Isn't 95.1% about 151 basis points less than 96.7%? Will this downtrend continue? Will it intensify? Do you see commercial real estate getting better in the next 5 years or worse? If you wanted buyers to perceive safety, you would quote an UPTREND in occupancy, would you not?

"It's a great execution for the borrower," says Scott Simon, managing director and head of mortgage- and asset-backed securities portfolio manager at Pimco, a leading bond house. "If other real-estate investors can borrow money at that rate, it would be a real game changer for the commercial real-estate market that has been so devoid of financing."

Mr. Simon declined to comment on whether Pimco would buy any of the Diversified Realty bonds. Bids for the securities are expected to come from many mutual funds, insurance companies and other institutional investors. Firms that are considering the deal include Babson Capital Management, the investment-management unit of Massachusetts Mutual Life Insurance Co. and Principal Financial Group, according to people familiar with the matter. Babson Capital declined to comment. A representative at Principal Financial didn't respond to requests for comment.

Institutional investors are attracted to the deal because it is viewed as a low-risk investment with relatively healthy returns when compared with five-year Treasurys, which are yielding about 2%.

Well, Treasurys don't have rollover issues (at least not yet), and CMBS do. There is usually a reason for higher yield, and that is often higher risk, actual and/or perceived. I will walk through why these CMBS buyers are getting twice the yield of treasuries in a moment, as well as explaining how they are so woefully under-compensated as to be tantamount to a crime (or is it a break in fiduciary duty?)

Investors buying the triple-A slice of the deal, totaling $323.5 million, can get an unleveraged return of about 4%, according to price information distributed to possible investors by Goldman late Friday and reviewed by The Wall Street Journal. If they finance their purchases with TALF funding, their returns can rise to about 6%.

I went into Fitch and its AAA ratings in "Reggie Middleton Personally Contragulates Goldman, but Questions How Much More Can Be Pulled Off". Anyone who believes Fitch's ratings actually mean anything should click that link scroll down to around the middle, then read tightly from a secure device. If you are carrying a pda, iphone, or notebook you may drop it from uncontrollable laughter!

The $400 million loan represents about half of the value of the underlying properties. By comparison, in the years before the financial crisis erupted in 2007, banks were willing to lend more than 70% of a property's value because the debt could be easily sold as CMBS. Even under a "stress" scenario, according to Fitch, the Developers Diversified properties would produce a cash flow of about 1.44 times what is required to service the debt. Back when credit was easy, the ratio for stress scenarios would even fall below one for many CMBS offerings.

This is the kicker, here. Loans can't get rolled over at 70%, 65% or even 60% LTV these days, and things are getting worse, not better. See Fitch's warning (that's right, the same guys that gave those very same tranches above AAA ratings) warning that Insurers Face $23 Billion Loss on Commercial Property.

The credit crisis has driven $138 billion worth of U.S. commercial properties into default, foreclosure or debt restructuring, according to New York-based Real Capital Analytics Inc. Commercial real estate prices have plunged almost 41 percent since October 2007, the Moody’s/REAL Commercial Property Price Indices show.

So, let's do a little simple math here. Goldman's salesman talks a good game (as the pimp) to the sweet little investor looking for yield (as the little girl just getting off the bus from a small town in the midwest looking for fame and stardom in the big city). They say, hey, I'll write these CMBS for this conservative CRE portfolio at only 50LTV. What could go wrong? This happens in October of 2007. In November of 2009, you find that your collateral is now around 89LTV (due to the 41 percent drop up to October in a rapidly decreasing asset value environment) and still dropping fast, with the LTV rapidly approaching 100, wherein you start taking guaranteed haircuts on your Fitch AAA rated (you can just imagine me cracking up in the background) tranched CMBS. Boy, those 400 measly basis points don't look like much compensation now, does it? You also see why Treasuries are yielding 2%, don't you? You are at risk of losing significant principal, for according to the WSJ article, the only deals getting done are at 50 LTV. Who the hell is going to cover that 390 point spread? You call your Goldman rep for help, but you can't reach him because he is in the Mediterranean with those TWO (that's right, not one but two) bad ass Italian chicks testing out his new Azimut 86S he just bought in a recession with YOUR commission dollars and the vig (oops, I mean spread) from your deal which is currently underwater!

If this deal would have went down this time, next year would GS have been in breach of their fiduciary duties: Dodd bill would make reps fiduciaries

A better question I know all of you are pondering, will this actually happen to the DDR deal? Well, let's bring back the chart of the week for the Japanese perspective from the "Bad CRE, Rotten Home Loans, and the End of US Banking Prominence?" post.

You tell me if these CMBS aren't worth more than 4 points?

Now, don't get me wrong. I have nothing against Goldman Sachs. It does rather irk me when everybody, and I mean everybody truly believes that their sh1t doesn't stink, though. I actually have to bring my kids to school, so I will finish this post up with what it means to insurance companies who buy things such as this DDR CMBS deal from Goldman later on today or tomorrow. I'll include tidbits of what my subscribers know about the insurance industry, and I will also release some sneak peaks of the upcoming REIT research to subscribers as well.

Published in Reggie's Blog & Proprietary Research

Thursday, 19 November 2009 00:00

Let's Have a Conversation About Brand Names, Finance and Investing

Yesterday, I commented on Goldman's CMBS offering through the government's leverage program known as TALF. I was very nice and diplomatic, yet despite such I still received what I would consider, inappropriate feedback. Okay, let's take the politically correct gloves off - they never fit me anyway. This deal probably flew because Goldman Sachs underwrote it. Goldman thrives off of brand name value primarily, other than that nothing really sets them apart. Contrary to mainstream media inspired belief, they are not better than everybody else at everything. I posit, they are probably not better at anybody else at anything other than marketing and lobbying which allows them the perception of being better than everybody else and the protection from the government to get away with things other banks can't (or are afraid to try). I want to delve further into that CMBS deal I outlined yesterday (so be sure to read through this, particularly if you're with an insurance company), but before I do let me try to dispel the Goldman myth once and for all...

Goldman is a bank, just like everybody else. They hire the same people who went to the same schools, taught by the same teachers to use the same models to do the same things as the other big banks. When Goldman hires a banker with experience, where do you think they hire them from? When Goldman loses a banker, where do you think they lose them to?

Think about it:

Financial shares slumped, their stock fell - just like everybody else.
The market turned on big broker/dealers, they had to run for government protection - just like everybody else.
The market recovered, their shares recovered - just like everybody else.
Goldman pays the vast majority of its net revenue out as compensation, not dividends! I haven't checked, but I would wager that they probably paid more than their outstanding market cap as bonuses since going public. What does this mean? It means that you are much better off working at Goldman than you are as a client or as a shareholder. Keep that in mind as we review the CMBS offering from an anecdotal perspective later on in this post.

From Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street:

Their stock is fraught with risk that the sell side never bothers to analyze, which is why they are considered superstars when they have good quarters. Adjust for risk, and Goldman actually underperforms - see "Who is the Newest Riskiest Bank on the Street?" where I break it down in detail, showing Goldman as the leader in leverage, cost of capital and VaR as compared to the decrease in Risk Adjusted Return. I addressed similar points in the previous year in Goldman Sachs Snapshot: Risk vs. Reward vs. Reputations on the Street.

Goldman Sachs Equity Guidance Would Have Made You a Fortune on Lehman!

I have outran their equity analysts and asset management arm on practically every stock I covered and I have a skeleton staff. Now, to be honest, I am devoid of the massive conflicts of interests that run through that company, but that is the point! To this day, we still have institutions that buy financial widgets because Goldman told them to, regardless of the fitness or viability of said widget.

For those with short term, or worse yet, media induced brand name fever, let's rehash "Is Lehman really a lemming in disguise?" (Thursday, 21 February 2008) and Is this the Breaking of the Bear?. Then peruse Lehman rumors may be more founded than some may have us believe Tuesday, 01 April 2008 (be sure to read through the comments, its like deja vu, all over again!), Lehman stock, rumors and anti-rumors that support the rumors Friday, 28 March 2008 and Funny CLO business at Lehman Friday, 04 April 2008

The esteemed Goldman Sachs did not agree with my thesis on Lehman. Reference the following graph, and click it if you need to enlarge. Notice the tone, and ultimately the outright indication of a fall in the posts from February through April 2008, and cross reference with the rather rosy and optimistic guidance from the esteemed Goldman (Sachs) boys during the same time period, then... Oh yeah, Lehman filed for bankruptcy!!!

Does anybody think that Lehman was a "one off" occurrence? Well download Blog vs. Broker Analysis - supplementary material and you will be able to track the performance of all of the big banks and broker recommendations for the year 2008 for the companies that I covered on my blog. I can save you the time it takes to read it and just tell you that it ain't all its cracked up to be. Again, I inquire as to why these companies' clients do not wise up?

Now, back to that CMBS Offering

Pray tell, educate me as to where Goldman's clients actually think they get all of their money from? Let's take that latest CMBS offering that they hawked Monday. In Reggie Middleton Personally Contragulates Goldman, but Questions How Much More Can Be Pulled Off, I blogged about the 4% (unlevered yield) Goldman was able to get for their underwriting clients (Developers Diversified Realty, a REIT that came up in another blog post of interest - "Here's a Big Company Bailout by the Taxpayer That Even the Taxpayer's Missed!"). This was actually a big win for DDR for they got access to 4% money at a time when commercial real estate is in the crapper. It was also a big win for Goldman, for they moved a big CRE/CMBS deal through a government leverage plan when such deals really haven't moved much. Was it a good deal for the institutions that Goldman peddled the securities to, though? Yet, I query further, who does Goldman really work for? To whom do they have a fiduciary duty? Is that duty to their bankers, traders, and analysts to get the biggest fees, commissions, and spreads possible? Quite possibly, since they are on track to announce record bonuses. I don't see clients putting out press releases touting record returns from dealing with Goldman! Is that duty to the share holder? Well, it doesn't look like it from a risk adjusted return perspective (see "Who is the Newest Riskiest Bank on the Street?"). Is that duty to DDR to get them the lowest rate possible? Quite possibly, for 4% is pretty damn good, and they lowered the rate due to being oversubscribed (high demand). But wait a minute, If their fiduciary duty is to DDR (or themselves), then they can't have a fiduciary duty to the insurance companies and asset managers who they are pitching these CMBS to, can they? Buyers should want a higher yield to compensate for the risk, no? The Wall Street Journal reported that this was a low risk deal. Really!!!??? Let's look deeper into that assertion from an anecdotal perspective, shall we?

In the WSJ.com article, it was stated the collateral (the mall properties) was conservative because they were occupied by discount chains where shoppers flock during hard times. Then they go on to contradict themselves by saying that occupancy is in a material downtrend:

The deal reflects the high bar the Fed has set for loans eligible for TALF financing. The 28 shopping centers in 19 states securing the bonds have stable cash flow because they often are occupied by discount retailers that tend to attract business even in a recession. For instance, one of the properties is Hamilton Marketplace, near Princeton, N.J., a 957,000-square-foot property whose tenants include Wal-Mart Stores, Lowe's, BJ's Wholesale Club and supermarket ShopRite. According to Fitch Ratings, the property has maintained an average occupancy of 96.7% since 2006 and is 95.1% occupied.

Isn't 95.1% about 151 basis points less than 96.7%? Will this downtrend continue? Will it intensify? Do you see commercial real estate getting better in the next 5 years or worse? If you wanted buyers to perceive safety, you would quote an UPTREND in occupancy, would you not?

"It's a great execution for the borrower," says Scott Simon, managing director and head of mortgage- and asset-backed securities portfolio manager at Pimco, a leading bond house. "If other real-estate investors can borrow money at that rate, it would be a real game changer for the commercial real-estate market that has been so devoid of financing."

Mr. Simon declined to comment on whether Pimco would buy any of the Diversified Realty bonds. Bids for the securities are expected to come from many mutual funds, insurance companies and other institutional investors. Firms that are considering the deal include Babson Capital Management, the investment-management unit of Massachusetts Mutual Life Insurance Co. and Principal Financial Group, according to people familiar with the matter. Babson Capital declined to comment. A representative at Principal Financial didn't respond to requests for comment.

Institutional investors are attracted to the deal because it is viewed as a low-risk investment with relatively healthy returns when compared with five-year Treasurys, which are yielding about 2%.

Well, Treasurys don't have rollover issues (at least not yet), and CMBS do. There is usually a reason for higher yield, and that is often higher risk, actual and/or perceived. I will walk through why these CMBS buyers are getting twice the yield of treasuries in a moment, as well as explaining how they are so woefully under-compensated as to be tantamount to a crime (or is it a break in fiduciary duty?)

Investors buying the triple-A slice of the deal, totaling $323.5 million, can get an unleveraged return of about 4%, according to price information distributed to possible investors by Goldman late Friday and reviewed by The Wall Street Journal. If they finance their purchases with TALF funding, their returns can rise to about 6%.

I went into Fitch and its AAA ratings in "Reggie Middleton Personally Contragulates Goldman, but Questions How Much More Can Be Pulled Off". Anyone who believes Fitch's ratings actually mean anything should click that link scroll down to around the middle, then read tightly from a secure device. If you are carrying a pda, iphone, or notebook you may drop it from uncontrollable laughter!

The $400 million loan represents about half of the value of the underlying properties. By comparison, in the years before the financial crisis erupted in 2007, banks were willing to lend more than 70% of a property's value because the debt could be easily sold as CMBS. Even under a "stress" scenario, according to Fitch, the Developers Diversified properties would produce a cash flow of about 1.44 times what is required to service the debt. Back when credit was easy, the ratio for stress scenarios would even fall below one for many CMBS offerings.

This is the kicker, here. Loans can't get rolled over at 70%, 65% or even 60% LTV these days, and things are getting worse, not better. See Fitch's warning (that's right, the same guys that gave those very same tranches above AAA ratings) warning that Insurers Face $23 Billion Loss on Commercial Property.

The credit crisis has driven $138 billion worth of U.S. commercial properties into default, foreclosure or debt restructuring, according to New York-based Real Capital Analytics Inc. Commercial real estate prices have plunged almost 41 percent since October 2007, the Moody’s/REAL Commercial Property Price Indices show.

So, let's do a little simple math here. Goldman's salesman talks a good game (as the pimp) to the sweet little investor looking for yield (as the little girl just getting off the bus from a small town in the midwest looking for fame and stardom in the big city). They say, hey, I'll write these CMBS for this conservative CRE portfolio at only 50LTV. What could go wrong? This happens in October of 2007. In November of 2009, you find that your collateral is now around 89LTV (due to the 41 percent drop up to October in a rapidly decreasing asset value environment) and still dropping fast, with the LTV rapidly approaching 100, wherein you start taking guaranteed haircuts on your Fitch AAA rated (you can just imagine me cracking up in the background) tranched CMBS. Boy, those 400 measly basis points don't look like much compensation now, does it? You also see why Treasuries are yielding 2%, don't you? You are at risk of losing significant principal, for according to the WSJ article, the only deals getting done are at 50 LTV. Who the hell is going to cover that 390 point spread? You call your Goldman rep for help, but you can't reach him because he is in the Mediterranean with those TWO (that's right, not one but two) bad ass Italian chicks testing out his new Azimut 86S he just bought in a recession with YOUR commission dollars and the vig (oops, I mean spread) from your deal which is currently underwater!

If this deal would have went down this time, next year would GS have been in breach of their fiduciary duties: Dodd bill would make reps fiduciaries

A better question I know all of you are pondering, will this actually happen to the DDR deal? Well, let's bring back the chart of the week for the Japanese perspective from the "Bad CRE, Rotten Home Loans, and the End of US Banking Prominence?" post.

You tell me if these CMBS aren't worth more than 4 points?

Now, don't get me wrong. I have nothing against Goldman Sachs. It does rather irk me when everybody, and I mean everybody truly believes that their sh1t doesn't stink, though. I actually have to bring my kids to school, so I will finish this post up with what it means to insurance companies who buy things such as this DDR CMBS deal from Goldman later on today or tomorrow. I'll include tidbits of what my subscribers know about the insurance industry, and I will also release some sneak peaks of the upcoming REIT research to subscribers as well.

Published in Reggie's Blog & Proprietary Research

Thursday, 04 January 2007 23:00

Press Coverage & Media Appearances & Awards

Recent Press Coverage and Media Appearances & Awards

Crain's New York

“His work is so detailed, so accurate, it's among the best in the world,” says Eric Sprott, CEO of Sprott Asset Management, a Toronto firm that manages about $5 billion and subscribes to Mr. Middleton's research.

Reggie in Forbes (Going short)