The New Robber Barons Page 16

  They seemed to be promulgating what Elizabeth Warren calls the "myth of the immoral debtor." Yet being in debt or even going bankrupt is not a crime in the United States. Loan originators' submission of fraudulent documents is a crime. Securities fraud is a crime. Foreclosure fraud is a crime.

  Afterwards, several people came to me and to the other questioners. Much of the audience complained to CCGA's conference organizers. All were disappointed in Professor Shiller. A male CPA in the audience later contacted me via my website and wrote that he was glad I had put the question to Shiller: "though I have a great deal of respect for him, I was disappointed in his 'response' (if you could call it that)."

  One woman who earned a Ph.D. in history found Shiller's response to me "incoherent:"

  I was with my husband, brother, and his wife. I chatted with the stranger next to me and at least two people escaping at the same time [leaving after the speech]. No one could believe what a huge "fail" the evening had been...the failure of our political and expert classes to address the core issues...have alienated even those working in the financial industry--right up into the rung below the top of the food chain...this feels like the Ancien Régime's last days.

  Class Warfare

  Alumni of the Federal Reserve, corrupt politicians, and willfully blind academics would be correct to say that evening was a case of "class warfare." Well-heeled U.S. patriots declared war on the lack of class demonstrated by their financial peers.

  CHAPTER 7

  POLITICIANS INACTION

  President Obama's Right to Free Speech

  May 10, 2009

  President Obama enjoys the same rights as the average citizen, even when he engages in political grandstanding and advocates substantively bad economic policies.

  Clifford Asness, Principal of AQR Capital Management, seems to disagree. He calls the president’s recent remarks about hedge funds “libelous,” but he may have meant to write slanderous. (Hedge Fund Manager Strikes Back at Obama, NYTimes Dealbook, May 5, 2009.)

  President Obama called hedge fund managers “speculators” who were “refusing to sacrifice like everyone else” and who wanted “to hold out for the prospect of an unjustified taxpayer-funded bailout” of Chrysler.

  Hedge fund managers are outraged, and Asness calls himself “unafraid” and paints himself a hero for speaking out against a popular President. He thinks hedge fund managers are caving out of fear.

  I agree with Mr. Asness that neither the United Auto Workers nor its pension fund should receive special treatment. Hedge fund managers are obliged not to “sacrifice” their clients’ money or agree to payouts that would have been out of order under bankruptcy.

  In Mr. Asness’s parlance it is “stealing” to “sacrifice” clients’ money. Mr. Asness says it is the job of hedge fund managers to maximize the outcome for its investors, but in this unregulated industry, many high profile hedge fund managers helped themselves to investors’ funds or made material misrepresentations to investors.

  I don’t recall Mr. Asness’s letter expressing outrage about outright theft by hedge fund managers. Then there is the more benign but galling hubris of “quant funds” that touted how their models enabled them to outperform the market—until they wildly underperformed the market during the current debacle. It probably felt like a “sacrifice” to their investors. Mr. Asness is not defending Eagle Scouts, albeit there are many hedge fund managers of high integrity, even when their returns are not high.

  Mr. Asness writes that “the President screaming that the hedge funds are looking for an unjustified taxpayer-funded bailout is the big lie writ large." He adds it is “because hedge funds have not taken government funds that they could stand up to this bullying.” Yet indirectly at least, some hedge funds have been beneficiaries of the taxpayer funded bailout, and some were direct contributors to the need for bailouts. Hedge funds may not have had a starring role in the financial meltdown, but they were supporting actors.

  Where was Mr. Asness’s outrage about the role of certain hedge funds in value destroying securitizations that fueled the financial meltdown? In my opinion, several hedge funds deserve scrutiny by the Department of Justice for their role in disastrous CDOs. If the worst hedge funds get is a misdirected scolding, then some of them are getting off too lightly.

  Taxpayers are on the hook both directly and indirectly. When the creditors of Bear Stearns Asset Management’s (BSAM) hedge funds demanded that Bear Stearns step in, it did. BSAM’s other hedge funds may have had their credit lines yanked if Bear Stearns had not bailed out the creditors of two of its problem funds. Those money-losing hedge fund assets ended up on the balance sheet of Bear Stearns. Now JPMorgan Chase is holding the bag. I’ll bet some of those assets or like-kind assets ended up in the $30 billion Maiden Lane vehicle that has already been written down by $4.4 billion.

  Citigroup took $9 billion of assets on balance sheet from Old Lane Partners, the hedge fund Vikram Pandit ran before he became CEO of Citigroup. Merrill Lynch, prior to its merger with Bank of America, supplied hedge funds with non-recourse financing, and those financed assets may boomerang back on its balance sheet. The U.S. taxpayer bailed out AIG’s credit default swap counterparty/creditors that included some hedge funds. Taxpayers handed over TARP money partly to fund these debacles. Many prime brokers are able to continue funding hedge funds only because the government (the taxpayer) is providing them with unprecedented funding. Saying that hedge funds have been truly off balance sheet is—to use Asness’s words—“the big lie writ large.”

  Mr. Asness ends with this taunt: “I am ready for my ‘personalized’ tax rate now.” Would that be the ‘personalized’ tax rate currently paid by most of his fellow citizens on their income? Mr. Asness should not be suggesting that other citizens—even when that citizen is the President—should have fewer citizenship rights than he, especially since he (along with other hedge fund managers) enjoys tax breaks on his hedge fund management fees unavailable to the average wage earner. Perhaps Mr. Asness is afraid hedge fund managers are caving from fear that their privileged tax breaks will be revoked.

  President Obama’s apparent financial naiveté—or perhaps a willingness to destroy capitalism by changing the rules—is indeed annoying. It is especially annoying to me if it was partly inspired by the actions of some hedge funds. But Mr. Asness is correct when he says: “I’m entitled to my voice and to speak it loudly...in this great country.” That is why I take issue when Mr. Asness seems to characterize a public Presidential scolding as illegal.

  In this great country, POTUS is equally free to vent his frustration as Mr. Asness. Nothing about President Obama’s remarks seemed slanderous; it is called free speech. POTUS has a right to spout bad financial policies in public. I disagree with POTUS that bond investors should take a back seat to union interests. But I also disagree that hedge fund managers should have the same easy access to leverage and tax breaks that they enjoyed in the past, since both investors and taxpayers have ultimately paid for the mistakes of hedge fund managers.

  Washington’s Bipartisan Betrayal: The 2015 Global Financial Crisis

  December 31, 2009

  The time has come for new year's resolutions. The House passed the Wall Street Reform and Consumer Protection Act of 2009 (H.R. 4173) on December 11, 2009. It gives $4 trillion in "emergency funding" to our largest banks during the next financial crisis. Instead of reform, Congress offers even bigger bailouts. Unless we change direction, we will have another crisis by 2015. Congress has made all the wrong moves to guarantee it.

  The economy did not just have a heart attack; we are suffering from financial appendicitis. Instead of doing the necessary surgery, Congress is prescribing potent addictive painkillers.

  How did we get here? Housing is the largest component of our economy. Cheap money from the Federal Reserve, crippling of states’ rights to reign in mortgage lenders, and failure to enforce securities laws allowed the largest Ponzi scheme in the history of the capital markets
to flourish.

  Wall Street's shadow banking system gave mortgage lenders large credit lines (similar to credit card debt) and packaged the loans into private-label residential mortgage backed securitizations. Most of each deal was rated "AAA," since subordinated investors absorbed the risk of a pre-agreed amount of loan losses. But hundreds of billions of dollars in private-label deals 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 related credit 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 (perhaps your pension fund) in doomed securities. New money allowed Wall Street to temporarily hide losses and pay enormous bonuses. This is a classic Ponzi scheme.

  When you leverage fraud riddled fixed income securities priced at 100 cents on the dollar, there is nowhere to go but down in a hurry. Confusion after the fraud fell apart led to a vicious cycle of selling as investors and lenders shunned both good and bad assets. The deflating debt bubble was followed by a classic liquidity crunch resulting in a global crisis.

  Wall Street protests that it sold toxic assets to sophisticated investors obliged to perform independent investigations of the risk. That argument no longer applies. U.S. taxpayers became unwilling unsophisticated investors funding Wall Street's bailout.

  Other parties--mortgage bankers, credit rating agencies, hedge funds, credit rating agency, insurers, mortgage brokers, regulators, Congress, and the Federal Reserve Bank--were supporting actors. If Wall Street's financial meth labs had been shut down earlier, the money machine would have stopped running.

  Recent arguments blame Fannie Mae and Freddie Mac, the indirect mortgage lending giants. This is misguided. The largest slug of new risky products and bad loans were created to fuel Wall Street's private-label securitizations. Fannie and Freddie were more at the effect than the cause (not blameless, but not the largest cause of the housing bubble). Now that shadow banking is dead, they are being stuffed with even more bad product to pick up the slack.

  Fannie Mae and Freddie Mac are the new motor for no-money-down mortgage loans and a host of new problems. The fraudsters involved with our last crisis went unpunished, and they will help create our next crisis. This brewing fraud fest will result in greater misery and systemic risk. Instead of reform, Congress responded on Christmas Eve by agreeing to cover unlimited loan losses.

  Bank depositors' money is guaranteed, if deposits are below the current FDIC deposit insurance limits. Banks did not need to be bailed out to protect depositors. We bailed out banks' other creditors with public money. We are printing so much money that now depositors should worry about inflation.

  Inflation is the great destroyer. Inflation will wipe out investment gains (and more) much more quickly than taxes. If you earn, say, 5% on your deposits, 5% inflation will wipe out your gains, (and you aren't earning 5% on your deposits or treasury notes in the first place). That is worse than any current or proposed tax rate, since that would translate to a 100% tax rate.

  Wall Street, Fannie Mae, and Freddie Mac supply a swinging door of jobs and paid projects for its financial regulators, Congressmen, appointed administration officials, and investigation committee staffers. Many members of Congress and our Presidents have received massive campaign contributions funded by Wall Street. This dependence is known as "capture," and the result is that instead of reigning in Wall Street, dependent thinking enables mayhem.

  We have an alternative to bailouts, one that does not violate the spirit of democracy. 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 return of Glass-Steagall, indict fraudsters, snuff out systemic fraud, and allow honest bankers to prosper.

  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.

  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 political will to implement them.

  * 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. Wall Street also engaged in suspect securitizations of some credit card receivables, auto loans, bank trust preferred securities, commercial real estate loans, and a variety of corporate loans.

  **When asked whether or not certain individuals had done anything illegal, I responded that I did "not think anyone did anything illegal, because Congress did not pass laws to make it so," because I did not want to scapegoat individuals. I should have said: "That is up to the Department of Justice to determine."

  CHAPTER 8

  RATING AGENCIES

  Revoke Rating Agencies’ NRSRO Designation for Structured Products

  September 17, 2009

  The IMF invited me to present my views on the global financial crisis as detailed in my book, Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street on Monday, September 21. Among other recommendations, I will suggest Congress approve more funding for investigations that should lead to felony indictments of financial professionals involved in the largest Ponzi scheme in the history of the capital markets. Predatory securitizations of fraudulent loans, the credit derivatives that referenced them, and fraudulent accounting enabled former investment banks and some legacy banks to raise money from new investors to pay back old investors (themselves and mortgage lenders) in what was known to be an unsustainable and fraud riddled business model.

  The rating agencies have been in the news as they fend off lawsuits for their ratings of ABS CDOs (collateralized debt obligations backed by asset backed securities). The rating agencies claim their ratings are protected by free speech, and they may or may not be successful in defending themselves in court. In my book, Structured Finance , I explain the rating agencies’ history of failure (in my opinion) to competently rate hundreds of billions of dollars’ worth of these and other structured products. The relevant rating agencies involved in these ratings are the top three: Moody’s Corporation; Standard & Poor’s (S&P), part of McGraw-Hill Cos., Inc.; and Fitch, owned by France-based Fimalac SA.

  The rating agencies are quick to point out that they do not perform due diligence on the data they use and take no responsibility for unearthing fraud; they merely issue “opinions.” But rating agencies can demand to see evidence of appropriate due diligence from the underwriters, who are obliged to perform it. Instead, rating agencies failed to adhere to basic statistical principles.

  Meanwhile, the SEC seeks comments about the steps it should take to regulate the rating agencies. In my letter to the SEC dated February 13, 2007, I called for the SEC to revoke the rating agencies’ registration as Nationally Recognized Statistical Rating Organizations (NRSRO) for structured products. The SEC failed to act in 2007, but it can correct that error and do it now.

  In addition to criticizing rating agencies for their ratings of CDOs, I mentioned another class of structured products, CPDOs that were rated “AAA” at the time I wrote the letter. I asserted CPDOs had substantial principal risk. That meant these “AAA” rated products deserved a junk rating. By January 2008, within a year of my warning, Moody’s noted that two of the originally AAA-rated CPDO’s would unwind causing substantial principal loss to investors. In fact
Moody’s, the rating agency that bases its “AAA” rating on expected loss, belatedly projected investors would have a 90 percent loss. Although I had flagged the looming danger to investors’ principal, the SEC did nothing.

  Ackman Versus Wall Street’s Ponzi Scheme

  May 4, 2010

  When nobody seems to be losing money, nobody cares. If a corrupt scheme is "making money," everyone involved--from the culprits to the dupes--viciously attacks anyone who tries to expose it. Bill Ackman, manager of hedge fund Pershing Square Capital Management, L.P., learned this lesson the hard way.

  "Friends in High Places"

  In 2002, Ackman used credit derivatives (and shorted stock) to place a "short" bet against MBIA, the largest of the municipal bond insurers. (Ackman later bet against other bond insurers.) Joseph "Jay" Brown, then MBIA's Chairman and CEO, met with Ackman in 2002 about a negative report Ackman was about to release. In Christine Richard's new book, Confidence Game, Ackman recalls this power-play: