The New Robber Barons Page 23
IX. CONCLUSION
The global market and regulatory framework has been built around credit ratings, even though savvy market professionals know better than to rely on them. Banks, hedge funds, insurance companies, pension funds, and corporations are all affected by ratings. Even the over-the-counter trading market is affected by ratings. Collateral requirements for swap counterparties are just one example of a ratings driven requirement. Banks have different capital reserve requirements depending on the ratings of assets. Insurance companies, pension funds, and mutual funds all have ratings requirements in their regulations or charters. Ratings driven regulations have been adopted globally, albeit regulations vary by venue.
Yet there is global distrust of the rating agencies. Congress and the SEC have not faced up to the key problems. The Dodd-Frank legislation in the United States illustrates Congress’s poor grasp of many of the issues and its inability—or unwillingness—to address them. Rating agencies have not been held accountable for past poor performance. The possibility of malfeasance or collusion with fraud has been skirted rather than addressed.
The Dodd-Frank Act proposes that financial regulations eliminate references to credit ratings for stock brokerages and money funds, but this has not yet been implemented. Likewise, banking regulators are pushing back on Dodd-Frank and asking for rewrites; in other words, they are stalling. The mistake in the Dodd-Frank Act is that there is no reliable globally recognized system with which to replace ratings as an indication of credit risk. Banks, insurance companies, pension funds, mutual funds, and other investors should do their own credit assessments, but the reality is they relied on rating agencies, and they continue to look to them for guidance.
Until there is an objective reproducible and reliable method of providing credit ratings to securitizations, it will be impossible to rehabilitate the alternative banking system. If one is to wean the global financial system off of government guaranteed debt, there has to be a viable means of agreeing on creditworthiness.
The top rating agencies, Moody’s and S&P, have a multi-year history of failure in rating some granular corporate credit risks and have a spectacular history of failure in rating heterogeneous structured credit products and securitizations. In particular, in rating securitizations, they have not followed statistical principles by any reasonable professional standard. None of the other rating agencies show evidence of filling this role, and would have to qualify in order to credibly rate these products. For this reason, I’ve revoked the Nationally Recognized Statistical Rating Organization (NRSRO) designation for all of the rating agencies for all but corporations that do not engage in a major way in structured financial products.
Just because the problem of creating a viable global credit rating system is difficult doesn’t mean it shouldn’t be done. In fact, it is precisely because it is difficult that there is a great need to thoroughly address the issue. The rating “agencies” are actually corporations, and they are domiciled in different countries. Nonetheless, an international regulator can determine which of these corporations will eventually earn the NRSRO designation. Meanwhile, it can determine which rating agencies will be allowed to continue to issue ratings, albeit without the NRSRO designation.
In revoking the NRSRO designation, I’m making the statement that I’m better qualified to opine on this than Congress or the SEC, since this is a matter of reasonable professional standards in following statistical principles. The top rating agencies, the one’s most relevant to the global financial community, do not meet the standard. The “Nationally Recognized Statistical Rating Organization” label cannot be legislated or awarded by regulators when it is demonstrably false any more than they can enact legislation to make the sun move around the earth.
The solution is to raise one or more rating agencies up to standard to merit the NRSRO label. Meanwhile, rating agencies can continue to issue ratings but must commit to coming up to standard. Those that cannot should have the privilege of issuing ratings completely revoked. The second part of the solution is to develop global third party benchmarks and global third party rating scales and make accurate ratings the only measurement of success.
The full text of this commentary including all Appendices is available in the “News” section of my website or via this link: “Tavakoli Structured Finance Revokes the Credit Rating Agencies’ NRSRO Designation,” July 26, 2011.
CHAPTER 9
Fannie Mae and Freddie Mac
“Fraud As a Business Model”
September 6, 2011
There were many factors that contributed to our recent financial bubble: deregulation, cheap money from the Fed, failure to enforce remaining regulations, crony capitalism, hubris, speculation, leverage, and fraud among other problems. While fraud wasn't the only issue, it was and is a significant contributor to the credit bubble. Restraining fraud is a necessary but not sufficient condition for a sound financial system. Congressional investigations in recent years have put ample evidence of fraud in the public domain.
To illustrate just one type of malicious mischief, Senator Carl Levin (D. Mich.), Chairman of a senate investigative panel, issued a memo stating that Goldman "magnified the impact of toxic mortgages." The Wall Street Journal reviewed data showing that a $38 million subprime-mortgage bond created in June 2006 was referenced in more than 30 debt pool causing around$280 million in losses to investors by 2008. In other words, Goldman kept repackaging, reselling or protecting (buying credit default protection on) losers. It took the wrong kind of nerve for Goldman's CEO to say he was doing "God's work."
Arianna Huffington pointed out that the financial system is rigged and that offenders get off lightly:
Until the Securities and Exchange Commission sued Goldman Sachs for fraud in April of 2010, it was easy to forget that we have a regulatory agency designed to protect the public from the pillaging of corporate America. Six months earlier, the SEC has arranged a settlement with JPMorgan that showed how rigged the system is. The banking giant agreed to pay a $25 million penalty and cancel $647 million in fees owed by Alabama's Jefferson County as the result of a complicated derivatives deal that blew up in the county's face. As part of the settlement, JPMorgan neither admitted nor denied wrongdoing--despite overwhelming evidence that it had engaged in plenty of wrongdoing.Third World America P. 153
On Friday, September 2, 2011, The U.S. Federal Housing Finance Agency (FHFA), the regulator for taxpayer-subsidized mortgage lending guarantors Fannie Mae and Freddie Mac, filed lawsuits against 17 of the world's largest banks over suspect mortgage loans which helped exacerbate the U.S. housing crisis. Both Fannie Mae and Freddie Mac were placed in conservatorship in September 2008 after they nearly collapsed. The FHFA claims banks misrepresented the value of the mortgage loans and mortgage securities they underwrote, arranged, and sold.
So far the banks being sued include Bank of America Corp along with its Countrywide Financial Corporation and Merrill Lynch & Company divisions, Goldman Sachs Group Inc., JP Morgan & Chase & Co, Citigroup Inc., Deutsche Bank AG, Barclays PLC, Nomura Holdings Inc., Morgan Stanley, Ally Financial Inc., Credit Suisse Group Inc., First Horizon National Corp, General Electric Co, the HSBC North America Holdings unit of HSBC Holdings, The Royal Bank of Scotland Group PLC and Société Générale SA. The FHFA is just getting started.
Critics of Fannie Mae, Freddie Mac, and their previous regulator, OFHEO, say that they were sophisticated investors, and they should have known better. William K. Black is a former bank regulator who played a role in hundreds of successful prosecutions after the Savings and Loan Crisis. He told the Wall Street Journal: "It's a great myth that you can't defraud sophisticated financial parties." Particularly when loans are fraudulent and material information was not disclosed.
The Financial Crisis Inquiry Commission published evidence from the testimony of officials of Clayton Holdings(among others), a due diligence firm, that underwriters and rating agencies ignored evidence of suspect loans and did not disclose this information to investor
s.
The FHFA's complaint involves tens of billions of dollars in potential recoveries that will benefit taxpayers. Yet, as Arianna Huffington points out, banks continue to find ways to get Americans to subsidize problems that the banks themselves were chiefly responsible for creating. Consumers struggle to keep up with payments as the unemployment rate rises along with prices for food, energy and healthcare. Meanwhile, job creation hovers near zero.
When consumers fail to keep up, banks, trying to offset losses in other areas, turn around, hike interest rates, and impose all manner of fees and penalties--all of which makes it less likely consumers will be able to pay off mounting debts.
Third World America Pp. 77 & 78.
Money is being put in taxpayers' pockets in the form of "recoveries" while being extracted again in the form of subsidies and cheap funding to shaky banks that continue to award record pay and record bonuses as they gouge consumers. We can expect more of the same if we continue to let banks off with a slap on the wrist for malfeasance--along with a taxpayer subsidized fine--while banks neither admit nor deny wrongdoing.
Banks won't change until we follow the law and take "prompt corrective action." Banks that committed widespread fraud should be placed in receivership. Bank of America was cited by William K. Black and L. Randall Wray in their October 2010 post as the place to start, and I agree.
On December 8, 2010, I presented an analysis to the Federal Housing Finance Agency (FHFA) in Washington D.C. of key causes of our current financial crisis: "Repairing the Damage of "Fraud as a Business Model." The phrase "fraud as a business model" comes from a comment referenced in the presentation made by Richard Cordray, then the Attorney General of Ohio and the current Director of the Consumer Financial Protection Bureau, when he discussed foreclosure fraud.
CHAPTER 10
Warren Buffett’s Twist:
“Please, sir, I want some more.”
Warren Buffett’s Wall Street War
October 20, 2009
In a January 2009 interview with NBC’s Tom Brokaw, Warren Buffett criticized leveraging “to the sky,” and creating “phony instruments [RMBSs, CDOs, et al.] that fool other people so you stick money in your pocket.” In 2002, he claimed over‐the‐counter derivatives are “financial weapons of mass destruction” and participants who account for them have “enormous incentives to cheat.”
Warren Buffett, the blogosphere’s “Oracle of Omaha,” often chastises the financial community. If you cost him money, he’s liable to write an expose. He posts annual shareholder letters on a low‐tech website and seems to labor under the assumption that rational people eagerly read his blog. Congress and regulators are dismissive of Buffett’s hyperbolic rhetoric; it is fit only for a banana republic.
In 2003, Buffett wrote of the manufactured housing industry’s “business model centered on the ability…to unload terrible loans on naïve lenders…The consequence has been huge numbers of repossessions and pitifully low recoverie[s].” Buffett alleged that the manufactured housing industry’s consumer financing practices were “atrocious,” and securitizations provided the money to fuel the financing.
Berkshire Hathaway’s investment in the distressed junk debt of Oakwood Homes lost money after the designer and manufacturer of modular homes went bankrupt in 2002. Buffett claimed “Oakwood participated fully in the insanity.”
Warren Buffett’s diatribe suggested that most of the manufactured housing industry was involved along with several Wall Street firms that underwrote the securitizations. Using money from new investors to pay returns to old investors in unsupportable investments is called a Ponzi scheme.
Oakwood’s loans to purchasers of manufactured homes were made possible by a line of credit from Credit Suisse First Boston (Credit Suisse). The credit line was similar to a credit card except that Oakwood had to put up the home loans as collateral. Credit Suisse earned fees for the loans and further fees when it packaged (securitized) Oakwood’s loans. Credit Suisse (the old investor) bought the securitized loans and then sold them to new so‐called sophisticated investors.
Sales of manufactured homes declined. Loan delinquencies (late payments) and repossessions rose. Oakwood Homes had crushing debt and falling income for at least three years before it filed for bankruptcy in November 2002. But securitizations had temporarily inflated the bubble for the collapsing enterprise. A June 2008 court opinion said Oakwood’s aggressive lending practices led to the high number of repossessions and a debt load that Oakwood could not support. Oakwood’s liquidator said the transactions it did with Credit Suisse were “value destroying.”
Someone should have muzzled Warren Buffett back in 2003. The Slumbering Esquires’ Club might have believed Buffett’s preposterous theory that after private securitizations became popular, the “industry’s conduct went from bad to worse.” Buffett’s wacky warnings could have jeopardized Wall Street’s subsequent mortgage lending securitization Ponzi scheme.
The SEC might have investigated Lehman Brothers’ questionable shenanigans, especially after it was held liable in 2003 by a California jury for allegedly helping FAMCO cheat borrowers. The SEC might have looked into the unsavory practices at Goldman Sachs Alternative Mortgage Products, Bear Stearns, Merrill Lynch or the entire private securitization industry, and their mortgage lending subsidiaries.
While the SEC slept inside a collapsing debt bubble, the Omaha conspiracy theorist spooked Goldman Sachs into believing it needed his money. In the fall of 2008, Buffett closed a deal for $5 billion in Goldman Sachs’s preferred stock paying a 10% annual dividend. Goldman even gave Buffett warrants to buy $5 billion in common stock at a price of $115 any time before October 1, 2013. [The Fed let Goldman buy back its warrants for chump change.9] Buffett’s warrants are now about $3 billion in‐the‐money and worth much more—a sweetener for his crispy calamari.
Hank Paulson, Ben Bernanke, and Tim Geithner10 ignored the historic ravings of the most successful living investor, and fueled some of the bombers piloted by Wall Street before finance’s Pearl Harbor. After they used taxpayer money to save the system and enriched the culpable with no strings attached, Buffett said “it could have turned out a lot differently,” and called each of them a four‐letter word. The label was undeserved.
Four‐letter words aside, Warren Buffett raised a good point. It could have—and should have—turned out a lot differently. But it’s not too late. Buffett called the crisis an economic Pearl Harbor and said that “Wall Street owes the American people one at this point.”8 During World War II, we imposed an excess profits tax. We should impose a 95% excess profits tax—or windfall profits tax—on certain financial institutions (including Goldman Sachs) enriching themselves with ongoing low‐cost Fed funding and debt guarantees.
Warren Buffett did not call for a windfall profits tax, but we should consider it with a host of other reforms.
Adapted from Dear Mr. Buffett, What an Investor Learns 1,269 Miles from Wall Street (Wiley 2009) by Janet Tavakoli
Warren Buffett, Stop Using My Credit Card!
November 23, 2009
I like Warren Buffett. I even wrote a book about the financial crisis contrasting his principles of prudent finance with recent excessive leverage, bad lending, and malfeasance (Dear Mr. Buffett). Buffett is not a regulator, an altruist, a consumer advocate, or an elected official. As CEO and largest shareholder of Berkshire Hathaway, his goal is to maximize shareholder value.
U.S. capitalism has morphed into a financial oligarchy. If Buffett’s choice is between getting along in the financial community or the public interest, public interest loses. But he didn’t cause our financial crisis, and he spoke out in advance about excessive leverage and bad lending. The financial markets are now wildly distorted. Others have funding advantages Buffett can only dream about, so he exploits an advantage when it becomes available.
I have been a trenchant critic of rampant financial malfeasance, and Buffett has only wished me well and told me to “keep writing.” For my
part, I try to keep in mind that we view the world through different lenses.
On October 25, 2009, when BBC’s Evan Davis interviewed him, Buffett surprised me : Click here to view the eight minute video. It started out so well, but after six minutes the interview went sideways. [Not shown in this clip Buffett said his $5 billion investment in Goldman Sachs’ preferred stock (plus free warrants) last year was, in part, a bet on a US government bailout.1 He thought the U.S. taxpayer got a good deal, but we got a worse deal than Buffett negotiated, and as I explain here, I feel taxpayers got chump change.]
At 3:14 min: Buffett explains that if there were only 50 people on a fertile island, we wouldn’t take the five smartest people out of the 50 and give them the most money and tax breaks for trading rice futures and speculating: “Hell no! We’d get everybody producing rice. The idea that people that move money around are some favored class—and they are in this country, even in terms of taxes—strikes me as getting pretty far away from where we should be.”
At 6:00 minutes: Buffett claims shareholder losses obviated moral hazard. Not true. In control frauds (first identified by William K. Black), financial institutions are destroyed, and shareholders lose. Only the agents: CEOs, CFOs, and highly paid employees are enriched. Unlike Buffett, these agents are “stewards,” not major owners. Moral hazard remains an intractable problem.