The New Robber Barons Page 13
Existing Solutions to Halt Growing Systemic Risk
An IMF official asserted: “You can’t prove fraud” and insisted it was in the interest of risk managers not to let their institutions collapse. (He was unable to attend my exposition based on Chs. 5-12 of Dear Mr. Buffett). This IMF officer isn’t just soft on crime; he’s in denial. Failure to recognize fraud led to statements like the one that opened Chapter 2 of the IMF’s April 2006 Global Financial Stability Report:
There is growing recognition that the dispersion of credit risk by banks to a broader and more diverse group of investors, rather than warehousing such risk on their balance sheets, has helped to make the banking and overall financial system more resilient.
The IMF’s source was a 2006 speech made by Treasury Secretary Timothy Geithner, then president and CEO of the New York Fed. The IMF gets the lion’s share of its funding from the United States and the United Kingdom, its stakeholders. Geithner’s views have more influence than those of former Fed Chairman Paul Volcker, who calls for a return of Glass-Steagall, a separation of traditional commercial banking from high-risk activities.
Wall Street supplies a swinging door of jobs for its financial regulators, and—in the case of many members of Congress and our Presidents—campaign contributions. This dependence is known as “capture,” and the result is that instead of reigning in Wall Street, dependent thinking enables mayhem.
In the recent Ponzi scheme only the agents—mortgage lenders, rating agencies, fund managers, securitization professionals, CFOs, CEOs, and other fee or bonus beneficiaries—prospered. Controls and risk management were undermined. The financial institutions and their shareholders, for which these agents are failed stewards, collapsed. Investors in toxic securitizations lost money. Had regulators done their jobs, they would have shut down Wall Street’s financial meth labs, and the Ponzi scheme would have quickly choked to death from lack of monetary oxygen.
After the Savings and Loan crisis of the late 1980’s, there were more than 1,000 felony indictments of senior officers. Recent fraud is much more widespread and costly. The consequences are much greater. Congress needs to fund investigations. Regulators need to get tough on crime.
Troubled financial entities should be put into receivership and restructured. Old shareholders will be wiped out. Debt-holders will take a haircut (discount) along with a debt for new equity swap to recapitalize the entity. But the job won’t be complete until we separate high risk activities from traditional banking in a return to a Glass-Steagall like structure with regulators that indict fraudsters, snuff out systemic fraud, and allow honest bankers to prosper.
The fact that many U.S. banks stuck to traditional banking and protected shareholders during this crisis is under-publicized, but their prudence worked.
We have the solutions. We need the will to implement them.
1 Collateralized Debt Obligations (CDOs and CDO-squared), Structured Investment Vehicles (SIVs), Real Estate Mortgage Investment Conduits (REMICs and Re-REMICs), Asset Backed Commercial Paper (ABCP), and related credit derivatives.
2 Rating agencies do not buy and sell securities, but they should have their special NRSRO designations immediately revoked as a start. One former rating agency official even suggests liquidation.
3 I later sent the IMF official a link to the April 2007 Report, and he admitted he misspoke.
4 In April 2005, I gave a presentation to the IMF including a discussion of flawed ratings of “super-senior” and “AAA-rated” structured products. Thereafter, loan fraud accelerated and securitization standards deteriorated, yet the IMF’s April 2006 report stated: “As a practical matter, the investors who may be least likely to appreciate such nuances (e.g., smaller regional banks and retail investors) typically only purchase the most senior (least risky) credit products.” In reality, many “super-senior” tranches and the “AAA” tranches subordinate to them had substantial principal risk.
Banging the U.S. Stock Market
May 10, 2010
Chicago residents grew up to the sound of local early morning radio rundowns of pork belly futures and other exchange traded commodities. Every trick in the book from manipulation of soybeans to silver has played out in Chicago's trading pits. Every market professional I've talked to in Chicago since Thursday is of the same opinion. It makes no difference whether human beings or computers are front running and manipulating trades. The gyrations in the market last week have the look and feel of classic market manipulation.
If you want to manipulate a market, deregulate it as much as possible. Then make it as "dark," and fast as possible. Make it hard for outsiders to view your trades as they get done, and make it even harder for anyone to figure out why you are trading. Get as much monopoly power as possible over the market. Get funding at the cheapest possible rate. The best possible rate is the near zero cost funding available from the Federal Reserve.
Next, get your "men" stationed in the most influential positions at the exchanges. Make sure your cronies have shock and awe market dominance through, say, High Frequency Trading algorithms that now make up the majority of stock trades.
Then, make sure you have advance information of major market-moving events. A bailout announcement by the European Union would do nicely. A few days before the announcement, "bang" the market. Pound down the value so you can monetize put options and other bearish instruments. Trigger customers' stop-loss orders, and pick up bargains at their expense. Then cash-in again when the market pops up on bailout news.
To paraphrase Paul Erdman's 1975 tongue-in-cheek observation: "The lack of discretion in financial and political circles these days is appalling."
Meanwhile, take the heat off of yourself by leaking "fat finger" rumors to CNBC, since they can be relied up on to repeat as gospel any self-serving news you throw at them. Did someone type billions? It should have been millions. If we want to rescue the market from the Jaws of future disasters, we have to recognize that "this was no boating (or typing) accident." The system itself is flawed.
The NYSE was supposed to provide market liquidity. Trading safeguards are no good unless they are system-wide. The current and former heads of the NYSE, billed as the "best and the brightest," i.e., the most connected, should be asked a few questions about High Frequency Trading and "liquidity" providers. Our mega-bank trading desks that control most of the volume on the exchanges should be called in for an accounting and justification of their trading activities. Trading patterns during last week's debacle and over the last year should be examined.
Unfortunately, as others have observed before, the SEC is both largely incompetent and captured. They are learning to crawl in the space age. Moreover, the next stop for SEC officials seems to always be a highly paid influential job at a law firm, fund, or other entity that heavily relies on Wall Street for revenues. Financial reform requires radical overhaul of our "regulators."
As for Wall Street mega-bank reform, Congress seems disinclined to break up our Too-Big-To-Fail banks, define proprietary trading, or sever Goldman Sachs, Morgan Stanley, and proprietary trading at large banks from the Federal Reserve's, i.e., taxpayers' heavy subsidies.
If everyone wants to stick to the story of "woe is us, we had no idea things could go this wrong," then fine. No one is in control; no one is in charge; and no one can competently regulate our current system. This is a compelling argument for immediate radical financial reform.
Update May 11, 2010: The Wall Street Journal published an article suggesting that a trade by Universa crashed the market. Nassim Taleb, author of "The Black Swan," with a second edition just coming out today, advises the hedge fund.
The WSJ article misleads the public about an important event. This trade did not crash the market. The other side of Universa's trade would have been "delta hedged," meaning the futures contracts required to hedge the trade would have been meaningless to the market, or one could have bought offsetting puts or an options spread trade to hedge. This trade was immaterial to the events
on Thursday. The transaction is immaterial and was not responsible for the market move.
The put options would expire worthless if the S&P were just above the strike in June. According to the WSJ article, the strike appears to be 800, but the article is a bit vague. Assuming the strike is 800, the contracts would only make some money at expiration if the S&P were below that, and the contracts would only make $4 billion if the S&P went to zero. Even on a high volatility day like last Thursday, Universa could have made money on the price of the put options, but even if it cashed out at the top of the market, it would only have made around $25 million after investing $7.5 million, and again, that is if Universa were lucky enough to sell at the highest level for the options for the day.
IKB’s CEO Found Guilty of Market Manipulation—Some U.S. Bank CEO’s Should Also Face Charges
July 16, 2010
Financial news media is abuzz with analyses of Goldman Sachs's settlement with the SEC for $550 million in a case of alleged fraud regarding the packaging and selling of a CDO called Abacus. Goldman Sachs admitted to no wrongdoing. The settlement is less than Tiger Wood's potential $700 million divorce settlement -- and Tiger didn't help bring the economy to its knees (he also publicly admitted his transgressions and expressed regret) -- but it's a start.
The SEC might want to look into the deals that Goldman Sachs underwrote on which other banks bought protection from AIG as well as the deals upon which Goldman Sachs itself bought protection from AIG. If all of these banks buy the securities back at the original price of par (100 cents on the dollar less interim principal payments), the tens of billions of dollars of proceeds can be used to pay back AIG's public debt. Instead, taxpayers heavily subsidize Goldman Sachs.
IKB received $150 million of the SEC's settlement with Goldman, recovering all of the money it lost on its investment in the investigated Abacus CDO. The bigger story is that the former CEO of IKB, Stefan Ortseifen, was found guilty of market manipulation by a German court. Yesterday, the Wall Street Journal reported the story on the second page of its markets section (C section), and it deserved more prominent coverage:
At the heart of the case was a press release that IKB issued on July 20, 2007, as credit markets worsened, assuring investors that its exposure to the subprime fallout was limited and that it remained on track to meet its profit outlook.
Ortseifen was fined €100,000 (around $127,000) and given a 10-month suspended sentence. That strikes me as a pretty light sentence for fluffing the truth about the fact that at the time, IKB was actually being crushed by its losses. IKB eventually needed a bailout of more than €10 billion (around $12.7 billion) in government-backed loans. The court's fine probably didn't even make a dent in Mr. Ortseifen's wallet, but it's a start.
In this post-Sarbanes-Oxley world, U.S. CEOs and CFOs should also be held accountable for their rosy statements during this period, along with their SEC filings.
While the Goldman Sachs settlement is a victory of sorts for the SEC, it shouldn't distract us from the larger issues. Massive widespread malfeasance helped bring the global economy to its knees.
CHAPTER 6
PUNDITS AND JUNK SCIENCE
Reporting v. PR: Meredith Whitney and AIG
March 23, 2009
Much of the financial media blows in the wind of PR machines. AIG, Washington, Congress, various former investment banks, banks and others worked overtime to spin financial information over the past several years forcing competent reporters to engage in time intensive research on complex financial products. Other times, the press simply misinterprets the facts.
Last week, Charlie Rose billed Meredith Whitney on his show as the woman who gave early warning about AIG. I found that surprising given that as far as I know, she did not. The L.A. Times’ review of House of Cards, a book about Bear Stearns, says author William Cohen gave Whitney credit for warning for some years that trading in credit derivatives and mortgage backed securities set us up for a credit implosion. This is not her expertise, but it is mine, and to the best of my knowledge she did not. Ironically, Whitney rated Bear Stearns perform and only downgraded it to underperform on March 14, 2008 as it tumbled 53% in one day. Whitney rated Lehmanoutperform in March 2008, while beleaguered Bear Stearns merged with JPMorgan Chase. She downgraded Lehman to perform towards the end of March 2008, and Lehman went under the following September.
Few specifically and publicly warned of the global financial meltdown in advance—when something could have been done about it—as far as I know, Whitney was not in that number. Warren Buffett, Jeremy Grantham, Jim Rogers, and I (among others) were. My early warnings of credit derivatives, structured products, and structured vehicles are well documented in articles and books over many years (see Bibliography). In August 2007, I spoke up about AIG to Warren Buffett, Jamie Dimon, and the Wall Street Journal.
Meredith Whitney seems best known for her analysis of Citigroup at the end of October 2007. Jim Rogers appeared with Whitney earlier in the year on Cavuto on Business and stated he was short Citigroup (he shorted C in late 2006/early 2007), and he said Citigroup was going to $5. Whitney rated Citi sector perform from October 3, 2005 until October 31, 2007. The stock lost 7.9% versus a 7.5% gain for the Philadelphia Stock Exchange/KBW Bank Index during this period (David Gaffen, WSJ, Nov 1, 2007). The following summarized the timeline to the best of my knowledge:
January 3, 2007 – October 31, 2007: Citigroup stock is $55.66 on January 3, 2007. It steadily drops to $42.25 by October 31, 2007. Legendary investor Jim Rogers is short, says Citi will fall to $5 when he appears on Cavuto on Business with Meredith Whitney. She rates Citigroup sector and refutes Jim Rogers.
October 31, 2007: Jim Rogers is still short. By now prominent analysts including Richard Bove, Charles Peabody and Michael Mayo have already told clients to sell. Whitney rates Citigroup sector underperform, but says it could trade in the low 30’s. She states Citi must cut its dividend. But it’s much too late to issue a warning about structured products, since problems were by now well-known and activity had already ground to a halt. Citigroup is $42.45 on October 31, 2007 and is below $30 by December 27, 2007 and still falling.
October 31, 2007 – March 19, 2009: Citi drops steadily. It hits $5 in January 2009, and it dips to $3.61 on March 19, 2009. Whitney became more negative. Jim Rogers took his profit.
At the end of October 2007, Whitney said Citigroup needed to cut its dividend. It was a refreshing contrast to some of her competitors. She rated the dropping stock sector underperform, but said it “could trade in the low $30s.” (“Analyst Raises Doubts About Citigroup Dividend,” NYTimes November 1, 2007). To my mind, Whitney’s was not an early call; the stock had been dropping steadily throughout the year. Jim Rogers had been short the stock for almost a year. Citigroup had already reported a $6.5 billion write-down for the third quarter of 2007. Whitney was ahead of many analysts who missed Citigroup’s problems, but at least three prominent competing analysts had previously told their investors to sell.
When it comes to press coverage of our major financial institutions, the stakes are higher and the issues are not innocuous.
When I challenged AIG’s second quarter 2007 financial reporting (“In Subprime, AIG Sees Small Risk; Others See More,” David Reilly, Wall Street Journal, 13 August 2007.), it was based on my analysis of a $19.2 billion super senior credit default swap position. With respect to potential principal loss or a mark-to-market loss, AIG had problems (even if AIG positioned some of its other contracts as “insurance” it still had to post collateral).
This was after the implosion of Bear Stearns Asset Managements’ two doomed hedge funds brought about by investment banks challenging the pricing of their “highly rated” assets and making collateral calls. [I publicly opposed Bear Stearns Asset Management’s proposed Everquest IPO and cited a dodgy Citigroup CDO therein, among other issues, in May 2007. This was one of the triggers of the price inquiries. (Dear Mr. Buffett, P. 131)]
Yet AIG’s PR spin was so e
ffective, that the financial press backed off for the time being. AIG spins its PR like a top. It realizes what an effective strategy this is in deflecting financial reporters from the truth.
AIG asserted that it could not imagine any scenario under which its positions would have losses. Despite evidence to the contrary, AIG claims the unimaginative employees in its AIG Financial Products unit are the “best and brightest.” In early 2008 it entered into retention bonus contracts for these employees, yet there were many structured products professionals in New York looking for work.
How the employees of AIG Financial Products came to be so exalted above other finance professionals, and distinguished like some new species, is worth inquiring into.
Looking back on true early warnings and how they were dismissed and discredited helps us understand the issues now threatening the global economy and the failings in our system. It is important to identify who provided thoughtful analysis when it mattered most, because that can be helpful as we work on solutions.