The New Robber Barons Read online

  The Silver Arbitrageurs

  In the 1960s Alan Rosenberg, a coin dealer, sold dollar bills that were silver certificates to a firm called Metals Quality. At the time, the Federal Reserve converted dollar silver certificates to a set amount of silver. Before the Fed finally discontinued the conversion, the converted silver was worth more than a dollar. The difference became great enough that it paid to buy up the certificates for slightly more than a dollar, convert the certificates to silver, and sell the silver for a profit. This is one of the rare instances of a true arbitrage.

  Not everyone wanted to go through the trouble of handling the conversion, so people like Rosenberg collected certificates and sold them for more than one dollar each, but for less than the price of the silver represented by the certificate. It was worth it to Rosenberg to have someone else do the work of squeezing out the last bit of value.

  That's where Metals Quality came in. It bought certificates from coin dealers and currency exchanges and handled the conversion to silver and sold the silver for a profit. Metals Quality paid Rosenberg for his silver certificates based on the first Comex price of silver for the day (less something for the trouble of the conversion and some profit). It made no difference whether the first price of the day was based on one contract or 100 contracts. Each contract represents 10,000 ounces of silver.

  The Silver Foxes

  Rosenberg figured out a way to make some extra money when he sold his certificates. He instructed his broker to go into the commodities trading pit first thing in the morning and bid up the price of the first silver contract each day.

  Rosenberg overpaid and lost money on the contract's 10,000 ounces when he sold the contract later in the day. By then, the price fell back to the actual market manipulation-free price. But as a result of his price manipulation, Rosenberg sold say 100,000 ounces to Metals Quality for an extra 3 or 4 cents per ounce. His profits from the price manipulation on 100,000 far exceeded the loss and trouble on the 10,000 ounces for which he artificially overpaid.

  Eager to make an even bigger profit margin, Rosenberg called Henry Jarecki, then owner of Federal Coin & Currency. Like Rosenberg, Jarecki collected bulk quantities of silver certificates for sale to Metals Quality. Rosenberg hoped that Jarecki would help him manipulate the first Comex price, the first silver trade on Comex in the spot month. Rosenberg figured Jarecki would help him pump up the price that Metals Quality would pay, and they could split the loss on the 10,000 ounces that had to be sold later at a lower price. Of course, that loss would be absorbed by the profits they made by getting Metals Quality to pay an above market price, and Rosenberg's loss would be only half his previous loss. His net profit would increase by the amount he reduced his initial loss.

  The only flaw in Rosenberg's loss-sharing idea is that he didn't know that when he spoke to Henry Jarecki, he was speaking both to Federal Coin & Currency and to Metals Quality.

  Silver Price War

  Rosenberg was costing Jarecki money, because Jarecki sold his silver on the usually lower London fixing price the previous night and was buying the certificates from coin dealers like Rosenberg at the higher manipulated first Comex price.

  Without explaining anything to Rosenberg, Jarecki sent a broker into the trading pits to do the opposite of Rosenberg's broker. Jarecki's broker sold the first contract very low, so he bought coin dealers' silver certificates cheaper than where he had sold silver on the London fixing price the night before.

  After waging this price war for a while, the two brokers struck a bargain. On one day Rosenberg's broker would buy the silver high, and the next day Jarecki's broker would sell silver very low. After a week or so, they decided it was counterproductive and they gave it up.

  Jarecki was lucky, because the costly silver price manipulation came to his attention through a serendipitous tip-off from the manipulator. When people slugged it out in the commodities pits, they often made their own justice. By the time regulators caught up with a price manipulator (if ever), it was too late to protect an aggrieved party.

  Moreover, it isn't easy to prove someone is manipulating prices by taking a small loss for a potentially much bigger gain. Many feel this is just being sharp.

  Absent Regulation

  Anomalous price moves are a red flag, and it seems regulators aren't even looking at them. If regulators ever did decide to launch a genuine investigation, the place to start is with those who gained the most in the short run--or those who avoided the most short run loss--from the price moves.

  The idea that the Commodity Futures Trading Commission (CFTC) can regulate credit derivatives when they aren't up to the task of regulating commodities is among the more ludicrous results of our financial crisis "regulation." The MF Global debacle and the price action in precious metals -- especially around options expiration dates -- show how lost our regulators are and how mistaken their overseers in Washington remain.

  CHAPTER 5

  Criminal Behavior: Beyond Justice

  Madoff Deserves Lots of Company

  December 13, 2008

  If justice is to be served, Madoff deserves many things, including many new acquaintances.

  A Giant Ponzi Scheme

  Bernard Madoff confessed—not the securitization “professionals” who work or worked for famous investment banks, certain CDO managers and certain hedge funds. On the plus side, U.S. taxpayers are not bailing out Madoff. News reports indicate he doesn't owe a certain famous large investment bank any money.

  The Wall Street Journal missed a golden opportunity (“Top Broker Accused of $50 Billion Fraud,” December 12, 2008). It wrote that if Madoff’s alleged losses exceeded $50 billion, it would “dwarf past Ponzi schemes.” Yet, Madoff is a piker.

  The largest Ponzi scheme in the history of the capital markets is the relationship between failed mortgage lenders and investment banks that securitized the risky overpriced loans and sold these packages to other investors—a Ponzi scheme by every definition applied to Madoff. These and other related deeds led to the largest global credit meltdown in the history of the world.

  Investment banks raised money from new investors to pay back old investors (mortgage lenders' dividends to shareholders and creditors of mortgage lenders which often included themselves).

  When mortgage lenders imploded, investment banks sped up opaque securitizations to offload worthless tranches of CDOs mixed in with others to careless so-called sophisticated investors along with naive investors. Raising money from new investors to pay back old investors, even if you are the old investor covering up losses is a Ponzi scheme. [Added May 8, 2009.]

  SEC Strategy

  The SEC’s enforcement strategy seems to be 1) ignore the charity of strangers such as Harry Markopolos: “Madoff Securities is the world’s largest Ponzi Scheme.” (“Fees, Even Returns and Auditor All Raised Flags,” Wall Street Journal, December 13, 2008), 2) “investigate” and drop the matter, and then 3) wait for the Perp to crack under the strain of being ignored and confess.

  The SEC employed a similar strategy with respect to the investment banking securitization activities it “regulated’ over the past several years. Congress and others agree claiming there will be time to find out who is responsible later. Bail now, scapegoat later.

  Complicated and Cryptic

  Madoff claimed his business was too complicated for outsiders to understand. He was “cryptic” about the firm’s business. He ran a secretive business, and kept his financial statements under lock and key. Just who does Madoff think he is—the Treasury Secretary or the Chairman of Federal Reserve? ("Fed Refuses to Disclose Recipients of $2 Trillion,” Bloomberg News, December 12, 2008).

  Investment banks and other “bailees” have hundreds of billions of dollars’ worth of assets in opaque accounting buckets known as Level 2 and Level 3. Good luck trying to find details.

  Bonuses

  Madoff wanted to pay his employees bonuses, earlier than usual, right after owning up to his problems.

  Trou
bled investment banks that engaged in troubling activity want to pay employees bonuses, too. They have owned up to nothing, and it looks as if they will get away with it.

  Premise of Fortune Cover Story is Incorrect

  January 11, 2009

  The premise of this week’s Fortune cover story, “Sending Wall Street to Jail,” (January 19, 2009) is not only incorrect, it lacks Common Sense. The article seems unable to muster outrage. In the words of Thomas Paine: “a long habit of not thinking a thing WRONG, gives it a superficial appearance of being RIGHT.” Fortune talks about the difficulty of proving criminal intent when the SEC, Fed chairman and others thought (or more to the point, studiously avoided rational thought) things had gotten as bad as they could get. Since when are the popular delusions of those outside one’s firm a defense for willfully failing to mark your positions to market and material accounting weaknesses, if not misstatements?

  Fortune also gives the benefit of the doubt to senior managers who were way off the mark in their earnings releases and says “we’re not talking here about …Ponzi schemes.” In a few cases, the latter is actually true, but in others, we should be talking about Ponzi schemes and asking why the SEC did not shut down the securitization groups at some of the major investment banks doing business in the United States.

  Investment Fund Managers: Nine Warning Signs

  February 9, 2009

  Lately, we’ve heard a lot about hedge funds and other types of investment funds that have both unlucky and dishonest. The overwhelming majority of these managers are men, because the world of finance is dominated by men. A woman can feel at a disadvantage, but when dealing with the wrong crowd, even savvy male money managers sometimes feel at a disadvantage. How can you tell if you should be worried?

  These nine warning signs alarm the savviest money managers in the world:

  • A cult figure. If the manager is a cult figure and has no independent third party that verifies his returns, you are probably already in trouble. Do-it-yourself reporting doesn’t cut it when it comes to your money.

  • The fund has a “gate,” meaning it can hang onto your money. The fund manager may have a period of time where he can prevent you from withdrawing your money, or can impose a penalty for early withdrawal. Sometimes the fund manager can change the rules later to prevent you from withdrawing your money. Sometimes there is a legitimate reason for this, such as in a real estate partnership, but hedge funds that invest chiefly in stocks shouldn’t tie up your money.

  • Small-time banks and accountants. Investment funds should be separate from a fund manager’s other accounts and placed in a custodial account with a well-known bank. The fudn manager should also have a credible auditor.

  • Poor transparency. You can’t get documents that tell you what the investment manager is investing in and the manager can change his strategy at will. Even a current list of investments won’t tell you what the manager is doing ten minutes from now.

  • The manager has absolute power over his investments and his staff, so there are effectively no risk controls beyond the manager’s whims. Your manager should be able to explain in simple terms how risk is controlled.

  • Lots of leverage. If you bought an uninsured car and put 20% down, you wouldn’t drag race on New Year’s Eve.

  • A single strategy. If one strategy dominates the fund performance, it’s a red flag. One investment strategy does not fit all markets.

  • Unlimited expenses. Most funds have a cap on expenses plus management performance fees. Ask your manager where you can find the fees in the documents, and ask for a thorough explanation. Then ask someone else and try to match the responses.

  • Deflects questions. Any question is a reasonable question when you are giving your money to someone else to manage. If your manager seems condescending or answers your questions with jargon, you are being mistreated. It’s a red flag if your manager shows irritation, impatience, or refuses to give reasonable clarification when asked. But beware of the charming manager who only seems to answer your questions, but whose answers and explanations are not satisfactory. Con artists are always pleasant while you’re being hustled.

  Wall Street’s Fraud and Solutions for Systemic Peril

  September 29, 2009

  Last week I gave a presentation to members of the International Monetary Fund (IMF) explaining the corrosive atmosphere that allowed the largest Ponzi scheme in the history of the capital markets to flourish. The following is a brief summary.

  Wall Street gave mortgage lenders large credit lines (similar to credit card debt) and packaged the loans into private-label residential mortgage backed securities (RMBS). Most of the RMBS was rated “AAA,” since subordinated investors absorbed the risk of a pre-agreed amount of loan losses. But many RMBSs were backed by portfolios comprising risky fraud-riddled loans.

  Most of the “AAA” investment was imperiled, and subordinated “investment grade” components were worthless. Wall Street disguised these toxic “investments” with new value-destroying securitizations and derivatives.

  Meanwhile, collapsing mortgage lenders paid high dividends to shareholders (old investors) and interest on credit lines to Wall Street (old investors) with money raised from new investors in doomed securities. New money allowed Wall Street to temporarily hide losses and pay enormous bonuses. This is a classic Ponzi scheme.

  Securities laws chiefly apply to financiers (the underwriters and traders) that create, sell, and trade securities. Underwriters are responsible for appropriate due diligence, an investigation into the risks.2 If you know or should know that investments are overrated and overpriced when they are sold, those facts must be specifically disclosed. If you fail to disclose material information, expect to be investigated for fraud. If you have a mortgage subsidiary, expect it to be investigated, too.

  Wall Street protests that it sold toxic assets to sophisticated investors obliged to perform independent due diligence, so those investors may have trouble claiming damages. But the ballgame has changed. Massive fraud damaged the U.S. economy. (Housing prices didn’t just fall; they plummeted as the fraud unraveled.) U.S. taxpayers became unwilling unsophisticated investors funding Wall Street’s bailout.

  The Fed uses tax dollars to keep some of our largest banks—weakened by reverse-Glass-Steagall mergers with troubled entities—from collapsing under heavy loan losses.

  Wall Street’s huge bonus payments were based on suspect accounting. Failure should not result in fortune. Yet, Wall Street once again proposes to pay out exorbitant bonuses.

  Many banks’ current illusion of profitability is only made possible by taxpayers' enormous subsidies including low cost borrowing, higher interest payments on bank capital deposits, a credit line for the FDIC (to be repaid with banks' subsidized profits), and continued government debt guarantees on bank debt. A large share of certain banks’ subsidized profits is due as reparation to unsophisticated investors, the U.S. taxpayers.

  Delusional Complacency

  When you leverage fraud riddled fixed income securities, there is nowhere to go but down in a hurry. Confusion after the fraud falls apart leads to a vicious cycle of selling, as investors and lenders shun both good and bad assets. The deflating debt bubble is followed by a classic liquidity crunch.

  By the end of 2006, public reports of implosions of large mortgage lenders eliminated CEOs’ plausible deniability. By January 2007, many (including me) publicly challenged the failure to account for losses. Instead, toxic securitization accelerated in the first half of 2007—classic malfeasance as a Ponzi scheme collapses.

  In August 2007, I projected hundreds of billions in principal losses for mortgage loans alone—not counting other troubled asset classes, derivative duplication, and leverage. Fed Chairman Ben Bernanke contemporaneously said mortgage loan losses would be $50-100 billion.

  At a lunch following my presentation, a senior officer claimed the IMF had estimated global losses of $1 trillion in its April 2007 Global Financial Stabi
lity Report. I averred the IMF’s Report followed a growing wave of billions in write-downs; by then Bloomberg News had reported potential global losses in the high hundreds of billions of dollars (Feb 2008). (Everyone’s estimates were too low.) Not so, other senior IMF officers said; they were “early” and had great political “courage.” But their heads were up their own hindsight bias. The IMF's estimate was in the April 2008 Report, after Bear Stearns’ March 2008 implosion.3 Blind to fraud, the IMF missed the message.4

  The IMF is not a financial regulator. Actual regulators did worse. The SEC dropped seminal investigations and failed to investigate ongoing securities fraud. In the spring of 2007, the Fed and the U.K.’s FSA reported that the degree of leverage in the global financial system was less than at the time of Long Term Capital Management, but in reality it was much greater. They are now repeating their mistakes. Winston Churchill said we must alert somnolent authority to novel dangers; but our regulators are complacent, and the dangers are not novel.