Tag: Gretchen Morgenson

Fees, Expenses and the S.E.C.

money penny

Andrew Bowden threw a grenade at the private fund industry three weeks ago when he spoke at PEI’s Private Fund Compliance Forum. He said that the SEC found violations of law or material weaknesses in over 50% of the exams they had conducted of private equity funds when it came to fees and expenses.

Mr. Bowden pointed to two particular types of fees and expenses: monitoring fees and operating partners. Although both of these are customary in private equity deal and disclosed in PPMs and financial statements, the SEC does not like them. He lumped them together with fraudulent expenses in the Camelot case.

Two recent news stories are carrying on Bowden’s view of private equity.

Last week, the Wall Street Journal ran a story on how KKR failed to credit certain fees back to investors because the unit was not an affiliate:  KKR Error Raises Question: What Cash Should Go to Investors? KKR is required to share with investors in its largest buyout fund 80% of any “consulting fees” collected by any KKR “affiliate.” The unit in question was owned by KKR’s management and not considered an affiliate. The article specifically tied back to Mr. Bowden’s speech.

On Sunday, Gretchen Morgenson penned an article in the New York Times about monitoring fees: The Deal’s Done. But Not the Fees. The article highlighted $30 million in monitoring fees paid to Goldman Sachs, Kohlberg Kravis Roberts and TPG Capital for their oversight of Biomet. The unpaid fees under the 10-year monitoring contract became due on the sale to Zimmer Holdings. This article also specifically mentions Mr. Bowden’s speech.

In my view, it’s not that the fees are illegal or “fraudulent, manipulative or deceptive” under Section 206. It’s a matter of disclosure to investors and internal procedure. Investors deserve a right to know the fees they are paying, either directly through the fees by the fund, or indirectly by the fees paid by the portfolio company to the fund manager. Perhaps in some fund documents the fees can be laid out in more detail. Fund managers should have internal procedures for how fees are implemented and checked to make sure they comply with the fund documents.

Personally, I think Mr. Bowden is lumping a lot of customary fees and expenses into his 50% bucket. I’m offended that he is including the case of fraud, like the Camelot case, in with instances of fees that the SEC merely does not like.

References:

Reckless Endangerment

So what caused the 2008 financial crisis? We know that the direct cause was the meltdown in the US housing market. I think we are still trying to put together the pieces and point the finger of blame. It was a big bubble and the explosive reaction when the bubble burst. It took many different forces to get the bubble so big.

In Reckless Endangerment, Gretchen Morgenson and Joshua Rosner take their turn looking at the outsized ambition, greed, and corruption that lead up to the crisis. They point the finger of blame directly at Fannie Mae and its executives.

The authors portray a company that ruthlessly leveraged the implicit government guarantee to create billions of dollars of shareholder wealth and millions of dollars in executive compensation. They beat the drumbeat of housing as the American Dream. Everyone should get a chance to own their own home. Fannie Mae used their version of the American Dream to bully Congress and their regulators to let them have a very thin capital reserve and to keep their finances very opaque. The authors pin the blame squarely on James Johnson, the CEO of Fannie Mae during the 1990s and his successor, Franklin Raines.

The rating agencies also get some of blame by the authors. I think the rating agencies have not received enough of the blame. Their shoddy rating of debt instruments let them get AAA ratings that they did not deserve. Only a handful of companies and a handful of countries get the top rating. But when it came to real estate backed securities, the rating agencies were handing them out like cotton candy at the state fair.

Institutional investors were looking for safe place for their money that could still earn a coupon. US treasury bonds were paying a very low interest rate. Pension funds and insurance companies determine their funding levels based on a projected rate or return. Many were limited to only invest in the highest quality asset either by regulation or internal policies. That meant they would only buy the top rated bonds.

Banks has to maintain their capital levels based on the quality of the loans/bonds/assets they held. With top-rated bonds, the banks had to retain very little capital. By holding AAA ratted bonds, the banks could retain less capital and put more to work.

The rating agencies were telling them that these mortgage-backed securities were top rated. (They were wrong.)

The vast majority of the book is spent sticking pins in Fannie Mae, their lobbying efforts, and their executives. I agree that Fannie Mae abused its position. I agree that Fannie Mae helped create an attitude that everyone should be a homeowner and everyone should be able to afford to buy a home. But their story comes to crashing halt in 2004 when Fannie Mae gets caught in large scale accounting fraud. Most of the manipulation can be tied directly to triggers for executive compensation.

In 2005 the first signs of bad mortgages were popping up and the buyers for the lower rated pieces of mortgage debt were not buying them. Without those buyers, the mortgage securitization would fail. Fannie Mae was leading the charge up until that point. But it didn’t stop there. That’s why have a problem pointing the finger at Fannie Mae. The mortgage/housing boom kept going.

The authors pull some of the dubious lenders into the book. Countrywide, Novastar, and Fremont all get ripped apart.

It’s not until the last chapter that they hit upon the issue that hyper-inflated the real estate bubble. The buyers for the lowest rated pieces of mortgage-backed securities were not buying as much. In part, this was because the increased quantity of junk they saw ending up in the pools. In part, it may be because they saw the bubble. Then the magic happened.

Wall Street firms packaged the lower rated pieces into new pools and sold those securities. These were the toxic assets. Somehow they convinced the rating agencies that some tranches of this pile of junk could still get the top ratings. Those high rated tranches were sold off to the institutional investors and the real nasty stuff was sold off to more speculative investors. This kept the mortgage securitization pipeline going for two more years.

Why keep going when you could see the bubble? It was their job. There were thousands of jobs tied to originating the mortgages, the warehouse lines that funded them, the organization of the pools and the selling of the final securities. It was not their job to assess the bubble and just stop working. There was no brakeman in the system. The regulators do not have the oversight, the power, or the willingness to stop an asset bubble. (Let’s see what happens with the price of gold.)

The brakes were slammed on when the Wall Street firms realized they were holding on to the lowest rated tranches of the securitizations and they couldn’t get rid of them. They stopped the production. They stopped it fast. In early 2007 warehouse lines were cut off and underwriting standards were suddenly raised to higher (more sensible?) levels.

With the pipeline cutoff, the hyper-inflated housing bubble reached the bursting point. Then mortgage-backed securities investors stopped getting their checks. They realized that their coupon-paying beauty queen was just a pig with lipstick.

I think All the Devils Are Here did a better job of putting all the pieces together and The Big Short did a better job explaining the mechanisms of the mortgage-backed securities industry. If you don’t like Fannie Mae or want to read a story of how corporate greed exploited American politics then Reckless Endangerment should be on your reading list.