David Einhorn's Remarks

Heilbrunn Center for Graham & Dodd Investing
17th Annual Graham & Dodd Breakfast
David Einhorn’s Prepared Remarks
October 19, 2007

Very good long article about the whole sub prime, credit, structured products, rating agencies, banking crisis.

The crisis came because there have been a lot of bad practices and a lot of bad ideas. Securitization is a mediocre idea. Re-securitization of already securitized assets into a CDO is a bad idea. Re-securitization of CDOs into CDO-squared is a really bad idea. So is funding a pool of long-term illiquid assets with very short-term funding in the so called asset backed commercial paper market. And as I will get to in a moment, it is a horrendous idea to delegate most of the responsibility for assessing credit risk to a group of credit rating agencies paid for by the issuers rather than the buyers of bonds.
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Last Saturday’s Wall Street Journal reported that the big fear that the US Treasury Department is working to avoid is, “the danger that dozens of huge bank-affiliated funds will be forced to unload billions of dollars in mortgage-backed securities and other assets, driving down their prices in a fire sale. That could force big write-offs by banks, brokerages and hedge funds that own similar investments and would have to mark them down to the new, lower market prices.” So the fear is that the new prices are actually disclosed. This is the “don’t ask-don’t tell” method of security valuation.

In my view, the credit issues aren’t just about subprime. Subprime is what the media says. Subprime is what parts of our financial establishment say. Subprime is about them — those people and the people who made foolish loans to them. The word “Subprime” is pejorative. Subprime is not about us, for we are not subprime. How convenient to be able to pass the blame.

There has been much talk from politicians and pundits about predatory lending –that is making loans at high rates to people who couldn’t reasonably be expected to pay them back. They are right, that is a bad practice, but that is not what’s shaking the markets. At issue today is that lenders of all sorts have lent too much money and did not demand enough interest to compensate them for the risks they took. There has been a colossal undercharging for credit across the board.
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The latest hedge fund getting bad press is Ellington management, a large participant in the mortgage business. A couple of weeks ago, it suspended redemptions from its funds because it could not determine the value of its assets. Apparently they own what I’d call 20/90 bonds. 20-bid and 90-offered. While Ellington made negative headlines for doing the right thing, acknowledging it is unfair to let people in or out in such circumstance, does anyone believe that the large mortgage players like Bear Stearns and Lehman Brothers don’t also have large portfolios of 20/90 bonds? When they reported their quarterly results, investors marveled at their risk controls. However, Lehman moved about $9 billion of mortgage securities into a special classification called Level 3 under FASB 157, which gives them more valuation discretion. Both Lehman and Bear claimed their Level 3 portfolios actually had gains in the quarter, so it looks like they put the 20/90 bonds closer to 90 or perhaps even 95. This appears to be a classic example of a hedge fund being vilified for doing the right thing, while others are cheered for doing the opposite.
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In early September, a senior Moody’s executive confirmed this suspicion at a small private dinner sponsored by one of the brokerage firms. He said, “Moody’s would never lower the credit ratings of a financial guarantor, because that would put the guarantors out of business.”

It is plain that the States and Cities and Towns in this country are triple A credits without triple A ratings and the financial guarantee companies have triple A ratings without being triple A credits.