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2008
Greenspan's Disastrous Agency Problem
In political science and economics, the principal-agent problem or
agency dilemma treats the difficulties that arise under conditions
of incomplete and asymmetric information when a principal hires an
agent. Various mechanisms may be used to try to align the interests
of the agent with those of the principal, such as piece
rates/commissions, profit sharing, efficiency wages, performance
measurement (including financial statements), the agent posting a
bond, or fear of firing. The principal-agent problem is found in
most employer/employee relationships, for example, when stockholders
hire top executives of corporations. Numerous studies in political
science have noted the problems inherent in the delegation of
legislative authority to bureaucratic agencies. The implementation
of legislation (such as laws and executive directives) is open to
bureaucratic interpretation, creating opportunities and incentives
for the bureaucrat-as-agent to deviate from the intentions or
preferences of the legislators. Variance in the intensity of
legislative oversight also serves to increase principal-agent
problems in implementing legislative preferences.
Wikipedia ---
http://en.wikipedia.org/wiki/Agency_theory
Not only
have individual financial institutions become less vulnerable to
shocks from underlying risk factors, but also the financial system
as a whole has become more resilient.
Alan Greenspan in 2004 as quoted by
Peter S. Goodman, Taking a Good Look at the Greenspan Legacy,"
The New York Times, October 8, 2008 ---
http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?em
The problem is
not that the contracts failed, he says. Rather, the people using
them got greedy. A lack of integrity spawned the crisis, he
argued in a speech a week ago at Georgetown University,
intimating that those peddling derivatives were not as reliable
as “the pharmacist who fills the prescription ordered by our
physician.”
But others hold a
starkly different view of how global markets unwound, and the
role that Mr. Greenspan played in setting up this unrest.
“Clearly,
derivatives are a centerpiece of the crisis, and he was the
leading proponent of the deregulation of derivatives,” said
Frank Partnoy, a law professor at the University of San Diego
and an expert on financial regulation.
The derivatives
market is $531 trillion, up from $106 trillion in 2002 and a
relative pittance just two decades ago. Theoretically intended
to limit risk and ward off financial problems, the contracts
instead have stoked uncertainty and actually spread risk amid
doubts about how companies value them.
If Mr. Greenspan
had acted differently during his tenure as Federal Reserve
chairman from 1987 to 2006, many economists say, the current
crisis might have been averted or muted.
Over the years,
Mr. Greenspan helped enable an ambitious American experiment in
letting market forces run free. Now, the nation is confronting
the consequences.
Derivatives were
created to soften — or in the argot of Wall Street, “hedge” —
investment losses. For example, some of the contracts protect
debt holders against losses on mortgage securities. (Their name
comes from the fact that their value “derives” from underlying
assets like stocks, bonds and commodities.) Many individuals own
a common derivative: the insurance contract on their homes.
On a grander
scale, such contracts allow financial services firms and
corporations to take more complex risks that they might
otherwise avoid — for example, issuing more mortgages or
corporate debt. And the contracts can be traded, further
limiting risk but also increasing the number of parties exposed
if problems occur.
Throughout the
1990s, some argued that derivatives had become so vast,
intertwined and inscrutable that they required federal oversight
to protect the financial system. In meetings with federal
officials, celebrated appearances on Capitol Hill and heavily
attended speeches, Mr. Greenspan banked on the good will of Wall
Street to self-regulate as he fended off restrictions.
Ever since
housing began to collapse, Mr. Greenspan’s record has been up
for revision. Economists from across the ideological spectrum
have criticized his decision to let the nation’s real estate
market continue to boom with cheap credit, courtesy of low
interest rates, rather than snuffing out price increases with
higher rates. Others have criticized Mr. Greenspan for not
disciplining institutions that lent indiscriminately.
But whatever
history ends up saying about those decisions, Mr. Greenspan’s
legacy may ultimately rest on a more deeply embedded and much
less scrutinized phenomenon: the spectacular boom and calamitous
bust in derivatives trading.
Bob Jensen's timeline of
derivatives scandals and the evolution of accounting standards
for accounting for derivatives financial instruments can be
found at
http://faculty.trinity.edu/rjensen/FraudCongress.htm#DerivativesFrauds
"‘I made a mistake,’ admits
Greenspan," by Alan Beattie and James Politi, Financial Times, October
23, 2008 ---
http://www.ft.com/cms/s/0/aee9e3a2-a11f-11dd-82fd-000077b07658.html?nclick_check=1
“I
made a mistake in presuming that the self-interest of
organisations, specifically banks and others, was such that they
were best capable of protecting their own shareholders,” he
said.
In the second of
two days of tense hearings on Capitol Hill, Henry Waxman,
chairman of the House of Representatives, clashed with current
and former regulators and with Republicans on his own committee
over blame for the financial crisis.
Mr Waxman said Mr
Greenspan’s Federal Reserve – along with the Securities and
Exchange Commission and the US Treasury – had propagated “the
prevailing attitude in Washington... that the market always
knows best.”
Mr Waxman blamed
the Fed for failing to curb aggressive lending practices, the
SEC for allowing credit rating agencies to operate under lax
standards and the Treasury for opposing “responsible oversight”
of financial derivatives.
Christopher Cox,
chairman of the Securities and Exchange Commission, defended
himself, saying that virtually no one had foreseen the meltdown
of the mortgage market, or the inadequacy of banking capital
standards in preventing the collapse of institutions such as
Bear Stearns.
Mr Waxman accused
the SEC chairman of being wise after the event. “Mr Cox has come
in with a long list of regulations he wants... But the reality
is, Mr Cox, you weren’t doing that beforehand.”
Mr Cox blamed the
fact that congressional responsibility was divided between the
banking and financial services committees, which regulate
banking, insurance and securities, and the agriculture
committees, which regulate futures.
“This
jurisdictional split threatens to for ever stand in the way of
rationalising the regulation of these products and markets,” he
said.
Mr Greenspan
accepted that the crisis had “found a flaw” in his thinking but
said that the kind of heavy regulation that could have prevented
the crisis would have damaged US economic growth. He described
the past two decades as a “period of euphoria” that encouraged
participants in the financial markets to misprice securities.
He had wrongly
assumed that lending institutions would carry out proper
surveillance of their counterparties, he said. “I had been going
for 40 years with considerable evidence that it was working very
well”.
Continued in the
article
Jensen Comment
In other words, he assumed the agency theory model that corporate
employees, as agents of their owners and creditors, would act hand
and hand in the best interest for themselves and their investors.
But agency theory has a flaw in that it does not understand Peter
Pan.
Peter Pan, the manager of Countrywide Financial on Main Street, thought he had
little to lose by selling a fraudulent mortgage to Wall Street. Foreclosures
would be Wall Street’s problems and not his local bank’s problems. And he got
his nice little commission on the sale of the Emma Nobody’s mortgage for
$180,000 on a house worth less than $100,000 in foreclosure. And foreclosure was
almost certain in Emma’s case, because she only makes $12,000 waitressing at the
Country Café. So what if Peter Pan fudged her income a mite in the loan
application along with the fudged home appraisal value? Let Wall Street or Fat
Fannie or Foolish Freddie worry about Emma after closing the pre-approved
mortgage sale deal. The ultimate loss, so thinks Peter Pan, will be spread over
millions of wealthy shareholders of Wall Street investment banks. Peter Pan is
more concerned with his own conventional mortgage on his precious house just two
blocks south of Main Street. This is what happens when risk is
spread even farther than Tinkerbell can fly!
Also see how corporate executives cooked the books ---
http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation
The Saturday Night Live Skit on the Bailout ---
http://patdollard.com/2008/10/it-is-here-the-banned-snl-skit-cannot-hide-from-louie/
|
Bankers (Men in Black)
bet with their
bank's capital, not their own. If the bet goes right, they get a
huge bonus; if it misfires, that's the shareholders' problem.
Sebastian Mallaby.
Council on Foreign Relations, as quoted by Avital Louria Hahn,
"Missing: How Poor Risk-Management Techniques Contributed to
the Subprime Mess," CFO
Magazine, March 2008, Page 53 ---
http://www.cfo.com/article.cfm/10755469/c_10788146?f=magazine_featured
Jensen Comment
Now that the Government is going to bail out these speculators with
taxpayer funds makes it all the worse. I received an email
message claiming that if you had purchased $1,000 of AIG
stock one year ago, you would have $42 left; with Lehman, you
would have $6.60 left; with Fannie or Freddie, you would have
less than $5 left. But if you had purchased $1,000 worth of beer
one year ago, drank all of the beer, then turned in the cans for
the aluminum recycling REFUND, you would have had $214. Based on
the above, the best current investment advice is to drink
heavily and recycle. It's called the 401-Keg. Why let others
gamble your money away when you can piss it away on your own? |
Peter, Paul, and Barney: An Essay on 2008 U.S.
Government Bailouts of Private Companies ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm
Bob Jensen's threads on earnings management and creative
accounting to cook the books ---
http://faculty.trinity.edu/rjensen/theory01.htm#Manipulation
2008
"Fed's rescue halted a derivatives Chernobyl," London
Telegraph, March 24, 2008 ---
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/03/23/ccfed123.xml
When the Federal Reserve stepped in
to save Bear Stearns, most people had no idea what was at stake, writes
Ambrose Evans-Pritchard
We may never know for sure whether
the Federal Reserve's rescue of Bear Stearns averted a seizure of the $516
trillion derivatives system, the ultimate Chernobyl for global finance.
The financial crisis in full
Read more by Ambrose Evans Pritchard
Roger Bootle: This is a crisis but not The Great Depression
"If the Fed had not stepped in, we would have had
pandemonium," said James Melcher, president of the New York hedge fund
Balestra Capital.
"There was the risk of a total meltdown at the
beginning of last week. I don't think most people have any idea how bad this
chain could have been, and I am still not sure the Fed can maintain the
solvency of the US banking system."
All through early March the frontline players had
watched in horror as Bear Stearns came under assault and then shrivelled
into nothing as its $17bn reserve cushion vanished.
Melcher was already prepared - true to form for a
man who made a fabulous return last year betting on the collapse of US
mortgage securities. He is now turning his sights on Eastern Europe, the
next shoe to drop.
"We've been worried for a long time there would be
nobody to pay on the other side of our contracts, so we took profits early
and got out of everything. The Greenspan policies that led to this have been
the most irresponsible episode the world has ever seen," he said.
Fed chairman Ben Bernanke has moved with
breathtaking speed to contain the crisis. Last Sunday night, he resorted to
the "nuclear option", invoking a Depression-era clause - Article 13 (3) of
the Federal Reserve Act - to be used in "unusual and exigent circumstances".
The emergency vote by five governors allows the Fed
to shoulder $30bn of direct credit risk from the Bear Stearns carcass. By
taking this course, the Fed has crossed the Rubicon of central banking.
To understand why it has torn up the rule book,
take a look at the latest Security and Exchange Commission filing by Bear
Stearns. It contains a short table listing the broker's holding of
derivatives contracts as of November 30 2007.
Bear Stearns had total positions of $13.4 trillion.
This is greater than the US national income, or equal to a quarter of world
GDP - at least in "notional" terms. The contracts were described as
"swaps", "swaptions", "caps", "collars" and "floors".
This heady edifice of new-fangled instruments was built on an asset base of
$80bn at best.
On the other side of these contracts are banks,
brokers, and hedge funds, linked in destiny by a nexus of interlocking
claims. This is counterparty spaghetti. To make matters worse, Lehman
Brothers, UBS, and Citigroup were all wobbling on the back foot as the
hurricane hit.
"Twenty years ago the Fed would have let Bear
Stearns go bust," said Willem Sels, a credit specialist at Dresdner
Kleinwort. "Now it is too interlinked to fail."
The International Swaps and Derivatives Association
says the vast headline figures in the contracts are meaningless. Positions
are off-setting. The actual risk is magnitudes lower.
The Bank for International Settlements uses a
concept of "gross market value" to weight the real exposure. This is roughly
2 per cent of the notional level. For Bear Stearns this would be $270bn, or
so.
"There is no real way to gauge the market risk,"
said an official
Continued in article
2008
Peter, Paul, and Barney: An Essay on 2008 U.S. Government Bailouts
of Private Companies ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm
2008
"Officials Say They Sought To Avoid Bear Bailout," by Kara Scannell and
Sudeer Reddy, The Wall Street Journal, April 4, 2008; Page A1 --
Click Here
The government sought a low sale price for Bear
Stearns Cos. to send a message that taxpayers wouldn't bail out firms making
risky bets, a top Treasury Department official testified, as regulators
offered Congress the first detailed explanation of the unprecedented rescue.
Representatives of Washington and Wall Street
painted a dire picture of the chaos they believe would have ensued if the
government hadn't orchestrated a rescue of Bear Stearns by J.P. Morgan Chase
& Co. over the hectic weekend of March 15-16.
"This would have been far more, in my opinion,
expensive to taxpayers had Bear Stearns gone bankrupt and added to the
financial crisis we have today," said J.P. Morgan chief executive James
Dimon. "It wouldn't have even been close."
Officials said they were acutely aware of the
moral-hazard problem, and that is why the government insisted that Bear
Stearns shareholders get a low price for their shares. In the original deal,
announced the night of March 16, J.P. Morgan agreed to pay $2 a share. After
Bear Stearns shareholders protested, J.P. Morgan raised its price a week
later to $10 a share -- still a fraction of the level Bear Stearns shares
had traded at before it faced a funding crisis.
"There was a view that the price should not be very
high or should be towards the low end...given the government's involvement,"
Treasury Undersecretary Robert Steel told a congressional committee during a
five-hour hearing Thursday.
"These were exceptionally consequential acts, taken
with extreme reluctance and care because of the substantial consequences it
would have for moral hazard in the financial system," added Timothy Geithner,
president of the Federal Reserve Bank of New York.
Mr. Steel and other officials told the Senate
Banking Committee that they didn't dictate the precise sale price, but
wanted to see a deal done quickly to avoid a sudden market-shaking crash of
the company.
At the hearing, the first one focusing on the Bear
Stearns rescue, lawmakers questioned top Fed officials, including Chairman
Ben Bernanke, as well as the chief executives of Bear Stearns and J.P.
Morgan. Held in a cavernous room reserved for big gatherings, rather than
the more-intimate regular room, the hearing sometimes had the feel of a
Hollywood red-carpet event as photographers descended on the panelists.
Officials rejected lawmakers' suggestions that they
bailed out Bear Stearns, noting that shareholders took steep losses and many
employees may lose their jobs. But under questioning, Mr. Bernanke agreed
with a lawmaker who suggested the Fed rescued Wall Street more broadly.
"If you want to say we bailed out the market in
general, I guess that's true," he said. "But we felt that was necessary in
the interest of the American economy." He reiterated comments from a day
earlier that the Fed doesn't expect to lose money on its $30 billion loan.
J.P. Morgan has agreed to cover the first $1 billion in losses, if there are
any.
Mr. Dimon said his bank "could not and would not
have assumed the substantial risk" of buying Bear without the Fed's
involvement.
At the hearing, the government and company
officials gave an exhaustive account of the frenetic scramble in the days
preceding the Bear Stearns sale. "We had literally 48 hours to do what
normally takes a month," said Mr. Dimon.
During the week of March 10, market rumors swirled
that Bear Stearns might not be able to stay in business. At the hearing Alan
Schwartz, Bear Stearns's chief executive, said that the firm's balance sheet
was strong -- as good as that of any other financial institution -- but that
Bear Stearns couldn't keep up with the rumors.
By Thursday, March 13, the rumors had become a
"self-fulfilling prophecy" and resulted in a "run on the bank," Mr. Schwartz
said. Bear Stearns reached out to the regulators, who worked throughout the
night. By Friday morning, March 14, the Fed agreed to extend financing to
Bear Stearns through J.P. Morgan. Then the firms and government officials
worked through the weekend to spur Bear Stearns's sale and prevent a
bankruptcy filing.
Along with the sale announcement on March 16, the
Fed announced that it would lend directly to investment banks from its
discount window, a historic reversal of its longtime policy of lending only
to banks. While some have said that Bear Stearns could have avoided a sale
if it had had access to the new lending program, Mr. Geithner said that
wasn't feasible.
"We only allow sound institutions to borrow against
collateral," he said. "I would have been very uncomfortable lending to Bear
given what we knew at that time."
When it became clear that a deal had to happen
before Asian markets opened late Sunday night, Bear Stearns's negotiating
leverage "went out the window," said Mr. Schwartz. Among the parties
examining Bear Stearns's books was a sophisticated buyer who was "prepared
to write a multibillion check to invest in equity," but that would have
required another financial institution to help finance the deal, Mr.
Schwartz said. He didn't identify the potential buyer.
Mr. Dimon testified that he couldn't recall whose
idea it was to bring in the Fed. Treasury's Mr. Steel said it was J.P.
Morgan that suggested the Fed's involvement.
Continued in article
2008
|
SEC, Justice Scrutinize AIG on Swaps Accounting
by
Amir Efrati and Liam Pleven
The Wall Street Journal
Jun 06, 2008
Page: C1
Click here to view the full article on WSJ.com
---
http://online.wsj.com/article/SB121271786552550939.html?mod=djem_jiewr_AC
TOPICS: Advanced
Financial Accounting, Auditing, Derivatives, Fair
Value Accounting, Internal Controls, Mark-to-Market
Accounting
SUMMARY: The SEC "...is investigating whether
insure American International Group Inc. overstated
the value of contracts linked to subprime
mortgages....At issue is the way the company valued
credit default swaps, which are contracts that
insure against default of securities, including
those backed by subprime mortgages. In February, AIG
said its auditor had found a 'material weakness' in
its accounting. Largely on swap-related
write-downs...AIG has recorded the two largest
quarterly losses in its history."
CLASSROOM APPLICATION: Financial reporting for
derivatives is at issue in the article; related
auditing issues of material weakness in accounting
for these contracts also is covered in the main
article and the related one.
QUESTIONS:
1. (Introductory) What are collateralized
debt obligations (CDOs)?
2. (Advanced) What are credit default
swaps? How are these contracts related to CDOs?
3. (Advanced) Summarize steps in
establishing fair values of CDOs and credit default
swaps.
4. (Introductory) What is a material
weakness in internal control? Does reporting
write-downs of such losses as AIG has shown
necessarily indicate that a material weakness in
internal control over financial reporting has
occurred? Support your answer.
Reviewed By: Judy Beckman, University of Rhode
Island
RELATED ARTICLES:
AIG Posts Record Loss, As Crisis Continues Taking
Toll
by Liam Pleven
May 09, 2008
Page: A1
|
From The Wall Street Journal
Accounting Weekly Review on June 13, 2008
"SEC, Justice Scrutinize AIG on Swaps
Accounting," by Amir Efrati and Liam Pleven, The Wall Street Journal,
June 6, 2008; Page C1 ---
http://online.wsj.com/article/SB121271786552550939.html?mod=djem_jiewr_AC
The Securities and Exchange
Commission is investigating whether insurer American International Group
Inc. overstated the value of contracts linked to subprime mortgages,
according to people familiar with the matter.
Criminal prosecutors from
the Justice Department in Washington and the department's U.S. attorney's
office in Brooklyn, New York, have told the SEC they want information the
agency is gathering in its AIG investigation, these people said. That means
a criminal investigation could follow.
In 2006, AIG, the world's
largest insurer, paid $1.6 billion to settle an accounting case. Its stock
has been battered because of losses linked to the mortgage market. The
earlier probe led to the departure of Chief Executive Officer Maurice R.
"Hank" Greenberg.
Officials for AIG, the SEC,
the Justice Department and the U.S. attorney's office declined to comment on
the new probe. A spokesman for AIG said the company will continue to
cooperate in regulatory and governmental reviews on all matters.
At issue is the way the
company valued credit default swaps, which are contracts that insure against
default of securities, including those backed by subprime mortgages. In
February, AIG said its auditor had found a "material weakness" in its
accounting.
Largely on swap-related
write-downs, which topped $20 billion through the first quarter, AIG has
recorded the two largest quarterly losses in its history. That has turned up
the heat on management, including CEO Martin Sullivan.
AIG sold credit default
swaps to holders of investments called collateralized-debt obligations, or
CDOs, backed in part by subprime mortgages. The buyers were protecting their
investments in the event of default on the underlying debt. In question is
how the CDOs were valued, which drives both the value of the credit default
swaps and the amount of collateral AIG must "post," or essentially hand
over, to the buyer of the swap to offset the buyer's credit risk.
AIG posted $9.7
billion in collateral related to its swaps, as of April 30, up from $5.3
billion about two months earlier.
Law Blog: Difficulties in Valuation 'Best Defense'
How much to bail out the banks now? $3.5 trillion by one estimate
A federal program to guarantee or buy bad assets from
the ailing U.S. bank sector could come with a $3.5 trillion price tag. That
would push the accumulated costs of rescuing the financial markets over the last
year through various federal loan, stock purchase, debt guarantee and other
programs close to $9 trillion and counting, with practically no end in sight for
the bad news battering the banking industry. That figure doesn't count the $825
billion economic stimulus plan also under consideration. "We expect massive
federal intervention into the financial sector from the new administration in
the coming months," says Keefe Bruyette & Woods analyst Frederick Cannon, who
calculated the $3.5 trillion figure, which is one-quarter of the banking
sector's $14 trillion in combined assets.
Liz Moyer, "A TARP In The Trillions?"
Forbes, January 21, 2009 ---
http://www.forbes.com/2009/01/21/tarp-banking-treasury-biz-wall-cx_lm_0121tarp.html
Lesson One: What Really Lies Behind the Financial Crisis?
According to Siegel: Financial firms bought, held and
insured large quantities of risky, mortgage-related assets on borrowed money.
The irony is that these financial giants had little need to hold these
securities; they were already making enormous profits simply from creating,
bundling and selling them. 'During dot-com IPOs of the early 1990s, the firms
that underwrote the stock offerings did not hold on to those stocks,' Siegel
says. 'They flipped them. But in the case of mortgage-backed securities, the
financial firms decided these were good assets to hold. That was their fatal
flaw.'
"Lesson One: What Really Lies Behind the Financial Crisis?" Knowledge@Wharton,
January 21, 2009 ---
http://knowledge.wharton.upenn.edu/article.cfm?articleid=2148
Jensen Comment
Lesson Two of what lies behind the financial crisis is that investment banks and
others like AIG wrote credit derivatives on the on the CDO collateralized debt
obligations that used mortgage backed securities as collateral. The companies
that wrote these derivatives did not have the insurance reserves to cover the
melt down of those CDOs. To avoid bankruptcy of giants such as AIG, the U.S.
treasury gave billions in bailout funds to cover the credit derivatives.
See Appendix E ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
I think there was a hidden agenda with respect to why Hank Paulson's first
billions in bailout funds went to cover the credit derivative obligations.
See Appendix Y ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#HiddenAgendaDetails
Bob Jensen's threads on credit derivatives (scroll down) ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms
2008
Question
Securitization entails lending with collateral that, in the
subprime crisis, was highly (and often fraudulently) overstated in
value to outside investors in that collateralized debt. What can be
done to save securitization in capital markets?
"Coming Soon ... Securitization with a New, Improved (and Perhaps
Safer) Face, Knowledge@Wharton, April 2, 2008 ---
http://knowledge.wharton.upenn.edu/article.cfm;jsessionid=a83051431af9532a7261?articleid=1933
For
generations, the strength of the U.S. housing market was due, in
part, to securitization of mortgages with guarantees from the
government-sponsored companies, Fannie Mae and Freddie Mac.
Following the savings and loan debacle of the late 1980s,
securitization -- which has been defined as "pooling and
repackaging of cash-flow producing financial assets into
securities that are then sold to investors" -- helped bring
capital back to battered real estate markets.
Today,
securitization of subprime real estate loans is blamed for the
global liquidity crisis, but Wharton faculty say securitization
itself is not at fault. Poor underwriting and other weaknesses
in the market for mortgage-backed securities led to the current
problems. Securitization, they say, will remain an important
part of the way real estate is funded, although it is likely to
undergo significant change.
"Securitization, in the long run, is a good thing," says Wharton
finance professor Franklin Allen. "We didn't have much
experience with falling real estate prices in recent years. The
mechanisms weren't designed for that." He explains that
economists were concerned about the incentives and accounting
that shaped the private mortgage securitization market in recent
years, but as long as real estate prices kept rising, the
weaknesses in the system did not become clear. Now, after credit
markets seized up and prices have declined sharply, those
problems have been exposed.
Allen
believes financial markets will get back into the business of
securitizing mortgage debt, but only after making some major
changes. One new feature of future securitization deals, he
says, could be a requirement that loan originators hold at least
part of the loans they write on their books. Before the current
crisis, loans were bundled into complex tranches that were
passed through the financial system and onto buyers with little
ability to assess the real value of the individual assets.
"The
way the collateralized debt obligations (CDOs) and other
vehicles are structured will change. They are too complicated,"
says Allen. "I'm sure the industry will figure out how to do it.
There will be a lot of industry-generated reform and the
industry will prosper. This is not, in my view, something that
should be regulated."
Privatizing Securitization
According to Wharton finance professor Richard J. Herring, for
decades, mortgage securitization was backed by government
guarantees through Fannie Mae and Freddie Mac, and it worked
well. Of course, these agencies were regulated and bound by
less-risky underwriting standards than those that ultimately
prevailed in the subprime market which was also, potentially,
more profitable. Indeed, default rates were so low in the
mortgage-based securities market that banks and other private
financial institutions were eager to take a piece of the
residential business.
At
first, the transition to private securitization worked, because
investors were willing to rely on three substitutes for the
government guarantees. These included ratings agencies, new
business models and monoline insurance designed to guarantee
specialized mortgage-backed bonds. "Positive experience with
private securitization led to an alphabet soup of innovations
that sliced and diced the cash flows from pools of mortgages in
increasingly complex ways," says Herring.
Now,
the subprime crisis has undermined confidence in all three
pillars of private securitization. Ratings proved unreliable as
even highly rated tranches experienced sudden, multiple-notch
downgrades that were unknown in corporate bonds. Models
developed by the most sophisticated firms selling
mortgage-backed securities, including Bear Stearns, Merrill
Lynch, Citigroup and UBS, failed. Monoline insurers, it turned
out, were not adequately capitalized.
"There
has been a highly rational flight to simplicity," says Herring.
Over time, he believes, the real estate securitization market
will reemerge as investors regain confidence in the ratings
agencies, new models evolve, and monoline insurers are able to
increase their capital. "But I think that it will be a long time
before the market will be willing to accept the complex, opaque
structures that failed," continues Herring. He adds that
recovery will be delayed until investors are confident that the
fall in house prices has reached the bottom.
Wharton
real estate professor Susan M. Wachter points out that many
recent -- and historic -- international financial problems
originated in real estate. The nature of real estate finance and
incentive structures is more to blame than securitization this
time around. "The most recent crisis is coming through the
securitization market, but this isn't the only real estate
crisis," Wachter notes, adding that the fundamental problem in
real estate finance is that there is no way to bet against the
industry. Real estate is essentially priced by optimists, and
rising prices themselves justify even higher values as assets
are marked to market, creating new incentives for investors to
overpay.
Wachter
points to real estate investment trusts (REITS), publicly traded
bundles of real estate assets, as an example of how
securitization can help provide liquidity, but also a chance for
short-sellers to correct against overly optimistic pricing.
Research indicates that REIT prices may not have increased as
much as other sectors of real estate finance because the
industry has at least 200 analysts looking at the underlying
assets in each REIT with the ability to point out faulty pricing
to investors. "REITS have performed fluidly relative to the
overall market, and that is a good thing," says Wachter.
Fee-driven Lending
Another
problem was that much of the subprime lending was fee-driven,
giving banks incentives to write loans to earn the fees because
they could then pass the risky assets along to securitized
bondholders. And even bank shareholders had no way to limit
their real estate exposure because banks invest in various kinds
of economic activity and not just in real estate. Biased pricing
and bubbles also arise because the supply of real estate is not
elastic. By the time the market recognizes supply has
outstripped demand, construction has already begun on many more
projects that will continue to be built out; this tends to
exacerbate oversupply and create downward pressure on prices for
years.
In a
research paper titled, "Incentives for Mortgage Lending in
Asia," Wachter and her co-authors write: "With [the] forbearance
of regulatory authorities and the intervention of governments,
banks may be bailed out, mitigating the consequences for
shareholders. Nonetheless, the fundamental factor which explains
why episodes of bank under-pricing of risk are likely to occur
is the inability of banking shareholders to identify these
episodes promptly and incentivize correct pricing."
Wharton
real estate professor Joseph Gyourko notes that significant
differences exist in the performance of commercial and
residential real estate securities. "Securitized commercial
property debt will come back once the market calms down," he
says, adding that there has been very little default in
commercial real estate finance. "You'll be able to pool
mortgages and securitize them, but almost certainly won't be
able to leverage them as much as you did in the past."
The
residential side, where there is significant default, is more
problematic. Gyourko believes the residential market will go
back to what it was in the mid-1990s and most borrowers will
have to put down at least 10% of the sales price. "We will get
rid of the exotic, highly leveraged loans," he says. "That will
lead to lower homeownership, but it should. We put a lot of
people into homeownership that we shouldn't have."
Wharton
emeritus finance professor Jack Guttentag, who runs a web site
called mtgprofessor.com, says the short-term future for
residential real estate is "bleak."
"Secured bondholders have been badly burned. They discovered to
their dismay that all kinds of problems are connected to
mortgage-backed securities, which they hadn't anticipated."
Guttentag also points to the failure of ratings agencies, which
are already being revamped. The methodologies used to determine
ratings were flawed, he says. "They used historic performance
over a period that simply wasn't representative."
"CDOs
are Doomed"
In the
future, ratings agencies will need to operate on the assumption
that a security rated AAA should be able to withstand a shock as
great as the current crisis.
"That
will mean that under the best of circumstances, it will be
harder to get a triple-A rating, which will reduce the
profitability of securities," Guttentag says. Some forms of
securities will die. CDOs are doomed, he adds, because the
market has seen they are extremely difficult to value. "In the
short term, the prospects are dismal. The market will recover,
but I don't think we'll ever see CDOs again and the standards
will be tougher, so the comeback will be gradual."
Gyourko
notes that the crisis is playing out in a presidential election
year, complicating the response. "I think this is the worst time
to have this happen. It's never a good time, but in an election
year, you're more likely to get a bad policy response," he says.
According to Guttentag, while Republican presidential candidate
John McCain is taking a laissez-faire stance, the Democratic
presidential candidates have focused on using the Federal
Housing Administration (FHA) to refinance loans that are in
default. The idea is similar to what happened during the Great
Depression of the 1930s with another agency called the Home
Owners' Loan Corp. which was created specifically for that
purpose.
The
problem, says Guttentag, is that FHA is not designed as a
bailout agency. "The FHA's core mission is predicated on it
being a solvent operation, actuarially sound, charging an
insurance premium large enough only to cover losses. How they
would reconcile that is not clear."
Guttentag says attempts may be made to create a separate bailout
agency within the FHA with different accountability. "But the
devil is in the details," he warns, "and the details have to do
with exactly who is going to be helped, what the requirements
are, what the nature of the assistance is going to be, and
myriad other factors that have to be worked out." The Bush
administration has taken some steps to ease the crisis,
including encouraging lenders to modify contracts to avoid
foreclosure. A strong case can be made for these measures,
Guttentag adds. "The cost of foreclosure is often greater than
the cost of modifying the contract and keeping the borrower in
the house." One downside is that once some loans are modified
for those truly on the brink of foreclosure, other borrowers who
could somehow manage to avoid foreclosure may demand the same
modifications, shortchanging investors.
In
testimony before the U.S. House of Representatives' Committee on
Oversight and Government Reform, Wachter laid out a proposal
developed with the Center for American Progress to resolve the
current crisis. Under the so-called SAFE loan plan, the U.S.
treasury and the Federal Reserve would run auctions, in which
FHA originators, as well as Fannie Mae and Freddie Mac and their
servicers, would purchase mortgages from current investors at a
discount determined at the auction.
Investors would take a reduction in asset value and yield in
exchange for liquidity and certainty and the auction process
would price pools and bring transparency back to the market. The
FHA, Fannie Mae, and Freddie Mac could then arrange for
restructuring of loans.
Meanwhile, Allen notes the Federal Reserve has taken some
dramatic steps with interest rate policy to resolve the current
economic crisis, but that could lead to tension with Europe and
Japan over currency valuations. As the dollar continues to fall,
U.S. companies are increasingly more competitive overseas. "The
Fed cut the rate at the beginning, and that was fine, but now
things are getting way out of line," he says.
Furthermore, it is not clear that cutting rates is going to
solve the basic problem. As rates continues to drop, foreigners
may begin withdrawing their money from dollar-denominated
investments, driving rates up. "What the Fed is doing is
unprecedented," says Allen. "It is laudable that it is trying to
stop a recession, but how many risks should you take to do that?
We're now moving into an area where the Fed is probably taking
too many risks. If inflation picks up and long-term rates go up,
we'll be in a situation where we have to raise short-term rates
as we go into recession, which is not a happy thing to."
Vulture
Capital
The
private sector has begun to show signs of willingness to get
back into the fray. A number of vulture funds have begun to form
to take advantage of distressed real estate prices. BlackRock
and Highfields Capital Management have announced they will raise
$2 billion to buy delinquent residential mortgages. The
companies have hired Sanford Kurland, the former president of
Countrywide Financial, to run the new venture called Private
National Mortgage Acceptance, or PennyMac. "Many distressed
funds will come in to discover prices," says Gyourko.
Wharton
real estate professor Peter Linneman offers an intriguing
prescription to bring prices down to the point where the
industry can start to rebuild. He suggests that the government
tell banks that if they want to maintain their federal
insurance, they should fire their CEO by the end of the day, and
the government will pay the CEO $10 million in severance.
Ousting the former CEOs gives the new bank CEOs an incentive to
write down all the bad assets immediately, so that any
improvement will make them look good going forward. That would
speed the painful process of gradual price declines.
"There's plenty of money out there waiting for these assets to
be written down to bargain prices," says Linneman. In another
quarter or two, the lenders would have new cash and be ready to
lend again. Meanwhile, he says, the government should tell
bankers it will keep interest rates down but raise them after
the end of the year. "That says, 'Get your house in order in the
next nine months because the subsidy ends at the end of the
year.'" Linneman figures that 1,000 CEOs are accountable for
about 80% of the current lending mess. If the government were to
spend $10 billion to restore liquidity to the market in nine
months with only 1,000 people losing their jobs, it would be the
best investment it could make to restore the economy. "I'm only
half-kidding," he quips.
Linneman also argues that concerns about moral hazard -- or the
tendency to take greater risks because of the presence of a
safety net -- because of a bailout are not valid. Those
concerns, he says, already exist and have been in place since
the U.S. government agreed to insure bank deposits. "The minute
you say to somebody, 'No matter what you do I'll give your
people their money back,' you've created moral hazard," he says.
"Now it's only a matter of how often and how much they will have
to spend to settle up. If you go through our history, every
eight years to 15 years we have had an episode."
Continued in article
The Timeline of
the Recent History of Fannie Mae Scandals 2002-2008 ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm#FannieMae
"Fannie Mayhem: A History," The Wall
Street Journal, July 14, 2008
2008
"Merrill Lynch Settlement With
SEC Worth Up to $7B," SmartPros, August 25, 2008 ---
http://accounting.smartpros.com/x62971.xml
Federal
regulators said Friday that investors who bought risky
auction-rate securities from Merrill Lynch & Co. before the
market for those bonds collapsed will be able to recover up to
$7 billion under a new agreement.
The largest U.S.
brokerage will buy back the securities from thousands of
investors under a settlement with the Securities and Exchange
Commission, New York Attorney General Andrew Cuomo and other
state regulators over its role in selling the high-risk bonds to
retail investors. Under that deal, announced Thursday, Merrill
agreed to hasten its voluntary buyback plan by repurchasing $10
billion to $12 billion of the securities from investors by Jan.
2.
Merrill also
agreed to pay a $125 million fine in a separate accord with
state regulators.
The $330 billion
market for auction-rate securities collapsed in mid-February.
The SEC's
estimate of a $7 billion recovery is based on its projection of
the eventual amount of the bonds that will be cashed in by the
affected investors, who bought them before Feb. 13. The $10
billion to $12 billion is the total amount that Merrill is
committing to buy back. The firm has to offer redemptions to all
investors, though not all may cash in the securities.
The SEC said the
new agreement will enable retail investors, small businesses and
charities who purchased the securities from Merrill "to restore
their losses and liquidity."
New York-based
Merrill neither admitted nor denied wrongdoing in agreeing to
the federal settlement, which is subject to approval by SEC
commissioners.
The firm wasn't
fined under the accord, but the SEC said Merrill "faces the
prospect" of a penalty after completing its obligations under
the agreement. The amount of the penalty, if any, would take
into account the extent of Merrill's misconduct in marketing and
selling auction-rate securities, and an assessment of whether it
fulfilled its obligations, the SEC said.
"Merrill Lynch's
conduct harmed tens of thousands of investors who will have the
opportunity to get their money back through this agreement,"
Linda Thomsen, the agency's enforcement director, said in a
statement. "We will continue to aggressively investigate
wrongdoing in the marketing and sale of auction-rate
securities."
Merrill, Goldman
Sachs Group Inc. and Deutsche Bank on Thursday brought to eight
the number of global banks that have settled a five-month
investigation into claims they misled customers into believing
the securities were safe.
The auction-rate
securities market involved investors buying and selling
instruments that resembled regular corporate debt, except the
interest rates were reset at regular auctions - some as
frequently as once a week. A number of companies and retail
clients invested in the securities because, thanks to the
regular auctions, they could treat their holdings as liquid,
almost like cash.
Major issuers
included companies that financed student loans and municipal
agencies like the Port Authority of New York and New Jersey.
When big banks ceased backstopping the auctions with supporting
bids because of concerns about credit exposure, the bustling
market collapsed. That left some issuers paying double-digit
interest rates because of the terms under which they issued the
securities.
Regulators have
been investigating the collapse in the market to determine who
was responsible for its demise and whether banks knowingly
misrepresented the safety of the securities when selling them to
investors.
Jensen Comment
It's unbelievable how many huge frauds there are in which Merrill
Lynch has been an active participant. For example, go to the top of
this document and do a word search for "Merrill."
For example, Merrill Lynch was a key player in the derivatives
instrument fraud that cost Orange County over a billion dollars.
This is just one of the many examples.
2008
"Former Diebold Sales Rep Settles Inside Trading Charges,"
Securities Law Prof Blog, November 26, 2008 ---
http://lawprofessors.typepad.com/securities/
On November 19, 2008, the
United States District Court for the Western District of
Oklahoma entered final judgment against Robert G. Cole in SEC v.
Cole, Civ 08-265 C (W.D. Okla.), an insider trading case the
Commission filed on March 13, 2008. The Commission’s complaint
alleged that Cole, a former sales representative for Diebold,
Inc., made over $500,000 in illegal profits by using material,
nonpublic information to trade Diebold securities. Diebold is an
Ohio-based public company that manufactures and sells automated
teller machines, bank security systems, and electronic voting
machines.
The Commission’s complaint
alleged that on September 15, 2005, shortly after learning from
his sales manager that revenues and orders in Diebold’s North
American regional bank business were significantly below target,
Cole began
purchasing hundreds of soon-to-expire Diebold put options
contracts, at a total cost of $70,110, anticipating that Diebold
would lower its earnings forecast and the price of Diebold stock
would fall. As
alleged in the complaint, on September 21, 2005 — one day after
Cole completed purchasing these Diebold put option contracts —
Diebold announced that it was lowering its earnings forecasts,
primarily because of a revenue shortfall in the company’s North
American regional bank business. After this public announcement,
Diebold’s stock price dropped sharply, closing at $37.27 per
share, which was a 16% drop from the previous day’s closing
price of $44.13. As the complaint alleged, Cole immediately sold
the Diebold put option contracts for $579,190, realizing illicit
profits of $509,080 (a 700% return).
The Commission alleged that
Cole violated Section 10(b) of the Securities Exchange Act of
1934, and Rule 10b-5 thereunder. Without admitting or denying
the allegations in the complaint, Cole consented to the entry of
a final judgment that permanently enjoins him from future
violations of these provisions, and orders him to disgorge his
illicit profits of $509,080, which will be deemed satisfied by a
forfeiture order entered in a related criminal case. In that
case, U.S. v. Robert Cole, No. 5:08-CR-327 (N.D. Ohio), Cole
pled guilty to a felony charge of securities fraud, and was
sentenced to a prison term of 1 year and 1 day, two years of
supervised release, forfeiture of $509,080, and a $180,000 fine.
Bob Jensen's fraud updates are at
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
Bob Jensen's Rotten to the Core threads are at
http://faculty.trinity.edu/rjensen/FraudRotten.htm
2008
"French Bank Rocked by Rogue
Trader Société Générale Blames $7.2 Billion in Losses On a Quiet
31-Year-Old," by David Gauthier-Villars, Carrick
Mollenkamp, and Alistair MacDonald, The Wall Street Journal,
January 25, 2008; Page A1 ---
http://online.wsj.com/article/SB120115814649013033.html?mod=djem_jiewr_ac
2008
"Derivatives the new 'ticking bomb'
Buffett and Gross warn: $516 trillion," by Paul B. Farrell,
Market Watch, March 10, 2008 ---
Click Here
Wall
Street didn't listen to Buffett. Derivatives grew into a
massive bubble, from about $100 trillion to $516 trillion by
2007. The new derivatives bubble was fueled by five key
economic and political trends:
-
Sarbanes-Oxley increased corporate disclosures and
government oversight
-
Federal Reserve's cheap money policies created the
subprime-housing boom
-
War budgets burdened the U.S. Treasury and future
entitlements programs
-
Trade deficits with China and others destroyed the value
of the U.S. dollar
-
Oil and commodity rich nations demanding equity payments
rather than debt
In
short, despite Buffett's clear warnings, a massive new
derivatives bubble is driving the domestic and global economies,
a bubble that continues growing today parallel with the
subprime-credit meltdown triggering a bear-recession
2008
A Primer on
Derivatives
I think there are
two CBS Sixty Minutes television modules by Steve Kroft that the entire world
should view. These are great videos for college students to view while keeping
in mind that both videos are negatively biased. What follows is my primer in
defense of derivative financial instruments and hedging activities.
CBS Video Module 1
Financial Derivatives Scandals Explode in 1995
|
|
CBS Video Module 2
Credit Derivatives Scandals Explode in 2008
|
|
Related to the above television programs is "The Trillion Dollar
Bet" video from PBS Nova ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#LTCM
Bob Jensen's Primer on Derivatives
Although the roots of the
sub-prime mortgage scandal lie in Main Street lending or more
money for housing than borrowers could ever afford to pay off, the
opportunity to do so was afforded by lenders like Countrywide
Financial (a mortgage lending company owned by Bank of America)
being able to pass on the default risk by selling the high risk
mortgages to Fannie Mae and Freddie Mac, quasi government
corporations that
took the brunt of the loan losses. But some banks like
Washington Mutual (WaMu became the largest bank failure in the
history of the world) were greedy and kept huge portfolios of these
high-return and high-risk mortgage investments.
Fannie, Freddie, WaMu and the other risk takers assumed that the
value of the real estate (the mortgage loan collateral) would be
sufficient to pay back the loans in case of mortgage default
foreclosures. But they underestimated the fraud going on on Main
Street where property appraisers were fraudulently estimating real
estate values way above market value and mortgage companies were
lending way above amounts that borrowers would ever be able to pay
back. My essay on the sub-prime mortgage scandal along with an
alphabet soup set of appendices can be found at
http://faculty.trinity.edu/rjensen/2008Bailout.htm
In
addition much of the current scandal also is attributed to Wall
Street writing of
credit derivative contracts that essentially "insured" against
default of debt with counterparties investing in debt instruments
that were "insured" by credit derivatives written by such giant
firms as Bear Stearns and American Insurance Group (AIG). But unlike
insurance where sufficient capital reserves are required, Congress
passed legislation in Year 2000 that allowed Wall Street to
write credit derivative insurance without having any capital
reserves to cover the losses. Congress and the Wall Street firms
just never anticipated the massive amount of mortgage defaults
attributable to Main Street's lending frauds. When the magnitude of
the amounts owing to counterparties on credit derivatives became
known, giant firms like Bear Stearns and AIG would've defaulted due
to credit derivative obligations to counterparties. This would have
led, in turn, to counterparty failure of many giants in the
world banking system. The Federal Reserve decided early on to bail
out Bear Stearns credit derivative losses, and the first $70 billion
given to AIG by Hank Paulsen in the new Bailout Bill went to pay off
AIG's counterparties to AIG's credit derivative contracts ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#SEC
So
what is a derivative financial instrument? Consider first a
financial debt instrument that historically was a contract in which
a borrower borrowed money from a lender and the risk for the entire
notional (the loan principal) passed from borrower to lender. For
example, if Company B sold bonds for $100 million to Company C, the
entire notional ($100 million) is at risk of being paid back to
Company B. Credit rating companies, in turn, rate those bonds as to
financial risk with such ratings as AAA (virtually certain to be
paid back) all the way down to junk bonds (very high risk of
default) of the entire notional amount. Credit ratings greatly
impact the price received by Company B for its bond sales.
A
derivative financial instrument is similar except that the notional
amount is often not at risk because these contracts "net settle."
For example, if Airline A enters into futures contracts to buy a
million gallons of jet fuel one year from now at a forward price of
$4 per gallon, the notional full value of a million gallons of fuel
never changes hands. After a year passes, Airline A net settles with
the counterparties on the net difference between the current spot
price and the contracted forward price. Although in some cases a
purchase/sale contract can specify physical delivery of the
notional, most derivative contracts net settle without putting the
entire notional amount at risk.
Hence, a derivative financial instrument has a notional (a quantity
such a a million bushels of corn), an underlying (such as the market
price of a particular grade of corn), and net settlement provisions
that do not put the value of the entire notional amount at risk.
Only the difference between forward and spot prices on the notional
is at risk. The entire notional becomes at risk only if the future
spot prices fall to zero or nearly zero. This is not likely to
happen in the case of commodities like corn, oil, copper, gold,
silver, etc. It can happen in the case of credit ratings where $100
million in AAA bonds fall to zero when the debtor is declared to be
hopelessly bankrupt. This is why credit
derivatives are much more risky than commodity derivatives. If a
credit derivative is written on a $100 million bond contract, the
entire $100 million might be lost. The probability of losing the
entire value of the notional is much greater with credit derivatives
than with commodities that are almost certain not to decline to $0
in value.
The
underlying is generally called an index. Examples include corn
prices, oil prices, interest rates (e.g., Treasury rates or LIBOR
rates), and credit ratings (AAA, AAB, BBB, etc.). A huge difference
between commodity versus credit derivatives lies in the depth
(number of buyers and sellers) and the frequency of trades in the
market. For example, in the derivatives markets for corn futures or
corn options (puts and calls) there are thousands upon thousands of
buyers and sellers and the market prices (e.g., futures, option, and
spot prices) change by the minute each trading day. In the case of a
credit derivative written on the bond rating by a credit rating
agency there is no deep market and the credit rating rarely changes.
There is no underlying "market" in the case of a credit derivative.
Hence a credit derivative differs
fundamentally from a commodity derivative in the depth of the market
and the frequency of trading on the market. Its a mistake to lump
credit derivatives and commodity derivatives in the same a single
type of contracting called derivatives.
By any other name, a credit
derivative is an insurance contract where risk of default is not market based
but depends upon some disaster just like casualty insurance protects against
such disasters as fire, wind, and flood. The entire value of the notional (the
entire value of each bond insured for credit risk or each house insured for fire
loss) is at risk.
In contrast, a commodity derivative
is market based and does not in general put the the entire notional at risk
because commodity values are not likely to be wiped out entirely. Commodities
may move up and down in value, thereby generating variations in the basis (which
is the difference between spot and forward prices), but it would be extremely
rare for the a commodity to fall to zero in value. It is much more common for an
insured house to be burned down entirely or an insured (with a credit
derivative) bond notional to fall into junk bond status.
AIG and Allstate and State Farm are
required by insurance laws to have capital reserves to cover a large number of
houses burning down at the same time. However, if all insured houses burned down
at the same time, insurance companies could not possibly cover all the losses.
This is why a single insurance company might refuse to insure more than a
certain percentage of houses in a give geographic area. Insurance written above
a company's limit is spread to other companies by a process called
reinsurance.
Insurance companies are subject to regulation that requires capital reserves to
cover actuary-determined expected losses and contract clauses that limit risk in
case of catastrophes such as nuclear holocaust.
Credit derivative insurers could not
write insurance contracts for credit default without capital reserves and other
catastrophe clauses until Congress in Year 2000 allowed investment banks like
Bear Stearns and insurance underwriters like AIG to enter into credit derivative
insurance without capital reserves and catastrophe clauses. The fraudulent
sub-prime loan market became a catastrophe in terms of real estate loans covered
against default by credit derivatives. Bear Stearns, AIG, and the other credit
derivative underwriters had insufficient capital reserves and would've defaulted
on their credit derivatives if the U.S. government had not stepped in to cover
amounts owed to credit derivative counterparties. The government justified
bailing out these obligations by stating that the domino effect would've
otherwise brought down the entire banking system. On this I'm a cynic, but
that's another matter entirely. History is history at this point.
What is sad today is that
derivatives in general are getting a bad name!
Commodity derivatives (including interest rate risk derivatives) are
great vehicles for managing financial risk provided
the commodities and their derivatives are both traded in deep markets with
virtually zero probability that commodity values will fall to zero. Sadly, most
people in the world just do not appreciate the importance of maintaining active
commodity derivative markets for managing risk.
Ignorant people, especially ignorant
members of congress, may move to ban or severely restrain all derivative markets
rather than to merely reclassify credit derivatives as insurance contracts
subject to insurance laws. This does not mean, however, that I think that
commodity derivative contracting should be more regulated for protection against
unscrupulous sellers of derivative contracts. Like my hero Frank Partnoy, I've
argued for years that there should be more regulation of sellers of derivative
contracts.
I have a detailed history of
derivative instrument contract scandals and the evolution of accounting rules
(national and international) for derivative contracts at
http://faculty.trinity.edu/rjensen/FraudCongress.htm#DerivativesFrauds
At each point in the way I've applauded Frank Partnoy's appeal for both expanded
use of derivative instruments for managing risk and expanded regulations to stop
firms like Merrill Lynch, Morgan Stanley, and other unscrupulous outfits from
writing derivatives with built-in financial complexity intended to obscure risk
and screw fund investors who did not understand what they were buying into.
Bob Jensen's free tutorials and
videos on complex accounting rules for accounting for derivative financial
instruments and hedging activities ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Bob Jensen's glossary on derivative
financial instruments ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
If Greenspan Caused the Subprime Real Estate
Bubble, Who Caused the Second Bubble That's About to Burst?
Answer: See
http://faculty.trinity.edu/rjensen/2008Bailout.htm#LiquidityBubble
2008
In March 2008 the United States
Financial Accounting Standards Board (FASB)
issued the
FAS
161 amendments of FAS 133. These amendments pertain to
disclosures of derivative financial instruments.
The use
and complexity of derivative instruments and hedging activities
have increased significantly over the past several years.
Constituents have expressed concerns that the existing
disclosure requirements in FASB Statement No. 133, Accounting
for Derivative Instruments and Hedging Activities, do not
provide adequate information about how derivative and hedging
activities affect an entity’s financial position, financial
performance, and cash flows. Accordingly, this Statement
requires enhanced disclosures about an entity’s derivative and
hedging activities and thereby improves the transparency of
financial reporting. This Statement is effective for financial
statements issued for fiscal years and interim periods beginning
after November 15, 2008, with early application encouraged. This
Statement encourages, but does not require, comparative
disclosures for earlier periods at initial adoption.
This
Statement is intended to enhance the current disclosure
framework in Statement 133. The Statement requires that
objectives for using derivative instruments be disclosed in
terms of underlying risk and accounting designation. This
disclosure better conveys the purpose of derivative use in terms
of the risks that the entity is intending to manage. Disclosing
the fair values of derivative instruments and their gains and
losses in a tabular format should provide a more complete
picture of the location in an entity’s financial statements of
both the derivative positions existing at period end and the
effect of using derivatives during the reporting period.
Disclosing information about credit-risk-related contingent
features should provide information on the potential effect on
an entity’s liquidity from using derivatives. Finally, this
Statement requires cross-referencing within the footnotes, which
should help users of financial statements locate important
information about derivative instruments.
1. FASB
Statement No. 133, Accounting for Derivative Instruments
and Hedging Activities, establishes, among other things,
the disclosure requirements for derivative instruments and
for hedging activities. This Statement amends and expands
the disclosure requirements of Statement 133 with the intent
to provide users of financial statements with an enhanced
understanding of:
a. How
and why an entity uses derivative instruments
b. How
derivative instruments and related hedged items are
accounted for under Statement 133 and its related
interpretations
c. How
derivative instruments and related hedged items affect
an entity’s financial position, financial performance,
and cash flows.
To meet those
objectives, this Statement requires qualitative disclosures
about objectives and strategies for using derivatives,
quantitative disclosures about fair value amounts of and
gains and losses on derivative instruments, and disclosures
about credit-risk-related contingent features in derivative
agreements.
2. This
Statement has the same scope as Statement 133. Accordingly,
this Statement applies to all entities. This Statement
applies to all derivative instruments, including bifurcated
derivative instruments (and nonderivative instruments that
are designated and qualify as hedging instruments pursuant
to paragraphs 37 and 42 of Statement 133) and related hedged
items accounted for under Statement 133 and its related
interpretations.
2008
Question
What could "swaps", "swaptions", "caps", "collars" and "floors"have to do with
the value of your home and the pillars of the banking enterprise?
"Pushovers at the Fed," The Wall Street Journal, March 25, 2008;
Page A22 ---
http://online.wsj.com/article/SB120640465860361041.html?mod=djemEditorialPage
Last week's Fed-led sale of Bear at least had the
virtue of sending a message that bad things happen to reckless investors. Bear
took a highly leveraged flyer on the mortgage securities market, ran into a
liquidity crisis as its creditors lost confidence, and had to ask the Fed for
help to avoid bankruptcy. The $2 sale price was a shock to Bear employees and
investors. But it was also condign market punishment for bad decisions, and a
bracing lesson for future investors. Meanwhile, the Fed's more troubling
agreement to guarantee Bear's mortgage paper could at least be justified in the
name of avoiding a larger financial breakdown. . . . If Bear holders
don't like the $2 price, they have every right to oppose it while taking their
chances with customers and creditors. If Mr. Dimon wants to pay more for Bear,
that's also his prerogative, but then he shouldn't demand that the Fed continue
to guarantee his paper. He's getting Bear at such a great price that he ought to
accept the mortgage-backed securities risk almost as a public service. We
suspect that's what the J.P. Morgan of the Panic of 1907 would have done . . .
The immediate political message is also terribly damaging. Congress is already
poised to overreact to the mortgage turmoil with a general bailout for subprime
borrowers, and yesterday's actions will only feed that beast. At least the $2
share price wasn't a bailout for Bear shareholders; at $10 a share, that's a
harder argument to sell, especially when taxpayers are also still indemnifying
those Bear-J.P. Morgan creditors. This makes us wonder if Treasury Secretary
Hank Paulson isn't already preparing to cave to Congress on the larger bailout.
2008
"The Accounting Cycle Biovail
Exposed, Part II," by: J. Edward Ketz , SmartPros, April
2008 ---
http://accounting.smartpros.com/x61530.xml
"Are Derivatives Too Complex? Is It Time to Regulate Their Usage?" by
J. Edward Ketz, SmartPros, March 20, 2008 ---
http://accounting.smartpros.com/x61241.xml
2008
The Worldwide Oligopoly of Audit Firms
Question: How much have audit fees allegedly increased since auditors put
on their SOX?
"On with the show? The auditing business, concentrated in the
hands of just a few companies, is far too cosy to operate with
consumers' best interests in mind," by Prim Sikka, The Guardian,
June 3, 2008 ---
http://commentisfree.guardian.co.uk/prem_sikka_/2008/06/on_with_the_show.html
Never mind showbusiness, there's no
business like the accountancy business. Accountancy firms have a
licence to print money because they enjoy access to a
state-guaranteed market for auditing. Companies, hospitals,
schools, charities, universities, trade unions and housing
associations have to submit to an audit, even though the auditor
might issue duff reports. Anyone refusing their services faces a
prison sentence.
Major company audits are the most
lucrative and that market is dominated by just four global
auditing firms. PricewaterhouseCoopers, Deloitte, KPMG and Ernst
& Young have global revenues of over $80 billion (Ł41bn) a year,
which is exceeded by the gross domestic product of only 54
nation states. These firms dominate the structures that make
accounting and auditing rules.
Following the Enron and WorldCom
debacles and the demise of Arthur Andersen, the auditing market
has become further concentrated in those four firms. Many major
companies looking for global coverage find that the auditor
choice is very restricted.
In the US, the big four audit 95% of
public companies with market capitalisations of over $750m. A US
study focusing on 1,300 companies, showed that the fees charged
by the big auditing firms have
increased by 345% in the five years to
2006. Median total auditor costs rose to $2.7m, from $1.4m in
2001. A major reason for the increase is said to be the
(SOX)
Sarbanes-Oxley Act (pdf) 2002, which
was introduced after audit failures at Enron and WorldCom.
In the UK, the big four firms audit 97%
of FTSE 350 companies. In 2001, the average FTSE 100 company
audit fee was Ł1.89m. By
2006, the
figure had increased to Ł3.7m. The rise in audit fees continues
to exceed the rates of inflation. For example, Northern Rock's
fees have increased from Ł1.8m in 2006 to Ł2.4m in 2007.
The firms cite the Sarbanes-Oxley Act
and international accounting and auditing standards to justify
higher fees. They are silent on the fact that their own audits
of Enron and WorldCom arguably prompted the Sarbanes-Oxley Act,
or that the big four firms finance and dominate the setting of
international accounting and auditing standards. These standards
rarely say anything about the public accountability of auditing
firms. Most firms refuse to reveal their profits.
The massive hike in audit fees has not
given us better audits.
Carlyle Capital Corporation collapsed
within days of receiving a clean bill of health form its
auditors.
Bear Stearns was bailed out within a
few days of receiving another clean bill of health. In the
current financial crisis, all major banks received a clean bill
of health even though they engaged in massive off balance sheet
accounting and around
$1.2tn
of toxic debts may have been hidden. But
perhaps ineffective auditors suit the corporate barons.
In market economies, producers of
shoddy goods and services are allowed to go to the wall.
Governments impose higher standards of care on them to improve
quality. But entirely the opposite has happened in the auditing
industry. Auditing firms have secured
liability concessions (pdf)
to shield them from the consequences of own their failures.
Charlie McCreevy, the EU commissioner
for the internal market and services, an accountant, is keen to
give them more. He favours an artificial "cap" on auditor
liability. The commissioner has failed to provide any evidence
to show that the liability shield provided to producers of poor
quality goods and services somehow encourages them to improve
the quality of their products.
Accountancy firms, EU commissioners and
regulators routinely preach competition to everyone else, but go
soft when it comes to dealing with auditing firms. They could
restrict the number of FTSE companies that any auditing firm can
audit and thus create for space for medium-sized firms to
advance. They could insist that some quoted companies should
have joint audits and thus again create space for medium-sized
firms. They could insist on compulsory retendering or company
audits and rotation of auditors. They could invite new players
to the audit market. The Securities Exchange Commission or the
Financial Services Authority could take charge of audits of
banks and financial institutions. None of these proposals are on
the radar of the corporate dominated UK accounting regulator,
the
Financial Reporting Council. It
advocates market led solutions, which raises the question of why
the markets have not resolved the problems already, and exerted
pressures for better audits.
As a society, we continue to give
auditing firms state-guaranteed markets, monopolies, lucrative
fees and liability concessions. None of it has given us, or is
likely to give us better audits, company accounts, corporate
governance or freedom from frauds and fiddles. Without effective
independent regulation, public accountability and demanding
liability laws, the industry cannot provide value for money.
Jensen Comment
You can access a fairly good summary of the Big Four at
http://en.wikipedia.org/wiki/Big_Four_auditors
Bob Jensen's threads on auditing firm scandals and
professionalism are at
http://faculty.trinity.edu/rjensen/Fraud001.htm
2008
"It's Time to Prepare for the Arrival of International
Accounting Standards: Good Bye (to U.S. GAAP), by Sarah
Johnson, CFO Magazine April 1, 2008 ---
http://www.cfo.com/article.cfm/10919122/c_10941875?f=magazine_coverstory
One of the densest thickets of
generally accepted accounting principles is revenue recognition.
By one tally, more than 160 pieces of authoritative literature
relate to how and when companies record revenue. Now, however,
U.S. and international accounting authorities are taking a
scythe to the rules. They will mow down "broad swaths" of GAAP,
says Robert Herz, chairman of the Financial Accounting Standards
Board, en route to producing a single set of global accounting
guidelines for revenue recognition.
This slash-and-burn approach
is a sign of things to come. For the past five years, FASB and
the International Accounting Standards Board (IASB) have been
working to merge U.S. accounting rules with international
financial reporting standards (IFRS). But this so-called
convergence is shaping up to be more of a takeover than a merger
of equals — many who favor a single global standard hope to wipe
out GAAP altogether.
Experts at the Big Four
accounting firms say a Securities and Exchange Commission
mandate for all U.S. publicly traded companies to use IFRS is
inevitable. The SEC does plan to release a road map in late
spring for transitioning U.S. public companies to the
international standards, but it has not yet said whether
adopting IFRS will be mandatory. Still, many SEC watchers expect
the agency to eventually scrap GAAP.
"If I'm reading the tea leaves
right, it's not a question of if but when," says Jeffrey Keefer,
CFO of chemical giant DuPont. Large U.S. companies could start
using IFRS instead of GAAP in three years, say accounting firms
and finance chiefs, while a mandatory conversion could take
effect in five years. Auditors urge CFOs to keep a weather eye
on the IFRS movement. "It's going to be bigger than anybody
expects," says Gary Illiano, a partner at Grant Thornton. Adds
Deloitte & Touche partner Joel Osnoss: "From the smallest public
companies to the largest, everyone should at least be thinking
about what the potential of this will be."
Large Benefits Audit firms and
multinationals have been pressuring the SEC to keep the
global-standards movement on the fast track ever since the end
of 2007, when the agency began allowing foreign companies to
submit their IFRS-prepared filings without reconciling them to
GAAP. That effectively blessed IFRS as high-quality, notes
Margaret Smyth, vice president and controller of United
Technologies Corp., some of whose international subsidiaries use
the global standards. "If it's good enough for the SEC, I would
think it's good enough for most people," she says.
And good enough especially for
large multinationals, whose CFOs are tired of using more than
one accounting system for regulatory purposes here and abroad.
"It's really not cost efficient to maintain two sets of books on
different standards," says Richard Fearon, CFO of
Cleveland-based Eaton Corp., which has manufacturing sites in 30
countries.
To eliminate the extra work of
adhering to U.S. GAAP as well as to other countries' accounting
rules, Fearon would consider using consolidated global
accounting rules. But he has reservations. For one, the current
form of IFRS is too principles-based for his taste; he would
prefer more specificity in the rules, ŕ a la GAAP. Also, he
believes the global standards have spawned too many variants
among the more than 100 countries that use IFRS-based standards
(see Insight, "One Standard, Many Laws").
Still, Fearon's 2008 agenda
includes an investigation into the differences between GAAP and
IFRS, particularly how the changes in revenue recognition,
taxation, and hedge accounting would affect his balance sheet
and income statement. Fearon isn't alone: finance departments at
other multinationals, such as PepsiCo and Procter & Gamble, are
conducting similar internal studies.
Continued in article
2008
PCAOB Oversight
Board Strategic Plan
Part of an April 28, 2008 message from Roger Debreceny
[roger@DEBRECENY.COM]
The PCAOB has issued its
strategic plan for the period from 2008 to 2013 at
http://www.pcaob.org/About_the_PCAOB/index.aspx
Key takeaways:
· Use by SEC foreign
issues of IFRS impacts work of PCAOB
· XBRL is on the agenda:
“The SEC has taken steps to encourage the implementation of
XBRL. As the SEC initiative develops, the PCAOB will have to
devote resources to familiarize itself with further XBRL
developments and to work closely with the SEC to consider
and, as appropriate, establish auditor responsibilities in
connection with XBRL-tagged data.”
· Subprime meltdown: The
PCAOB’s risk-based approach enables it to nimbly adapt its
programs in response to emerging issues. For example, given
the recent subprime crisis, the PCAOB has devoted, and may
continue to devote, certain resources to monitor these
developments, as well as train staff in this area. In
addition, the PCAOB has made certain adjustments to its
inspection program to assess subprime-related auditing
implications. As the subprime crisis unfolds, related
auditing implications may require further adjustments to the
PCAOB’s programs, training, and staffing levels.”
· Globalization: “Given
the breadth of the effect of globalization on PCAOB
programs, the PCAOB’s strategies related to globalization
permeate this Strategic Plan.”
· Case against legal
foundation of PCAOB marches along: “On March 21, 2007, the
U.S. District Court for the District of Columbia issued its
decision granting summary judgment to the PCAOB in the
constitutional lawsuit filed by the Free Enterprise Fund and
Beckstead & Watts LLP. On April 13, 2007, plaintiffs filed
an appeal to the United States Court of Appeals for the
District of Columbia. The continued defense of the lawsuit
will likely require significant resources.”
I have not read every word of
the Plan in detail, but what does seem to be missing is a
thorough analysis of the standards setting activities of the
Board. My perception is that audit standards in the US continue
to fall behind the quality of those promulgated by the IAASB.
Yet the agenda for new and revised standards from the PCAOB
seems modest indeed. There is discussion about the need to work
with ASB and IAASB and Goal 1(C) talks in general terms about
the need improvement in standards and guidance.
Bob Jensen's threads on XBRL are at
http://faculty.trinity.edu/rjensen/XBRLandOLAP.htm
Bob Jensen's timeline of financial scandals and the evolution of
accounting standards and the PCAOB are at
http://faculty.trinity.edu/rjensen/FraudCongress.htm
Bob Jensen's threads on accounting standard setting are at
http://faculty.trinity.edu/rjensen/Theory01.htm
2008
I came across this interesting speech by
CFTC Commissioner, Bart Chillton. In this speech he gives three
loopholes exploited by future market traders - Enron loophole,
London loophole and Swaps loophole. Basically all have a similar
theme- one market is regulated and other is not and both have near
similar products. The regulators can only watch the former and the
traders switch and build volumes in the latter. This is actually
problematic as because of innovation, one can create similar
instruments in another exchange and build up positions (he explains
that is what Amaranth traders did). Now what should a regulator do?
He says we need more cooperation between regulators.
Amol Agrawal, Mostly Economics, September 1, 2008 ---
http://mostlyeconomics.wordpress.com/
2008
"Greater Regulation of Financial Markets?" by Nobel
Laureate Gary Becker, The Becker-Posner Blog, April 28, 2008
---
http://www.becker-posner-blog.com/
The major deregulation
movement of the past 100 years started with the Ford and Carter
administrations in the 1970s, and continued through the Reagan
years. This movement came to an end with the passage of the
Americans with Disabilities Act of 1990 under the administration
of George W. Bush. Since then some sectors, such as labor
markets and product safety, have been regulated much more
extensively, while others, including commercial and investment
banking, have had no further declines in the extent of
regulation. Despite the considerable and tangible successes of
this deregulation movement, the pressure is intense to
significantly increase the regulations affecting consumer
safety, the introduction of new drugs, and especially financial
markets.
The 1970s saw a bipartisan
reduction in the regulation of airline travel, trucking,
security exchanges, and commercial banking. Measures of the
success of this deregulation include sharp declines in the cost
of air travel and of shipping goods by truck, huge reductions in
commissions on stock transactions, and higher interest rates on
bank deposits. Not only has no serious attempt been made to
re-regulate these activities, but also European and many other
nations on all continents have copied the American deregulation
of airlines and securities.
The impetus to tighter
regulations varies from sector to sector, although there is a
growing belief that many activities are insufficiently
regulated. Obviously, the current turmoil in the financial
sector is stimulating many proposals to regulate extensively
various types of financial transactions. Yet it is not obvious
that the problems in the financial sector resulted mainly
because of insufficient regulation. For example, commercial
banks are probably the most heavily regulated group in the
financial sector, yet they are in much greater difficulties than
say the hedge fund industry, which is one of the least regulated
industries in the financial sector. Banks participated very
extensively in originating mortgages, including subprime
mortgages, and in buying mortgage-backed securities, and so they
are suffering from the high foreclosure rates, and the sharp
decline in the market value of these securities.
One reason why extensive
regulation of commercial banks did not prevent many banks from
getting into trouble is that bank examiners became optimistic
along with banks about the risks associated with mortgages and
other bank assets because the market priced these assets as if
they carried little risk. It would run counter to human nature
for regulators to take a skeptical attitude toward the riskiness
of various assets when the market is indicating that these
assets are not so risky, and when originating and holding these
assets has been quite profitable. One can expect regulators to
mainly follow rather than lead the market in assessing riskiness
and other asset characteristics.
To some extent that was also
true of the Fed's behavior during the past few years. I believe
that Alan Greenspan is right in claiming that the main cause of
the housing boom was not the Fed's actions but the worldwide low
interest rates due to an abundant world supply of savings. The
demand for very durable assets like housing is greatly increased
by low interest rates. Still, the Fed seems to have contributed
to the booming demand for housing and other assets by keeping
the federal funds rate artificially low during the boom years of
2003-05.
In evaluating the need for
greater financial regulation, one should also not forget that
the American economy greatly outperformed the European and
Japanese economies during the past 25 years. Might that not be
related in part to the fact that the United States led the way
with major financial innovations like investment banks, hedge
funds, futures and derivative markets, and private equity funds
that were only lightly regulated? An infrequent period of
financial turmoil may be the price that has to be paid for more
rapid growth in income and low unemployment. Rapid income and
employment growth might be worth an occasional period of turmoil
especially if they do not lead to prolonged slowdowns in the
real part of the economy. So far the effects on GDP and
employment have not been severe, although the financial distress
is not yet completely over.
Nevertheless, a few important
regulatory changes are probably warranted. For the first time
the Fed allowed investment banks access to its federal funds
window, and the Fed guaranteed $29 billion worth of
mortgage-backed assets to induce J.P. Morgan to take over that
investment company. Since these types of Fed actions would
likely be repeated in the event of future financial turmoil,
investment banks would have an incentive to take on additional
risk since they can reasonably expect to be helped out by the
Fed in the future. For this reason it might be desirable for the
government to impose upper bounds on the permissible ratios of
assets to equity held by investment banks. The ratio of assets
to the equity of the five leading investment banks did increase
greatly from about 23 in 2004 to the highly leveraged level of
30 in 2007.
Other regulations of financial
institutions may also be merited, but elaborate new regulations
of the financial sector would be counterproductive. For example,
the Fed has proposed limits on how much mortgage interest rates
can exceed the prime rate for low-income borrowers with poor
credit ratings. This would be a foolish intervention into the
details of credit contracts that have all the defects of usury
laws.
The financial sector has
served the economy well by managing, dividing, and pricing
different types of risks in the economy. It would be a mistake
if Congress and the President allow the present financial
turmoil to panic them into inefficient new financial
regulations.
"Greater Regulation of Financial Markets?" by Richard
Posner, The Becker-Posner Blog, April 28, 2008 ---
http://www.becker-posner-blog.com/
Re-Regulate Financial
Markets?--Posner's Comment I no longer believe that deregulation
has been a complete, an unqualified, success. As I indicated in
my posting of last week, deregulation of the airline industry
appears to be a factor in the serious deterioration of service,
which I believe has imposed substantial costs on travelers,
particularly but not only business travelers; and the partial
deregulation of electricity supply may have been a factor in the
western energy crisis of 2000 to 2001 and the ensuing Enron
debacle. The deregulation of trucking, natural gas, and
pipelines has, in contrast, probably been an unqualified
success, and likewise the deregulation of the long-distance
telecommunications and telecommunications terminal equipment
markets, achieved by a combination of deregulatory moves by the
Federal Communications Commission beginning in 1968 and the
government antitrust suit that culminated in the breakup of AT&T
in 1983.
Although one must be tentative
in evaluating current events, I suspect that the deregulation
(though again partial) of banking has been a factor in the
current credit crisis. The reason is related to Becker's very
sensible suggestion that, given the moral hazard created by
government bailouts of failing financial institutions, a tighter
ceiling should be placed on the risks that banks are permitted
to take. Because of federal deposit insurance, banks are able to
borrow at low rates and depositors (the lenders) have no
incentive to monitor what the banks do with their money. This
encourages risk taking that is excessive from an overall social
standpoint and was the major factor in the savings and loan
collapse of the 1980s. Deregulation, by removing a variety of
restrictions on permitted banking activities, has allowed
commercial banks to engage in riskier activities than they
previously had been allowed to engage in, such as investing in
derivatives and in subprime mortgages, and thus deregulation
helped to bring on the current credit crunch. At the same time,
investment banks such as Bear Sterns have been allowed to engage
in what is functionally commercial banking; their lenders do not
have deposit insurance--but their lenders are banks that for the
reason stated above are happy to make risky loans.
The Federal Deposit Insurance
Reform Act of 2005 required the FDIC to base deposit insurance
premiums on an assessment of the riskiness of each banking
institution, and last year the Commission issued regulations
implementing the statutory directive. But, as far as I can
judge, the risk-assessed premiums vary within a very narrow band
and are not based on an in-depth assessment of the individual
bank’s riskiness.
Now it is tempting to think
that deregulation has nothing to do with this, that the problem
is that the banks mistakenly believed that their lending was not
risky. I am skeptical. I do not think that bubbles are primarily
due to avoidable error. I think they are due to inherent
uncertainty about when the bubble will burst. You don't want to
sell (or lend, in the case of banks) when the bubble is still
growing, because then you may be leaving a lot of money on the
table. There were warnings about an impending collapse of
housing prices years ago, but anyone who heeded them lost a
great deal of money before his ship came in. (Remember how
Warren Buffett was criticized in the late 1990s for missing out
on the high-tech stock boom.) I suspect that the commercial and
investment banks and hedge funds were engaged in rational risk
taking, but that (except in the case of the smaller hedge
funds--the largest, judging from the bailout of Long-Term
Capital Management in 1998, are also considered by federal
regulators too large to be permitted to go broke) they took
excessive risks because of the moral hazard created by deposit
insurance and bailout prospects.
Perhaps what the savings and
loan and now the broader financial-industry crises reveal is the
danger of partial deregulation. Full deregulation would entail
eliminating both government deposit insurance (especially
insurance that is not experience-rated or otherwise proportioned
to risk) and bailouts. Partial deregulation can create the worst
of all possible worlds, as the western energy crisis may also
illustrate, by encouraging firms to take risks secure in the
knowledge that the downside risk is truncated.
There has I think been a
tendency of recent Administrations, both Republican and
Democratic but especially the former, not to take regulation
very seriously. This tendency expresses itself in deep cuts in
staff and in the appointment of regulatory administrators who
are either political hacks or are ideologically opposed to
regulation. (I have long thought it troublesome that Alan
Greenspan was a follower of Ayn Rand.) This would be fine if
zero regulation were the social desideratum, but it is not. The
correct approach is to carve down regulation to the optimal
level but then finance and staff and enforce the remaining
regulatory duties competently and in good faith. Judging by the
number of scandals in recent years involving the regulation of
health, safety, and the environment, this is not being done. And
to these examples should probably be added the weak regulation
of questionable mortgage practices and of rating agencies'
conflicts of interest and, more basically, a failure to
appreciate the gravity of the moral hazard problem in the
financial industry.
Bob Jensen's threads on Credit Derivative and Credit Risk Swap
---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms
Scroll down to "Credit Derivative and Credit Risk Swap."
2008
Unlike many other nations that either did not have national
accounting standards or had weak and incomplete sets of standards,
the FASB over the years produced the best set of accounting
standards in the world (although there is no such thing a perfect
set since companies are always writing contracts to circumvent most
any standard). The FASB standards were heavily rule-based due to the
continual battles fought by the FASB in the trenches of U.S. firms
seeking to manage earnings and keep debt of the balance sheet with
ever-increasing contract complexities such as interest rate swaps
invented in the 1980s, SPE ploys, securitization "sales," synthetic
leasing, etc.
- The experiences of those
frazzled executives in charge of reducing risks in the
credit derivatives market are starting to resemble Alice’s
adventures in Wonderland. Alice shrank after drinking a
potion, but was then too small to reach the key to open the
door. The cake she ate did make her grow, but far too much.
It was not until she found a mushroom that allowed her to
both grow and shrink that she was able to adjust to the
right size, and enter the beautiful garden. It took an
awfully long time, with quite a number of unpleasant
experiences, to get there.
Aline van Duyn, "The adventure never ends in the derivatives
Wonderland," Financial Times, September 11, 2008 ---
Click Here
- While Lehman Brothers was
fighting for its life in the markets today, it was also
battling in a Senate panel's hearing on whether the company
and others created a set of financial products whose primary
purpose is to dodge taxes owned on U.S. stock dividends. The
"most compelling" reason for entering into dividend-related
stock swaps are the tax savings, Highbridge Capital
Management Treasury and Finance Director Richard Potapchuk
told the Senate's Permanent Subcommittee on Investigations.
Lehman Brothers (nyse: LEH - news - people ), Morgan Stanley
(nyse: MS - news - people ) and Deutsche Bank (nyse: DB -
news - people ) are among the companies behind the products.
Anitia Raghaven, The Tax Dodge Derivative, Forbes,
September 11, 2008 ---
Click Here
- What's Right and
What's Wrong With (SPEs), SPVs, and
VIEs ---
http://faculty.trinity.edu/rjensen//theory/00overview/speOverview.htm
2008
"Taking liberties (and tax dollars)," by Prem Sekka, The Guardian,
September 15, 2008 ---
http://www.guardian.co.uk/commentisfree/2008/sep/15/creditcrunch.taxandspending
Financial institutions are teetering
and are relying on the taxpayer to bail them out. Fannie Mae and
Freddie Mac have effectively been nationalised at a possible
cost of $200bn (Ł111.3bn) or more. A soft loan of $29bn
persuaded JP Morgan to buy
Bear Stearns.
Lehman Brothers has filed for
bankruptcy.
Merrill Lynch has been swallowed by
Bank of America. Commercial banks are borrowing around $19bn a
day from the US Treasury's emergency lending programme to keep
them afloat and new
rescue funding is being created.
Northern Rock has been bailed out by the UK taxpayer. The Bank
of England has provided around Ł200bn of emergency funding to
support financial institutions. The
European Central Bank
has lent banks some €467bn (Ł378bn) as it tries to deal with
chaos manufactured in corporate boardrooms.
Banks are expecting taxpayers to save
them from the consequences of poor financial decisions. Yet at
the same time, behind a veil of secrecy, they have been eroding
tax revenues by designing and marketing tax-avoidance schemes.
A
recent investigation by the US Senate
permanent subcommittee on investigations found that major
financial institutions have "devised complex financial
structures to enable their offshore clients to dodge US dividend
taxes". The offshore dodges are estimated to cost the US
Treasury around $100bn a year in lost tax revenues. The Senate
subcommittee highlighted the use of stock swaps and stock
lending transactions to avoid taxes on dividends paid by US
companies. Its report focuses on transactions devised and
carried out by Lehman Brothers, Morgan Stanley, Deutsche Bank,
UBS, Merrill Lynch and Citigroup.
The data available to the subcommittee
– page 8 of the
report (pdf) – showed that from
2000-2007, Morgan Stanley's dividend transactions:
... enabled clients to escape
payment of US dividend taxes totalling more than $300m. An
internal Lehman Brothers presentation estimates that, in
2004 alone, its transactions enabled clients to dodge
payment of dividend taxes of as much as $115m. UBS data on
its stock loan transactions over a four-year period, from
2004 to 2007, indicate that its clients escaped payment of
US dividend taxes totalling about $62m ... Maverick Capital
Management, calculated that over an eight-year period, from
2000 to 2007, it had entered into 'US Dividend Enhancements'
with a variety of firms that enabled it to escape paying US
dividend taxes totalling nearly $95m ... Citigroup told the
IRS that it had failed to withhold dividend taxes on a
limited set of transactions from 2003 to 2005, and
voluntarily paid those taxes which totalled $24m.
Needless to say, the financial
institutions made significant profits from the above
transactions. The subcommittee report (page 7) notes:
Morgan Stanley estimated that its
2004 revenues from its dividend-related transactions
totalled $25m. Lehman calculated that its Cayman
stock-lending operations produced a 2003 profit of $12m, and
projected doubling those profits the next year to $25m. UBS
estimated its 2005 profits at $5m and predicted double that
amount in 2006. Deutsche Bank stated that, in 2007, its
stock loans alone had produced profits of $4m.
In an earlier
inquiry (pdf) into tax avoidance, the
Senate subcommittee found (page 9) that banks played a key role
in the schemes marketed by KPMG. It stated that "Major banks,
such as Deutsche Bank, HVB, UBS, and NatWest, provided purported
loans for tens of millions of dollars essential to the
orchestrated transactions".
The above practices may well be
replicated around the globe, facilitating enormous leakage of
tax revenues. Banks routinely make claims about ethical
behaviour and social responsibility. Yet their statements are
not matched by their practices. In pursuit of private profits
they facilitate tax avoidance and erode tax revenues.
Ironically, these are the very revenues that, as we have seen,
can be used to save them.
Chief executives of banks have
collected fat-cat salaries, but none have offered any apology or
explanation for their predatory practices, or shed light on
their offshore dealings. Whatever the outcome of the current
financial crisis, tougher regulation is needed to curb the
tax-avoidance industry. The deposit-taking licence of banks
peddling tax-avoidance schemes should be withdrawn. Their
executives should be made personally liable for the losses
inflicted on the taxpayers
2008
Stanford University Law School Securities Class Action
Clearinghouse ---
http://securities.stanford.edu/
Index for 1996-? ---
http://securities.stanford.edu/companies.html
Federal securities class action lawsuits
increased 19 percent in 2008, with almost half involving firms in
the financial services sector according to the annual report
prepared by the Stanford Law School Securities Class Action
Clearinghouse in cooperation with Cornerstone Research ---
http://securities.stanford.edu/scac_press/20080106_YIR08_Press_Release.pdf
Especially note the 2008 Year in Review link at
http://securities.stanford.edu/clearinghouse_research/2008_YIR/20080106.pdf
More on the Bare Sterns Scandal
From Jim Mahar's blog on July 1, 2008 ---
http://financeprofessorblog.blogspot.com/
Financier Starts Sentence in Prostitution Case - NYTimes.com
It has not been a good year for Jeff
Epstein. A billionaire money advisor who owned his own island in
the Caribbean as well as a large townhouse in NY, Epstein used
to be
known for his secrecy,
smart friends, dislike of suits and ties, and yoga.
That has changed in the past year. In fact, it has changed in a
big way! Read on:
Financier Starts Sentence in Prostitution Case - NYTimes.com:
"On Monday
morning, he turned himself in and began serving 18 months
for soliciting prostitution....It is a stunning downfall for
Mr. Epstein...a tabloid monument to an age of hyperwealth.
Mr. Epstein owns a Boeing 727 and the largest town house in
Manhattan. He has paid for college educations for personal
employees and students from Rwanda, and spent millions on a
project to develop a thinking and feeling computer and on
music intended to alleviate depression.
But Mr.
Epstein also paid women, some of them under age, to give him
massages that ended with a sexual favor, the authorities
say."
In addition to
these charges, he was also recently was identified as a major
investor in Bear Stearns' (where he used to work) hedge funds
that collapsed last year:
Remember a month or so ago when the
WSJ had a series of articles on Bear?
I thoght they were great. Well this may be better! By Bryan
Burrough who helped write "Barbarians at the Gate" (one of my
all time favorites).
From Jim Mahar's blog on June 30, 2008 ---
http://financeprofessorblog.blogspot.com/
What Really Killed Bear Stearns? - Mergers, Acquisitions,
Venture Capital, Hedge Funds -- DealBook - New York Times:
One look in:
"According to
Mr. Burrough’s account, Bear did not have a liquidity
problem, at least at first. In fact, he said it had more
than $18 billion in cash to cover its trades when the week
began. There were no major withdrawals until late in the
week, after rumors flew that the company was in trouble.
A top Bear
executive told Mr. Burrough, “There was a reason [the rumor]
was leaked, and the reason is simple: someone wanted us to
go down, and go down hard.”
Bear executives frantically tried
to find the source of the rumors, but failed to do so in
time. They have their suspicions, and they have turned over
the names to federal authorities that are investigating the
matter."
If that was all
the article would be great, but there is so much more. Granted
some is based on rumor and sort of one sided and designed to
sell magazines, but who cares? A very good read!
And the NY Times
Deal Book goes even further providing links to Fed meetings on
the collapse. This will definitely be used in class!
Jensen Comment
Maybe a young little chippie bird sang like a canary.
2008
Question
Is the history of Arthur Levitt Jr. at the SEC so pure?
He does charge out at $900 per hour ---
http://en.wikipedia.org/wiki/Arthur_Levitt
When he was Director of the SEC, Arthur Levitt and his Chief SEC
Accountant gave the large auditing firms considerable trouble
(unlike SEC Chairman Harvey Pitt). But to my knowledge Levitt was
pretty much hands off on free-wheeling Wall Street financial
institutions and is now probably given too much credence in terms of
cleaning up the mess after Chris Cox was the disastrous head of the
SEC ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#SEC
Leavitt was easily duped by his close friend Bernie Madoff,
probably not separating church and state when Levitt was head of the
SEC and Madoff was committing fraud (for over 28 years of phony
stock trades in his investment fund that Levitt, Pitt, and Cox left
unregulated to the point of not even requiring audits by registered
auditing firms).
Re-arranging the deck chairs on the USS SEC.
We understand why Ms. Schapiro would want
to show some love to the staff after the blistering attack it
received last Wednesday on the Hill. Said liberal New York
Congressman Gary Ackerman, "You have totally and thoroughly failed
in your mission." Then he went negative, referring to the SEC's
difficulty in finding a part of the human anatomy "with two hands
with the lights on." Mr. Markopolos added that his many interactions
with the agency "led me to conclude that the SEC securities'
lawyers, if only through their investigative ineptitude and
financial illiteracy, colluded to maintain large frauds such as the
one to which Madoff later confessed." . . . If Ms. Schapiro seeks to
learn from the SEC's recent history, she might start by considering
the most basic lesson from the Madoff incident. Private market
participants spotted the fraud, while SEC lawyers couldn't seem to
grasp it. Rather than giving her staff lawyers still more autonomy,
she should instead be supervising them more closely, while trying to
harness the intelligence of the marketplace. Meantime, investors
should remember that their own skepticism and diversified investing
remain their best defenses against fraudsters.
"Just Don't Mention Bernie: Unleashing the SEC enforcers who
were already unleashed," The Wall Street Journal, February
10, 2009 ---
http://online.wsj.com/article/SB123423071487965895.html?mod=djemEditorialPage
From The Wall Street Journal Accounting Weekly Review on
January 23, 2009
Good and Bad Ideas on How to Thwart Another Madoff
by
Kevin Rosenberg, Paul L Comstock, Eunice Bet-Mansour,
Ph.D., and Porter Landreth
The Wall Street Journal
Jan 10, 2009
Click here to view the full article on WSJ.com
TOPICS: Auditing,
Fraudulent Financial Reporting, SEC, Securities and
Exchange Commission
SUMMARY: These letters to the editor express a
range of opinions on another op-ed piece by Arthur
Levitt Jr., former Chairman of the SEC. In Levitt's
January 5 Op-Ed piece, he stated that he "never saw
an instance where credible information about
misconduct was not followed up by the agency."
CLASSROOM APPLICATION: Understanding the role of
the SEC and the skill set needed to fulfill its
mission are the primary uses of this article.
QUESTIONS:
1. (Introductory) Who is Arthur Levitt?
Summarize his recent opinion-page piece that led to
these letters in response.
2. (Introductory) What concerns the CPA,
Kevin Rosenberg, who describes the types of audit
and accounting firms associated with recent
financial reporting frauds and failures?
3. (Advanced) One op-ed writer, Paul L.
Comstock, argues that "the SEC can only do so much
to protect without paralyzing our capital markets."
But does Eunice Bet-Mansour, Ph.D., necessarily call
for a greater quantity of regulatory steps to avoid
another Ponzi scheme or fraud such as that committed
by Mr. Madoff?
4. (Advanced) What level of skill set does
Dr. Bet-Mansour say is needed among SEC staffers?
What level of education provides this analytical
skill set? In your answer, consider the level of
education held by Harry Markopoulos.
Reviewed By: Judy Beckman, University of Rhode
Island
RELATED ARTICLES:
How the SEC Can Prevent More Madoffs
by Arthur Levitt, Jr.
Jan 05, 2009
Online Exclusive
|
Bob Jensen's threads on fraud are at
http://faculty.trinity.edu/rjensen/fraud001.htm
Bob Jensen's Rotten to the Core threads are at
http://faculty.trinity.edu/rjensen/FraudRotten.htm
2009
"Chinese official raps US banks on derivatives,"
AsiaLynx, December 4, 2009 ---
http://www.asialynx.com/2009/12/04/chinese-official-raps-us-banks-on-derivatives/
BEIJING (Agencies): A senior Chinese official criticized foreign
banks for selling derivatives with “fraudulent characteristics”
that led to heavy losses for state-owned airlines and other
companies.
“Some international investment banks
are the biggest villains,” said Li Wei, deputy chairman of the
agency that oversees China’s biggest state companies, in a
commentary in this week’s edition of the Study Times, a
newspaper published by the school of the Communist Party’s
Central Committee.
The comments were the Chinese
government’s most pointed public criticism yet of foreign
institutions. Li’s agency said in September it would support
companies that want to challenge the contracts in court.
Li said Chinese companies were to blame for most of their losses
but complained that derivatives tied oil prices and other
matters were too complex and made potential risks too hard to
identify.
“Of course, first of all we need to
find problems in the companies themselves,” Li wrote in the
front-page commentary. “But it also is largely related to
international investment banks maliciously peddling
high-leverage, complex products with fraudulent
characteristics.”
Some 68 of the 136 major banks,
airlines and other companies directly controlled by the Cabinet
invested in derivatives and recorded book losses totaling 11.4
billion yuan ($1.7 billion) by the end of October 2008,
according to Li.
Li made no specific accusations against
individual banks. But he noted that airlines and shipping
companies bought fuel contracts from Goldman Sachs Group,
Merrill Lynch — now a unit of Bank of America Corp. — and Morgan
Stanley, while banks bought derivatives from Merrill Lynch,
Morgan Stanley and Citigroup.
Spokespeople in China for Goldman and
Citigroup declined to comment. Spokespeople for Morgan Stanley
and Merrill Lynch did not immediately respond to phone messages
and e-mails.
– read more at ChinaDaily.com
Bob Jensen's timeline for derivative financial instruments
frauds ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
The Greatest Swindle in the History of the World ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
2009
"2009 Securities Litigation Study," by
PricewaterhouseCoopers (PwC), May 6, 2010 ---
http://snipurl.com/pwc050610
Summary:
The financial crisis continued to dominate the litigation
landscape in 2009 - although to a lesser degree than in 2008,
according to the annual PwC Securities Litigation Study.
Governments worldwide remained focused on regulatory overhaul,
stimulus plans and investigations into the "who, what, when,
where, why, and how" of alleged wrongdoings related to the
crisis.
This is an annual PwC study.
Bob Jensen's threads on securities frauds ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm
Bob Jensen's threads on auditing firm litigation ---
http://faculty.trinity.edu/rjensen/Fraud001.htm
Bob Jensen's Fraud Updates ---
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
2009
"Lack of Candor and the AIG Bailout: If AIG wasn't too big to fail,
why did the government rescue it? And why do we need to turn the financial
system upside down?" by Peter J. Wallison, The Wall Street Journal,
November 27, 2009 ---
http://online.wsj.com/article/SB10001424052748704779704574551861399508826.html?mod=djemEditorialPage
Since last September, the government's case for
bailing out AIG has rested on the notion that the company was too big to
fail. If AIG hadn't been rescued, the argument goes, its credit default swap
(CDS) obligations would have caused huge losses to its counterparties—and
thus provoked a financial collapse.
Last week's news that this was not in fact the
motive for AIG's rescue has implications that go well beyond the Obama
administration's efforts to regulate CDSs and other derivatives. It's one
more example that the administration may be using the financial crisis as a
pretext to extend Washington's control of the financial sector.
The truth about the credit default swaps came out
last week in a report by TARP Special Inspector General Neil Barofsky. It
says that Treasury Secretary Tim Geithner, then president of the New York
Federal Reserve Bank, did not believe that the financial condition of AIG's
credit default swap counterparties was "a relevant factor" in the decision
to bail out the company. This contradicts the conventional assumption, never
denied by the Federal Reserve or the Treasury, that AIG's failure would have
had a devastating effect.
So why did the government rescue AIG? This has
never been clear.
The Obama administration has consistently argued
that the "interconnections" among financial companies made it necessary to
save AIG and Bear Stearns. Focusing on interconnections implies that the
failure of one large financial firm will cause debilitating losses at
others, and eventually a systemic breakdown. Apparently this was not true in
the case of AIG and its credit default swaps—which leaves open the question
of why the Fed, with the support of the Treasury, poured $180 billion into
AIG.
The broader question is whether the entire
regulatory regime proposed by the administration, and now being pushed
through Congress by Rep. Barney Frank and Sen. Chris Dodd, is based on a
faulty premise. The administration has consistently used the term "large,
complex and interconnected" to describe the nonbank financial institutions
it wants to regulate. The prospect that the failure of one of these firms
might pose a systemic risk is the foundation of the administration's
comprehensive regulatory regime for the financial industry.
Up to now, very few pundits or reporters have
questioned this logic. They have apparently been satisfied with the
explanation that the "interconnectedness" created by those mysterious credit
default swaps was the culprit.
But the New York Fed is the regulatory body most
familiar with the CDS market. If that agency did not believe AIG's failure
would have actually brought down its counterparties—and ultimately the
financial system itself—it raises serious questions about the
administration's credibility, and about the need for its regulatory
proposals. If "interconnections" among financial institutions are indeed the
source of the financial crisis, the administration should be far more
forthcoming than it has been about exactly what these interconnections are,
and how exactly a broad new system of regulation and resolution would
eliminate or reduce them.
The administration's unwillingness or inability to
clearly define the problem of interconnectedness is not the only weakness in
its rationale for imposing a whole new regulatory regime on the financial
system. Another example is the claim—made by Mr. Geithner and President
Obama himself—that predatory lending by mortgage brokers was one of the
causes of the financial crisis.
No doubt some deceptive practices occurred in
mortgage origination. But the facts suggest that the government's own
housing policies—and not weak regulation—were the source of these bad loans.
At the end of 2008, there were about 26 million
subprime and other nonprime mortgages in our financial system. Two-thirds of
these mortgages were on the balance sheets of the Federal Housing
Administration, Fannie Mae and Freddie Mac, and the four largest U.S. banks.
The banks were required to make these loans in order to gain approval from
the Fed and other regulators for mergers and expansions.
The fact that the government itself either bought
these bad loans or required them to be made shows that the most plausible
explanation for the large number of subprime loans in our economy is not a
lack of regulation at the mortgage origination level, but government-created
demand for these loans.
Finally, although there may be a good policy
argument for a new consumer protection agency for financial services and
products, the scope of what the administration has proposed goes far beyond
lending, or even deposit-taking. In the administration's proposed
legislation, the Consumer Financial Protection Agency would cover any
business that provides consumer credit of any kind, including the common
layaway plans and Christmas clubs that small retailers offer their
customers.
Under the guise of addressing the causes of a
global financial crisis, the Obama administration's bill would have
regulated credit counseling, educational courses on finance, financial-data
processing, money transmission and custodial services, and dozens more small
businesses that could not possibly cause a financial crisis. Even Chairmen
Frank and Dodd balked at this overreach. Their bills exempt retailers if
their financial activity is incidental to their other business. Still, many
vestiges of this excess remain in the legislation that is now being pushed
toward a vote.
The lack of candor about credit default swaps, the
effort to blame lack of regulation for the subprime crisis and the excessive
reach of the proposed consumer protection agency are all of a piece. The
administration seems to be using the specter of another financial crisis to
bring more and more of the economy under Washington's control.
With the help of large Democratic majorities in
Congress, this train has had considerable momentum. But perhaps—with the
disclosure about credit default swaps and the AIG crisis—the wheels are
finally coming off.
Bob Jensen's threads on the Greatest Swindle in the World are at
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze
Bob
Jensen's threads on why the infamous "Bailout" won't work ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#BailoutStupidity
2009
Credit Derivative Swap Fraud
"SEC Charges Pair with Insider Trading in Swaps," SmartPros, May
5, 2009 ---
http://accounting.smartpros.com/x66466.xml
The Securities and Exchange Commission
on Tuesday charged a securities salesman and a portfolio manager
with insider trading in the first such case involving credit
default swaps.
The SEC alleges that Jon-Paul Rorech, a
salesman at Deutsche Bank Securities Inc., tipped off Renato
Negrin, a former portfolio manager at hedge fund investment
adviser Millennium Partners LP, about a possible change in terms
of a bond being issued by VNU NV, a Dutch publishing company
that owns Nielsen Media and other media businesses, in 2006.
Deutsche Bank was acting as the lead underwriter of the VNU bond
issuance.
With knowledge of the potential change
in bond terms, Negrin purchased credit default swaps on VNU for
a Millennium hedge fund, according to the SEC complaint. After
news of the bond terms was released, Negrin sold the swaps at a
profit of $1.2 million, according to the SEC.
Credit default swaps are an
insurance-like contract that protects a buyer from potential
losses that might be incurred on an underlying financial
investment, such as a corporate bond or mortgage-backed
security. Many of those types of underlying investments have
lost much of their value or increasingly defaulted amid the
credit crisis.
If the underlying financial investment
is not repaid, the buyer of the swap is covered in full for the
losses through the swap.
Credit default swaps have been widely
seen as one of the major factors in the credit crisis. The
trading of swaps helped push Lehman Brothers Holdings Inc. into
bankruptcy protection and American International Group Inc. the
to brink of failure before being bailed out by the government.
Richard Strassberg, a lawyer
representing Rorech, said in a statement that his client acted
"consistently with the accepted practice in the industry."
Strassberg said Rorech did not violate any securities laws tied
to the sale of the VNU bonds.
A lawyer for Negrin was not immediately
available to comment on the case.
The SEC is asking for the judge to
force the two to repay the money gained from the transaction,
plus penalties and back interest on the allegedly ill-gotten
gains.
The SEC's hedge fund working group
handled the investigation. The group has brought more than 100
cases alleging fraud and manipulation by hedge funds over the
past five years, including more than 20 in 2009.
Bob Jensen's threads on bank fraud are at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking
Bob Jensen's threads on derivative financial instruments fraud
---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
2009
I’d been working for the bank for about five weeks
when I woke up on the balcony of a ski resort in the Swiss Alps. It was midnight
and I was drunk. One of my fellow management trainees was urinating onto the
skylight of the lobby below us; another was hurling wine glasses into the
courtyard. Behind us, someone had stolen the hotel’s shoe-polishing machine and
carried it into the room; there were a line of drunken bankers waiting to use
it. Half of them were dripping wet, having gone swimming in all their clothes
and been too drunk to remember to take them off. It took several more weeks of
this before the bank considered us properly trained. . . . By the time I arrived
on Wall Street in 1999, the link between derivatives and the real world had
broken down. Instead of being used to reduce risk, 95 per cent of their use was
speculation - a polite term for gambling. And leveraging - which means taking a
large amount of risk for a small amount of money. So while derivatives, and the
financial industry more broadly, had started out serving industry, by the late
1990s the situation had reversed. The Market had become a near-religious force
in our culture; industry, society, and politicians all bowed down to it. It was
pretty clear what The Market didn’t like. It didn’t like being closely watched.
It didn’t like rules that governed its behaviour. It didn’t like goods produced
in First-World countries or workers who made high wages, with the notable
exception of financial sector employees. This last point bothered me especially.
Philipp Meyer,
American Rust (Simon & Schuster, 2009) ---
http://search.barnesandnoble.com/American-Rust/Philipp-Meyer/e/9780385527514/?itm=1
American excess: A Wall Street trader tells all - Americas, World - The
Independent
http://www.independent.co.uk/news/world/americas/american-excess--a-wall-street-trader-tells-all-1674614.html
Jensen Comment
This book reads pretty much like an update on the derivatives scandals featured
by Frank Partnoy covering the Roaring 1990s before the dot.com scandals broke.
There were of course other insiders writing about these scandals as well ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
It would seem that bankers and investment bankers do not learn from their own
mistake. The main cause of the scandals is always pay for performance schemes
run amuck.
2009
|
What makes this such a big scandal is
that the savings of half the households in the U.S. are
at stake here. The tragedy is that now that the scandal
is surfacing in the media and in state courts, the SEC
is only wrist slapping mutual funds. This is along with
the continued wrist slapping of investment banking
(e.g., why is Merrill Lynch still in existence after
frauds dating back to Orange
County ?) is the real evidence of
industry power over regulators. Sarbanes-Oxley won’t do
it! It’s still Congress to the core in
Washington
DC as long as industries have regulators in
their well-financed pockets ---
http://faculty.trinity.edu/rjensen/fraud.htm#Cleland
|
Before FAS 133 and IAS 39 Swaps Did Not Even
Have to Be Booked
Booking does not necessarily put an end to speculation and fraud
1.93 Billion Euros: Derivatives Fraud
Worse Than Orange County
‘Impossible to Understand’ Swap Burns 290-Person Italian Hamlet
Share," by Alan Katz, Lorenzo Totaro and Elisa Myartinuzzi,
Bloomberg News, June 19, 2009 ---
http://www.bloomberg.com/apps/news?pid=20601085&sid=a04MS8q.QQTM
Ortenzio Matteucci points to towns down
the wooded Nerina valley in Italy’s Umbria region and blames
peer pressure for his decision to let Polino, population 290,
buy a U.S.-inspired financial swap he didn’t understand.
A retired steelworker with wavy gray
hair, Polino’s Mayor Matteucci says he agreed to the
interest-rate swap because Milan, with more than 1 million
residents, and local towns Arrone and Stroncone all bought
derivatives to try to save money. Polino’s contract has cost the
village 6,579.66 euros ($9,200) more than it has earned since
the town made the deal in 2005.
“At the time I thought: Can the
Province of Terni, the City of Terni and all the other
municipalities bigger than us, such as Milan, be all wrong?”
said Matteucci, 59, dressed in a blue polo shirt and jeans. “You
can make a mistake if you don’t have an appropriate and deep
knowledge of this and just follow what other local governments
do.”
Derivatives have burned towns from
Polino to Milan to Erie, Pennsylvania. Jefferson County,
Alabama, said it might need to declare bankruptcy because of
costs associated with the contracts. Responsibility for the
expenses in Italy’s second- biggest city and in Umbria’s
smallest village sits with elected officials who agreed to
financial instruments they didn’t fully grasp, said Stefano
Taurini, a lawyer who specializes in corporate law in Milan.
1.93 Billion Euros
In Italy, some 600 local authorities
had taken out more than 1,000 derivative contracts on about 35.5
billion euros of debt by the end of last year, according to
national Treasury data provided to the Italian Senate Finance
Commission.
The governments had unrealized losses
of 1.93 billion euros on over-the-counter derivative bets placed
with Italian banks and local units of foreign banks at the end
of 2008, according to data from the Rome-based Bank of Italy,
the country’s central bank.
Continued in article
Bob Jensen's free tutorials on accounting for derivative
financial instruments ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
2009
"Efficient Market Theory and the Crisis: Neither the rating
agencies' mistakes nor the overleveraging by financial firms was the
fault of an academic hypothesis," by Jeremy J. Siegel, The
Wall Street Journal, October 27, 2009 ---
http://online.wsj.com/article/SB10001424052748703573604574491261905165886.html?mod=djemEditorialPage
Financial journalist and best-selling
author Roger Lowenstein didn't mince words in a piece for the
Washington Post this summer: "The upside of the current Great
Recession is that it could drive a stake through the heart of
the academic nostrum known as the efficient-market hypothesis."
In a similar vein, the highly respected money manager and
financial analyst Jeremy Grantham wrote in his quarterly letter
last January: "The incredibly inaccurate efficient market theory
[caused] a lethally dangerous combination of asset bubbles, lax
controls, pernicious incentives and wickedly complicated
instruments [that] led to our current plight."
But is the Efficient Market Hypothesis
(EMH) really responsible for the current crisis? The answer is
no. The EMH, originally put forth by Eugene Fama of the
University of Chicago in the 1960s, states that the prices of
securities reflect all known information that impacts their
value. The hypothesis does not claim that the market price is
always right. On the contrary, it implies that the prices in the
market are mostly wrong, but at any given moment it is not at
all easy to say whether they are too high or too low. The fact
that the best and brightest on Wall Street made so many mistakes
shows how hard it is to beat the market.
This does not mean the EMH can be used
as an excuse by the CEOs of the failed financial firms or by the
regulators who did not see the risks that subprime
mortgage-backed securities posed to the financial stability of
the economy. Regulators wrongly believed that financial firms
were offsetting their credit risks, while the banks and credit
rating agencies were fooled by faulty models that underestimated
the risk in real estate.
After the 1982 recession, the U.S. and
world economies entered into a long period where the
fluctuations in variables such as gross domestic product,
industrial production, and employment were significantly lower
than they had been since World War II. Economists called this
period the "Great Moderation" and attributed the increased
stability to better monetary policy, a larger service sector and
better inventory control, among other factors.
The economic response to the Great
Moderation was predictable: risk premiums shrank and individuals
and firms took on more leverage. Housing prices were boosted by
historically low nominal and real interest rates and the
development of the securitized subprime lending market.
According to data collected by Prof.
Robert Shiller of Yale University, in the 61 years from 1945
through 2006 the maximum cumulative decline in the average price
of homes was 2.84% in 1991. If this low volatility of home
prices persisted into the future, a mortgage security composed
of a nationally diversified portfolio of loans comprising the
first 80% of a home's value would have never come close to
defaulting. The credit quality of home buyers was secondary
because it was thought that underlying collateral—the home—could
always cover the principal in the event the homeowner defaulted.
These models led credit agencies to rate these subprime
mortgages as "investment grade."
But this assessment was faulty. From
2000 through 2006, national home prices rose by 88.7%, far more
than the 17.5% gain in the consumer price index or the paltry 1%
rise in median household income. Never before have home prices
jumped that far ahead of prices and incomes.
This should have sent up red flags and
cast doubts on using models that looked only at historical
declines to judge future risk. But these flags were ignored as
Wall Street was reaping large profits bundling and selling the
securities while Congress was happy that more Americans could
enjoy the "American Dream" of home ownership. Indeed, through
government-sponsored enterprises such as Fannie Mae and Freddie
Mac, Washington helped fuel the subprime boom.
Neither the rating agencies' mistakes
nor the overleveraging by the financial firms in the subprime
securities is the fault of the Efficient Market Hypothesis. The
fact that the yields on these mortgages were high despite their
investment-grade rating indicated that the market was rightly
suspicious of the quality of the securities, and this should
have served as a warning to prospective buyers.
With few exceptions (Goldman Sachs
being one), financial firms ignored these warnings. CEOs failed
to exercise their authority to monitor overall risk of the firm
and instead put their faith in technicians whose narrow models
could not capture the big picture. One can only wonder if the
large investment banks would have taken on such risks when they
were all partnerships and the lead partner had all his wealth in
the firm, as they were just a few decades ago.
The misreading of these economic trends
did not just reside within the private sector. Former Fed
Chairman Alan Greenspan stated before congressional committees
last December that he was "shocked" that the top executives of
the financial firms exposed their stockholders to such risk. But
had he looked at their balance sheets, he would have realized
that not only did they put their own shareholders at risk, but
their leveraged positions threatened the viability of the entire
financial system.
As home prices continued to climb and
subprime mortgages proliferated, Mr. Greenspan and current Fed
Chairman Ben Bernanke were perhaps the only ones influential
enough to sound an alarm and soften the oncoming crisis. But
they did not. For all the deserved kudos that the central bank
received for their management of the crisis after the Lehman
bankruptcy, the failure to see these problems building will
stand as a permanent blot on the Fed's record.
Our crisis wasn't due to blind faith in
the Efficient Market Hypothesis. The fact that risk premiums
were low does not mean they were nonexistent and that market
prices were right. Despite the recent recession, the Great
Moderation is real and our economy is inherently more stable.
But this does not mean that risks have
disappeared. To use an analogy, the fact that automobiles today
are safer than they were years ago does not mean that you can
drive at 120 mph. A small bump on the road, perhaps
insignificant at lower speeds, will easily flip the
best-engineered car. Our financial firms drove too fast, our
central bank failed to stop them, and the housing deflation
crashed the banks and the economy.
Dr. Siegel, a professor of finance at the University of
Pennsylvania's Wharton School, is the author of "Stocks for the
Long Run," now in its 4th edition from McGraw-Hill.
Eugene Fama Lecture: Masters of Finance, Oct 2, 2009
Videos Fama Lecture: Masters of Finance From the American Finance
Association's "Masters in Finance" video series, Eugene F. Fama
presents a brief history of the efficient market theory. The lecture
was recorded at the University of Chicago in October 2008 with an
introduction by John Cochrane.
http://www.dimensional.com/famafrench/2009/10/fama-lecture-masters-of-finance.html#more
Fama Video on Market Efficiency in a Volatile Market
Widely cited as the father of the efficient market hypothesis and
one of its strongest advocates, Professor Eugene Fama examines his
groundbreaking idea in the context of the 2008 and 2009 markets. He
outlines the benefits and limitations of efficient markets for
everyday investors and is interviewed by the Chairman of Dimensional
Fund Advisors in Europe, David Salisbury.
http://www.dimensional.com/famafrench/2009/08/fama-on-market-efficiency-in-a-volatile-market.html#more
Other Fama and French Videos ---
http://www.dimensional.com/famafrench/videos/
Jensen Comment
This does not mean the EMH and its wildly popular stepchild CAPM are
not in deep keeshee (theory and practice) ---
http://faculty.trinity.edu/rjensen/theory01.htm#EMH
Warren Buffett did a lot of almost fatal damage to the EMH
If you really want to understand the problem you’re apparently
wanting to study, read about how Warren Buffett changed the whole
outlook of a great econometrics/mathematics researcher (Janet
Tavkoli). I’ve mentioned this fantastic book before ---
Dear Mr. Buffett. What opened her eyes is how
Warren Buffet built his vast, vast fortune exploiting the errors of
the sophisticated mathematical model builders when valuing
derivatives (especially options) where he became the writer of
enormous option contracts (hundreds of millions of dollars per
contract). Warren Buffet dared to go where mathematical models could
not or would not venture when the real world became too complicated
to model. Warren reads financial statements better than most anybody
else in the world and has a fantastic ability to retain and process
what he’s studied. It’s impossible to model his mind.
I finally grasped what Warren was saying. Warren has such a wide
body of knowledge that he does not need to rely on “systems.” .
. . Warren’s vast knowledge of corporations and their finances
helps him identify derivatives opportunities, too. He only
participates in derivatives markets when Wall Street gets it
wrong and prices derivatives (with mathematical models)
incorrectly. Warren tells everyone that he only does certain
derivatives transactions when they are mispriced.
Wall Street derivatives traders construct trading models with no
clear idea of what they are doing. I know investment bank
modelers with advanced math and science degrees who have never
read the financial statements of the corporate credits they
model. This is true of some credit derivatives traders, too.
Janet Tavakoli, Dear Mr. Buffett, Page 19
Bob Jensen's threads on the economic crisis are at
http://faculty.trinity.edu/rjensen/2008Bailout.htm
2009
Financial WMDs (Credit Derivatives) on Sixty Minutes (CBS) on August 30,
2009 ---
http://www.cbsnews.com/video/watch/?id=5274961n&tag=contentBody;housing
I downloaded the video (5,631 Kbs) to
http://www.cs.trinity.edu/~rjensen/temp/FinancialWMDs.rv
Steve Kroft examines the complicated financial instruments known
as credit default swaps and the central role they are playing in the
unfolding economic crisis. The interview features my hero Frank
Partnoy. I don't know of anybody who knows derivative securities
contracts and frauds better than Frank Partnoy, who once sold these
derivatives in bucket shops. You can find links to Partnoy's books
and many, many quotations at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
For years I've used the term "bucket shop" in financial
securities marketing without realizing that the first bucket shops
in the early 20th Century were bought and sold only gambles on stock
pricing moves, not the selling of any financial securities. The
analogy of a bucket shop would be a room full of bookies selling
bets on NFL playoff games.
See "Bucket Shop" at
http://en.wikipedia.org/wiki/Bucket_shop_(stock_market)
I was not aware how fraudulent the credit derivatives markets had
become. I always viewed credit derivatives as an unregulated
insurance market for credit protection. But in 2007 and 2008 this
market turned into a betting operation more like a rolling crap game
on Wall Street.
Bob Jensen's Rotten to the Core threads are at
http://faculty.trinity.edu/rjensen/FraudRotten.htm
Also see "Credit Derivatives" under the C-Terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms
Simoleon Sense
Reviews Janet Tavakoli’s Dear Mr. Buffett ---
http://www.simoleonsense.com/simoleon-sense-reviews-janet-tavakolis-dear-mr-buffett/
What’s The Book (Dear Mr. Buffett) About
Dear Mr. Buffett,
chronicles the agency problems, poor regulations, and participants
which led to the current financial crisis. Janet accomplishes this
herculean task by capitalizing on her experiences with derivatives,
Wall St, and her relationship with Warren Buffett. One wonders how
she managed to pack so much material in such few pages!
Unlike many books which only analyze past events, Dear Mr.
Buffett, offers proactive advice for improving financial markets.
Janet is clearly very concerned about protecting individual rights,
promoting honesty, and enhancing financial integrity. This is
exactly the kind of character we should require of our financial
leaders.
Business week once called Janet the Cassandra of Credit
Derivatives. Without a doubt Janet should have been listened to. I’m
confident that from now on she will be.
Closing thoughts
Rather than a complicated book on financial esoterica, Janet has
created a simple guide to understanding the current crisis. This
book is a must read for all students of finance, economics, and
business. If you haven’t read this book, please do so.
Warning –This book is likely to infuriate you, and that’s a good
thing!
Janet provides indicting evidence and citizens may be tempted to
initiate vigilante like witch trials. Please
consult with your doctor before taking this financial medication.
Continued in article
September 1, 2009 reply from Rick Lillie
[rlillie@CSUSB.EDU]
Hi Bob,
I am reading Dear Mr. Buffett, What an
Investor Learns 1,269 Miles from Wall Street, by Janet Tavakoli.
I am just about finished with the book. I am thinking about
giving a copy of the book to students who perform well in my
upper-level financial reporting classes.
I agree with the reviewer’s comments
about Tavakoli’s book. Her explanations are clear and concise
and do not require expertise in finance or financial derivatives
in order to understand what she (or Warren Buffet) says. She
explains the underlying problems of the financial meltdown with
ease. Tavakoli does not blow you over with “finance BS.” She
does in print what Steve Kroft does in the 60 Minutes story.
Tavakoli delivers a unique perspective
throughout the book. She looks through the eyes of Warren
Buffett and explains issues as Buffett sees them, while
peppering the discussion with her experience and perspective.
The reviewer is correct. Tavakoli lets
the finance world, along with accountants, attorneys, bankers,
Congress, and regulators, have it with both barrels!
Tavakoli’s book is the highlight of my
summer reading.
Best wishes,
Rick Lillie
Rick Lillie, MAS, Ed.D., CPA Assistant
Professor of Accounting Coordinator - Master of Science in
Accountancy (MSA) Program Department of Accounting and Finance
College of Business and Public Administration CSU San Bernardino
5500 University Pkwy, JB-547 San Bernardino, CA. 92407-2397
Telephone Numbers: San Bernardino
Campus: (909) 537-5726 Palm Desert Campus: (760) 341-2883, Ext.
78158
For technical details see the following book:
Structured Finance and Collateralized Debt Obligations: New
Developments in Cash and Synthetic Securitization (Wiley
Finance) by Janet M. Tavakoli (2008)
Of all the corporate bailouts that have taken place
over the past year, none has proved more costly or contentious than the rescue
of American International Group (AIG). Its reckless bets on subprime mortgages
threatened to bring down Wall Street and the world economy last fall until the
U.S Treasury and the Federal Reserve stepped in to save it. So far, the huge
insurance and financial services conglomerate has been given or promised $180
billion in loans, investments, financial injections and guarantees - a sum
greater than the annual cost of the wars in Iraq and Afghanistan."
"Why AIG Stumbled, And Taxpayers Now Own It," CBS Sixty Minutes,
May 17, 2009 ---
http://www.cbsnews.com/stories/2009/05/15/60minutes/main5016760.shtml?source=RSSattr=HOME_5016760
Jensen Comment
To add pain to misery, AIG lied to the media about the extent of bonuses granted
after receiving TARP funds.
Bob Jensen's threads on AIG are at
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
AIG now says it paid out more than $454 million in
bonuses to its employees for work performed in 2008. That is nearly four times
more than the company revealed in late March when asked by POLITICO to detail
its total bonus payments. At that time, AIG spokesman Nick Ashooh said the firm
paid about $120 million in 2008 bonuses to a pool of more than 6,000 employees.
The figure Ashooh offered was, in turn, substantially higher than company CEO
Edward Liddy claimed days earlier in testimony before a House Financial Services
Subcommittee. Asked how much AIG had paid in 2008 bonuses, Liddy responded: “I
think it might have been in the range of $9 million.”
Emon Javers, "AIG bonuses four times
higher than reported," Politico, May 5, 2009 ---
http://www.politico.com/news/stories/0509/22134.html
Bank Meltdown
Collateralized Debt Obligations (CDOs) and Credit Derivatives (CDR) Got Too Much
of the Blame
As more U.S. banks get shut down by the Federal Deposit
Insurance Corp., it is becoming clear that most bank failures have nothing to do
with investments in complex financial products that bear risks that are
difficult for laymen to understand. Today, banks fail the old-fashioned way:
They make loans but do not ever get the money back. These loans are going bad at
a rate far beyond what banks and regulators imagined.
"Most Failing Banks Are Doing It the Old-School Way," by Floyd Norris, The
New York Times, August 20, 2009 ---
http://www.nytimes.com/2009/08/21/business/21norris.html?_r=1&ref=business
Banks are now losing money and going broke the
old-fashioned way: They made loans that will never be repaid.
As the number of banks closed by the Federal
Deposit Insurance Corporation has grown rapidly this year, it has become
clear that most of them had nothing to do with the strange financial
products that seemed to dominate the news when the big banks were nearing
collapse and being bailed out by the government.
There were no C.D.O’s, or S.I.V.’s or AAA-rated
“supersenior tranches” that turned out to have little value. Certainly there
were no “C.D.O.-squareds.”
Staying away from strange securities has not made
things better. Jim Wigand, the F.D.I.C.’s deputy director of resolutions and
receiverships, says banks that are failing now are in worse shape — in terms
of the amount of losses relative to the size of the banks — than the ones
that collapsed during the last big wave of failures, from the savings and
loan crisis.
The severity of the current string of bank failures
shows that many of the proposed remedies batted about since the financial
crisis erupted would have done nothing to stem this wave of closures. These
banks did not get in over their heads with derivatives or hide their bad
assets in off-balance sheet vehicles. Nor did their traders make bad bets;
they generally had no traders. They did not make loans that they expected to
sell quickly, so they had plenty of reason to care that the loans would be
repaid.
What they did do is see loans go bad, in some cases
with stunning rapidity, in volumes that they never thought possible.
The fact that so many loans are souring is a
testament to how bad the recession, and the collapse in property prices, has
been. But looking at some of the banks in detail shows that they were also
victims of their own apparent success. Year after year, these banks grew and
grew, and took more and more risks. Losses were minimal. Cautious bankers
appeared to be missing opportunities.
As the great economist Hyman P. Minsky pointed out,
stability eventually will be destabilizing. The absence of problems in the
middle of this decade was taken as proof that nothing very bad was likely to
happen. Any bank that did not lower its lending standards from 2005 through
mid-2007 would have stopped growing, simply because its competitors were
offering more and more generous terms.
Take the recent failure of Temecula Valley Bank, in
Riverside County, Calif. For most of this decade, it grew rapidly. Deposits
leapt by 50 percent a year, rising to $1.1 billion in 2007, from less than
$100 million in 2001.
That growth was powered by construction loans, on
which it suffered virtually no losses for many years. By 2005, loans to
builders amounted to more than half its total loans — and to 450 percent of
its capital.
Temecula appeared to be very well capitalized. But
virtually all that capital vanished when the boom stopped.
When the F.D.I.C. stepped in last month, the bank
had $1.5 billion in assets. The agency thinks it will lose about a quarter
of that amount.
Across the country, at Security Bank of Bibb
County, Ga., the story was remarkably similar. Its fast growth was powered
by construction loans, although in this case the loans mostly financed
commercial buildings, not houses. When those loans went bad, what had
appeared to be a well-capitalized bank went under. The F.D.I.C. estimates
its losses will be almost 30 percent of the bank’s $1.2 billion in assets.
In both of those cases, to get another bank to take
over the failed bank, the F.D.I.C. had to agree to share future losses on
most of the loans. That is one reason the agency’s estimates of its eventual
losses could turn out to be wrong. In the best of all worlds, the loss
estimates would be too high because the economy and property prices recover
rapidly. But if the recovery is slow, the losses could grow.
In either case, the F.D.I.C. may soon need to seek
more money to pay for failing banks. It could seek that cash from the
Treasury, where it has a line of credit, or it could seek to raise the fees
it charges banks.
So far this year, the F.D.I.C. has closed 77 banks,
and there almost certainly will be more on Friday, the agency’s preferred
day for bank closures. Last Friday there were five. Not since June 12 has
there been a Friday without a bank closing. By contrast, there were three
failures in 2007 and 25 in 2008.
Of the 77 failures in 2009, the F.D.I.C. could not
even find a bank to acquire eight of them. Of the other 69, the agency
signed loss-sharing agreements on 41.
By contrast, the agency found acquirers for all of
the 25 failed banks in 2008, and had to sign loss-sharing agreements for
just three of the banks.
“Loss-sharing” is something of a misnomer. In
practice, the vast majority of the losses are borne by the F.D.I.C.
Typically, it takes 80 percent of the losses up to a negotiated limit, and
95 percent of losses above that level.
Continued in article
2009
Added Insights on How the CDO Scandals Worked
February 9, 2009 message from Phillip Chiu
[p_chill@hotmail.com]
Dear Professor Jensen,
I am writing on behalf of a group of
investors numbering several tens of thousands in Hong Kong who
believe they have been duped by Lehman Brothers in purchasing
what is described as ‘credit-linked’ notes (a small portion is
variously described as ‘equity-linked note’ and the like).
The complexity of the products only
gradually came to light after the bankruptcy of Lehman Brothers
last September, followed by the rather irresponsible conduct
manifested by the refusal of the distributor banks and the
regulators (the Securities and Futures Commission and the Hong
Kong Monetary Authority) to answer queries relating to the
approval and sales of such Notes.
The Notes were being sold
indiscriminately to the public without any regard to suitability
of the particular investor. By a rough estimate (profiles of the
victimized investors have been withheld by the government),
about 40% of the entire body of investors are retirees, elderly,
uneducated or suffering from other handicaps.
We believe that the so-called
credit-linked notes actually conceal poor quality synthetic CDO
described as ‘underlying security’. Ostensibly the Notes are
advertised as ‘credit-linked’ to a handful of well-known
companies, but this is no more than a façade in order to obscure
the all-important role played by the portfolios of credit
derivatives. I attach the issue prospectus and programme
prospectus of one of the many series for your ease of reference.
From your remarkable wealth of
knowledge in white collar fraud, I wonder if you would be
interested in having a look of the attachment and considering
adding this scam in your website. Being mere amateurs in
finance, we have been struggling to unravel the fraud without
any assistance from the banks and the regulators. We would be
most grateful for any advice from you such as similar deceptive
practice (mischaracterizing highly risky derivatives as
‘security’ in order to mislead the investors in this instance),
or any other aspects that you may consider we should pay
attention to.
No details about the ‘underlying
security’ was given in the prospectuses and Lehman sought to
excuse the non-disclosure by asserting that final decision had
not been made when the prospectus went to print. The intervals
between each series of the Notes could be as short as one month
which renders the assertion implausible. After all, some issuers
of similar notes have adopted the practice of revealing an
‘expected portfolio’ and cognate details. We consider this a key
aspect of intentional withholding of information. Your opinion
on this would be very much appreciated.
May I thank you in advance for taking
time to read our request.
Yours faithfully
Philip Chiu
Attachment 1 ---
http://faculty.trinity.edu/rjensen/HongKongLehman01.pdf
Attachment 2 ---
http://faculty.trinity.edu/rjensen/HongKongLehman02.pdf
Bob Jensen’s Rotten to the Core threads are at
http://faculty.trinity.edu/rjensen/FraudRotten.htm
You can read more about CDO scandals at
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
Bob Jensen's Fraud Updates are at
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
2009
The Woman Who Tried Early On to Save Our Money and Prevent This
Economic Crisis and Countless Financial Frauds
Brooksley Born ---
http://en.wikipedia.org/wiki/Brooksley_Born
In 1964, Brooksley was the first female student in history to
become President of Stanford's Law Review.
The Obama administration has pledged an
overhaul of the financial system, including the way derivatives are
regulated. Worrisome to some observers is the fact that his economic
team includes some former Treasury officials who were lined up in
opposition to Born a decade ago.
"Prophet and Loss," by Rick Schmitt, Stanford Magazine,
March/April 2009, pp. 40-47.
Brooksley Born (the first woman at
Stanford to be president of the Law Review) was named to head
the Commodity Futures Trading Commission in 1996. She “advocated
reigning in the huge and growing market for financial
derivatives…Back in the 1990’s, however, Born’s proposal stirred
an almost visceral response from other regulators in the Clinton
administration (notably explosive and rude 1998 reactions
from Treasury Secretary Robert Rubin and Deputy Secretary Larry
Summers and SEC Chairman Arthur Levitt to her suggestion that
derivatives swap markets be regulated)
as well as members of Congress and
lobbyists…Ultimately Greenspan and the other regulators foiled
Born’s efforts and Congress took the extraordinary step of
enacting legislation that prohibited her agency from taking any
action…Speaking out for the first time, Born says she takes no
pleasure from the turn of events. She says she was just doing
her job based on the evidence in front of her. Looking back, she
laments what she says was the outsized influence of Wall Stret
lobbyists on the process, and the refusal of her fellow
regulators, especially Greenspan, to discuss even modest
reforms. ‘Recognizing the dangers…was not rocket science, but it
was contrary to the conventional wisdom and certainly contrary
to the economic interests of Wall Street at the moment,‘ she
says.”
As quoted on March 20, 2009 at
http://openpalm.wordpress.com/2009/03/20/the-woman-who-tried-to-save-our-money/
2009
Re-arranging the deck chairs on the USS SEC.
We understand why Ms. Schapiro would want
to show some love to the staff after the blistering attack it
received last Wednesday on the Hill. Said liberal New York
Congressman Gary Ackerman, "You have totally and thoroughly failed
in your mission." Then he went negative, referring to the SEC's
difficulty in finding a part of the human anatomy "with two hands
with the lights on." Mr. Markopolos added that his many interactions
with the agency "led me to conclude that the SEC securities'
lawyers, if only through their investigative ineptitude and
financial illiteracy, colluded to maintain large frauds such as the
one to which Madoff later confessed." . . . If Ms. Schapiro seeks to
learn from the SEC's recent history, she might start by considering
the most basic lesson from the Madoff incident. Private market
participants spotted the fraud, while SEC lawyers couldn't seem to
grasp it. Rather than giving her staff lawyers still more autonomy,
she should instead be supervising them more closely, while trying to
harness the intelligence of the marketplace. Meantime, investors
should remember that their own skepticism and diversified investing
remain their best defenses against fraudsters.
"Just Don't Mention Bernie: Unleashing the SEC enforcers who
were already unleashed," The Wall Street Journal, February
10, 2009 ---
http://online.wsj.com/article/SB123423071487965895.html?mod=djemEditorialPage
2009
Questions
Did the FASB's amended fair value guidelines gives the players (banks), umpires
(regulators), and fans (notably shareholders like Steve Forbes and Warren
Buffett seeking a new stock market bubble) the overvalued wine they were
seeking? Or will the new guidelines mostly increase client pressures on auditors
to sign off on fantasy financial statements?
Although the new FASB Guidelines for estimating fair value under FAS 157 and FAS
115 in "broken markets" expands client/auditor discretion for some types of
assets having long-term value such as real estate, it's asking a lot to have
auditors agree once again to rosy valuation of sorry-looking toxic investments
such as the value of a mortgage that's about to wither on the vine. You can't
squeeze sweet grape juice from shriveled homeowners, let alone fine wine. It
may, however, be that higher value on foreclosed properties in bank inventories
will lead to some partying over banks' financial statements.
The wonderful December 30, 2008 research report of the SEC shows that fair value
accounting is neither the cause nor the cure for the banking crisis. The
liquidity problem of the holders of the toxic investments is caused by trillions
of dollars invested in underperforming (often zero performing) of bad
investments mortgages or mortgaged-backed bonds that have to be written down
unless auditors agree to simply lie about values. That is not likely to happen,
but client pressures on auditors to value on the high side for many properties
will be heavy handed.
The wonderful full SEC report that bankers and
regulators do not want to read can be freely downloaded at
http://www.sec.gov/news/studies/2008/marktomarket123008.pdf
The FASB probably did its best to maintain integrity in the face of massive
political pressures. I hope the IASB is able to resist the same pressures in the
international arena. To me the new FASB Guidelines are mostly old wine in new
bottles since FAS 157 previously gave considerable discretion in valuing items
in broken markets.
"Expedited fair value guidance may ease pressure on banks,"
AccountingWeb, March 17, 2009 ---
http://www.accountingweb.com/cgi-bin/item.cgi?id=107232
Following a hearing at a
House Financial Services subcommittee last week, the Financial Accounting
Standards Board (FASB) agreed to expedite release of their proposed guidance
for the application of FAS 157 "Fair Value Measurement." The proposed
guidance was published for public comment on March 17th and will be voted on
by the Board on April 2. If approved, the FASB recommends that the guidance
be effective for interim and annual periods ending after March 15, 2009.
According to CFO.com, FASB chairman, Robert H. Herz, chairman of the
Financial Accounting Standards Board (FASB), told legislators, "We can have
the guidance in three weeks, but whether that will fix everything is another
[issue]."
SB's proposal give more detailed guidance for
valuing assets that would be classified as Level 3 under FAS 157, where
values are assigned in the absence of an active market or where a sale has
occurred in distressed circumstances when prices are temporarily weighed
down. The new guidance allows companies to use their own models and
estimates and exercise "significant judgment" to determine whether a market
exists or whether the input is from a distressed sale. Under FAS 157,
financial instruments' fair values cannot be based on distressed sales.
FASB had planned to issue the proposed guidance by
the end of the second quarter. A study on mark-to-market accounting
standards conducted by the Securities and Exchange Commission (SEC), which
was mandated by the Emergency Economic Stabilization Act of 2008, concluded
that more application guidance to determine fair values was needed in
current market conditions. On February 18, Herz announced that FASB agreed
with the SEC study and would develop additional guidance.
Thomas Linsmeier, FASB board member, said that they
hoped that the new guidance could lead to more accurate and possibly higher
values, CFO.com reports. "What we are voting on will hopefully elevate fair
values to a more reasonable price so investors are more comfortable
investing in the banking system," he said.
Edward Yingling, president of the American Bankers
Association, said in a statement he welcomed the proposal but expressed
caution about the ways it might be used by auditors, MarketWatch says.
"While we welcome today's news, it will be important to look at the details
of the written proposal to see how fully it improves the guidance. It will
also be imperative to examine the practical effect the proposal will have
based on the various ways it is interpreted."
The FASB proposal recommends that companies take
two steps to determine whether there an active market exists and whether a
recent sale is distressed before applying their own models and judgment:
Step 1: Determine whether there are factors
present that indicate that the market for the asset is not active at the
measurement date. Factors include:
- Few recent transactions (based on volume and
level of activity in the market). Thus, there is not sufficient
frequency and volume to provide pricing information on an ongoing basis.
- Price quotations are not based on current
information.
- Price quotations vary substantially either
over time or among market makers (for example, some brokered markets).
- Indices that previously were highly correlated
with the fair values of the asset are demonstrably uncorrelated with
recent fair values.
- Abnormal (or significant increases in)
liquidity risk premiums or implied yields for quoted prices when
compared to reasonable estimates of credit and other nonperformance risk
for the asset class.
- Significant widening of the bid-ask spread.
- Little information is released publicly (for
example, a principal-to-principal market).
If after evaluating all the factors the sum of the
evidence indicates that the market is not active, the reporting entity shall
apply step 2.
Step 2: Evaluate the quoted price (that is,
a recent transaction or broker price quotation) to determine whether the
quoted price is not associated with a distressed transaction. The reporting
entity shall presume that the quoted price is associated with a distressed
transaction unless the reporting entity has evidence that indicates that
both of the following factors are present for a given quoted price:
- There was a period prior to the measurement
date to allow for marketing activities that are usual and customary for
transactions involving such assets or liabilities (for example, there
was not a regulatory requirement to sell).
- There were multiple bidders for the asset.
The proposed guidance also provides examples of
measurement approaches in the event that the observable input is from a
distressed sale.
At Monday's meeting, Herz deflated any beliefs that
FASB's new guidance will be a panacea for the many ills of the U.S. economy.
"There's not much accounting can do other than help people get the facts and
use their best judgment," he said.
The International Accounting Standards Board, which
sets accounting rules followed by more than 100 countries, plans to publish
a draft rule to replace and simplify fair-value accounting rules. Critics
say the rules have exacerbated the credit crunch by forcing write-downs. "We
plan to replace it, the whole thing. We want to stop patching up the
standard and we want to write a new one. We are aware that the current model
is too complex. We need to simplify.... We will move to exposure draft
hopefully within the next six months," said Philippe Danjou, a member of the
IASB board.
Professor Schiller at Yale asserts housing prices are still overvalued
and need to come down to reality
The median value of a U.S. home in 2000 was
$119,600. It peaked at $221,900 in 2006. Historically, home prices have
risen annually in line with CPI. If they had followed the long-term trend,
they would have increased by 17% to $140,000. Instead, they skyrocketed by
86% due to Alan Greenspan’s irrational lowering of interest rates to 1%, the
criminal pushing of loans by lowlife mortgage brokers, the greed and hubris
of investment bankers and the foolishness and stupidity of home buyers. It
is now 2009 and the median value should be $150,000 based on historical
precedent. The median value at the end of 2008 was $180,100. Therefore, home
prices are still 20% overvalued. Long-term averages are created by periods
of overvaluation followed by periods of undervaluation. Prices need to fall
20% and could fall 30%.....
Watch the video on Yahoo Finance ---
Click Here
See the chart at
http://www.businessinsider.com/the-housing-chart-thats-worth-1000-words-2009-2
Also see Jim Mahar's blog at
http://financeprofessorblog.blogspot.com/2009/02/shiller-house-prices-still-way-too-high.html
Jensen Comment
In the worldwide move toward fair value accounting that replaces cost
allocation accounting, the above analysis by Professor Schiller is sobering.
It suggests how much policy and widespread fraud can generate misleading
"fair values" in deep markets with many buyers and sellers, although the
housing market is a bit more like the used car market than the stock market.
Each house and each used car are unique, non-fungible items that are many
times more difficult to update with fair value accounting relative to
fungible market securities and new car markets.
Bob Jensen's threads on fair value accounting are at
http://faculty.trinity.edu/rjensen/Theory01.htm#FairValue
Don't Blame Fair Value Accounting Standards (Except in Terms of Executive
Bonus Payments) ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#FairValueAccounting
"IASB Enhances Financial Instruments Disclosures," SmartPros,
March 5, 2009 ---
http://accounting.smartpros.com/x65784.xml
The International Accounting Standards Board (IASB)
today issued amendments that improve the
disclosure requirements about fair value measurements
and reinforce existing principles for disclosures about the
liquidity risk associated with financial
instruments.
The amendments form part of the IASB’s focused
response to the financial crisis and addresses the G20 conclusions aimed at
improved transparency and enhanced accounting guidance. The improvements
also reflect discussions by the IASB’s Expert Advisory Panel on measuring
and disclosing fair values of financial instruments when markets are no
longer active.
Responding to the calls of policymakers, many
investor groups and other interested parties, the IASB is bringing the
disclosure requirements of International Financial Reporting Standards (IFRSs)
more closely into line with US standards. The amendments to IFRS 7 Financial
Instruments: Disclosures introduce a three-level hierarchy for fair value
measurement disclosures and require entities to provide additional
disclosures about the relative reliability of fair value measurements. These
disclosures will help to improve comparability between entities about the
effects of fair value measurements. In addition, the amendments clarify and
enhance the existing requirements for the disclosure of liquidity risk. This
is aimed at ensuring that the information disclosed enables users of an
entity’s financial statements to evaluate the nature and extent of liquidity
risk arising from financial instruments and how the entity manages that
risk.
The amendments to IFRS 7 apply for annual periods
beginning on or after 1 January 2009. However, an entity will not be
required to provide comparative disclosures in the first year of
application.
Introducing the amendments, Sir David Tweedie,
Chairman of the IASB, said: The financial crisis has shown that a clear
understanding of how entities determine the fair value of financial
instruments, particularly when only limited information is available, is
crucial to maintaining confidence in the financial markets. The additional
disclosure requirements and the three-level hierarchy will help to increase
the clarity of the information. The amendments will also enhance the
disclosures about the liquidity risks associated with financial instruments.
The proposals build on the advice we have received from the IASB’s Expert
Advisory Panel. For more information about measures undertaken by the IASB
in response to the financial crisis, visit
www.iasb.org
2009
"In Defense of Derivatives and How to Regulate Them: The
much-maligned financial instruments have legitimate uses," by Rene M. Stulz,
The Wall Street Journal, April 6, 2009 ---
http://online.wsj.com/article/SB123906100164095047.html#mod=djemEditorialPage
A lengthy quotation is provided below after some introductory remarks.
Jensen Comment
For years I've maintained a Timeline on derivative financial
instruments fraud and the evolution of FAS 133, FIN 141(R), and IAS
39 provisions to steadily improve the accounting for such
instruments. At the same time, however, the Federal Reserve under
Alan Greenspan and the SEC under various inept directors allowed
investment banks to conduct frauds year after year in unregulated
markets, albeit that many of the transactions were not fraudulent.
However, many were highly fraudulent even in the most prestigious
investment banks and brokerage firms like Merrill Lynch that, among
other frauds, bilked Orange County of over a billion dollars.
My Timeline beginning in Roman times is at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
Steve Kroft on Sixty Minutes, July 23,
1995
Introductory Segment ---
http://www.cbsnews.com/video/watch/?id=4501762n%3fsource=search_video
Another (more revealing) Segment on the infamous 1994 $1 billion
losses in derivatives for Orange County instigated by complex
derivatives sold by Merrill Lynch to Orange County's naive Treasurer
---
http://faculty.trinity.edu/rjensen/acct5341/Calgary/CDfiles/video/FAS133/SIXTY01.wmv
My hero has been Frank Partnoy who was for a short time one of
the bad guys selling dubious derivatives. Frank had a conscience and
since the early 1990s wrote whistle blowing books that, while
entertaining, did not persuade policy makers like Alan Greenspan and
Arthur Levitt to regulate the wild west derivatives market.
1994
Infectious
Greed: How Deceit and Risk Corrupted the Financial
Markets (Henry Holt and Company, 2003, Page 229,
ISBN 0-8050-7510-0)
Third, financial derivatives were now everywhere ---
and largely unregulated. Increasingly, parties were
using financial engineering to take advantage of the
differences in legal rules among jurisdictions, or
to take new risks in new markets. In 1994, The
Economist magazine noted, "Some financial
innovation is driven by wealthy firms and
individuals seeking ways of escaping from the
regulatory machinery that governs established
financial markets." With such innovation, the
regulators' grip on financial markets loosened
during the mid-to-late 1990s . . . After Long-Term
Capital (Management) collapsed, even Alan Greenspan
admitted that financial markets had been close to
the brink.
|
Infectious Greed: How Deceit and Risk Corrupted the
Financial Markets (Henry Holt and Company, 2003,
Page 17, ISBN 0-8050-7510-0)
As 1987 began, Andy Krieger
(at
Salomon Brothers and doing currency trading
through
Bankers Trust)
found what he believed was an incredible opportunity
to make money trading currency options The U.S.
Federal Reserve and various central banks in Europe
had implemented policies to maintain their
currencies within a stable zone. The dollar had been
falling for several years, but during 1987 it
stabilized, and by the fall of 1987 the volatility
numbers traders were using to evaluate currency
options were very low. As a result, currency options
were incredibly cheap . . . If these (currency
trading banks) had been buying and selling stocks
instead of currencies, such efforts to move
short-term prices would have constituted "market
manipulation." But currency markets were unregulated
free-for-all, where manipulative trading tactics
were quite common and perfectly legal. By
manipulating prices, a trader might be able to
generate profits even if the markets were quite
efficient. This was something academics studying
financial markets hadn't yet considered. And it was
something the traders loved to do.
Manipulative practices were especially common in the
over-the-counter markets --- the wild Wild West of
trading. Instead of buying and selling options on a
centralized exchange, which acted as a counterparty
to all trades, traders could enter into private
contracts with buyers and selliers, typically other
banks . . . The exchanges monitored manipulative
practices but nobody watched the over-the-counter
traders.
In one infamous episode,
Krieger sold, or shorted, roughly the entire
money supply of New Zealand.
He also held call options ---
of similar amounts --- which benevit if the kiwi
went up, and therefore woudl offset any losses from
his short position . . . Krieger's stragegy drew
from one of the central insights of modern finance,
generally known as parity (or put-call
parity), and it is worth taking a few minutes to
contemplate ---
http://en.wikipedia.org/wiki/Put-call_parity
. . .
Currency-options traders were shocked, and trading
currency options nearly halted for a few hours
before Krieger resigned. Again, rumors swirled about
Krieger's resignation, including word that Banker
Trust had incurred huge losses in currency options,
perhas as mch as $100 million. A spokesman denied
the rumors, the the denial only fed speculation
about what had happened at Bankers Trust.
|
"In Defense of Derivatives and How to Regulate Them: The
much-maligned financial instruments have legitimate uses," by
Rene M. Stulz, The Wall Street Journal, April 6, 2009 ---
http://online.wsj.com/article/SB123906100164095047.html#mod=djemEditorialPage
There are two sides to derivatives --
one positive and beneficial, one exploitive and negative. Of the
latter, the most visible example today comes to us courtesy of
the American International Group (AIG) and reveals what happens
when a lightly regulated but highly interconnected financial
institution ends up positioned in a way that it cannot survive a
housing crash and then such a crash occurs.
The other side of derivatives, however,
involves the less-publicized but widespread use of these
financial instruments in ways that benefit companies.
Derivatives have been immensely valuable tools and will be
instrumental in providing the liquidity needed to jump-start the
economy. Derivatives are used by a vast number of U.S.
companies, both small and large, to manage various risks that
arise in connection with their businesses.
From the perspective of Main Street
companies, derivatives are not just about high finance, quants
and politics, but about investing in America's core industries,
jobs and economic recovery. Companies find that over-the-counter
derivatives are essential to their day-to-day operations.
Derivatives help insulate them from risk, which allows them to
borrow capital at better prices than they would otherwise. And
derivatives are more useful than ever in these days of unusual
volatility in financial markets.
For example, not being able to hedge
currency risk through the use of a derivative can leave a
company exposed to fluctuations in currency markets. Without
derivatives companies could see movements in exchange rates turn
a profitable export contract into a money-losing agreement.
In its current annual report,
Caterpillar Inc. makes the case for why it relies on
derivatives: "Our risk management policy . . . allows for the
use of derivative financial instruments to prudently manage
foreign currency exchange rate, interest rate, commodity price
and Caterpillar stock price exposures."
For those unfamiliar with market
jargon, credit default swaps, which are most often in the news,
are simply financial contracts between two parties. If, for
example, you own bonds in a company and are worried that the
company will default, you can manage your risk and protect your
holdings with a credit default swap. Under it, you would make
regular payments to maintain the contract. If the company does
not default, you're out-of-pocket the payments. But if the
company does default, the swap serves as a form of insurance by
giving you the right to exchange the questionable bonds for the
principal amount, or to be reimbursed in other ways. There's
nothing exotic or complex about these contracts. They can be
highly valuable for Main Street firms, because they enable them
to protect themselves against the failure of large customers.
However, Main Street firms cannot
afford derivatives unless there is a competitive market for them
with participants willing to take the opposite position.
Restricting access to derivative markets, which is being
proposed by some in Congress as well as by some regulators,
would make the costs of derivatives prohibitively expensive and
eliminate liquidity.
That derivatives benefit our financial
system and our national economy is well established. Twenty-nine
of the 30 companies that make up the Dow Jones Industrial
Average use derivatives. According to data from Greenwich
Associates, two-thirds of large companies (those that have sales
of more than $2 billion) use over-the-counter derivatives and
more than half of all mid-size companies (those that have sales
between $500 million and $2 billion) are very active in
derivatives markets. Derivatives are necessary and helpful tools
for companies seeking to manage financial risk.
The most important benefit of
derivatives is that they allow businesses to hedge risks that
otherwise could not be hedged. This does a number of positive
things. It transfers risk, allowing firms to guard against being
forced into financial distress. It also frees lenders to offer
credit on better terms, giving companies access to funds that
they can use to keep their doors open, lights on and, even,
invest in new technologies, build new plants, or hire new
employees.
It's important for regulators not to
overreact by pushing for counterproductive new rules. The
regulators, after all, were no better at foreseeing the current
crisis than the private sector, proving that regulation has
obvious limits and cannot replace efforts by financial
institutions to devise risk-management approaches that enable
them to cope with crises in the financial markets of the 21st
century.
At the same time, some sensible
regulations are in order. With the interconnectedness of markets
today and the systemic problems facing the world's economies,
there is a lot that can be done to limit systemic risks. One
beneficial step would be for Congress to adopt some version of a
systemic-risk regulator that would place every participant in
the financial markets that poses a systemic risk, including
derivatives traders, under federal regulatory oversight.
Unbelievably, the arm of AIG that dealt
with derivative products was not subject to serious scrutiny by
a federal agency with relevant experience. A systemic-risk
regulator, or markets-stability regulator, should oversee every
kind of financial institution that is found to be systemically
important, including banks, broker-dealers, insurance companies,
hedge funds, private equity funds and others. That regulator
should have the authority to ensure that such financial
institutions have sufficient capital to reduce the risks they
pose to the financial system, to examine parent companies and
subsidiaries, and to bring enforcement actions.
Additionally, a clearinghouse for
standardized credit default swaps was launched in March, and
other competitor clearinghouses are under construction.
Clearinghouses clear and settle trades and limit the risk to the
larger financial system if any one dealer, like AIG, fails to
meet its obligations. A clearinghouse also allows regulators to
monitor the exposure firms have to these products, while
simultaneously ensuring that each firm posts the necessary
collateral to cover its obligations under its trades.
However, clearinghouses should be
reserved for established and standardized derivatives, leaving
participants in capital markets free to engage in bilateral
contracts for derivatives that fulfill specific needs as well as
for new products. Further, use of a clearinghouse should not be
compulsory, but capital-requirement regulations should recognize
that derivatives positions that are not put through a
clearinghouse may pose greater systemic risks than those that
are.
The subprime mess triggered one of the
most destructive financial crises in decades. It's not
surprising, then, that the hunt is on for culprits. But
derivatives are not the culprit. They had little to do with the
rise and collapse of housing prices. Wider availability of
housing derivatives would have actually reduced the impact of
the collapse of housing prices if homeowners had been able to
hedge against possible decreases in home values.
Our businesses need derivatives. Most
of us choose to drive cars even though they sometimes crash. But
we also insist that cars are made as safe as it makes economic
sense for them to be, and that speed limits and other rules of
the road are enforced. The same logic should apply to
derivatives.
Dr. Stulz is a professor of finance at the Fisher College
of The Ohio State University.
From The Wall
Street Journal Accounting Weekly Review on April 23, 2009
Don't Kill the Good Part of the
Derivatives Market
by
Gary DeWaal and Michael Hope
The Wall Street Journal
Apr 17, 2009
Click here to view the full article
on WSJ.com ---
http://online.wsj.com/article/SB123993535782328107.html?mod=djem_jiewr_AC
TOPICS: Advanced
Financial Accounting, Derivatives
SUMMARY: "René
Stulz makes an excellent case why the responsible use of
derivatives can help bona fide users, and ultimately help Main
Street," writes this New York resident to the WSJ Opinion page
editors. However, Mr. Hope of Pacific Palisades, CA, recalls in
his letter a time when, as a "young, inexperienced chief
financial officer of a Fortune 500 company," he decided against
"investing" in interest rate swaps "pitched" by "a prominent
investment banking firm." Professor Stulz's related letter was
published on the opinion page on April 7.
CLASSROOM APPLICATION: Accounting
students studying derivatives should realize the economic and
finance issues behind these contracts in addition to
understanding the accounting requirements and being able to
execute entries for them. The letter describing how a CFO raised
questions about transactions new to him at the time provides a
helpful perspective as well.
QUESTIONS:
1. (Introductory)
Refer to the related article by Professor René Stulz of the
Finance Department at the Ohio State University's Fisher College
of Business. In it, he cites the financial statement disclosure
by Caterpillar, Inc., regarding the risks it hedges by using
derivatives. List these risks and state the derivatives used to
hedge against those risks.
2. (Advanced)
Why must there be a market behind derivatives in order for them
to be executed? In your answer, comment on the difference
between standardized derivatives traded via a clearinghouse and
individualized derivative contracts.
3. (Advanced)
What derivatives did Mr. Hope consider using as a "young,
inexperienced CFO at a Fortune 500 company"? What risks were
those derivatives designed to hedge? In your answer, explain how
that hedging contract could benefit his company. Also, explain
what economic factors likely led to the fact that a strategy of
not using derivatives "worked out fine" for his company. (Hint:
consider what happened to interest rates during the 1980s.)
4. (Introductory)
What questions did Mr. Hope raise regarding the market for the
interest rate swap he was considering for his company? How are
those questions similar to considerations now for developing
regulations over derivatives markets?
Reviewed By: Judy Beckman, University of Rhode Island
RELATED ARTICLES:
In Defense of Derivatives and How
to Regulate Them
by René M. Stulz
Apr 06, 2009
Online Exclusive
While Frank Portnoy was fighting for
more financial markets regulation, guess who was fighting against it
tooth and nail?
Few remember that Bill Clinton's administration, along with
Greenspan and Levitt, fought successfully against regulation of
financial markets.
It's now Deja vu Larry Summers who is the liberal Keynesian scholar
behind President Obama's economic recovery and budget spending.
People remember Larry Summers as Harvard President who was forced
out of office by feminists.
But few remember that he was also Treasury Secretary during the
presidency of Bill Clinton.
Even fewer remember him as a virulent
opponent of financial markets regulation.
2009
In 1997, Brooksley Born warned in
congressional testimony that unregulated trading in derivatives
could "threaten our regulated markets or, indeed, our economy
without any federal agency knowing about it." Born called for
greater transparency--disclosure of trades and reserves as a buffer
against losses. Instead of heeding this oracle's warnings,
Greenspan, Rubin & Summers rushed to silence her. As the Times story
reveals, Born's wise warnings "incited fierce opposition" from
Greenspan and Rubin who "concluded that merely discussing new rules
threatened the derivatives market." Greenspan deployed condescension
and told Born she didn't know what she doing and she'd cause a
financial crisis . . . In early 1998, according to the Times story,
one of the guys, Larry Summers, called Born to "chastise her for
taking steps he said would lead to a financial crisis. But Born kept
at it, unwilling to let arrogant men undermine her good judgment.
But it got tougher out there. In June 1998, Greenspan, Rubin and the
then head of the SEC, Arthur Levitt, Jr., called on Congress "to
prevent Ms. Born from acting until more senior regulators developed
their own recommendations." (Levitt now says he regrets that
decision.) Months later, the huge hedge fund Long Term Capital
Management nearly collapsed--confirming some of Born's warnings.
(Bets on derivatives were a key reason.) "Despite that event," the
Times reports, " Congress (apparently as a result of Greenspan &
Summer's urging, influence-peddling and pressure) "froze" Born's
Commissions' regulatory authority. The next year, Born left as head
of the Commission.Born did not talk to the Times for their article.
What emerges is a story of reckless, willful and arrogant action and
behaviour designed to undermine a wise woman's good judgment. The
three marketeers' disdain for modest regulation of new and risky
financial instruments reveals a faith-based fundamentalist approach
to the management of markets and risk. If there is any
accountability left in our system, Greenspan, Rubin and Summers
should not be telling anyone how to run anything. Instead, Barack
Obama might do well to bring back Brooksley Born and promote to his
team economists who haven't contributed to the ugly mess we're in.
Katrina vanden Heuvel,
"The Woman Greenspan, Rubin & Summers Silenced," The Nation,
October 9, 2008 ---
http://www.thenation.com/blogs/edcut/370925/the_woman_greenspan_rubin_summers_silenced
Link forwarded by Jagdish Gangolly
The Woman Who Tried Early On to Save Our Money and Prevent
This Economic Crisis and Countless Financial Frauds
Brooksley Born ---
http://en.wikipedia.org/wiki/Brooksley_Born
In 1964, Brooksley was the first female student in history to
become President of Stanford's Law Review.
The Obama administration has pledged an
overhaul of the financial system, including the way derivatives are
regulated. Worrisome to some observers is the fact that his economic
team includes some former Treasury officials who were lined up in
opposition to Born a decade ago.
"Prophet and Loss," by Rick Schmitt, Stanford
Magazine, March/April 2009, pp. 40-47.
Brooksley Born (the first woman at
Stanford to be president of the Law Review) was named to head
the Commodity Futures Trading Commission in 1996. She “advocated
reigning in the huge and growing market for financial
derivatives…Back in the 1990’s, however, Born’s proposal stirred
an almost visceral response from other regulators in the Clinton
administration (notably explosive and rude 1998 reactions
from Treasury Secretary Robert Rubin and Deputy Secretary Larry
Summers and SEC Chairman Arthur Levitt to her suggestion that
derivatives swap markets be regulated) as
well as members of Congress and lobbyists…Ultimately Greenspan
and the other regulators foiled Born’s efforts and Congress took
the extraordinary step of enacting legislation that prohibited
her agency from taking any action…Speaking out for the first
time, Born says she takes no pleasure from the turn of events.
She says she was just doing her job based on the evidence in
front of her. Looking back, she laments what she says was the
outsized influence of Wall Stret lobbyists on the process, and
the refusal of her fellow regulators, especially Greenspan, to
discuss even modest reforms. ‘Recognizing the dangers…was not
rocket science, but it was contrary to the conventional wisdom
and certainly contrary to the economic interests of Wall Street
at the moment,‘ she says.”
As quoted on March 20, 2009 at
http://openpalm.wordpress.com/2009/03/20/the-woman-who-tried-to-save-our-money/
Not only have individual financial
institutions become less vulnerable to shocks from underlying risk
factors, but also the financial system as a whole has become more
resilient.
Alan Greenspan in 2004
as quoted by Peter S. Goodman, Taking a Good Look at the
Greenspan Legacy," The New York Times, October 8, 2008 ---
http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?em
“I made a mistake in presuming that the
self-interest of organisations, specifically banks and others, was
such that they were best capable of protecting their own
shareholders,” he said. In the second of two days of tense hearings
on Capitol Hill, Henry Waxman, chairman of the House of
Representatives, clashed with current and former regulators and with
Republicans on his own committee over blame for the financial
crisis.
"‘I made a mistake,’ admits Greenspan," by
Alan Beattie and James Politi, Financial Times, October 23,
2008 ---
http://www.ft.com/cms/s/0/aee9e3a2-a11f-11dd-82fd-000077b07658.html?nclick_check=1
Rubin, Fed chairman Alan Greenspan and
Summers were concerned that even a hint of regulation would send all
the derivatives trading overseas, costing America business. Summers
bluntly insisted that Born drop her proposal, says Greenberger.
"The Reeducation of Larry Summers: He's become a
champion of massive government intervention in the economy, and he's
even learning how to play nice. ," by Michael Hirsh and Evan Thomas,
Newsweek Magazine, March 2, 2009 ---
http://www.newsweek.com/id/185934
Larry Summers had the rumpled,
slightly sleepy look of a professor who has been up all night
solving equations. President Obama's top economic adviser, the
man mainly in charge of the immense government bailout, splayed
himself on a sofa in the Roosevelt Room in the White House,
beneath a portrait of Franklin Roosevelt, and did his best to be
patient with two NEWSWEEK reporters. They were asking him to
explain how he had changed—reeducated himself—since the
freewheeling days of the late 1990s, when Summers had been part
of a government that basically got out of the way of the
financial markets as they headed for the edge of the cliff.
Summers responded by quoting
John Maynard Keynes, whose economic theory calling for massive
government spending became identified with Roosevelt's New Deal
and is at the heart of the Obama administration's stimulus plan.
"Keynes famously said of someone who accused him of
inconsistency: 'When circumstances change, I change my
opinion'," said Summers, raising his heavy-lidded eyes at the
reporters as he quoted Keynes's kicker: " 'What do you do?' "
The implication, not so subtle, is that smart people are not
dogmatic—stuck in one narrow ideological groove —but rather
open-minded, flexible and intellectually alert—able to change
with the times.
. . .
Some of the stories go well
beyond complaints about his manners.
Brooksley Born,
chairwoman of the Commodity Futures Trading Commission, received
a call in March 1998 in her office in downtown Washington. On
the other end was Deputy Treasury Secretary Summers.
According to witnesses at the
CFTC, Summers proceeded to dress her down, loudly and rudely.
"She was ashen," recalls Born's deputy Michael Greenberger, who
walked in as the call was ending. "She said, 'That was Larry
Summers. He was shouting at me'." A few weeks before,
Born had put out a proposal
suggesting that U.S. authorities begin exploring how to regulate
the vast global market in derivatives. Summers's phone call was
the first sign that her humble plan had riled America's reigning
economic elite.
Rubin, Fed chairman Alan
Greenspan and Summers were concerned that even a hint of
regulation would send all the derivatives trading overseas,
costing America business. Summers bluntly insisted that Born
drop her proposal, says Greenberger.
According to another former CFTC official who would recount the
episode only on condition of anonymity, Born was "astonished"
Summers would take the position "that you shouldn't even ask
questions about a market that was many, many trillions of
dollars in notional value—and that none of us knew anything
about."
Arthur Levitt, who was head of
the SEC at the time of Born's proposal, today admits flatly that
she had things right about derivatives while he, Rubin,
Greenspan and Summers didn't. ("All tragedies in life are
preceded by warnings," Levitt says. "We had a warning. It was
from Brooksley Born. We didn't listen.") Summers told NEWSWEEK:
"I believed at the time, and believe much more strongly today,
that new regulations with respect to systemic risk were
appropriate and necessary, but expressed the strong view of
Secretary Rubin, chairman Greenspan and SEC chief Levitt that
the way the CFTC was proposing to go about it was likely to be
ineffective and itself imposed major risks into the market." (At
the time, the Rubin Treasury Department argued against the Born
proposal by maintaining that the CFTC didn't have legal
jurisdiction.) Still, Summers allowed that "there's no question
that with hindsight, stronger regulation would have been
appropriate" before the financial crash. He added: "Large swaths
of economics are going to have to be rethought on the basis of
what's happened." In the past year Summers has refashioned
himself as a champion of intensive financial regulation. In his
last column for the Financial Times before joining the Obama
administration, Summers said the pendulum "should now swing
towards an enhanced role for government in saving the market
system from its excesses and inadequacies."
Continued in article
Unlike many other nations that either did not have national
accounting standards or had weak and incomplete sets of
standards, the FASB over the years produced the best set of
accounting standards in the world (although there is no such
thing a perfect set since companies are always writing contracts
to circumvent most any standard). The FASB standards were
heavily rule-based due to the continual battles fought by the
FASB in the trenches of U.S. firms seeking to manage earnings
and keep debt of the balance sheet with ever-increasing contract
complexities such as interest rate swaps invented in the 1980s,
SPE ploys, securitization "sales," synthetic leasing, etc.
- The
experiences of those frazzled executives in charge of
reducing risks in the credit derivatives market are
starting to resemble Alice’s adventures in Wonderland.
Alice shrank after drinking a potion, but was then too
small to reach the key to open the door. The cake she
ate did make her grow, but far too much. It was not
until she found a mushroom that allowed her to both grow
and shrink that she was able to adjust to the right
size, and enter the beautiful garden. It took an awfully
long time, with quite a number of unpleasant
experiences, to get there.
Aline van Duyn, "The
adventure never ends in the derivatives Wonderland,"
Financial Times, September 11, 2008 ---
Click Here
- While
Lehman Brothers was fighting for its life in the markets
today, it was also battling in a Senate panel's hearing
on whether the company and others created a set of
financial products whose primary purpose is to dodge
taxes owned on U.S. stock dividends. The "most
compelling" reason for entering into dividend-related
stock swaps are the tax savings, Highbridge Capital
Management Treasury and Finance Director Richard
Potapchuk told the Senate's Permanent Subcommittee on
Investigations. Lehman Brothers (nyse: LEH - news -
people ), Morgan Stanley (nyse: MS - news - people ) and
Deutsche Bank (nyse: DB - news - people ) are among the
companies behind the products.
Anitia Raghaven, The Tax Dodge Derivative,
Forbes, September 11, 2008 ---
Click Here
There will be a time “beyond crisis,”
asserts Robert C. Merton, who delves into the dense science of
derivatives — a field he has fundamentally shaped — to explain how
the vast global economic collapse has come about, and how financial
innovations at the heart of the collapse could also be tools for
reconstruction. \Merton uses deceptively simple graphs to show how
risk propagated rapidly across financial networks, bringing down
financial institutions. While he admits the crisis “is very big and
complicated,” Merton boils a piece of it down to the use of put
options, a derivative contract that’s been around since the 17th
century. This asset-value insurance contract, a guarantee of debt,
is the basis for the credit default swaps widely adopted by
financial giants in the last few years — now widely regarded as a
primary cause of the meltdown. It turns out, says Merton, that the
put “makes risky debt very complicated, and treacherous…” In these
puts, if the value of assets goes down, the guarantee value goes up,
so the value of the written insurance is worth more. The value of
this guarantee is very sensitive to the movement of the underlying
asset. When dealing with puts on the local level, this movement can
be tracked and managed more easily. But when financial institutions
manipulate bundles of assets (for instance, mortgage-backed
securities), the increase in risk proves non-linear. Add some
volatility, like the jolts posed by widespread drops in housing
prices, and the difference between the decline in asset value and
the value of the guarantee becomes enormous — leading to mountains
of debt and felling behemoths like AIG (insurer to lenders).
"Video: Robert C. Merton: Observations on the Science of
Finance in the Practice of Finance," Simoleon Sense, April 6, 2009
---
Click Here
Snipped Link ---
http://snipurl.com/mertenputs [www_simoleonsense_com]
Jensen Comment
Nobel Economist Robert Merton knows very well about the dense
science and practice of derivatives. He was a principle loser in
Long Term Capital's 1993 "Trillion Dollar Bet" that nearly brought
down Wall Street ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#LTCM
2009
Among many other things, the Lehman bankruptcy
symbolized the breakdown of an overly complex, fragmented, opaque, unwieldy and
ungovernable financial system. But while it's easy to think that these issues
are systemic and beyond our individual control, perhaps there are steps that
each one of us can take, in our own small way, to prevent the next Lehman from
occurring?
Ron Ashkenas, How Can You Help
Prevent the Next Lehman," Harvard Business Publishing, September 14, 2009 ---
Click Here
http://blogs.harvardbusiness.org/cs/2009/09/how_you_can_help_prevent_the_n.html?cm_mmc=npv-_-DAILY_ALERT-_-AWEBER-_-DATE
Derivatives still pose huge risk, says BIS
The global market for derivatives rebounded to $426
trillion in the second quarter as risk appetite returned, but the system remains
unstable and prone to crises, according to the Bank for International
Settlements (BIS). The BIS said in its quarterly report that total turnover of
derivatives rose 16pc, mostly due to a surge in futures and options contracts on
three-month interest rates. Stephen Cecchetti, the bank's chief economist, said
over-the-counter markets for derivatives are still opaque and pose "major
systemic risks" for the financial system. The danger is that regulators will
again fail to see that big institutions have taken far more exposure than they
can handle in shock conditions, repeating the errors that allowed the giant US
insurer AIG to write nearly "half a trillion dollars" of unhedged insurance
through credit default swaps. The misjudgement was to think the banks and
insurers were safe because their "net" exposure was modest. That proved to be an
illusion. "The crisis has cast doubt on the apparent safety of firms that have
small net exposures associated with large positions," Mr Cecchetti wrote. "As
major market-makers suffered severe credit losses, their access to funding
declined much faster than nearly anyone expected. When that happened, it was
gross exposure that mattered. "The use of derivatives by hedge funds and the
like can create large, hidden exposures," he added, citing the discovery that
firms in Brazil, Korea and Mexico held huge foreign exchange contracts in
late-2008.
London Telegraph, September 13, 2009
---
Click Here
Bob Jensen’s
tutorials (including videos) on accounting for derivatives are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Bob Jensen's timeline for derivatives frauds ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
2009
Some regulations proposed for credit default swaps do not solve the
problems such as the AIG default problems
"A Central Clearing House Doesn’t Reduce CDS Risk," by Bill
Snyder, Stanford GSB News, April 2009 ---
http://www.gsb.stanford.edu/news/research/duffie_clearinghouse.html?cmpid=kb0904
A plan by global financial regulators
to fix the mess created by the misuse of credit default swaps is
flawed, says Darrell Duffie, professor of finance at the
Stanford Graduate School of Business.
In a preliminary research paper, Duffie,
and GSB doctoral student Haoxiang Zhu, conclude that the central
clearing houses founded to rationalize the $27 trillion market
for credit default swaps will not remove nearly as much risk as
regulators might hope. What's more, despite a mistaken belief by
some commentators, the clearing houses are unlikely to bring
much needed transparency to trades of credit-default swaps, or
CDS, says Duffie.
Credit default swaps are essentially
insurance policies used to hedge risky bonds. Their misuse has
been blamed for the near-collapse of American International
Group (AIG) and the subsequent damage to the global financial
system in an over-the-counter market, out of view and off the
public record.
Because there was, until recently, no
central clearing house for the CDS market, buyers and sellers
have been unnecessarily exposed to the risk of default. A
clearing house stands between buyers and sellers, ensuring that
accounts are settled properly when trades are made, and that
margin requirements have been met. In effect, the clearing house
acts as a buyer to every seller and a seller to every buyer,
reducing the risk of default by either counterparty, as
participants in such trades are called.
Responding to pressure from regulators,
dealers in Europe and the United States, agreed to the
establishment of CDS clearing houses, and by early spring two
had been opened and more are planned.
Duffie, a member of the Financial
Advisory Roundtable of the New York Federal Reserve Bank,
supported the establishment of a clearinghouse in testimony last
year to the U.S. Senate Committee on Banking, Housing, and Urban
Affairs. He still supports that idea, but maintains that the
current implementation is flawed in several respects.
Although the worldwide market for
credit default swaps is huge at $27 trillion, it has shrunk by
more than 50 percent in the past year, and is too small—and the
number of participating institutions is too small—for a
clearinghouse that deals only in CDS to efficiently reduce
counterparty risk, says Duffie. Instead, Duffie and Zhu suggest
that the clearinghouse should clear a much larger fraction of
trades made in the $500 trillion market for over-the-counter
(off-exchange) derivatives.
"Our results make it clear that
regulators and dealers should carefully consider the tradeoffs
involved in carving out a particular class of derivatives, such
as credit default swaps, for clearing," the research paper
states. Here's why:
Banks reduce risk by trading across
various classes of options, derivatives, and other financial
instruments. Ultimately, positions between two counterparties
tend to have offsetting exposures; some are of positive market
value to a given counterparty, and others are of negative market
value. These have a "netting effect," that is, only the net
amount of market value is at risk in a default by one of the
counterparties
Duffie and his co-author built a
theoretical model to clarify an important tradeoff between two
types of netting opportunities, "namely bilateral netting
between pairs of dealers across different underlying assets,
versus multilateral netting among many dealers across a single
class of underlying assets, such as credit default swaps." The
latter of these is the method by which the new clearinghouses
will work.
Their model reveals that clearing only
credit default swaps can actually increase the risk to the
counterparties because the benefits of bilateral netting across
asset classes is reduced in this case.
For instance, if Dealer A is exposed to
Dealer B by $100 million on CDS, while at the same time Dealer B
is exposed to Dealer A by $150 million on interest-rate swaps,
then the introduction of central clearing for only credit
default swaps increases the maximum loss between these two
dealers, before collateral and after netting, from $50 million
to $150 million. Additionally, CDS-only clearing would likely
result in demands for additional, expensive, collateral to
protect the two parties.
A CDS-only clearinghouse would work if
the market were larger, say Duffie and Zhu. More precisely,
their report finds that a dedicated central clearing
counterparty [a clearinghouse] improves netting efficiency for
these dealers if and only if the fraction of a typical dealer's
expected exposure attributable to CDS is the majority of the
total expected exposures of all remaining bilaterally netted
classes of derivatives. In fact, the credit-default swap market
is now too small to reach that threshold.
Making matters somewhat worse was the
decision to establish multiple clearing houses. Having more than
one reduces the netting effect even more, says Duffie, adding
that each additional clearing house exacerbates the problem.
Even though the clearinghouse plan is
flawed with respect to reducing counterparty risk, it has been
suggested that establishing these new entities would at least
add much needed transparency to the CDS market. Actually, the
same level of information about CDS trades that would be
available to regulators in a clearing house is already available
through the Depository Trust and Clearing Corporation (DTCC).
With or without a clearing house, there is no plan to reveal
trades to the public. So, the stories of improved transparency
are a red herring.
Public discussion, says Duffie, assumes
that the clearinghouses would act like exchanges, such as the
New York Stock Exchange, by systematically reporting all trades.
"I’m sorry to disappoint, but most of the information about
default swaps remains confidential even when cleared," he said
during an interview.
Moreover, a clearinghouse can only
clear standard transactions. But most of the credit default
swaps initiated by AIG, are not standard, and would never have
been cleared, even if a clearing house had existed years ago.
Presented in mid-February of 2009, the
preliminary draft of the Duffie-Zhu paper is titled: "Does a
Central Clearing Counterparty Reduce Counterparty Risk?" The
work is something of a departure for Duffie, who says he rarely
writes a paper to meet the immediate needs of a policy debate,
but felt compelled to weigh in because of the critical nature of
the discussion.
"During a research discussion over
lunch, my co-author and I had a hunch that there was an
important concept missing from the policy discussion. We could
not confirm our intuition without building and solving a model.
Once we did, it was obvious that we should present our results
in a new research paper," he said in the interview.
Darrell Duffie is the Dean Witter
Distinguished Professor in Finance at the Stanford Graduate
School of Business and Senior Fellow, by courtesy, at the
Stanford Institute for Economic Policy Research.
2009
The Greatest Swindle in the History of the World
Paulson and Geithner Lied Big Time
"The Ugly AIG Post-Mortem: The TARP Inspector General's report
has a lot more to say about the rating agencies than it does about
Goldman Sachs," by Holman Jenkins, The Wall Street Journal,
November 24m 2009 ---
Click Here
A year later, the myrmidons of the media have gotten around to the
question of why, after the government took over AIG, it paid 100
cents on the dollar to honor the collateral demands of AIG's
subprime insurance counterparties.
By all means, read TARP Inspector General Neil Barofsky's report on
the AIG bailout—but read it honestly.
It does not say AIG's bailout was a "backdoor bailout" of Goldman
Sachs. It does not say the Fed was remiss in failing to require
Goldman and other counterparties to settle AIG claims for pennies on
the dollar.
It does not for a moment doubt the veracity of officials who say
their concern was to stem a systemic panic that might have done
lasting damage to the U.S. standard of living.
To be sure, Mr. Barofsky has some criticisms to offer, but the
biggest floats inchoate between the lines of a widely overlooked
section headed "lessons learned," which focuses on the credit rating
agencies. The section notes not only the role of the rating
agencies, with their "inherently conflicted business model," in
authoring the subprime mess in the first place—but also the role of
their credit downgrades in tipping AIG into a liquidity crisis, in
undermining the Fed's first attempt at an AIG rescue, and in the
decision of government officials "not to pursue a more aggressive
negotiating policy to seek concessions from" AIG's counterparties.
Though not quite spelling it out, Mr. Barofsky here brushes close to
the last great unanswered question about the AIG bailout. Namely:
With the government now standing behind AIG, why not just tell
Goldman et al. to waive their collateral demands since they now had
the world's best IOU—Uncle Sam's?
Congress might not technically have put its full faith and credit
behind AIG, but if banks agreed to accept this argument, and
Treasury and Fed insisted on it, and the SEC upheld it, the rating
agencies would likely have gone along. No cash would have had to
change hands at all.
This didn't happen, let's guess, because the officials—Hank Paulson,
Tim Geithner and Ben Bernanke—were reluctant to invent legal and
policy authority out of whole cloth to overrule the ratings
agencies—lo, the same considerations that also figured in their
reluctance to dictate unilateral haircuts to holders of AIG subprime
insurance.
Of course, the thinking now is that these officials, in bailing out
AIG, woulda, shoulda, coulda used their political clout to force
such haircuts, but quailed when the banks, evil Goldman most of all,
insisted on 100 cents on the dollar.
This story, in its gross simplification, is certainly wrong. Goldman
and others weren't in the business of voluntarily relinquishing
valuable claims. But the reality is, in the heat of the crisis, they
would have acceded to any terms the government dictated.
Washington's game at the time, however, wasn't to nickel-and-dime
the visible cash transfers to AIG. It was playing for bigger
stakes—stopping a panic by asserting the government's bottomless
resources to uphold the IOUs of financial institutions.
What's more, if successful, these efforts were certain to cause the
AIG-guaranteed securities to rebound in value—as they have. Money
has already flowed back to AIG and the Fed (which bought some of the
subprime securities to dissolve the AIG insurance agreements) and is
likely to continue to do so for the simple reason that the
underlying payment streams are intact.
Never mind: The preoccupation with the Goldman payments amounts to a
misguided kind of cash literalism. For the taxpayer has assumed much
huger liabilities to keep homeowners in their homes, to keep
mortgage payments flowing to investors, to fatten the earnings of
financial firms, etc., etc. These liabilities dwarf the AIG
collateral calls, inevitably benefit Goldman and other firms, and
represent the real cost of our failure to create a financial system
in which investors (a category that includes a lot more than just
Goldman) live and die by the risks they voluntarily take without
taxpayers standing behind them.
No, Moody's and S&P are not the cause of this policy failure—yet Mr.
Barofsky's half-articulated choice to focus on them is profound. For
the role the agencies have come to play in our financial system
amounts to a direct, if feckless and weak, attempt to contain the
incentives that flow from the government's guaranteeing of so many
kinds of private liabilities, from the pension system and bank
deposits to housing loans and student loans.
The rating agencies' role as gatekeepers to these guarantees is, and
was, corrupting, but the solution surely is to pare back the
guarantees themselves. Overreliance on rating agencies, with their
"inherently conflicted business model," was ultimately a product of
too much government interference in the allocation of credit in the
first place.
The Mother of Future Lawsuits Directly Against Credit Rating
Agencies and I, ndirectly Against Auditing Firms
It has been shown how Moody's and some other credit rating agencies
sold AAA ratings for securities and tranches that did not deserve
such ratings ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#CreditRatingAgencies
Also see
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze
My friend Larry sent me the following link indicating that a lawsuit
in Ohio may shake up the credit rating fraudsters.
Will 49 other states and thousands of pension funds follow suit?
Already facing a spate of private
lawsuits, the legal troubles of the country’s largest credit rating
agencies deepened on Friday when the attorney general of Ohio sued
Moody’s Investors Service,
Standard & Poor’s and
Fitch, claiming that they had cost
state retirement and pension funds some $457 million by approving
high-risk Wall Street securities that went bust in the financial
collapse.
http://www.nytimes.com/2009/11/21/business/21ratings.html?em
Jensen Comment
The credit raters will rely heavily on the claim that they relied on
the external auditors who, in turn, are being sued for playing along
with fraudulent banks that grossly underestimated loan loss reserves
on poisoned subprime loan portfolios and poisoned tranches sold to
investors ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#AuditFirms
Bad things happen in court where three or more parties start blaming
each other for billions of dollars of losses that in many cases led
to total bank failures and the wiping out of all the shareholders in
those banks, including the pension funds that invested in those
banks. A real test is the massive lawsuit against Deloitte's
auditors in the huge Washington Mutual (WaMu) shareholder lawsuit.
"Ohio Sues Rating Firms for Losses in Funds," by David Segal, The
New York Times, November 20m 2009 ---
Click Here
Already facing a spate of private lawsuits, the legal troubles of
the country’s largest credit rating agencies deepened on Friday when
the attorney general of Ohio sued Moody’s Investors Service,
Standard & Poor’s and Fitch, claiming that they had cost state
retirement and pension funds some $457 million by approving
high-risk Wall Street securities that went bust in the financial
collapse.
Already facing a spate of private lawsuits, the legal troubles of
the country’s largest credit rating agencies deepened on Friday when
the attorney general of Ohio sued Moody’s Investors Service,
Standard & Poor’s and Fitch, claiming that they had cost state
retirement and pension funds some $457 million by approving
high-risk Wall Street securities that went bust in the financial
collapse.
The case could test whether the agencies’ ratings are
constitutionally protected as a form of free speech.
The lawsuit asserts that Moody’s, Standard & Poor’s and Fitch were
in league with the banks and other issuers, helping to create an
assortment of exotic financial instruments that led to a disastrous
bubble in the housing market.
“We believe that the credit rating agencies, in exchange for fees,
departed from their objective, neutral role as arbiters,” the
attorney general, Richard Cordray, said at a news conference. “At
minimum, they were aiding and abetting misconduct by issuers.”
He accused the companies of selling their integrity to the highest
bidder.
Steven Weiss, a spokesman for McGraw-Hill, which owns S.& P., said
that the lawsuit had no merit and that the company would vigorously
defend itself.
“A recent Securities and Exchange Commission examination of our
business practices found no evidence that decisions about rating
methodologies or models were based on attracting market share,” he
said.
Michael Adler, a spokesman for Moody’s, also disputed the claims.
“It is unfortunate that the state attorney general, rather than
engaging in an objective review and constructive dialogue regarding
credit ratings, instead appears to be seeking new scapegoats for
investment losses incurred during an unprecedented global market
disruption,” he said.
A spokesman for Fitch said the company would not comment because it
had not seen the lawsuit.
The litigation adds to a growing stack of lawsuits against the three
largest credit rating agencies, which together command an 85 percent
share of the market. Since the credit crisis began last year, dozens
of investors have sought to recover billions of dollars from
worthless or nearly worthless bonds on which the rating agencies had
conferred their highest grades.
One of those groups is largest pension fund in the country, the
California Public Employees Retirement System, which filed a lawsuit
in state court in California in July, claiming that “wildly
inaccurate ratings” had led to roughly $1 billion in losses.
And more litigation is likely. As part of a broader financial
reform, Congress is considering provisions that make it easier for
plaintiffs to sue rating agencies. And the Ohio attorney general’s
action raises the possibility of similar filings from other states.
California’s attorney general, Jerry Brown, said in September that
his office was investigating the rating agencies, with an eye toward
determining “how these agencies could get it so wrong and whether
they violated California law in the process.”
As a group, the attorneys general have proved formidable opponents,
most notably in the landmark litigation and multibillion-dollar
settlement against tobacco makers in 1998.
To date, however, the rating agencies are undefeated in court, and
aside from one modest settlement in a case 10 years ago, no one has
forced them to hand over any money. Moody’s, S.& P. and Fitch have
successfully argued that their ratings are essentially opinions
about the future, and therefore subject to First Amendment
protections identical to those of journalists.
But that was before billions of dollars in triple-A rated bonds went
bad in the financial crisis that started last year, and before
Congress extracted a number of internal e-mail messages from the
companies, suggesting that employees were aware they were giving
their blessing to bonds that were all but doomed. In one of those
messages, an S.& P. analyst said that a deal “could be structured by
cows and we’d rate it.”
Recent cases, like the suit filed Friday, are founded on the premise
that the companies were aware that investments they said were sturdy
were dangerously unsafe. And if analysts knew that they were
overstating the quality of the products they rated, and did so
because it was a path to profits, the ratings could forfeit First
Amendment protections, legal experts say.
“If they hold themselves out to the marketplace as objective when in
fact they are influenced by the fees they are receiving, then they
are perpetrating a falsehood on the marketplace,” said Rodney A.
Smolla, dean of the Washington and Lee University School of Law.
“The First Amendment doesn’t extend to the deliberate manipulation
of financial markets.”
The 73-page complaint, filed on behalf of Ohio Police and Fire
Pension Fund, the Ohio Public Employees Retirement System and other
groups, claims that in recent years the rating agencies abandoned
their role as impartial referees as they began binging on fees from
deals involving mortgage-backed securities.
At the root of the problem, according to the complaint, is the
business model of rating agencies, which are paid by the issuers of
the securities they are paid to appraise. The lawsuit, and many
critics of the companies, have described that arrangement as a
glaring conflict of interest.
“Given that the rating agencies did not receive their full fees for
a deal unless the deal was completed and the requested rating was
provided,” the attorney general’s suit maintains, “they had an acute
financial incentive to relax their stated standards of ‘integrity’
and ‘objectivity’ to placate their clients.”
To complicate problems in the system of incentives, the lawsuit
states, the methodologies used by the rating agencies were outdated
and flawed. By the time those flaws were obvious, nearly half a
billion dollars in pension and retirement funds had evaporated in
Ohio, revealing the bonds to be “high-risk securities that both
issuers and rating agencies knew to be little more than a house of
cards,” the complaint states.
"Rating agencies lose free-speech claim," by Jonathon Stempel,
Reuters, September 3, 2009 ---
http://www.reuters.com/article/GCA-CreditCrisis/idUSTRE5824KN20090903
There are two superpowers in the world today in my opinion. There’s
the United States and there’s Moody’s Bond Rating Service. The
United States can destroy you by dropping bombs, and Moody’s can
destroy you by down grading your bonds. And believe me, it’s not
clear sometimes who’s more powerful. The most that we can safely
assert about the evolutionary process underlying market equilibrium
is that harmful heuristics, like harmful mutations in nature, will
die out.
Martin Miller, Debt and Taxes as quoted by Frank Partnoy, "The
Siskel and Ebert of Financial Matters: Two Thumbs Down for Credit
Reporting Agencies," Washington University Law Quarterly,
Volume 77, No. 3, 1999 ---
http://faculty.trinity.edu/rjensen/FraudCongressPartnoyWULawReview.htm
Credit rating agencies gave AAA ratings to mortgage-backed
securities that didn't deserve them. "These ratings not only gave
false comfort to investors, but also skewed the computer risk models
and regulatory capital computations," Cox said in written testimony.
SEC Chairman Christopher Cox as quoted on October 23, 2008 at
http://www.nytimes.com/external/idg/2008/10/23/23idg-Greenspan-Bad.html
"How Moody's sold its ratings - and sold out investors," by
Kevin G. Hall, McClatchy Newspapers, October 18, 2009 ---
http://www.mcclatchydc.com/homepage/story/77244.html
Paulson and Geithner Lied Big Time:
The Greatest Swindle in the
History of the World
What was their real motive in the greatest fraud conspiracy in the
history of the world?
Bombshell: In 2008 and early 2009, Treasury Secretary leaders
Paulson and
Geithner told the media and Congress that
AIG needed a global bailout due to not having cash reserves to
meet credit default swap (systematic risk) obligations and insurance
policy payoffs. On November 19, 2009 in Congressional testimony
Geithner now admits that all this was a pack of lies. However, he
refuses to resign as requested by some Senators.
"AIG and Systemic Risk Geithner says credit-default swaps weren't
the problem, after all," Editors of The Wall Street Journal,
November 20, 2009 ---
Click Here
TARP Inspector General Neil Barofsky keeps committing flagrant
acts of political transparency, which if nothing else ought to
inform the debate going forward over financial reform. In his
latest bombshell, the IG discloses that the New York Federal
Reserve did not believe that AIG's credit-default swap (CDS)
counterparties posed a systemic financial risk.
Hello?
For the last year, the entire Beltway theory of the financial
panic has been based on the claim that the "opaque," unregulated
CDS market had forced the Fed to take over AIG and pay off its
counterparties, lest the system collapse. Yet we now learn from
Mr. Barofsky that saving the counterparties was not the reason
for the bailout.
In the fall of 2008 the New York Fed drove a baby-soft bargain
with AIG's credit-default-swap counterparties. The Fed's
taxpayer-funded vehicle, Maiden Lane III, bought out the
counterparties' mortgage-backed securities at 100 cents on the
dollar, effectively canceling out the CDS contracts. This was
miles above what those assets could have fetched in the market
at that time, if they could have been sold at all.
The New York Fed president at the time was none other than
Timothy Geithner, the current Treasury Secretary, and Mr.
Geithner now tells Mr. Barofsky that in deciding to make the
counterparties whole, "the financial condition of the
counterparties was not a relevant factor."
This is startling. In April we noted in these columns that
Goldman Sachs, a major AIG counterparty, would certainly have
suffered from an AIG failure. And in his latest report, Mr.
Barofsky comes to the same conclusion. But if Mr. Geithner now
says the AIG bailout wasn't driven by a need to rescue CDS
counterparties, then what was the point? Why pay Goldman and
even foreign banks like Societe Generale billions of tax dollars
to make them whole?
Both Treasury and the Fed say they think it would have been
inappropriate for the government to muscle counterparties to
accept haircuts, though the New York Fed tried to persuade them
to accept less than par. Regulators say that having taxpayers
buy out the counterparties improved AIG's liquidity position,
but why was it important to keep AIG liquid if not to protect
some class of creditors?
Yesterday, Mr. Geithner introduced a new explanation, which is
that AIG might not have been able to pay claims to its insurance
policy holders: "AIG was providing a range of insurance products
to households across the country. And if AIG had defaulted, you
would have seen a downgrade leading to the liquidation and
failure of a set of insurance contracts that touched Americans
across this country and, of course, savers around the world."
Yet, if there is one thing that all observers seemed to agree on
last year, it was that AIG's money to pay policyholders was
segregated and safe inside the regulated insurance subsidiaries.
If the real systemic danger was the condition of these highly
regulated subsidiaries—where there was no CDS trading—then the
Beltway narrative implodes.
Interestingly, in Treasury's official response to the Barofsky
report, Assistant Secretary Herbert Allison explains why the
department acted to prevent an AIG bankruptcy. He mentions the
"global scope of AIG, its importance to the American retirement
system, and its presence in the commercial paper and other
financial markets." He does not mention CDS.
All of this would seem to be relevant to the financial reform
that Treasury wants to plow through Congress. For example, if
AIG's CDS contracts were not the systemic risk, then what is the
argument for restructuring the derivatives market? After
Lehman's failure, CDS contracts were quickly settled according
to the industry protocol. Despite fears of systemic risk, none
of the large banks, either acting as a counterparty to Lehman or
as a buyer of CDS on Lehman itself, turned out to have major
exposure.
More broadly, lawmakers now have an opportunity to dig deeper
into the nature of moral hazard and the restoration of a healthy
financial system. Barney Frank and Chris Dodd are pushing to
give regulators "resolution authority" for struggling firms.
Under both of their bills, this would mean unlimited ability to
spend unlimited taxpayer sums to prevent an unlimited universe
of firms from failing.
Americans know that's not the answer, but what is the best
solution to the too-big-to-fail problem? And how exactly does
one measure systemic risk? To answer these questions, it's
essential that we first learn the lessons of 2008. This is where
reports like Mr. Barofsky's are valuable, telling us things that
the government doesn't want us to know.
In remarks Tuesday that were interpreted as a veiled response to
Mr. Barofsky's report, Mr. Geithner said, "It's a great strength
of our country, that you're going to have the chance for a range
of people to look back at every decision made in every stage in
this crisis, and look at the quality of judgments made and
evaluate them with the benefit of hindsight." He added, "Now,
you're going to see a lot of conviction in this, a lot of strong
views—a lot of it untainted by experience."
Mr. Geithner has a point about Monday-morning quarterbacking. He
and others had to make difficult choices in the autumn of 2008
with incomplete information and often with little time to think,
much less to reflect. But that was last year. The task now is to
learn the lessons of that crisis and minimize the moral hazard
so we can reduce the chances that the panic and bailout happen
again.
This means a more complete explanation from Mr. Geithner of what
really drove his decisions last year, how he now defines
systemic risk, and why he wants unlimited power to bail out
creditors—before Congress grants the executive branch unlimited
resolution authority that could lead to bailouts ad infinitum.
Jensen Comment
One of the first teller of lies was the highly respected Gretchen
Morgenson of The New York Times who was repeating the lies
told to her and Congress by the Treasury and the Fed. This was when
I first believed that the problem at AIG was failing to have capital
reserves to meet CDS obligations. I really believed Morgenson's lies
in 2008 ---
http://www.nytimes.com/2008/09/21/business/21gret.html
Here's what I wrote in 2008 ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
Credit Default Swap (CDS)
This is an insurance policy that essentially "guarantees" that if a
CDO goes bad due to having turds mixed in with the chocolates, the
"counterparty" who purchased the CDO will recover the value
fraudulently invested in turds. On September 30, 2008 Gretchen
Morgenson of The New York Times aptly explained that the huge
CDO underwriter of CDOs was the insurance firm called AIG. She also
explained that the first $85 billion given in bailout money by Hank
Paulson to AIG was to pay the counterparties to CDS swaps. She also
explained that, unlike its casualty insurance operations, AIG had no
capital reserves for paying the counterparties for the the turds
they purchased from Wall Street investment banks.
"Your Money at Work, Fixing Others’ Mistakes," by Gretchen Morgenson,
The New York Times, September 20, 2008 ---
http://www.nytimes.com/2008/09/21/business/21gret.html
Also see "A.I.G., Where Taxpayers’ Dollars Go to Die," The New
York Times, March 7, 2009 ---
http://www.nytimes.com/2009/03/08/business/08gret.html
What Ms. Morgenson failed to explain, when Paulson eventually gave
over $100 billion for AIG's obligations to counterparties in CDS
contracts, was who were the counterparties who received those
bailout funds. It turns out that most of them were wealthy Arabs and
some Asians who we were getting bailed out while Paulson was telling
shareholders of WaMu, Lehman Brothers, and Merrill Lynch to eat
their turds.
You tube had a lot of videos about a CDS. Go to YouTube and read in
the phrase "credit default swap" ---
http://www.youtube.com/results?search_query=Credit+Default+Swaps&search_type=&aq=f
In particular note this video by Paddy Hirsch ---
http://www.youtube.com/watch?v=kaui9e_4vXU
Paddy has some other YouTube videos about the financial crisis.
Bob Jensen’s threads on accounting for credit default swaps are
under the C-Terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm#C-Terms
The Greatest Swindle in the History of the World
"The Greatest Swindle Ever Sold," by Andy Kroll, The Nation,
May 26, 2009 ---
http://www.thenation.com/doc/20090608/kroll/print
Bob Jensen's threads on why the infamous
"Bailout" won't work ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#BailoutStupidity
Bob Jensen's "Rotten to the Core" threads ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm
2009
"A derivatives scandal in Milan may be the tip of an iceberg,"
The Economist, Page 77, May 2-8, 2009 ---
http://www.economist.com/finance/displaystory.cfm?story_id=13579036
YOU might have expected more from
people whose forebears invented the phrase caveat emptor. On
April 28th it emerged just how unwary city elders of Milan had
been when details emerged of staggering sums they have allegedly
lost on a derivatives bet.
The disclosures came amid a swoop by
the country’s financial police on some of the world’s biggest
banks, seizing €476m ($634m) of their assets. The four banks,
UBS, JPMorgan Chase, Deutsche Bank and Hypo Real Estate’s DEPFA
unit, helped the city take a huge bet on interest rates in 2005
that had lost Milan, by its own estimate, €298m last June.
The banks are declining to comment on
the case. In it, Italian prosecutors say they are investigating
whether the banks fraudulently made more than €100m in “illicit
profits” from the Milan deal and took advantage of naive buyers.
Yet the case has ramifications around
the world as other big banks face accusations of mis-selling
complex products before the credit crunch. Should there be
restrictions on whom they sell such financial dynamite to? And
should some institutions, such as local governments, be
protected from themselves?
When Milan signed the deal in 2005, it
thought (and, investigators suspect, it was assured) that it
could barely lose from the deal. In an effort to cut its
borrowing costs, it swapped the fixed interest rate it was
paying on about €1.6 billion in borrowings for a floating rate.
Prosecutors claim that the bankers promised Milan savings of
almost €60m. Although the details of the transaction are vague,
it seems that the city council agreed on an “interest-rate
collar” that meant it would have been paid if rates increased
but would have had to pay out if rates fell.
That such big potential penalties were
missed by (or, as investigators suspect, concealed from) the
council is staggering. A clue as to how this may have happened
is found in a revealing deposition by an official involved in
the negotiations who, according to Il Sole 24 Ore, a newspaper,
swore that: “The banks’ representatives always presented every
operation to me as being in the council’s best interests, always
underlining—now I realise—only the profitable short-term
aspects.” This positive spin, investigators suspect, was central
to the deal. Under Italian law, councils can restructure their
debts only if it leaves them in a better position than before.
Whether Milan was fooled or just plain
foolish (people involved in the deals claim it has benefited
from offsetting gains), it is not the only public body to have
played dangerously with derivatives. Achim Duebel, a consultant
in Berlin, reckons that as many as 700 German local authorities
could lose money on such instruments as a result of a
combination of mis-selling and insufficient financial regulation
of local authorities. Such bets could have gone either way for
the councils. But they were usually in the interests of the
sellers, because they enabled them to offset interest-rate risk
that they had accrued elsewhere.
In Italy the problem seems to have been
just as widespread. Some estimate that as many as 600 Italian
town councils could lose money on derivatives. And in
neighbouring Austria the state-owned railway said on April 29th
that it had made a loss of almost €1 billion, partly because of
a €420m write-down on complex credit derivatives bought from
Deutsche Bank in 2005. Bloomberg reported that the railway is
appealing against a court judgment in February dismissing the
claim that the lender did not disclose the risks.
Given the scale of the losses that are
emerging, more such deals will probably end up in court. In
America Jefferson County in Alabama is suing JPMorgan Chase for
allegedly mis-selling credit derivatives. In most cases, buyers
of credit derivatives will claim they were victims. In the case
of public bodies, at least, voters should reserve judgment. For
such claims to succeed, the officials who agreed to the deals
will have to testify convincingly that they had no idea what
they were doing. As Milan’s elders must be uneasily aware, the
price they may have to pay for victory in court could be their
jobs in the council.
Jensen Comment
Sounds like a page of the free wheeling derivatives scandals of Wall
Street in the Roaring 1990s ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
2009
Greece and Goldman
March 24, 2010 message from Miklos A. Vasarhelyi
[miklosv@ANDROMEDA.RUTGERS.EDU]
Does anyone
understand how the derivative contracts goldman create for
Greece obfuscated its financial conditions?
how much is this a problem today for banks and industrials?
miklos
March 24, 2010 reply from Bob Jensen
Hi Miklos,
Especially note Titlos PLC ---
http://www.cs.trinity.edu/~rjensen/Calgary/CD/DerivativesTitlosPLC.pdf
Note the relatively early date on the
article below (and especially note the comments that follow the
article)
"Open Source Inquiry Opportunity: Some of Goldman's Greece Swaps ,"
Naked Capitalism, February 15, 2010
Click Here
http://www.nakedcapitalism.com/2010/02/open-source-inquiry-opportunity-some-of-goldmans-greece-swaps-made-public.html
In a
New York Times op-ed late
last year,
Bill
Black,
Frank
Partnoy,
and Eliot Spitzer called for
an open source
investigation:
we know where the
answers are. They are in
the trove of e-mail
messages still backed up
on A.I.G. servers, as
well as in the key
internal accounting
documents and financial
models generated by
A.I.G. during the past
decade. Before releasing
its regulatory clutches,
the government should
insist that the company
immediately make these
materials public. By
putting the evidence
online, the government
could establish a new
form of “open source”
investigation.
Once the documents are
available for everyone
to inspect, a thousand
journalistic flowers can
bloom, as reporters,
victims and angry
citizens have a chance
to piece together the
story. In past cases of
financial fraud — from
the complex swaps that
Bankers Trust sold to
Procter & Gamble in the
early 1990s to the I.P.O.
kickback schemes of the
late 1990s to the fall
of Enron — e-mail
messages and internal
documents became the
central exhibits in our
collective understanding
of what happened, and
why.
Now it is worth noting that
the emphasis in the Black/Partnoy/Spitzer
argument was to get a lot of
eyeballs on a large stash of
source material that is
presumably pretty accessible
to the public, namely,
e-mails.
But there is a second line
of potential open-source
inquiry that would be at
least as valuable: getting
people who have expertise in
certain types of
documentation to look probe
transaction documentation
for deals that were
deceptive or had significant
negative outcomes. Even with
more and more investigators
of various sorts getting
their noses into various
suspect-looking activities,
a lot of the destructive
behavior took place in the
form of transactions that
industry participants at the
time would argue fell within
normal, accepted practice.
Understanding what was
deficient about prevailing
practice is therefore key to
developing durable reforms.
For instance, one of the
requirements in the FDIC’s
proposed securitization
reforms is to have the
participants disclose their
motivations and intentions
as well as their fees. That
means that parties like
Goldman and Deutschebank,
who teed up CDOs for the
purpose of them taking a
short position would have
had to disclose that
objective under the proposed
regulations.
Reader Nick has provided a
link to
one of the now-infamous
Goldman-Greek government
swaps,
which
served to camouflage the
magnitude of its fiscal
deficits from the EU. His
comments:
I came across the
prospectus for the 5.1bn
Euro Titlos PLC Asset
Backed Notes which
Goldman arranged for
Greece in 2008.
This was the
restructuring of a
controversal 2005 swap,
which, in turn, related
to the infamous
“Aeolos” deal in 2001.
Aeolos was the SPV which
GS and the “Hellenic
Civil Aviation
Authority” used
to enable the Greeks to
hide its borrowing and
enter the EU under false
pretenses.
See page 47 of the pdf
file (page 43 of the
document) under “Use of
Proceeds”. I’m curious
that no mention of
Greece’s real motivation
to do this deal — or
previous ones — is
mentioned. (Maybe it’s
in the doc, but I sure
couldn’t find it.)
Will the final net
result of these
derivative trades be a
transfer from German and
French taxpayers to
Greece along with $300mm
or so to GS?
Yves here. Per the remarks
above on the FDIC, I’m not
surprised at all regarding
the lack of disclosure. And
Nick’s comment raises a more
basic point: how the use of
forms and mechanisms from
regulated markets have
served to lull investors and
issuers into a false sense
of security.
Now here, Greece presumably
knew exactly what it was
doing. The whole point of
this deal was to allow it to
hide its failure to live up
to its Maasricht
obligations.
But even though I have
looked at various types of
deal documents for decades,
something that should have
been blindingly obvious
occurred to me only tonight.
This document, like all of
its cousins, says very
clearly that the securities
(in this case, notes) will
not be registered with the
SEC, but will be listed on
the Luxembourg stock
exchange. So this one at
least is subject to certain
disclosure requirements. But
as Nick points out, you sure
couldn’t tell what the real
motivation for the note deal
was from this prospectus (as
in the stated aim, while not
necessarily untrue, was not
the real driver).
But investors
have over the course of
decades come to expect that
documents like this make a
full and fair disclosure.
The use of this particular
form of presentation conveys
the message (among others)
that everything you need to
know to invest is here. It
may be somewhat obscured by
clever lawyering or the
relegation of key facts to
financial footnotes, but the
belief surrounding documents
like this is that the
investors have been told
what they needed to know.
But we now know they
weren’t. The SEC has a key
notion in its disclosure
rules, that failure to state
a material fact is a no-no.
It isn’t just that what a
prospectus says has to be
accurate, it also must not
omit to state any material
fact that would make the
statements in the disclosure
documents false or
misleading.
And where did the chicanery
that led to the crisis take
place? Not in areas subject
to the full force of SEC
regulations, but areas
completely outside its reach
(derivatives) or where much
weaker rules were operative
(the rule 3a-7 exemption for
asset backed securities).
In case readers think I am
making overmuch of this
process, consider:
propaganda similarly suborns
existing channels, in this
case, the media. Most people
believe that the press and
TV tell them what they need
to know, both in the sense
that what they say is
accurate, and anything they
fail to cover must not be
newsworthy. And even though
we have had some stark
evidence to the contrary,
that the media can be used
by the state for its own
ends (witness the Creel
Commission in World War I,
as well as the run-up to the
Iraq war) as well as
influenced by powerful
private interests, the
conditioning, which is to
trust the media, remains
very much intact.
So as much as I welcome and
encourage reader comments on
the document that Nick
pointed out, I’d also
welcome reader input on
where they think disclosure
fell short, and why.
Bob Jensen's free tutorials on
derivatives and accounting for derivative financial instruments and
hedging activities are at
http://faculty.trinity.edu/rjensen/caseans/000index.htm
2009
"Keeping Derivatives in the Dark," Floyd Norris, The
New York Times, November 26, 2009 ---
http://www.nytimes.com/2009/11/27/business/27norris.html?_r=2&emc=tnt&tntemail1=y
Opaque markets breed insider profits
and abuse of investors. Sunshine can bring competition and lower
costs even if regulators do little beyond letting the sunlight
shine.
You might think that as Congress
considers just how much regulation is needed for the shadow
financial system — the one that largely escaped regulation in
the past — letting in such light would be an easy and
uncontroversial move.
But it is not proving to be easy at
all, and is one part of the Obama administration’s financial
reform package that is most in jeopardy.
Timothy Geithner, the secretary of the
Treasury, will testify before the Senate Agriculture Committee
next week in an effort to hold on to important provisions of the
proposal that have come under attack by banks fearful of losing
one of their most profitable franchises — the selling of
customized derivatives to corporate customers. Remarkably, the
banks have persuaded customers that keeping the market for those
products secret is in their interest.
Last week, Gary Gensler, the chairman
of the Commodities Futures Trading Commission, faced the same
panel, and ran into questions that indicated at least some
senators were sympathetic to efforts to keep large parts of the
derivatives market in the dark.
Those markets allow companies to bet on
— or, if you prefer, hedge themselves against losses from —
changing interest rates and commodity prices. They also allow
investors to use credit-default swaps to bet on whether a
company will go broke. The administration wants to standardize
those products when possible, and force the trading of them onto
exchanges when possible.
Banks want to whittle away the reforms
if they can, and to minimize the roles of the C.F.T.C. and the
Securities and Exchange Commission, experienced market
regulators who have been generally kept away from
over-the-counter derivatives in the past. Instead, the banks
would like to leave it to banking regulators to oversee the
dealers, something regulators totally failed to do in the past.
Unless Mr. Geithner can persuade legislators otherwise, one of
the great bank lobbying campaigns will have succeeded, in large
part because some companies that buy derivatives from banks have
been persuaded that their costs will rise if needed reforms were
made.
The opposite is probably true. The
history of nearly all markets is that customers suffer if
dealers are able to keep them ignorant of what is actually going
on.
Until the beginning of this decade,
that was true in the corporate bond market, where actual trades
were kept confidential. That made it easy for bond dealers to
charge big markups when they sold bonds to customers.
After regulators forced timely
disclosures, the bid-ask spreads — the difference between what
customers paid when they bought bonds and what they could get
when selling them — declined significantly. The result was
smaller profits for bond dealers, and better returns for bond
investors.
“It is now time,” Mr. Gensler
testified, “to promote similar transparency in the relatively
new marketplace” for derivatives traded over the counter.
“Lack of regulation in these markets,”
he added, “has created significant information deficits.”
He listed “information deficits for
market participants who cannot observe transactions as they
occur and, thus, cannot benefit from the transparent price
discovery function of the marketplace; information deficits for
the public who cannot see the aggregate scope and scale of the
markets; and information deficits for regulators who cannot see
and police the markets.”
In the listed markets for derivative
securities, like futures, there are margins that must be posted
every day if markets move against the buyer of the derivative.
Corporate customers of over-the-counter derivatives fear that
they might face similar margin requirements if their contracts
were to be traded on exchanges, and have persuaded some
legislators that would be horrible.
Of course, because prices aren’t made
public, we can only hope that the banks currently are pricing
the credit at reasonable levels. The banks say they are. Robert
Pickel, the chief executive of the International Swaps and
Derivatives Association, an industry group, assured me this week
that “the cost of credit is taken into account in the collateral
relationship and in the bid-ask spread.”
In layman’s terms, that means that
customers with worse credit would face different prices than
customers with excellent credit, which Mr. Pickel argued would
make price disclosure of limited value.
Mr. Gensler, the C.F.T.C. chairman,
argues that customers would be better off if the two markets —
for the derivatives and for the credit — were separated and had
clear pricing. “How else,” he asked in an interview, “can
customers know if they are getting fair prices?”
Remarkably, big corporations like
Boeing, Caterpillar and many others that use derivatives to
hedge risk have been persuaded by bankers that they should not
worry about that.
Continued in article
2010
"Goldman Sachs accused of fraud by US regulator SEC," BBC News,
April 16, 2010 ---
http://news.bbc.co.uk/2/hi/business/8625931.stm
Link forwarded by Roger Collins
Goldman Sachs, the Wall Street powerhouse, has been
accused of defrauding investors by America's financial regulator.
The Securities and Exchange Commission (SEC)
alleges that Goldman failed to disclose conflicts of interest.
The claims concern Goldman's marketing of sub-prime
mortgage investments just as the US housing market faltered.
Goldman rejected the SEC's allegations, saying that
it would "vigorously" defend its reputation.
News that the SEC was pressing civil fraud charges
against Goldman and one of its London-based vice presidents, Fabrice Tourre,
sent shares in the investment bank tumbling 12%.
The SEC says Goldman failed to disclose "vital
information" that one of its clients, Paulson & Co, helped choose which
securities were packaged into the mortgage portfolio.
These securities were sold to investors in 2007.
But Goldman did not disclose that Paulson, one of
the world's largest hedge funds, had bet that the value of the securities
would fall.
The SEC said: "Unbeknownst to investors, Paulson...
which was posed to benefit if the [securities] defaulted, played a
significant role in selecting which [securities] should make up the
portfolio."
"In sum, Goldman Sachs arranged a transaction at
Paulson's request in which Paulson heavily influenced the selection of the
portfolio to suit its economic interests," said the Commission.
Housing collapse
The whole building is about to collapse anytime
now... Only potential survivor, the fabulous Fabrice...
Email by Fabrice Tourre The SEC alleges that
investors in the mortgage securities, packaged into a vehicle called Abacus,
lost more than $1bn (Ł650m) in the US housing collapse.
Mr Tourre was principally behind the creation of
Abacus, which agreed its deal with Paulson in April 2007, the SEC said.
The Commission alleges that Mr Tourre knew the
market in mortgage-backed securities was about to be hit well before this
date.
The SEC's court document quotes an email from Mr
Tourre to a friend in January 2007. "More and more leverage in the system.
Only potential survivor, the fabulous Fab[rice Tourre]... standing in the
middle of all these complex, highly leveraged, exotic trades he created
without necessarily understanding all of the implications of those
monstrosities!!!"
Goldman denied any wrongdoing, saying in a brief
statement: "The SEC's charges are completely unfounded in law and fact and
we will vigorously contest them and defend the firm and its reputation."
The firm said that, rather than make money from the
deal, it lost $90m.
The two investors that lost the most money, German
bank IKB and ACA Capital Management, were two "sophisticated mortgage
investors" who knew the risk, Goldman said.
And nor was there any failure of disclosure,
because "market makers do not disclose the identities of a buyer to a seller
and vice versa."
Calls to Mr Tourre's office were referred to the
Goldman press office. Paulson has not been charged.
Asked why the SEC did not also pursue a case
against Paulson, Enforcement Director Robert Khuzami told reporters: "It was
Goldman that made the representations to investors. Paulson did not."
The firm's owner, John Paulson - no relation to
former US Treasury Secretary Henry Paulson - made billions of dollars
betting against sub-prime mortgage securities.
In a statement, Paulson & Co. said: "As the SEC
said at its press conference, Paulson is not the subject of this complaint,
made no misrepresentations and is not the subject of any charges."
'Regulation risk'
Goldman, arguably the world's most prestigious
investment bank, had escaped relatively unscathed from the global financial
meltdown.
This is the first time regulators have acted
against a Wall Street deal that allegedly helped investors take advantage of
the US housing market collapse.
The charges come as US lawmakers get tough on Wall
Street practices that helped cause the financial crisis. Among proposals
being considered by Congress is tougher rules for complex investments like
those involved in the alleged Goldman fraud.
Observers said the SEC's move dealt a blow to
Goldman's standing. "It undermines their brand," said Simon Johnson, a
professor at the Massachusetts Institute of Technology and a Goldman critic.
"It undermines their political clout."
Analyst Matt McCormick of Bahl & Gaynor said that
the allegation could "be a fulcrum to push for even tighter regulation".
"Goldman has a fight in front of it," he said.
"Goldman CDO case could be tip of iceberg,"
by Aaron Pressman and Joseph Giannone, Reuters, April 17, 2010 ---
http://in.reuters.com/article/businessNews/idINIndia-47771020100417
The case against Goldman Sachs Group
Inc over a 2007 mortgage derivatives deal it set up for a hedge
fund manager could be just the start of Wall Street's legal
troubles stemming from the subprime meltdown.
The U.S. Securities and Exchange
Commission charged Goldman with fraud for failing to disclose to
buyers of a collaterlized debt obligation known as ABACUS that
hedge fund manager John Paulson helped select mortgage
derivatives he was betting against for the deal. Goldman denied
any wrongdoing.
The practice of creating synthetic CDOs
was not uncommon in 2006 and 2007. At the tail end of the real
estate bubble, some savvy investors began to look for more ways
to profit from the coming calamity using derivatives.
Goldman shares plunged 13 percent on
Friday and shares of other financial firms that created CDOs
also fell. Shares of Deutsche Bank AG ended down 9 percent,
Morgan Stanley 6 percent and Bank of America, which owns Merrill
Lynch, and Citigroup each declined 5 percent.
Merrill, Citigroup and Deutsche Bank
were the top three underwriters of CDO transactions in 2006 and
2007, according to data from Thomson Reuters. But most of those
deals included actual mortgage-backed securities, not related
derivatives like the ABACUS deal.
Hedge fund managers like Paulson
typically wanted to bet against so-called synthetic CDOs that
used derivatives contracts in place of actual securities. Those
were less common.
The SEC's charges against Goldman are
already stirring up investors who lost big on the CDOs,
according to well-known plaintiffs lawyer Jake Zamansky.
"I've been contacted by Goldman
customers to bring lawsuits to recover their losses," Zamansky
said. "It's going to go way beyond ABACUS. Regulators and
plaintiffs' lawyers are going to be looking at other deals, to
what kind of conflicts Goldman has."
An investigation by the online site
ProPublica into Chicago-based hedge fund Magnetar's 2007 bets
against CDO-related debt also turned up allegations of conflicts
of interest against Deutsche Bank, Merrill and JPMorgan Chase.
Magnetar has denied any wrongdoing.
Deutsche Bank declined to comment. Merrill and JPMorgan had no
immediate comment.
The Magnetar deals have spawned at
least one lawsuit. Dutch bank Cooperatieve Centrale
Raiffeisen-Boerenleenbank B.A., or Rabobank for short, filed
suit in June against Merrill Lynch over Magnetar's involvement
with a CDO called Norma.
"Merrill Lynch teamed up with one of
its most prized hedge fund clients -- an infamous short seller
that had helped Merrill Lynch create four other CDOs -- to
create Norma as a tailor-made way to bet against the
mortgage-backed securities market," Rabobank said in its
complaint filed on June 12 in the Supreme Court of New York.
The two matters are unrelated and the
claims today are not only unfounded but were not included in the
Rabobank lawsuit filed nearly a year ago, said Merrill Lynch
spokesman Bill Halldin.
Rabobank was a lender, not an investor,
he added.
Regulators at the SEC and around the
country said they would be investigating other deals beyond
ABACUS.
We are looking very closely at these
products and transactions," Robert Khuzami, head of the SEC's
enforcement division, said. "We are moving across the entire
spectrum in determining whether there was (fraud)."
Meanwhile, Connecticut Attorney General
Richard Blumenthal said in a statement his office had already
begun a preliminary review of the Goldman case.
"A key question is whether this case
was an isolated incident or part of a pattern of investment
banks colluding with hedge funds to purposely tank securities
they created and sold to unwitting investors," Connecticut
Attorney General Richard Blumenthal said in a statement.
"Goldman under investigation for its securities dealings,"
by Greg Gordon, McClatchy Newspapers, January 22, 2010 ---
http://www.mcclatchydc.com/251/story/82899.html
WASHINGTON — One of Congress' premier watchdog
panels is investigating Goldman Sachs' role in the subprime mortgage
meltdown, including how the firm sold securities backed by risky home loans
while it simultaneously bet that those bonds would lose value, people
familiar with the inquiry said Friday.
The investigation is part of a broader examination
by the Senate Permanent Subcommittee on Investigations into the roots of the
economic crisis and whether financial institutions behaved improperly, said
the individuals, who insisted upon anonymity because the matter is
sensitive.
Disclosure of the investigation comes amid a
darkening mood at the White House, in Congress and among the American public
over the long-term economic impact of the subprime crisis, prompting demands
to hold the culprits accountable.
It marks at least the third federal inquiry
touching on Goldman's dealings related to securities backed by risky home
mortgages.
The separate, congressionally appointed Financial
Crisis Inquiry Commission, which was created to investigate causes of the
crisis, began holding hearings Jan. 13 and took sworn testimony from
Goldman's top officer. In addition, the Securities and Exchange Commission,
which polices Wall Street, is investigating Goldman's exotic bets against
the housing market, using insurance-like contracts known as credit-default
swaps, in offshore deals, knowledgeable people have told McClatchy.
Goldman, the world's most prestigious investment
bank, has denied any improprieties and said that the use of "hedges," or
contrary bets, is a "cornerstone of prudent risk management."
Asked about the Senate inquiry late Friday, Goldman
spokesman Michael DuVally said only: "As a matter of policy, Goldman Sachs
does not comment on legal or regulatory matters."
A spokeswoman for the Senate subcommittee declined
to comment on the investigation, which was spawned by a four-part McClatchy
series published in November that detailed the Wall Street firm's role in
the debacle, which stemmed from subprime loans to millions of marginally
qualified borrowers.
The subcommittee, part of the Homeland Security and
Governmental Affairs Committee, is led by veteran Democratic Sen. Carl Levin
of Michigan, who said last year that his panel was "looking into some of the
causes and consequences of the financial crisis."
The panel has a history of conducting formal,
highly secretive investigations in which it typically issues subpoenas for
documents and witnesses, produces extensive reports and sometimes refers
evidence to the Justice Department for possible criminal prosecution.
It couldn't immediately be learned whether the
panel has subpoenaed Goldman executives or company records. However, the
subcommittee has issued at least one major subpoena seeking records related
to Seattle-based Washington Mutual, which collapsed in September 2008 after
being swamped by losses from its subprime lending. J.P. Morgan Chase then
purchased WaMu's banking assets.
Goldman was the only major Wall Street firm to
safely exit the subprime mortgage market. McClatchy reported, however, that
Goldman sold off more than $40 billion in securities backed by over 200,000
risky home loans in 2006 and 2007 without telling investors of its secret
bets on a sharp housing downturn, prompting some experts to question whether
it had crossed legal lines.
McClatchy also has reported that Goldman peddled
unregulated securities to foreign investors through the Cayman Islands, a
Caribbean tax haven, in some cases exaggerating the soundness of the
underlying home mortgages. In numerous deals, records indicate, the company
required investors to pay Goldman massive sums if bundles of risky mortgages
defaulted. Goldman has said its investors were fully informed of the risks.
Federal auditors found that Goldman placed $22
billion of its swap bets against subprime securities, including many it had
issued, with the giant insurer American International Group. In late 2008,
when the government bailed out AIG, Goldman received $13.9 billion.
Goldman's chairman and chief executive, Lloyd
Blankfein, appeared to acknowledge last week that the firm behaved
inappropriately when he was asked about the secret bets in sworn testimony
to the Financial Crisis Inquiry Commission.
Blankfein first said that the firm's contrary
trades were "the practice of a market maker," then added: "But the answer is
I do think that the behavior is improper, and we regret the result — the
consequence that people have lost money in it."
A day later, Goldman issued a statement denying
that Blankfein had admitted improper company behavior and said that his
ensuing answer stressed that the firm's conduct was "entirely appropriate."
Senate investigators were described as having pored
over Goldman's SEC filings in recent weeks.
Underscoring the breadth of the Senate
investigation is the disclosure by federal banking regulators in a recent
filing in the WaMu bankruptcy case.
In it, the Federal Deposit Insurance Corp. revealed
that the Senate subcommittee had served the agency with "a comprehensive
subpoena" for documents relating to WaMu, whose primary regulator was the
Office of Thrift Supervision.
The subcommittee's jurisdiction is "wide-ranging,"
the FDIC's lawyers wrote. "It covers, among other things, the study or
investigation of the compliance or noncompliance of corporations, companies,
or individual or other entities with the rules, regulations and laws
governing the various governmental agencies and their relationships with the
public." The subpoena, they said, "is correspondingly broad."
The Puget Sound Business Journal first reported on
the FDIC's disclosure.
Goldman's former chairman, Henry Paulson, served as
Treasury secretary during the bailouts that benefitted the firm and while
other Wall Street investment banks foundered because of their subprime
market exposure, its profits have soared.
In reporting a $13.4 billion profit for 2009 on
Thursday, the bank sought to quell a furor over its taxpayer-aided success
by scaling back employee bonuses. It also has limited bonuses for its 30
most senior executives to restricted stock that can't be sold for five years.
MORE FROM MCCLATCHY
Goldman Sachs: Low Road to High Finance
Justice Department eyes possible fraud on Wall Street
Goldman admits 'improper' actions in sales of securities
Goldman: Blankfein didn't say firm's practices were 'improper'
Facing frustrated voters, more senators oppose Bernanke
Obama moves to restrict banks, take on Wall Street
Check
out McClatchy's politics blog: Planet Washington
Bob Jensen's threads on subprime sleaze are at
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze
Bob Jensen's threads on banking fraud are at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking
The Greatest Swindle in the History of the World ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
2010
Dodd–Frank Wall Street Reform and Consumer Protection Act ---
http://en.wikipedia.org/wiki/Dodd%E2%80%93Frank_Wall_Street_Reform_and_Consumer_Protection_Act
I've been a long-time advocate of increased regulations of
derivatives financial instruments that turned bankers into banksters
defrauding investors ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
But the mess that Dodd and Frank engineered this year is way off
the mark. After the hidden and downstream costs of the Dodd-Frank
legislation are considered for Main Stereet, and the partying and
political pats on the back of Dodd, Frank, and Obama die down, I
hope Congress will consider greatly revised legislation that does
not destroy Main Street while trying to discourage derivatives
abuses of Wall Street.
The article below also discusses how Main Street uses derivatives
to manage financial risks in order to focus greater attention on the
main products and services of their enterprises. This is enterprise
risk management in action.
"The Hangover, Part II: New derivatives rules could
punish firms that pose no systemic risk," The Wall Street
Journal, November 29, 2010 ---
http://online.wsj.com/article/SB10001424052748704104104575622583155296368.html
. . .
But after the pair completed their
mad-cap all-nighter, no hilarity ensued. That's because Main
Street companies that had nothing to do with the financial
crisis woke up to find billions of dollars in potential new
costs. The threat was new authority for regulators to require
higher margins on various financial contracts, even for small
companies that nobody considers a systemic risk. The new rules
could apply to companies that aren't speculating but are simply
trying to protect against business risks, such as a sudden price
hike in a critical raw material.
Businesses with good credit that have
never had trouble off-loading such risks might have to put up
additional cash at the whim of Washington bureaucrats, or simply
hold on to the risks, making their businesses less competitive.
Companies that make machine tools, for example, want to focus on
making machine tools, not on the fluctuations of interest rates
or the value of a foreign customer's local currency. So
companies pay someone else to manage these risks. But Washington
threatens to make that process much more costly.
Messrs. Frank and Dodd responded to the
uproar first by suggesting that the problem could be fixed later
in a "corrections" bill and then by denying the problem existed.
Both proclaimed that their bill did not saddle commercial
companies with new margin rules. But as we noted last summer,
comments from the bill's authors cannot trump the language of
the law.
Flash forward to today, and the
Commodity Futures Trading Commission (CFTC) is drafting its new
rules for swaps, the common derivatives contracts in which two
parties exchange risks, such as trading fixed for floating
interest rates. We're told that CFTC Chairman Gary Gensler has
said privately that his agency now has the power to hit Main
Street with new margin requirements, not just Wall Street.
Main Street companies that use these
contracts are known as end-users. When we asked the CFTC if Mr.
Gensler believes regulators can require swap dealers to demand
margin from all end-users, a spokesman said, "It would be
premature to say that a rule would include such a requirement or
that the Chairman supports such a requirement."
It may only be premature until next
month, when the CFTC is expected to issue its draft rules. While
the commission doesn't have jurisdiction over the entire swaps
market, other financial regulators are expected to follow its
lead. Mr. Gensler, a Clinton Administration and Goldman Sachs
alum, may not understand the impact of his actions outside of
Washington and Wall Street.
In a sequel to the Dodd-Frank
all-nighter, the law requires regulators to remake financial
markets in a rush. CFTC Commissioner Michael Dunn said recently
that to comply with Dodd-Frank, the commission may need to write
100 new regulations by next July.
"In my opinion it takes about three
years to really promulgate a rule," he said, according to
Bloomberg News. Congress instructed us to "forget what's
physically possible," he added. The commission can't really use
this impossible schedule as an excuse because Mr. Gensler had as
much impact as anyone in crafting the derivatives provisions in
Dodd-Frank. No surprise, the bill vastly expands his agency's
regulatory turf.
And if anyone can pull off a complete
overhaul of multi-trillion-dollar markets in a mere eight
months, it must be the CFTC.
Just kidding. An internal CFTC report
says that communication problems between the CFTC's enforcement
and market oversight divisions "impede the overall effectiveness
of the commission's efforts to not only detect and prevent, but
in certain circumstances, to take enforcement action against
market manipulation." The report adds that the commission's two
primary surveillance programs use incompatible software.
Speaking generally and not in response to the report, Mr.
Gensler says that the agency is "trying to move more toward the
use of 21st century computers," though he warns that "it's a
multiyear process." No doubt.
The CFTC report also noted that "the
staff has no standard protocol for documenting their work." If
we were tasked with restructuring a complex trading market to
conform to the vision of Chris Dodd and Barney Frank, we
wouldn't want our fingerprints on it either.
The report was completed in 2009 but
only became public this month thanks to a Freedom of Information
Act request from our colleagues at Dow Jones Newswires. Would
Messrs. Dodd and Frank have responded differently to Mr.
Gensler's power grab if they had realized how much trouble the
CFTC was having fulfilling its traditional mission? We doubt it,
but it certainly would have made their reform a tougher sell,
even to the Washington press corps.
Congress should scrutinize this process
that is all but guaranteed to result in ill-considered, poorly
crafted regulation. In January, legislators should start acting,
not like buddies pulling all-nighters, but like adults who
understand it's their job to make the tough calls, rather than
kicking them over to the bureaucracy with an arbitrary deadline.
2010
Absolutely Must-See CBS Sixty Minutes Videos
You, your students, and the world in general really should
repeatedly study the following videos until they become perfectly
clear!
Two of them are best watched after a bit of homework.
Video 1
CBS Sixty Minutes featured how bad things became when poison was
added to loan portfolios. This older Sixty Minutes Module is
entitled "House of Cards" ---
http://www.cbsnews.com/video/watch/?id=3756665n&tag=contentMain;contentBody
This segment can be understood without much preparation except that
it would help for viewers to first read about Mervene and how the
mortgage lenders brokering the mortgages got their commissions for
poisoned mortgages passed along to the government (Freddie Mack and
Fannie Mae) and Wall Street banks. On some occasions the lenders
like Washington Mutual also naively kept some of the poison planted
by some of their own greedy brokers.
The cause of this fraud was separating the compensation for
brokering mortgages from the responsibility for collecting the
payments until the final payoff dates.
First Read About Mervene ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze
Then Watch Video 1 at
http://www.cbsnews.com/video/watch/?id=3756665n&tag=contentMain;contentBody
Videos 2 and 3
Inside the Wall Street Collapse (Parts 1 and 2) first shown on
March 14, 2010
Video 2 (Greatest Swindle in the History of the World) ---
http://www.cbsnews.com/video/watch/?id=6298154n&tag=contentMain;contentAux
Video 3 (Swindler's Compensation Scandals) ---
http://www.cbsnews.com/video/watch/?id=6298084n&tag=contentMain;contentAux
My wife and I watched Videos 2 and 3 on March 14. Both videos
feature one of my favorite authors of all time, Michael Lewis, who
hhs been writing (humorously with tongue in cheek) about Wall Street
scandals since he was a bond salesman on Wall Street in the 1980s.
The other person featured on in these videos is a one-eyed physician
with Asperger Syndrome who made hundreds of millions of dollars
anticipating the collapse of the CDO markets while the shareholders
of companies like Merrill Lynch, AIG, Lehman Bros., and Bear Stearns
got left holding the empty bags.
The major lessons of videos 2 and 3 went over the head of my
wife. I think that viewers need to do a bit of homework in order to
fully appreciate those videos. Here's what I recommend before
viewing Videos 2 and 3 if you've not been following details of the
2008 Wall Street collapse closely:
This is not necessary to Videos 2 and 3, but to really
appreciate what suckered the Wall Street Banks into spreading
the poison, you should read about how they all used the same
risk diversification mathematical function --- David Li's
Gaussian Copula Function:
Can the
2008 investment banking failure be traced to a math error?
Recipe for Disaster: The Formula That Killed Wall Street ---
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
Link forwarded by Jim Mahar ---
http://financeprofessorblog.blogspot.com/2009/03/recipe-for-disaster-formula-that-killed.html
Some highlights:
"For five years, Li's formula, known as a
Gaussian copula function,
looked like an unambiguously positive breakthrough, a piece of
financial technology that allowed hugely complex risks to be
modeled with more ease and accuracy than ever before. With his
brilliant spark of mathematical legerdemain, Li made it possible
for traders to sell vast quantities of new securities, expanding
financial markets to unimaginable levels.
His method was adopted by everybody from bond investors and Wall
Street banks to ratings agencies and regulators. And it became
so deeply entrenched—and was making people so much money—that
warnings about its limitations were largely ignored.
Then the model fell apart." The article goes on to show that
correlations are at the heart of the problem.
"The reason that ratings agencies and investors felt so safe
with the triple-A tranches was that they believed there was no
way hundreds of homeowners would all default on their loans at
the same time. One person might lose his job, another might fall
ill. But those are individual calamities that don't affect the
mortgage pool much as a whole: Everybody else is still making
their payments on time.
But not all calamities are individual, and tranching still
hadn't solved all the problems of mortgage-pool risk. Some
things, like falling house prices, affect a large number of
people at once. If home values in your neighborhood decline and
you lose some of your equity, there's a good chance your
neighbors will lose theirs as well. If, as a result, you default
on your mortgage, there's a higher probability they will
default, too. That's called correlation—the degree to which one
variable moves in line with another—and measuring it is an
important part of determining how risky mortgage bonds are."
I would highly recommend reading the entire thing that gets much
more involved with the
actual formula etc.
The “math error” might truly be have been an error or it might
have simply been a gamble with what was perceived as miniscule
odds of total market failure. Something similar happened in the
case of the trillion-dollar disastrous 1993 collapse of Long
Term Capital Management formed by Nobel Prize winning economists
and their doctoral students who took similar gambles that
ignored the “miniscule odds” of world market collapse -- -
http://faculty.trinity.edu/rjensen/FraudRotten.htm#LTCM
The rhetorical question
is whether the failure is ignorance in model building or risk
taking using the model?
- You should understand how the Wall Street Banks used the big
credit rating agencies to give AAA ratings to sell CDO bonds
that should've instead been rated as junk bonds. Michael Lewis
in Video 2 seems to think the credit rating agencies were just
naive and were manipulated by the Wall Street bankers. I'm more
inclined to think the CRAs were knowingly and greedily part of
the frauds ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze
CRA ---
http://en.wikipedia.org/wiki/Credit_rating_agency
- You should also understand what a credit default swap (CDS)
is and how Video 2 above keeps calling it unregulated credit
"insurance." Essentially, this is how some banks, particularly
Goldman Sachs was "insuring" against the value collapse of the
poisoned CDOs they were creating and selling. The "insurance"
company brokering the AIG credit default swaps was AIG.
CDS ---
http://en.wikipedia.org/wiki/Credit_default_swap
Here's how they worked ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze
- Understand how some Wall Street Banks were better connected
in the Treasury Department and Federal Reserve than other banks.
In particular, Goldman Sachs alumni were practically in charge
while
Hank Paulson (former Goldman Sachs CEO) was U.S. Treasury
Secretary. Why did Paulson save Goldman Sachs and let others
watch their shareholders get wiped out like Lehman Bros., Bear
Stearns, Merrill Lynch, etc.? Understand why saving Goldman
Sachs with TARP money entailed saving AIG since saving AIG was
crucial to paying off the CDS insurance.
- For the above three videos it is not necessary to understand
the lack of professionalism (at best) among the bank auditors
that never provided any warning that thousands of banks that
failed had badly underestimated bad debts and overvalued
poisoned loan portfolios. The above videos do not get into the
failings of the CPA auditors in this regard, but you can read
about these failings at
http://faculty.trinity.edu/rjensen/2008Bailout.htm#AuditFirms
For more on the inside track of all of this I highly recommend
Janet Tavakili's great book entitled Dear Mr. Buffett (Wiley,
2009). Videos 1-3 will help you understand some of the
technicalities in her fantastic and very depressing book.
Here are some of the take-aways from the three CBS videos above:
- The root cause of the 2008 meltdown of Wall Street was
really the failings on Main Street where the poison was first
added to mortgages by Main Street brokers who were willing to
broker mortgages (including re-financings) that were bound to be
defaulted. Note that the problem was not just in brokering
mortgages for poor people (Barney's Rubble). Poisoned mortgages
were also being written for higher income people who were
borrowing beyond their means for those four-car garage dream
houses with swimming pools and marble floors. In other words the
root cause was the ability to broker a poisoned mortgage and
then sell it to Freddie Mack, Fannie Mae, and the Wall Street
Banks.
- The next cause of the 2008 meltdown was David Li's risk
diversification formula that all the Wall Street banks were
using on the theory that default risk of mortgage investments
could be diversified by crumbling mortgage cookies into crumbs
that were reassembled into thousands of CDOs (each CDO having
only a small crumble of each mortgage's poison). With the
blessings of credit rating agencies, these CDO bonds were then
sold as AAA-rated when in fact they were worse than junk.
- Videos 2 and 3 above stress how the underlying cause of
allowing a one-eyed physician with Asperger Syndrome make
hundreds of millions dollars by detecting the collapse of the
CDO values way in advance of the Wall Street pros is that the
Wall Street pros were paid not to look for the CDO risks. And
the bank CDO sellers who perhaps did understand the risks were
willing to screw their eimployers (such as Lehman, Bear Stearnes,
etc.) because it was so easy to steal hundreds of millions from
these employers who were even willing and still are willing to
pay them bonuses in spite of their thefts.
- After the government bailed them out, the Wall Street banks
that survived because of the government's bailout are still
paying out billions in bonuses. One of my favorite quotes in
Video 2 goes something like:
"If Goldman does not pay its best people billions in bonuses
they will quit and go to JP Morgan, and if JP Morgan does not
pay its best people billions in bonuses they will quit and go to
Goldman." Meanwhile the taxpayers got screwed out of nearly a
trillion dollars.
- Video 2 leaves us with the impression that Wall Street is no
longer a value-added part of U.S. economy. The TARP in reality
is truly the Greatest Swindle in the
History of the World ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
Meanwhile the surviving swindlers and their credit rating
agencies and their auditors are still thriving as if nothing has
happened. Opps! I forgot that the credit rating agencies and
auditing firms still have some multi-billion shareholder
lawsuits pending that do threaten their survival. But a lot of
big swindlers still have their yachts thanks to Hank and Ben and
Tim.
I highly recommend the outstanding and often humorous books of
both Michael Lewis and Frank Partnoy.
My timeline of these books and the scandals they write about can be
found at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
Rotten to the Core ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm
Related CBS Sixty Minutes videos are as follows:
I also recommend watching all the David Walker videos on
YouTube.
Watch them and weep.
2010
GLOBAL DERIVATIVE DEBACLES: From Theory to Malpractice ---
http://www.worldscibooks.com/economics/7141.html
by Laurent L Jacque (Tufts University, USA & HEC School of Management, France)
World Scientific Books, ISBN: 978-981-283-770-7, 628pp
978-981-281-853-9: US$54 / Ł36 US$40.50 / Ł27
Table of Contents (44k) --- http://www.worldscibooks.com/etextbook/7141/7141_toc.pdf
Preface (27k)--- http://www.worldscibooks.com/etextbook/7141/7141_preface.pdf
Chapter 1: Derivatives and the Wealth of Nations (133k) ---
http://www.worldscibooks.com/etextbook/7141/7141_preface.pdf
Jensen Comment
This book is weak on derivatives accounting but stronger on
economics, finance, and law.
Chapter 1 has a short summary of ancient history.
2010
Ah, the innocence of youth.
What really happened in the poisonous CDO markets?
I previously mentioned three CBS Sixty Minutes videos that are must-views for
understanding what happened in the CDO scandals. Two of those videos centered on
muckraker Michael Lewis. My friend, the Unknown Professor, who runs the
Financial Rounds Blog, recommended that readers examine the Senior Thesis of a
Harvard student.
"Michael Lewis’s ‘The Big Short’? Read the Harvard Thesis Instead," by Peter
Lattman, The Wall Street Journal, March 20, 2010 ---
http://blogs.wsj.com/deals/2010/03/15/michael-lewiss-the-big-short-read-the-harvard-thesis-instead/tab/article/
Deal Journal has yet to
read “The Big Short,” Michael Lewis’s yarn on the financial crisis that hit
stores today. We did, however, read his acknowledgments, where Lewis praises
“A.K. Barnett-Hart, a Harvard undergraduate who had just written a thesis about
the market for subprime mortgage-backed CDOs that remains more interesting than
any single piece of Wall Street research on the subject.”
While unsure if we can
stomach yet another book on the crisis, a killer thesis on the topic? Now that
piqued our curiosity. We tracked down Barnett-Hart, a 24-year-old financial
analyst at a large New York investment bank. She met us for coffee last week to
discuss her thesis, “The Story of the CDO Market Meltdown: An Empirical
Analysis.” Handed in a year ago this week at the depths of the market collapse,
the paper was awarded summa cum laude and won virtually every thesis honor,
including the Harvard Hoopes Prize for outstanding scholarly work.
Last October,
Barnett-Hart, already pulling all-nighters at the bank (we agreed to not name
her employer), received a call from Lewis, who had heard about her thesis from a
Harvard doctoral student. Lewis was blown away.
“It was a classic example
of the innocent going to Wall Street and asking the right questions,” said Mr.
Lewis, who in his 20s wrote “Liar’s Poker,” considered a defining book on Wall
Street culture. “Her thesis shows there were ways to discover things that
everyone should have wanted to know. That it took a 22-year-old Harvard student
to find them out is just outrageous.”
Barnett-Hart says she
wasn’t the most obvious candidate to produce such scholarship. She grew up in
Boulder, Colo., the daughter of a physics professor and full-time homemaker. A
gifted violinist, Barnett-Hart deferred admission at Harvard to attend
Juilliard, where she was accepted into a program studying the violin under
Itzhak Perlman. After a year, she headed to Cambridge, Mass., for a broader
education. There, with vague designs on being pre-Med, she randomly took “Ec
10,” the legendary introductory economics course taught by Martin Feldstein.
“I thought maybe this
would help me, like, learn to manage my money or something,” said Barnett-Hart,
digging into a granola parfait at Le Pain Quotidien. She enjoyed how the subject
mixed current events with history, got an A (natch) and declared economics her
concentration.
Barnett-Hart’s interest
in CDOs stemmed from a summer job at an investment bank in the summer of 2008
between junior and senior years. During a rotation on the mortgage
securitization desk, she noticed everyone was in a complete panic. “These CDOs
had contaminated everything,” she said. “The stock market was collapsing and
these securities were affecting the broader economy. At that moment I became
obsessed and decided I wanted to write about the financial crisis.”
Back at Harvard, against
the backdrop of the financial system’s near-total collapse, Barnett-Hart
approached professors with an idea of writing a thesis about CDOs and their role
in the crisis. “Everyone discouraged me because they said I’d never be able to
find the data,” she said. “I was urged to do something more narrow, more
focused, more knowable. That made me more determined.”
She emailed scores of
Harvard alumni. One pointed her toward LehmanLive, a comprehensive database on
CDOs. She received scores of other data leads. She began putting together charts
and visuals, holding off on analysis until she began to see patterns–how Merrill
Lynch and Citigroup were the top originators, how collateral became heavily
concentrated in subprime mortgages and other CDOs, how the credit ratings
procedures were flawed, etc.
“If you just randomly
start regressing everything, you can end up doing an unlimited amount of
regressions,” she said, rolling her eyes. She says nearly all the work was in
the research; once completed, she jammed out the paper in a couple of weeks.
“It’s an incredibly
impressive piece of work,” said Jeremy Stein, a Harvard economics professor who
included the thesis on a reading list for a course he’s teaching this semester
on the financial crisis. “She pulled together an enormous amount of information
in a way that’s both intelligent and accessible.”
Barnett-Hart’s thesis is
highly critical of Wall Street and “their irresponsible underwriting practices.”
So how is it that she can work for the very institutions that helped create the
notorious CDOs she wrote about?
“After writing my thesis,
it became clear to me that the culture at these investment banks needed to
change and that incentives needed to be realigned to reward more than just
short-term profit seeking,” she wrote in an email. “And how would Wall Street
ever change, I thought, if the people that work there do not change? What these
banks needed is for outsiders to come in with a fresh perspective, question the
way business was done, and bring a new appreciation for the true purpose of an
investment bank - providing necessary financial services, not creating
unnecessary products to bolster their own profits.”
Ah, the innocence of
youth.
The Senior Thesis
"The Story of the CDO Market Meltdown: An Empirical Analysis,"
by Anna Katherine Barnett-Hart, Harvard University, March 19, 2010
---
http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf
A former colleague and finance
professor at Trinity University recommends following up this Harvard
student’s senior thesis with the following:
Rene M. Stulz. 2010. Credit default
swaps and the credit crisis. J of Economic Perspectives,
24(1): 73-92 (not free) ---
http://www.aeaweb.org/jep/index.php
Absolutely Must-See CBS Sixty Minutes Videos
You, your students, and the world in general really should repeatedly study the
following videos until they become perfectly clear!
Two of them are best watched after a bit of homework.
Video 1
CBS Sixty Minutes featured how bad things became when poison was added to loan
portfolios. This older Sixty Minutes Module is entitled "House of Cards" ---
http://www.cbsnews.com/video/watch/?id=3756665n&tag=contentMain;contentBody
This segment can be understood without much preparation except that it would
help for viewers to first read about Mervene and how the mortgage lenders
brokering the mortgages got their commissions for poisoned mortgages passed
along to the government (Freddie Mack and Fannie Mae) and Wall Street banks. On
some occasions the lenders like Washington Mutual also naively kept some of the
poison planted by some of their own greedy brokers.
The cause of this fraud was separating the compensation for brokering mortgages
from the responsibility for collecting the payments until the final payoff
dates.
First Read About Mervene ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze
Then Watch Video 1 at
http://www.cbsnews.com/video/watch/?id=3756665n&tag=contentMain;contentBody
Videos 2 and 3
Inside the Wall Street Collapse (Parts 1 and 2) first shown on March 14,
2010
Video 2 (Greatest Swindle in the History of the World) ---
http://www.cbsnews.com/video/watch/?id=6298154n&tag=contentMain;contentAux
Video 3 (Swindler's Compensation Scandals) ---
http://www.cbsnews.com/video/watch/?id=6298084n&tag=contentMain;contentAux
My wife and I watched Videos 2 and 3 on March 14. Both videos feature one of
my favorite authors of all time, Michael Lewis, who hhs been writing (humorously
with tongue in cheek) about Wall Street scandals since he was a bond salesman on
Wall Street in the 1980s. The other person featured on in these videos is a
one-eyed physician with Asperger Syndrome who made hundreds of millions of
dollars anticipating the collapse of the CDO markets while the shareholders of
companies like Merrill Lynch, AIG, Lehman Bros., and Bear Stearns got left
holding the empty bags.
The major lessons of videos 2 and 3 went over the head of my wife. I think
that viewers need to do a bit of homework in order to fully appreciate those
videos. Here's what I recommend before viewing Videos 2 and 3 if you've not been
following details of the 2008 Wall Street collapse closely:
This is not necessary to Videos 2
and 3, but to really appreciate what suckered the Wall Street Banks into
spreading the poison, you should read about how they all used the same risk
diversification mathematical function --- David Li's Gaussian Copula Function:
Can the
2008 investment banking failure
be traced to a math error?
Recipe for Disaster: The
Formula That Killed Wall Street ---
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
Link forwarded by Jim Mahar ---
http://financeprofessorblog.blogspot.com/2009/03/recipe-for-disaster-formula-that-killed.html
Some highlights:
"For five years, Li's
formula, known as a
Gaussian copula function, looked like an
unambiguously positive breakthrough, a piece of financial technology that
allowed hugely complex risks to be modeled with more ease and accuracy than ever
before. With his brilliant spark of mathematical legerdemain, Li made it
possible for traders to sell vast quantities of new securities, expanding
financial markets to unimaginable levels.
His method was adopted
by everybody from bond investors and Wall Street banks to ratings agencies and
regulators. And it became so deeply entrenched—and was making people so much
money—that warnings about its limitations were largely ignored.
Then the model fell apart." The
article goes on to show that correlations are at the heart of the problem.
"The reason that
ratings agencies and investors felt so safe with the triple-A tranches was that
they believed there was no way hundreds of homeowners would all default on their
loans at the same time. One person might lose his job, another might fall ill.
But those are individual calamities that don't affect the mortgage pool much as
a whole: Everybody else is still making their payments on time.
But not all calamities
are individual, and tranching still hadn't solved all the problems of
mortgage-pool risk. Some things, like falling house prices, affect a large
number of people at once. If home values in your neighborhood decline and you
lose some of your equity, there's a good chance your neighbors will lose theirs
as well. If, as a result, you default on your mortgage, there's a higher
probability they will default, too. That's called correlation—the degree to
which one variable moves in line with another—and measuring it is an important
part of determining how risky mortgage bonds are."
I would highly recommend reading the
entire thing that gets much more involved with the
actual formula etc.
The “math error” might truly be have
been an error or it might have simply been a gamble with what was perceived as
miniscule odds of total market failure. Something similar happened in the case
of the trillion-dollar disastrous 1993 collapse of Long Term Capital Management
formed by Nobel Prize winning economists and their doctoral students who took
similar gambles that ignored the “miniscule odds” of world market collapse -- -
http://faculty.trinity.edu/rjensen/FraudRotten.htm#LTCM
The rhetorical question is whether the failure is
ignorance in model building or risk taking using the model?
Bob Jensen’s threads on the CDO and CDS scandals ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze
2010
"Derivatives Clearinghouses Are No Magic Bullet: Will
the Dodd bill create another kind of institution that's too big to
fail?" by Harvard's Mark J. Roe, The Wall Street Journal,
May 6, 2010 ---
http://online.wsj.com/article/SB10001424052748703871904575216251915383146.html
As the Senate finalizes its financial
reform legislation, a consensus is developing that if we could
just get derivatives traded through a centralized clearinghouse
we could avoid a financial crisis like the one we just went
through. This is false. Clearinghouses provide efficiencies in
transparency and trading, but they are no cure-all. They can
even exacerbate problems in a financial crisis.
If I agree to sell you a product next
month through a clearinghouse, I'll deliver the product to the
clearinghouse and you'll deliver the cash to the clearinghouse
on the due date. Let's say we both have many trades going
through the clearinghouse and we've posted collateral to cover
any single trade that fails. This is more efficient than each of
us posting collateral privately for each trade. Moreover, we're
not worried that I won't deliver or you won't pay because we
both count on the clearinghouse to deliver and pay up if one of
us doesn't.
This clearing system makes trading more
efficient. If you default, the cost is spread through the
clearinghouse so I don't get hurt severely. And if the
clearinghouse has enough collateral from you, there's no loss to
spread. But there's also a potential downside: The clearinghouse
reduces our incentives to worry about counterparty risk. Your
business might collapse before you need to pay up, but that's
not my problem because the clearinghouse pays me anyway. The
clearinghouse weakens private market discipline.
Still, if the clearinghouse is as good
or better at checking up on your creditworthiness as I am, all
will be well. But one has to wonder how good a clearinghouse
will be, or can be.
Consider two of our biggest
derivatives-related failures—Long-Term Capital Management in
1998 and the subprime market in 2008. When Russia's ruble
dropped unexpectedly, LTCM was exposed on its more than $1
trillion in interest-rate and foreign-exchange derivatives. It
could not pay up and collapsed. Ten years later the market
rapidly revalued subprime mortgage securities, rendering several
institutions insolvent. AIG was over-exposed in credit default
swaps tied to the value of subprime mortgages.
Could a clearinghouse really have been
ahead of the curve in getting sufficient capital posted before
these problems became serious and well-known? I'm not so sure.
Worse yet, major types of derivatives have built-in
discontinuities—"jump-to-default" in derivatives-speak.
For a credit default swap, one
counterparty guarantees the debt of another company to you, in
return for you paying a fee for that guarantee. If no one goes
bankrupt, the counterparty just collects the fees from you. But
if the guarantee is called because the company you were worried
about goes bankrupt, the counterparty must all of a sudden pay
out a huge amount immediately.
Yet the guarantor is often called upon
to pay in a weak economy, just when it can itself be too weak to
pay. You get credit default protection on your real-estate
investments from me, just in case the economy turns sour. But
just when you need me the most, in a sour economy, I turn out to
be so overextended I can't pay up. Collateralizing and
monitoring such discontinuous obligations will not be so easy
for the clearinghouse.
Moreover, if trillions of dollars of
derivatives trading goes through a clearinghouse, we will have
created another institution that's too big to fail. Regulators
worried that an interconnected Bear or AIG could drag down the
economy. Imagine what an interconnected clearinghouse's failure
could do.
AIG needed $85 billion in government
cash to avoid defaulting on its debts, including its derivatives
obligations. Could one clearinghouse meet even a fraction of
that call without backup from the U.S.? True, we could have many
clearinghouses, each not too big to fail—but then maybe each
would be too small to do enough good.
The Senate bill would allow a
clearinghouse to grab new collateral out from failing
derivatives-trading banks to cover old, but suddenly toxic,
debts the banks owe to the clearinghouse. This could harm other
creditors and cause the firm to suffer a run. Nevertheless, to
protect itself in a declining market, a clearinghouse would have
to make those big collateral calls. That's good if it protects
the clearinghouse. But it's bad if it starts a run on a weakened
but important bank.
One key but missing element in the
search for reform has yet to gain traction in Washington.
Derivatives players obtained exceptions from typical bankruptcy
and bank resolution rules in the past few decades for their
contracts with a bankrupt counterparty. This allowed them to
grab and keep collateral other creditors cannot. That gives
derivatives traders reason to pay less attention to their
counterparties' riskiness and weakens market discipline. These
rules should be changed before the Senate is done.
To say that a clearinghouse solution is
very incomplete is not to say there is an easy solution out
there. We may be unable to do more than to make incomplete
improvements and muddle through.
Derivatives trades first of all should
not just be centrally cleared, but should also be taken out from
the government-guaranteed entities, such as commercial banks (or
at least we need to impose tight capital requirements on those
banks that deal in derivatives). Derivatives traders like doing
business with Citibank because they know the government won't
let Citibank go down. But this puts taxpayers at risk. It would
be better to run those trades through an affiliate, not through
the bank, so counterparties realize they might not be bailed out
if the affiliate failed. If a banking affiliate's counterparty
is the clearinghouse, then the clearinghouse will have
incentives to make sure that the affiliate is well-capitalized.
This is particularly so if the clearinghouse won't get any
special priority treatment in a bankruptcy.
Critics of proposals to establish
separate bank affiliates for derivatives trading complain about
the large amount of capital that would be needed for such
affiliates. But the capital that might be needed to buttress a
bank affiliate indicates some level of the value (i.e., the
taxpayer subsidy) to derivatives players of trading with a
too-big-to-fail entity that they know the government will step
in to save. They are implicitly getting insurance and should pay
for it.
And, since a clearinghouse is itself at
risk of being too big to fail, regulators need to police its
capital and collateral requirements. If the derivatives market
sees the clearinghouse as too big to fail, the potential for
derivatives players making overly risky derivatives trades
becomes real. Clearinghouses can help manage some systemic risk
if they're run right. If not, they can become the Fannie and
Freddie of the next financial meltdown.
Mr. Roe is a professor at Harvard Law
School, where he teaches bankruptcy and corporate law.
My Hero Lawyer, Professor, and Wall Street Financial Expert
Weighs In
Question
In the bankruptcy court examiner's report on Lehman's downfall, is
Volume 3 more or less important than Volume 2?
Answer
For Ernst & Young it is probably Volume 3, but my true hero exposing
Wall Street scandals opts for Volume 2.
My favorite Wall Street books exposing the inside greed and fraud
on Wall Street are those written by Frank Partnoy. My timeline of
his exposes can be found at
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
.
Professor Partnoy's Senate Testimony was among the first solid
explanations of how derivative financial instruments frauds took
place at Enron. His entire testimony can be found at
http://faculty.trinity.edu/rjensen/FraudEnron.htm#FrankPartnoyTestimony
See his explanation of the infamous Footnote 16 of the Year 2000
Enron Annual report ---
http://faculty.trinity.edu/rjensen/FraudEnron.htm#Senator
His books are among the funniest and best books I've ever read in
my life, even better than the books of Michael Lewis.
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
They are the most dog-eared and scruffed up books in my entire
library.
"Lehman Examiner Punted on Valuation,"
by Frank Partnoy, Professor of Law and Finance University of San
Diego School of Law and author of Fiasco,
Infectious Greed, and The Match King
Naked Capitalism, March 14, 2010 ---
http://www.nakedcapitalism.com/2010/03/frank-partnoy-lehman-examiner-punted-on-valuation.html
The buzz on the Lehman bankruptcy
examiner’s report has focused on Repo 105, for good reason. That
scheme is one powerful example of how the balance sheets of
major Wall Street banks are fiction. It also shows why Congress
must include real accounting reform in its financial
legislation, or risk another collapse. (If you have 8 minutes to
kill, here is my
recent talk on the off-balance sheet problem,
from the Roosevelt Institute financial
conference.)
But an
even more troubling section of the Lehman report is not Volume 3
on Repo 105. It is Volume 2, on Valuation.
The Valuation section is 500 pages of utterly terrifying
reading. It shows that, even eighteen months after Lehman’s
collapse, no one – not the bankruptcy examiner, not Lehman’s
internal valuation experts, not Ernst and Young, and certainly
not the regulators – could figure out what many of Lehman’s
assets and liabilities were worth. It shows Lehman
was too complex to do anything but fail.
The report cites extensive evidence of
valuation problems. Check out page 577, where the report
concludes that Lehman’s high credit default swap valuations were
reasonable because Citigroup’s marks were ONLY 8% lower than
Lehman’s. 8%? And since when are Citigroup’s valuations the
objective benchmark?
Or page 547, where the report describes
how Lehman’s so-called “Product Control Group” acted like
Keystone Kops: the group used third-party prices for only 10% of
Lehman’s CDO positions, and deferred to the traders’ models,
saying “We’re not quants.” Here are two money quotes:
While the function of the Product
Control Group was to serve as a check on the
desk marks set by Lehman’s traders, the CDO product
controllers were hampered in
two respects. First, the Product Control Group did not
appear to have sufficient
resources to price test Lehman’s CDO positions
comprehensively. Second, while the
CDO product controllers were able to effectively verify the
prices of many positions
using trade data and third‐party prices, they did not have
the same level of quantitative sophistication as many of the
desk personnel who developed models to price CDOs. (page
547)
Or this one:
However, approximately a quarter of
Lehman’s CDO positions were not affirmatively priced by the
Product Control Group, but simply noted as ‘OK’ because the
desk had already written down the position significantly.
(page 548)
My favorite section describes the
valuation of Ceago, Lehman’s largest CDO position. My corporate
finance students at the University of San Diego School of Law
understand that you should use higher discount rates for riskier
projects. But the Valuation section of the report found that
with respect to Ceago, Lehman used LOWER discount rates for the
riskier tranches than for the safer ones:
The discount rates used by Lehman’s
Product Controllers were significantly understated. As
stated, swap rates were used for the discount rate on the
Ceago subordinate tranches. However, the resulting rates
(approximately 3% to 4%) were significantly lower than the
approximately 9% discount rate used to value the more senior
S tranche. It is inappropriate to use a discount rate on a
subordinate tranche that is lower than the rate used on a
senior tranche. (page 556)
It’s one thing to have product
controllers who aren’t “quants”; it’s quite another to have
people in crucial risk management roles who don’t understand
present value.
When the examiner compared Lehman’s
marks on these lower tranches to more reliable valuation
estimates, it found that “the prices estimated for the C and D
tranches of Ceago securities are approximately one‐thirtieth of
the price reported by Lehman. (pages 560-61) One thirtieth?
These valuations weren’t even close.
Ultimately, the examiner concluded that
these problems related to only a small portion of Lehman’s
overall portfolio. But that conclusion was due in part to the
fact that the examiner did not have the time or resources to
examine many of Lehman’s positions in detail (Lehman had 900,000
derivative positions in 2008, and the examiner did not even try
to value Lehman’s numerous corporate debt and equity holdings).
The bankruptcy examiner didn’t see
enough to bring lawsuits. But the valuation section of the
report raises some hot-button issues for private parties and
prosecutors. As the report put it, there are issues that “may
warrant further review by parties in interest.”
For example, parties in interest might
want to look at the report’s section on Archstone, a publicly
traded REIT Lehman acquired in October 2007. Much ink has been
spilled criticizing the valuation of Archstone. Here is the
Report’s finding (at page 361):
… there is sufficient evidence to
support a finding that Lehman’s valuations for its Archstone
equity positions were unreasonable beginning as of the end
of the first quarter of 2008, and continuing through the end
of the third quarter of 2008.
And Archstone is just one of many
examples.
The Repo 105 section of the Lehman
report shows that Lehman’s balance sheet was fiction. That was
bad. The Valuation section shows that Lehman’s approach to
valuing assets and liabilities was seriously flawed. That is
worse. For a levered trading firm, to not understand your
economic position is to sign your own death warrant.
2011
"What Caused the Bubble? Mission accomplished: Phil Angelides succeeds in
not upsetting the politicians," by Holman W, Jenkins, Jr., The Wall
Street Journal, January 29. 2011 ---
http://online.wsj.com/article/SB10001424052748704268104576108000415603970.html#mod=djemEditorialPage_t
The 2008 financial crisis happened because no one
prevented it. Those who might have stopped it didn't. They are to blame.
Greedy bankers, incompetent managers and
inattentive regulators created the greatest financial breakdown in nearly a
century. Doesn't that make you feel better? After all, how likely is it that
some human beings will be greedy at exactly the same time others are
incompetent and still others are inattentive?
Oh wait.
You could almost defend the Financial Crisis
Inquiry Commission's (FCIC) new report if the question had been who, in
hindsight, might have prevented the crisis. Alas, the answer is always going
to be the Fed, which has the power to stop just about any macro trend in the
financial markets if it really wants to. But the commission was asked to
explain why the bubble happened. In that sense, its report doesn't seem even
to know what a proper answer might look like, as if presented with the
question "What is 2 + 2?" and responding "Toledo" or "feral cat."
The dissenters at least propose answers that might
be answers. Peter Wallison focuses on U.S. housing policy, a diagnosis that
has the advantage of being actionable.
The other dissent, by Keith Hennessey, Bill Thomas
and Douglas Holtz-Eakin, sees 10 causal factors, but emphasizes the
pan-global nature of the housing bubble, which it attributes to ungovernable
global capital flows.
That is also true, but less actionable.
Let's try our hand at an answer that, like Mr.
Wallison's, attempts to be useful.
The Fed will make errors. International capital
flows will sometimes be disruptive. Speculators will be attracted to hot
markets. Bubbles will be a feature of financial life: Building a bunch of
new houses is not necessarily a bad idea; only when too many others do the
same does it become a bad idea. On that point, not the least of the
commission's failings was its persistent mistaking of effects for causes,
such as when banks finally began treating their mortgage portfolios as hot
potatoes to be got rid of.
If all that can't be changed, what can? How about
the incentives that invited various parties to shovel capital into housing
without worrying about the consequences?
The central banks of China, Russia and various
Asian and Arab nations knew nothing about U.S. housing. They poured hundreds
of billions into it only because Fannie and Freddie were perceived as
federally guaranteed and paid a slightly higher yield than U.S. Treasury
bonds. (And one of the first U.S. actions in the crisis was to assure China
it wouldn't lose money.)
Borrowers in most states are allowed to walk away
from their mortgages, surrendering only their downpayments (if any) while
dumping their soured housing bets on a bank. Change that even slightly and
mortgage brokers and home builders would find it a lot harder to coax people
into more house than they can afford.
Mortgage middlemen who don't have "skin in the
game" and feckless rating agencies have also been routine targets of blame.
But both are basically ticket punchers for large institutions that should
have and would have been assessing their own risk, except that their own
creditors, including depositors, judged them "too big to fail," creating a
milieu where they could prosper without being either transparent or
cautious. We haven't even tried to fix this, say by requiring banks to take
on a class of debtholder who would agree to be converted to equity in a
bailout. Then there'd be at least one sophisticated marketplace demanding
assurance that a bank is being run in a safe and sound manner. (Sadly, the
commission's report only reinforces the notion that regulators are
responsible for keeping your money safe, not you.)
The FCIC Chairman Phil Angelides is not stupid, but
he is a politician. His report contains tidbits that will be useful to
historians and economists. But it's also a report that "explains" poorly.
His highly calculated sound bite, peddled from one interview to the next,
that the crisis was "avoidable" is worthless, a nonrevelation. Everything
that happens could be said to happen because somebody didn't prevent it. So
what? Saying so is saying nothing.
Mr. Angelides has gone around trying to convince
audiences that the commission's finding was hard hitting. It wasn't. It was
soft hitting. More than any other goal, it strives mainly to say nothing
that would actually be inconvenient to Barack Obama, Harry Reid, Barney
Frank or even most Republicans in Congress. In that, it succeeded.
Jensen Comment
And then the subprime crisis was followed by the biggest swindle in the history
of the world ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
At this point time in 2011 there's only marginal benefit in identifying all
the groups like credit agencies and CPA audit firms that violated
professionalism leading up to the subprime crisis. The credit agencies,
auditors, Wall Street investment banks, Fannie Mae, and Freddie Mack were all
just hogs feeding on the trough of bad and good loans originating on Main
Streets of every town in the United States.
If the Folks on Main Street that Approved the Mortgage Loans in the First
Stage Had to Bear the Bad Debt Risks There Would've Been No Poison to Feed Upon
by the Hogs With Their Noses in the Trough Up to and Including Wall Street and
Fannie and Freddie.
If the Folks on Main Street that Approved the Mortgage Loans in the First
Stage Had to Bear the Bad Debt Risks All Would've Been Avoided
The most interesting question in my mind is what might've prevented the poison (uncollectability)
in the real estate loans from being concocted in the first place. What
might've prevented it was for those that approved the loans (Main Street banks
and mortgage companies in towns throughout the United States) to have to bear
all or a big share of the losses when borrowers they approved defaulted.
Instead those lenders that approved the loans easily passed those loans up
the system without any responsibility for their reckless approval of the
loans in the first place. It's easy to blame Barney Frank for making it
easier for poor people to borrow more than they could ever repay. But the fact
of the matter is that the original lenders like Countrywide were approving
subprime mortgages to high income people that also could not afford their
payments once the higher prime rates kicked in under terms of the subprime
contracts. If lenders like Countrywide had to bear a major share of the bad debt
losses the lenders themselves would've been more responsible about only
approving mortgages that had a high probability of not going into default.
Instead Countrywide and the other Main Street lenders got off scott free until
the real estate bubble finally burst.
And why would a high income couple refinance a fixed rate mortgage with a
risky subprime mortgage that they could not afford when the higher rates kicked
in down the road? The answer is that the hot real estate market before the crash
made that couple greedy. They believed that if they took out a subprime loan
with a very low rate of interest temporarily that they could turn over their
home for a relatively huge profit and then upgrade to a much nicer mansion on
the hill from the profits earned prior to when the subprime rates kicked into
higher rates.
When the real estate bubble burst this couple got left holding the bag and
received foreclosure notices on the homes that they had gambled away. And the
Wall Street investment banks, Fannie, and Freddie got stuck with all the poison
that the Main Street banks and mortgage companies had recklessly approved
without any risk of recourse for their recklessness.
If the Folks on Main Street that Approved the Mortgage Loans in the First
Stage Had to Bear the Bad Debt Risks There Would've Been No Poison to Feed Upon
by the Hogs With Their Noses in the Trough Up to and Including Wall Street and
Fannie and Freddie.
Bob Jensen's threads on this entire mess are at
http://faculty.trinity.edu/rjensen/2008Bailout.htm
"Washington’s Financial Disaster," by Frank Partnoy,
The New York Times, January 29, 2011 ---
http://www.nytimes.com/2011/01/30/opinion/30partnoy.html?_r=1&nl=todaysheadlines&emc=tha212
THE long-awaited Financial Crisis
Inquiry Commission report, finally published on Thursday, was
supposed to be the economic equivalent of the 9/11 commission
report. But instead of a lucid narrative explaining what
happened when the economy imploded in 2008, why, and who was to
blame, the report is a confusing and contradictory mess, part
rehash, part mishmash, as impenetrable as the collateralized
debt obligations at the core of the crisis.
The main reason so much time, money and
ink were wasted — politics — is apparent just from eyeballing
the report, or really the three reports. There is a 410-page
volume signed by the commission’s six Democrats, a leaner
10-pronged dissent from three of the four Republicans, and a
nearly 100-page dissent-from-the-dissent filed by Peter J.
Wallison, a fellow at the American Enterprise Institute. The
primary volume contains familiar vignettes on topics like
deregulation, excess pay and poor risk management, and is
infused with populist rhetoric and an anti-Wall Street tone. The
dissent, which explores such root causes as the housing bubble
and excess debt, is less lively. And then there is Mr.
Wallison’s screed against the government’s subsidizing of
mortgage loans.
These documents resemble not an
investigative trilogy but a left-leaning essay collection, a
right-leaning PowerPoint presentation and a colorful far-right
magazine. And the confusion only continued during a press
conference on Thursday in which the commissioners had little to
show and nothing to tell. There was certainly no Richard Feynman
dipping an O ring in ice water to show how the space shuttle
Challenger went down.
That we ended up with a political split
is not entirely surprising, given the structure and composition
of the commission. Congress shackled it by requiring bipartisan
approval for subpoenas, yet also appointed strongly partisan
figures. It was only a matter of time before the group
fractured. When Republicans proposed removing the term “Wall
Street” from the report, saying it was too pejorative and
imprecise, the peace ended. And the public is still without a
full factual account.
For example, most experts say credit
ratings and derivatives were central to the crisis. Yet on these
issues, the reports are like three blind men feeling different
parts of an elephant. The Democrats focused on the credit rating
agencies’ conflicts of interest; the Republicans blamed
investors for not looking beyond ratings. The Democrats stressed
the dangers of deregulated shadow markets; the Republicans
blamed contagion, the risk that the failure of one derivatives
counterparty could cause the other banks to topple. Mr. Wallison
played down both topics. None of these ideas is new. All are
incomplete.
Another problem was the commission’s
sprawling, ambiguous mission. Congress required that it study 22
topics, but appropriated just $8 million for the job. The
pressure to cover this wide turf was intense and led to
infighting and resignations. The 19 hearings themselves were
unfocused, more theater than investigation.
In the end, the commission was the
opposite of Ferdinand Pecora’s famous Congressional
investigation in 1933. Pecora’s 10-day inquisition of banking
leaders was supposed to be this commission’s exemplar. But
Pecora, a former assistant district attorney from New York, was
backed by new evidence of widespread fraud and insider dealings,
shocking documents that the public had never seen or imagined.
His fierce cross-examination of Charles E. Mitchell, the head of
National City Bank, Citigroup’s predecessor, put a face on the
crisis.
This commission’s investigation was
spiritless and sometimes plain wrong. Richard Fuld, the former
head of Lehman Brothers, was thrown softballs, like “Can you
talk a bit about the risk management practices at Lehman
Brothers, and why you didn’t see this coming?” Other bankers
were scolded, as when Phil Angelides, the commission’s chairman,
admonished Lloyd Blankfein, the chief executive of Goldman
Sachs, for practices akin to “selling a car with faulty brakes
and then buying an insurance policy on the buyer of those cars.”
But he couldn’t back up this rebuke with new evidence.
The report then oversteps the facts in
its demonization of Goldman, claiming that Goldman “retained”
$2.9 billion of the A.I.G. bailout money as “proprietary
trades.” Few dispute that Goldman, on behalf of its clients,
took both sides of trades and benefited from the A.I.G. bailout.
But a Goldman spokesman told me that the report’s assertion was
false and that these trades were neither proprietary nor a
windfall. The commission’s staff apparently didn’t consider
Goldman’s losing trades with other clients, because they were
focused only on deals with A.I.G. If they wanted to tar Mr.
Blankfein, they should have gotten their facts right.
Lawmakers would have been wiser to
listen to Senator Richard Shelby of Alabama, who in early 2009
proposed a bipartisan investigation by the banking committee.
That way seasoned prosecutors could have issued subpoenas,
cross-examined witnesses and developed cases. Instead, a few
months later, Congress opted for this commission, the last act
of which was to coyly recommend a few cases to prosecutors, who
already have been accumulating evidence the commissioners have
never seen.
There is still hope. Few people
remember that the early investigations of the 1929 crash also
failed due to political battles and ambiguous missions.
Ferdinand Pecora was Congress’s fourth chief counsel, not its
first, and he did not complete his work until five years after
the crisis. Congress should try again.
Frank Partnoy is a law professor at the University of San
Diego and the author of “The Match King: Ivar Kreuger, the
Financial Genius Behind a Century of Wall Street Scandals.”
Jensen Comment
Professor Partnoy is one of my all-time fraud fighting heroes. He
was at one time an insider in marketing Wall Street financial
instrument derivatives products and, while he was one of the bad
guys, became conscience-stricken about how the bad guys work.
Although his many books are somewhat repetitive, his books are among
the best in exposing how the Wall Street investment banks are rotten
to the core.
Frank Partnoy has been a a strong advocate of regulation of the
derivatives markets even before Enron's energy trading scams came to
light. His testimony before the U.S. Senate about Enron's infamous
Footnote 16 ---
http://faculty.trinity.edu/rjensen/FraudEnron.htm#Senator
I quote Professor Partnoy's books frequently in my Timeline of
Derivative Financial Instruments Frauds ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
2011
Mr. Buffett, who has interests in both
companies, claimed there was another agenda (aside from
hedging with derivatives). “The reason many
of them do it (invest in derivative contracts)
is that they want to smooth earnings,”
he said, referring to the idea of trying to make quarterly numbers
less volatile. “And I’m not saying there’s anything wrong with that,
but that is the motivation.”
"Derivatives, as Accused by Buffett," by Andrew Ross
Sorkin, The New York Times, March 14, 2011 ---
http://dealbook.nytimes.com/2011/03/14/derivatives-as-accused-by-buffett/?ref=business
Mr. Buffett once described derivatives
as “financial weapons of mass destruction.” Yet some of his most
ardent fans have quietly raised eyebrows at his pontifications,
given that he plays in the opaque market. In the fourth quarter
alone, Berkshire made $222 million on derivatives. TheStreet.com
published a column last spring with the headline: “Warren
Buffett Is a Hypocrite.”
¶His comments, which were released last
month by the financial crisis commission, come as the government
is writing rules for derivatives as part of the Dodd-Frank
financial regulatory overhaul. And the statements could
influence the debate.
¶Mr. Buffett appeared to backpedal from
his oft-quoted line, explaining: “I don’t think they’re evil per
se. It’s just, they, I mean there’s nothing wrong with having a
futures contract or something of the sort. But they do let
people engage in massive mischief.”
¶The problems arise, Mr. Buffett said,
when a bank’s exposure to derivatives balloons to grand
proportions and uninformed investors start using them.
¶It “doesn’t make much difference if
it’s, you know, one guy rolling dice against another, and
they’re doing $5 a throw. But it makes a lot of difference when
you get into big numbers.”
¶What worries him most is the big
financial institutions that have millions of contracts. “If I
look at JPMorgan, I see two trillion in receivables, two
trillion in payables, a trillion and seven netted off on each
side and $300 billion remaining, maybe $200 billion
collateralized,” he said, walking through his thinking. “That’s
all fine. But I don’t know what discontinuities are going to do
to those numbers overnight if there’s a major nuclear, chemical
or biological terrorist action that really is disruptive to the
whole financial system.”
¶“Who the hell knows what happens to
those numbers?” he asked. “I think it’s virtually unmanageable.”
¶Mr. Buffett defended Berkshire
Hathaway’s use of derivatives, arguing that the company
maintains a limited amount. At the time of the interview, the
company had only about 250 derivative contracts. (It’s now down
to 203.) “I want to know every contract, and I can do that with
the way we’ve done it. But I can’t do it with 23,000 that a
bunch of traders are putting on.”
¶He noted that when Berkshire bought
General Re in 1998, the reinsurance company had 23,000
derivative contracts. “I could have hired 15 of the smartest
people, you know, math majors, Ph.D.’s. I could have given them
carte blanche to devise any reporting system that would enable
me to get my mind around what exposure that I had, and it
wouldn’t have worked,” he said to the government panel. “Can you
imagine 23,000 contracts with 900 institutions all over the
world with probably 200 of them names I can’t pronounce?”
Berkshire decided to unwind the derivative deals, incurring some
$400 million in losses.
¶Mr. Buffett said he used derivatives
to capitalize on discrepancies in the market. (That’s what other
investors must think they are doing — just not as successfully.)
¶Perhaps the most insightful nugget in
the interview was Mr. Buffett’s explanation of why corporations
use derivatives — and why they probably shouldn’t.
¶Many companies, as diverse as
Coca-Cola and Burlington Northern, argue that they employ
derivatives to hedge their risk.
¶The United States-based Coca-Cola
tries to protect against fluctuations in currencies since it
does business around the world. Burlington Northern, the
railroad giant, uses the investments to limit the effect of fuel
prices.
¶Mr. Buffett, who has interests in both
companies, claimed there was another agenda. “The reason many of
them do it is that they want to smooth earnings,” he said,
referring to the idea of trying to make quarterly numbers less
volatile. “And I’m not saying there’s anything wrong with that,
but that is the motivation.”
¶The numbers all even out eventually,
he cautioned, so derivatives don’t really make much difference
in the long term.
¶“They’re going to lose as much on the
diesel fuel contracts over time as they make,” he said of
Burlington Northern. “I wouldn’t do it.”
Continued in article
Bob Jensen's threads on creative accounting, smoothing, and
earnings management ---
http://faculty.trinity.edu/rjensen/Theory02.htm#Manipulation
Bob Jensen's tutorials on accounting for derivative financial
instruments ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
2011
That some bankers
have ended up in prison is not a matter of scandal, but what is outrageous is
the fact that all the others are free.
Honoré de Balzac
Bankers bet with their bank's capital, not their own. If the bet goes right,
they get a huge bonus; if it misfires, that's the shareholders' problem.
Sebastian Mallaby. Council on Foreign Relations, as quoted by
Avital Louria Hahn, "Missing: How Poor Risk-Management Techniques Contributed
to the Subprime Mess," CFO Magazine, March 2008, Page 53 ---
http://www.cfo.com/article.cfm/10755469/c_10788146?f=magazine_featured
Now that the Fed is going to
bail out these crooks with taxpayer funds makes it all the worse.
Wall Street
Remains Congress to the Core
The boom in corporate mergers
is creating concern that illicit trading ahead of deal announcements is becoming
a systemic problem. It is against the law to trade on inside information about
an imminent merger, of course. But an analysis of the nation’s biggest mergers
over the last 12 months indicates that the securities of 41 percent of the
companies receiving buyout bids exhibited abnormal and suspicious trading in the
days and weeks before those deals became public. For those who bought shares
during these periods of unusual trading, quick gains of as much as 40 percent
were possible.
Gretchen Morgenson, "Whispers of Mergers Set Off Suspicious Trading," The New
York Times, August 27, 2006 ---
Click Here
Hmm --- JP (pronounced gyp) Morgan Chase legal settlements
$861 million +$154 million + $211 million and still counting up the frauds
And the Bush and Obama Administration bailed these crooks out
"JPMorgan Settles Bond Bid-Rigging Case for $211 Million," by Eric
Dash, The New York Times, July 7, 2011 ---
http://www.nytimes.com/2011/07/08/business/jpmorgan-settles-bond-bid-rigging-case-for-211-million.html
JPMorgan Chase reached a $211 million settlement
with federal and state authorities on Thursday to resolve allegations that
it cheated governments in 31 states by rigging the bidding process for
reinvesting the proceeds of dozens of municipal bond transactions.
Without admitting or denying wrongdoing, the bank
settled accusations that it had improperly entered secret agreements with
bidding agents that gave it a “last look” at bids submitted by its
competitors. The bank has agreed to return about $129.7 million to the
municipalities that were harmed.
In addition, the Securities and Exchange Commission
said it would bar James L. Hertz, a former JPMorgan executive at the center
of the bid-rigging scandal, from working in the municipal finance industry.
Last December, Mr. Hertz pleaded guilty to conspiracy and wire fraud charges
for his role in the improper deals.
JPMorgan Chase said in a statement that it “does
not tolerate anticompetitive activity” and that the executives involved had
concealed their behavior from management.
“The firm’s policies, both now and during the
period in question, expressly prohibit the conduct that gave rise to these
proceedings,” the statement said. The bank said the employees involved were
no longer with the company and that it had improved its compliance program
and increased ethics training for staff in the public finance group.
The $211 million pact is the largest of three major
settlements that securities regulators have reached in an effort to clean up
municipal finance.
In December, authorities struck a $137 million
settlement with Bank of America to resolve similar fraud charges. In May,
UBS agreed to pay more than $150 million to settle municipal bid-rigging
charges. The JPMorgan settlement was reached amid public outrage toward Wall
Street for its role in the financial crisis. Federal regulators are under
increasing pressure to hold bankers accountable.
To resolve the charges, JPMorgan plans to pay $51.2
million to the Securities and Exchange Commission, $50 million to the
Internal Revenue Service, $35 million to the Office of the Comptroller of
the Currency and $75 million to a group of state attorneys general. The bank
also reached settlements with the Federal Reserve Bank of New York and the
antitrust division of the Justice Department.
Elaine C. Greenberg, the chief of the S.E.C.’s
municipal securities unit, said that the settlement would send a message
that undermining the fairness of the public sector bond market would not be
tolerated. “Rather than playing by the rules, the rules got played,” she
said in a statement.
Typically, when investors buy municipal bonds,
local governments temporarily invest the tax-exempt proceeds until they are
used. Banks help states and cities invest the money in so-called municipal
reinvestment products and bid for the right by offering competitive interest
rates. That process lets municipalities claim tax-exempt status for the
money.
But regulators say JPMorgan undermined the
competition. From 1997 to 2005, they say, members of the bank’s municipal
derivatives desk made misrepresentations and omissions in at least 93
transactions. The moves affected the prices that governments paid and
jeopardized the tax-exempt status of billions of dollars worth of those
securities. JPMorgan marketers rigged the bids with help from at least 11
bidding agents.
At times, court documents said, the bank won
investment business because it got information from bidding agents about
what its competitors were bidding. In other cases it deliberately submitted
nonwinning bids to satisfy tax requirements.
The case was settled on the heels of a JPMorgan
settlement last month in which it agreed to pay $153.6 million to resolve
federal civil accusations that it misled investors in a mortgage securities
transaction in 2007.
Continued in article
"Judge Clears $861 Million J.P. Morgan-Lehman Settlement," The Wall
Street Journal, June 23, 2011 ---
http://blogs.wsj.com/deals/2011/06/23/judge-clears-861-million-j-p-morgan-lehman-settlement/
A judge on Thursday approved a settlement that
calls for J.P. Morgan Chase to pay $861 million in cash and securities to
customers of the defunct broker-deal business of Lehman Brothers Holdings.
The settlement is the largest to date reached by
the trustee winding down’s Lehman’s former U.S. brokerage business.
“I’m satisfied that this is indeed an excellent
result,” Judge James Peck of U.S. Bankruptcy Court in Manhattan said. He
added, “This is obviously a very substantial step forward of the LBI
liquidation.” LBI is the brokerage subsidiary, Lehman Brothers Inc.
Greatest Swindle in the History of the World ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
Bob Jensen's Rotten to the Core Threads ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm
2011
"Accused of Deception, Citi Agrees to Pay $285 Million,"
by Edward Wyatt, The New York Times, October 19, 2011 ---
http://www.nytimes.com/2011/10/20/business/citigroup-to-pay-285-million-to-settle-sec-charges.html?hp
Citigroup agreed to pay $285 million to
settle charges that it misled investors in a $1 billion
derivatives deal tied to the United States housing market, then
bet against investors as the housing market began to show signs
of distress, the Securities and Exchange Commission said
Wednesday.
The S.E.C. also brought charges against
a Citigroup employee who was responsible for structuring the
transaction, and brought and settled charges against the asset
management unit of Credit Suisse and a Credit Suisse employee
who also had responsibility for the derivative security.
¶ The S.E.C. said that the $285 million
would be returned to investors in the deal, a collateralized
debt obligation known as Class V Funding III. The commission
said that Citigroup exercised significant influence over the
selection of $500 million of assets in the deal’s portfolio.
¶ Citigroup then took a short position
against those mortgage-related assets, an investment in which
Citigroup would profit if the assets declined in value. The
company did not disclose to the investors to whom it sold the
collateralized debt obligation that it had helped to select the
assets or that it was betting against them.
¶ The S.E.C. also charged Brian Stoker,
the Citigroup employee who was primarily responsible for putting
together the deal, and Samir H. Bhatt, a Credit Suisse portfolio
manager who was primarily responsible for the transaction.
Credit Suisse served as the collateral manager for the C.D.O.
transaction.
¶ “The securities laws demand that
investors receive more care and candor than Citigroup provided
to these C.D.O. investors,” said Robert Khuzami, director of the
S.E.C.’s division of enforcement. “Investors were not informed
that Citigroup had decided to bet against them and had helped
choose the assets that would determine who won or lost.”
¶ Citigroup received fees of $34
million for structuring and marketing the transaction and
realized net profits of at least $126 million from its short
position. The $285 million settlement includes $160 million in
disgorgement plus $30 million in prejudgment interest and a $95
million penalty, all of which will be returned to investors.
¶ The companies and individuals who
settled the charges neither admitted nor denied the charges.
Continued in article
Bob Jensen's threads on the derivatives scandals in 2007 and
2008 ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm
Fraud Updates ---
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
2011
Collateralized Debt Obligation (CDO) ---
http://en.wikipedia.org/wiki/CDOs
"Sleight of hand: BofA moves dodgy Merrill derivatives to bank,"
by Mark December, The New York Post, October 21, 2011 ---
http://www.nypost.com/p/news/business/sleight_of_hand_uy96iNSbW99JHMRnbxgvfL
A plan by beleaguered Bank of America
to foist trillions of dollars of funky Merrill Lynch derivatives
onto its depositors is raising eyebrows on Wall Street.
The rarely used move will likely save
the bank millions of dollars in collateral but could put
depositors’ cash behind the eight ball.
The move also brought to light fissures
between the nation’s top banking regulators, the Federal Deposit
Insurance Corp. and the Federal Reserve, in the wake of new
regulations meant to curb the free-wheeling habits that fostered
the worst crisis in a generation back in 2008.
At issue is BofA’s decision to shift
what sources say is some $55 trillion in derivatives at Merrill
Lynch to the retail bank unit, which houses trillions in
deposits insured by the FDIC.
Critics say the move potentially
imperils everyday depositors by placing their money and savings
at risk should BofA run into trouble.
Sources say that the derivative
transfers from Merrill to BofA’s bank subsidiary were sparked by
credit-rating downgrades to the bank holding company and are
meant to help BofA avoid having to fork over more money to post
as collateral to its derivative counterparties.
BofA officials who have talked
privately say the move was requested by its counterparties and
shouldn’t be perceived as problematic for the bank giant,
sources said.
A BofA spokesman declined to comment.
For weeks, BofA CEO Brian Moynihan has
been dogged about the health of one of the nation’s largest
banking franchises and its massive exposures to toxic debt after
its shotgun mergers with Merrill and Countrywide Financial
during the credit crisis three years ago.
Under Moynihan, BofA has been
attempting to right the bank’s ship and convince shareholders
that the firm is healthy and doesn’t need to raise fresh capital
to backstop against potential losses from faulty foreclosures
and other mortgage-related lawsuits.
In the third quarter, BofA posted
profit of $6.23 billion, or 56 cents a share, down 15 percent
from the same period a year ago.
The bank’s shares gained 1 percent
yesterday, to $6.47. They are off 51 percent this year.
BofA’s third-quarter performance comes
as fears persist about the big bank’s ability to make money amid
stiff economic headwinds and a host of potential land mines that
could see it shelling out billions.
The derivatives transfer has irked
officials at the FDIC which, sources said, was informed of
BofA’s plan to shift the contracts to a retail deposit-taking
entity just last week.
One source says that the FDIC is in the
process of reviewing the transfer and will relay its opinion to
the Federal Reserve.
But ultimately it’s the Fed that has
the final say on authorizing any transfers.
Neither the Fed nor the FDIC would
comment on BofA’s plans, which were first reported by Bloomberg.
Continued in article
Jensen Comment
What is more bizarre is that BofA really did not want to buy Merrill
Lynch at any price in the 2008 Bailout after digging deeper into the
financial records of CDO-battered Merrill Lynch.. Then Treasury
Secretary Hank Paulson for some unknown reason did not want throw
Merrill Lynch under the bus in the same manner that he threw Bear
Stearns under the bus. In my opinion, both of these giants should
have been ground up in the tires of the bus.
After the subprime collapse then BofA CEO, Ken Lewis, most
certainly did not want to use BofA money to stop the free fall of
Merrill Lynch. However, U.S. Treasury Secretary Hank Paulson
resorted to personal blackmail according to Ken Lewis.
"Bank Chief Tells of U.S. Pressure to Buy Merrill Lynch," by
Louise Story and Jo Becker, The New York Times, June 11. 2009
---
http://www.nytimes.com/2009/06/12/business/12bank.html
Of course once BofA decided to concede to Paulson's demands does
not condone the alleged behavior of BofA executives or Merrill Lynch
executives in closing the deal.
"Ken Lewis BLASTS Merrill Lynch-Bank Of America Merger Lawsuit,
Calls It 'Implausible'," by David B. Caruso, August 21, 2010 ---
http://www.huffingtonpost.com/2010/08/21/ken-lewis-blasts-merrill-_n_690215.html
Actually BofA was in great shape well into the subprime mortgage
crisis. BofA had been smart enough in 2007 to hold none of the
poisoned mortgages and CDOs that plagued most of the big banks and
brokerage houses like Merrill Lynch. But in a twist of fate BofA
became drawn to the fire sale pricing of big outfits like
Countrywide and Merrill Lynch that were dying from subprime poison.
BofA just did not look these gift horses in the mouth until it was
too late to get them out of the BofA stables. There's no excuse for
the stupid purchase of Countrywide which left BofA will millions of
defaulted mortgages. There is purportedly an excuse for the purchase
of Merrill Lynch. Ken Lewis was a chicken sh*t. Ironically, he
eventually lost his job anyway.
Now it appears that BofA wants to pass trillions in Merrill Lynch
CDO losses on to depositors who will pay for these losses in nickels
and dimes of daily bank charges for things like debit cards for the
next 1,000 years. In reality, the counterparties to the CDO
contracts should've absorbed the loan loss poison, but Treasury
Secretary Paulson and President George Bush did not want to piss off
the investors who finance U.S. Government budget deficits ---
especially our friends in Asia and the Middle East and large banks
like Goldman that had bought these poison-laced CDO bonds.
Ironically, it is now BofA depositors who will now be paying off
the bad debts that rightfully belonged to sovereign funds of Asia
and the Middle East as well as derivatives contract counterparties
at Goldman.
2011
Billings for Services Never Rendered
"SEC Charges Morgan Stanley Investment Management for Improper
Fee Arrangement," SEC, November 14, 2011 ---
http://sec.gov/news/press/2011/2011-244.htm
Morgan Stanley settled the charges for $3.3 million fine
Bob Jensen's Fraud Updates ---
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
2011
Remember when the 2007/2008 severe economic collapse was caused
by "street events":
Fraud on Main Street
Issuance of "poison" mortgages (many
subprime) that lenders knew could never be repaid by borrowers.
Lenders didn't care about loan defaults because they sold the poison
mortgages to suckers like Fannie and Freddie.
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Sleaze
For low income borrowers the Federal Government forced Fannie and
Freddie to buy up the poisoned mortgages ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Rubble
Math Error on Wall Street
Issuance of CDO portfolio bonds laced with a
portion of healthy mortgages and a portion of poisoned mortgages.
The math error is based on an assumption that risk of poison can be
diversified and diluted using a risk diversification formula.
The risk diversification formula is called the
Gaussian copula function
The formula made a fatal assumption that loan defaults would be
random events and not correlated.
When the real estate bubble burst, home values plunged and loan
defaults became correlated and enormous.
Fraud on Wall Street
All the happenings on Wall Street were not merely
innocent math errors
Banks and investment banks were selling CDO bonds that they knew
were overvalued.
Credit rating agencies knew they were giving AAA high credit ratings
to bonds that would collapse.
The banking industry used powerful friends in government to pass its
default losses on to taxpayers.
Greatest Swindle in the History of the World ---
http://faculty.trinity.edu/rjensen/2008Bailout.htm#Bailout
Can the 2008 investment banking failure be traced to a math
error?
Recipe for Disaster: The Formula That Killed Wall Street ---
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
Link forwarded by Jim Mahar ---
http://financeprofessorblog.blogspot.com/2009/03/recipe-for-disaster-formula-that-killed.html
Some highlights:
"For five years, Li's formula,
known as a
Gaussian copula function, looked like an unambiguously
positive breakthrough, a piece of financial technology that
allowed hugely complex risks to be modeled with more ease
and accuracy than ever before. With his brilliant spark of
mathematical legerdemain, Li made it possible for traders to
sell vast quantities of new securities, expanding financial
markets to unimaginable levels.
His method was adopted by everybody
from bond investors and Wall Street banks to ratings
agencies and regulators. And it became so deeply
entrenched—and was making people so much money—that warnings
about its limitations were largely ignored.
Then the model fell apart." The article goes on to show that
correlations are at the heart of the problem.
"The reason that ratings agencies
and investors felt so safe with the triple-A tranches was
that they believed there was no way hundreds of homeowners
would all default on their loans at the same time. One
person might lose his job, another might fall ill. But those
are individual calamities that don't affect the mortgage
pool much as a whole: Everybody else is still making their
payments on time.
But not all calamities are
individual, and tranching still hadn't solved all the
problems of mortgage-pool risk. Some things, like falling
house prices, affect a large number of people at once. If
home values in your neighborhood decline and you lose some
of your equity, there's a good chance your neighbors will
lose theirs as well. If, as a result, you default on your
mortgage, there's a higher probability they will default,
too. That's called correlation—the degree to which one
variable moves in line with another—and measuring it is an
important part of determining how risky mortgage bonds are."
I would highly recommend reading the entire thing that gets
much more involved with the
actual formula etc.
The “math
error” might truly be have been an error or it might have simply
been a gamble with what was perceived as miniscule odds of total
market failure. Something similar happened in the case of the
trillion-dollar disastrous 1993 collapse of Long Term Capital
Management formed by Nobel Prize winning economists and their
doctoral students who took similar gambles that ignored the
“miniscule odds” of world market collapse -- -
http://faculty.trinity.edu/rjensen/FraudRotten.htm#LTCM
History
(Long Term
Capital Management and CDO Gaussian Coppola failures)
Repeats Itself in Over a Billion Lost in MF Global
"Models
(formulas) Behaving Badly Led to MF’s Global Collapse – People
Too," by Aaron Task, Yahoo Finance, November 21, 2011 ---
http://finance.yahoo.com/blogs/daily-ticker/models-behaving-badly-led-mf-global-collapse-people-174954374.html
"The entire system has been utterly
destroyed by the MF Global collapse," Ann Barnhardt, founder and
CEO of Barnhardt Capital Management, declared last week in a
letter to clients.
Whether that's hyperbole or not is a
matter of opinion, but MF Global's collapse — and the inability
of investigators to find about $1.2 billion in "missing"
customer funds, which is twice the amount previously thought —
has only further undermined confidence among investors and
market participants alike.
Emanuel Derman, a professor at Columbia
University and former Goldman Sachs managing director, says
MF
Global was undone by an over-reliance on short-term funding,
which dried up as revelations of its leveraged bets on European
sovereign debt came to light.
In the accompanying video, Derman says
MF Global was much more like Long Term Capital Management than
Goldman Sachs, where he worked on the risk committee for
then-CEO John Corzine.
A widely respected expert on risk
management, Derman is the author of a new book
Models. Behaving. Badly: Why Confusing Illusion with Reality Can
Lead to Disaster, on Wall Street and in Life.
As discussed in the accompanying video,
Derman says the "idolatry" of financial models puts Wall Street
firms — if not the entire banking system — at risk of
catastrophe. MF Global was an extreme example of what can happen
when the models — and the people who run them -- behave badly,
but if Barnhardt is even a little bit right, expect more
casualties to emerge.
Jensen
Comment
MF Global's auditor (PwC) will now be ensnared, as seems appropriate
in this case, the massive lawsuits that are certain to take place in
the future ---
http://faculty.trinity.edu/rjensen/Fraud001.htm
2012
From The Wall Street Journal Accounting Weekly Review on
March 30, 2012
Top MF Global Witness Talks Deal With Justice
by: Aaron Lucchetti, Michael Rothfeld and Mike Spector
Mar 28, 2012
Click here to view the full article on WSJ.com
Click here to view the video on WSJ.com ![WSJ Video]()
TOPICS: Bankruptcy, Internal Controls
SUMMARY: This article describes the actions of
two responsible accountants at MF Global, Ms. Edith O'Brien,
Assistant Treasurer, and Ms. Christine Serwinski, Chief
Financial Officer of MF Global's North America Unit. These
accounting executives conducted reviews of reconciliations for
missing customer funds on October 30, 2011, just prior to the
firm's collapse. Ultimately, customer funds totaling $1.2
billion were missing following transfers from accounts
containing both the firms' and its customers' funds. NOTE: The
related article was published December 31, 2011 and was covered
in this Review. The Review is available on the WSJ's Professor
Journal web site at
http://www.profjournal.com/educators_reviews/article_page_new.cfm?article_id=35301.
Click on Search the Database; search for Accounting Discipline
for keyword MF Global. The summary of that review provides an
answer to the first question in this review.
CLASSROOM APPLICATION: The topic may be used
when covering topics in reconciliations in auditing, internal
control systems, and financial accounting classes.
QUESTIONS:
1. (Advanced) What is MF Global? What problems with
customer accounts came to light during the company's recent
demise? (You may base your answer on the related article.)
2. (Introductory) Who is Ms. Edith O'Brien? What was
her role at MF Global?
3. (Introductory) Who is Ms. Christine Serwinski? What
was her role at MF Global?
4. (Introductory) What is a reconciliation? What types
of items arise in reconciliations?
5. (Introductory) How can reconciliations between
control accounts and subsidiary ledger totals maintain internal
controls in any business operation? How can they help maintain
control when accounts contain both the firm's and its customers'
funds?
6. (Advanced) Based on the information in the article,
what types of reconciliations were being investigated to find
the source of the missing customer funds that ultimately have
become the subject of these Congressional hearings?
7. (Introductory) What are the accountants'
responsibilities with respect to these missing funds? What are
the possible outcomes of this investigation into whether those
responsibilities were upheld, particularly for Ms. O'Brien?
Reviewed By: Judy Beckman, University of Rhode Island
RELATED ARTICLES:
The Unraveling of MF Global
by Aaron Lucchetti and Mike Spector
Dec 31, 2011
Page: B1
"Top MF Global Witness Talks Deal With Justice," by: Aaron
Lucchetti, Michael Rothfeld and Mike Spector, The Wall Street
Journal, March 28, 2012 ---
http://online.wsj.com/article/SB10001424052702303816504577307502611998054.html?mod=djem_jiewr_AC_domainid
The star witness in a congressional
hearing about MF Global Holdings Ltd.'s collapse has told
Justice Department representatives through her lawyers details
about transactions that ended up dipping into customer funds,
people familiar with the matter said.
But Edith O'Brien, the assistant
treasurer at MF Global, isn't expected to reveal those details
when she appears at Wednesday's hearing of the House Financial
Services Committee's oversight and investigations subcommittee.
Ms. O'Brien plans to invoke her constitutional right against
self-incrimination and to decline to answer questions, people
familiar with the matter said.
Ms. O'Brien, 46 years old, who has been
working for an MF Global bankruptcy trustee, wasn't expected as
of Tuesday afternoon to give a statement, but members of the
subcommittee will still direct questions to her, a person
familiar with the matter said. After the hearing, she is
planning to depart Washington for a family vacation, another
person familiar with the matter said.
In recent months, lawyers for Ms.
O'Brien offered a so-called proffer at a meeting in New York as
part of an effort to negotiate immunity from prosecution in
exchange for her cooperation with federal investigators, one of
the people said.
In a proffer, a person under
investigation tells the government how he or she would testify
in exchange for immunity, nonprosecution or leniency at
sentencing. Normally, if the talks break down the government
can't use information it didn't already know in a subsequent
prosecution.
Enlarge Image mfglobal0208 mfglobal0208
Mario Tama/Getty Images
Edith O'Brien's name was first brought
into the spotlight in December, when former MF Global chief Jon
Corzine testified before Congress that Ms. O'Brien was the
back-office official who provided him assurances that a $175
million transfer to an MF Global account in London was proper..
It is unclear what Ms. O'Brien's
attorneys discussed with federal officials and it is unlikely
that congressional officials will be able to unearth details
about the conversations.
A different MF Global official is
expected to testify Wednesday that she had concerns about
apparent shortfalls in the buffer of firm money meant to protect
customer accounts just before the firm's Oct. 31 bankruptcy
filing. Customer funds aren't supposed to be touched under
federal regulations.
A big part of the MF Global
investigation centers on exactly what Ms. O'Brien knew. Because
MF Global customer accounts dropped into a deficit in the days
before the bankruptcy filing, investigators have scrutinized
movements of customer money and the state of mind of officials
who ordered money to be moved to meet margin calls and other
needs as the firm tried to stay solvent.
Ms. O'Brien's name was first brought
into the spotlight in December, when former MF Global chief Jon
Corzine testified before Congress that Ms. O'Brien was the
back-office official who provided him assurances that a $175
million transfer to an MF Global account in London was proper.
She later declined to sign a document certifying that it indeed
followed the rules, and later, it was discovered that the money
had come ultimately from the firm's customer account.
The second MF Global official,
Christine Serwinski, said in her statement that she had concerns
about the company's handling of customer money on Oct. 27, four
days before the firm collapsed and more than $1 billion went
missing from customer accounts.
Ms. Serwinski, chief financial officer
of MF Global's North America unit, said in remarks posted on a
congressional website Tuesday morning that she was "not
comfortable with the firm putting customer funds at risk," when
she had learned that one metric for the company's financial
health had "showed a substantial deficit" for Wednesday, Oct.
26.
MF Global officials who have testified
and discussed the shortfall in customer money previously have
said they didn't know the shortfall had developed until late on
Oct. 30, four days after a bankruptcy trustee later said it had
started growing.
Ms. Serwinski, who like Ms. O'Brien was
based in Chicago, added in her testimony that she was told that
the "firm had borrowed money" from its futures unit, where some
customer money was held, "on an intraday basis and had missed
the wire deadline to pay it back."
Checking in by email and telephone from
a planned vacation, Ms. Serwinski said she was "assured that the
matter was under control and being addressed and that the funds
would be returned on Thursday," Oct. 27.
Ms. Serwinski decided to cut her
vacation short, returning from a ballroom-dancing competition in
Las Vegas on Sunday, Oct. 30.
"I was not alarmed, but I believed it
would be better to return early" to the office, she said in her
statement.
When she returned that Sunday evening,
Ms. O'Brien and others at the company were investigating an
apparent shortfall in customer funds that was at the time blamed
on an error in reconciling accounts.
The witnesses at the hearing will also
include MF Global General Counsel Laurie Ferber and Chief
Financial Officer Henri Steenkamp, who may face questions about
another MF Global trustee's plan to pay performance bonuses.
Continued in article
Bob Jensen's threads on MF Global are at
http://faculty.trinity.edu/rjensen/Fraud001.htm
Conduct a word search for "MF Global"
The above search will lead to two additional teaching cases on
the MF Global Scandal
Bob Jensen's Fraud Updates are at
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
Bob Jensen's threads on derivatives scandals ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
2012
LIBOR ---
http://en.wikipedia.org/wiki/Libor
This is Crime, Not Capitalism
"Wall Street con trick," by Ellen Brown, Asia Times,
March 24, 2012 ---
http://www.atimes.com/atimes/Global_Economy/NC24Dj05.html
"Far from reducing risk, derivatives
increase risk, often with catastrophic results." -
Derivatives expert Satyajit Das, Extreme Money (2011)
*****************
Jensen Comment
Derivatives are great contracts to manage risk if their markets
are efficient, fair, and transparent.
They don't reduce risk in most instances because it's
impossible in hedging to reduce risk in most instances.
Rather hedging entails shifting risk. For example, a company
that has cash flow risk due to variable interest rate debt can
hedge that cash flow risk. However, elimination of cash flow
risk creates fair value risk. The issue is not one of
reducing risk. Rather it is a shift in risk preferences.
******************
The "toxic culture of greed" on Wall
Street was highlighted again last week, when Greg Smith went
public with his resignation from Goldman Sachs in a scathing
oped published in the New York Times. In other recent
eyebrow-raisers, London Interbank Offered Rates (or LIBOR) - the
benchmark interest rates involved in interest rate swaps - were
shown to be manipulated by the banks that would have to pay up;
and the objectivity of the International
Swaps and Derivatives Association was
called into question, when a 50% haircut for creditors was not
declared a "default" requiring counterparties to pay on credit
default swaps on Greek sovereign debt.
Interest rate swaps are less often in the news than credit
default swaps, but they are far more important in terms of
revenue, composing fully 82% of the derivatives trade. In
February, JP Morgan Chase revealed that it had cleared US$1.4
billion in revenue on trading interest rate swaps in 2011,
making them one of the bank's biggest sources of profit.
According to the Bank for International Settlements:
[I]nterest rate swaps are the largest
component of the global OTC derivative market. The notional
amount outstanding as of June 2009 in OTC [over-the-counter]
interest rate swaps was $342 trillion, up from $310 trillion
in Dec 2007. The gross market value was $13.9 trillion in
June 2009, up from $6.2 trillion in Dec 2007.
For more than a decade, banks and
insurance companies convinced local governments, hospitals,
universities and other non-profits that interest rate swaps
would lower interest rates on bonds sold for public projects
such as roads, bridges and schools. The swaps were entered into
to insure against a rise in interest rates; but instead,
interest rates fell to historically low levels.
This was not a flood, earthquake, or other insurable risk due to
environmental unknowns or "acts of God". It was a deliberate,
manipulated move by the Federal Reserve, acting to save the
banks from their own folly in precipitating the credit crisis of
2008. The banks got into trouble, and the Federal Reserve and
federal government rushed in to bail them out, rewarding them
for their misdeeds at the expense of the taxpayers.
How the swaps were supposed to work was explained by Michael
McDonald in a November 2010 Bloomberg article titled "Wall
Street Collects $4 Billion From Taxpayers as Swaps Backfire":
In an interest-rate swap, two parties
exchange payments on an agreed-upon amount of principal.
Most of the swaps Wall Street sold in the municipal market
required borrowers to issue long-term securities with
interest rates that changed every week or month. The
borrowers would then exchange payments, leaving them paying
a fixed-rate to a bank or insurance company and receiving a
variable rate in return. Sometimes borrowers got lump sums
for entering agreements.
Banks and borrowers were supposed to be
paying equal rates: the fat years would balance out the lean.
But the Fed artificially manipulated the rates to the save the
banks.
After the credit crisis broke out, borrowers had to continue
selling adjustable-rate securities at auction under the deals.
Auction interest rates soared when bond insurers' ratings were
downgraded because of subprime mortgage losses; but the periodic
payments that banks made to borrowers as part of the swaps
plunged because they were linked to benchmarks such as Federal
Reserve lending rates, which were slashed to almost zero.
Continued in article
Bob Jensen's fraud updates ---
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
Bob Jensen's tutorials on derivative financial instruments ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
2012
"The LIBOR Mess: How Did It Happen -- and What Lies Ahead?"
Knowledge@Wharton, July 18, 2012 ---
http://knowledge.wharton.upenn.edu/article.cfm?articleid=3056
Finance Professor Jim Mahar says Barclays really should be
removing these advertisements as soon as possible.
Barclays ---
http://en.wikipedia.org/wiki/Barclays#Rate-fixing_scandal
Rate-fixing scandal
In June 2012, as a result of an international investigation,
Barclays Bank was fined a total of Ł290 million (US$450 million)
for attempting to manipulate the daily settings of London
Interbank Offered Rate (Libor)
and the Euro Interbank Offered Rate (Euribor).
The United States Department of Justice and Barclays officially
agreed that "the manipulation of the submissions affected the
fixed rates on some occasions".[94]
The bank was found to have made 'inappropriate submissions' of
rates which formed part of the Libor and Euribor setting
processes, sometimes to make a profit, and other times to make
the bank look more secure during the financial crisis.[95]
This happened between 2005 and 2009, as often as daily.[96]
The
BBC said revelations concerning the fraud were "greeted with
almost universal astonishment in the banking industry."[97]
The UK's
Financial Services Authority (FSA), which levied a fine of
Ł59.5 million ($92.7 million), gave Barclays the biggest fine it
had ever imposed in its history.[96]
The FSA's director of enforcement described Barclays' behaviour
as "completely unacceptable", adding "Libor is an incredibly
important benchmark reference rate, and it is relied on for
many, many hundreds of thousands of contracts all over the
world."[95]
The bank's chief executive
Bob Diamond decided to give up his bonus as a result of the
fine.[98]
Liberal Democrat politician
Lord Oakeshott criticised Diamond, saying: "If he had any
shame he would go. If the Barclays board has any backbone,
they'll sack him."[95]
The U.S. Department of Justice has also been involved, with
"other financial institutions and individuals" under
investigation.[95]
On 2 July 2012, Marcus Agius resigned from the chairman position
following the interest rate rigging scandal.[99]
On 3 July 2012, Bob Diamond resigned with immediate effect,
leaving Marcus Agius to fill his post until a replacement is
found.[100]
LIBOR ---
http://en.wikipedia.org/wiki/Libor
"How Barclays Rigged the Machine," by Rana Foroohar, Time Magazine,
July 23, 2012 ---
http://www.time.com/time/subscriber/article/0,33009,2119318,00.html
Ever wonder why surveys about very personal topics
(think sex and money) are done anonymously? Of course you don't, because
it's obvious that people wouldn't tell the truth if they were identified on
the record. That's a key point in understanding the latest scandal to hit
the banking industry, which comes, as ever, with much hand-wringing,
assorted apologies and a crazy-sounding acronym--this time, LIBOR. That's
short for the London interbank offered rate, the interest rate that banks
charge one another to borrow money. On June 27, Britain's Barclays bank
admitted that it had deliberately understated that rate for years.
LIBOR is a measure of banks' trust in their
solvency. And around the time of the financial crisis of 2008, Barclays'
rate was rising. If a bank revealed publicly that it could borrow only at
elevated rates, it would essentially be admitting that it--and perhaps the
financial system as a whole--was vulnerable. So Barclays gamed the system to
make the financial picture prettier than it was. The charade was possible
because LIBOR is calculated not on the basis of documented lending
transactions but on the banks' own estimates, which can be whatever bankers
decree. This Kafkaesque system is overseen for bizarre historical reasons by
an association of British bankers rather than any government body.
The LIBOR scandal has already claimed Barclays'
brash American CEO, Bob Diamond, a man infamous for taking huge bonuses
while his company's share price and profit were declining. Diamond resigned,
but his head may not be the only one to roll. As many as 20 of the world's
largest banks are being sued or investigated for manipulating over the
course of many years the interest rate to which $350 trillion worth of
derivatives contracts are pegged. Bank of England and former
British-government officials accused of colluding with Barclays to stem a
financial panic may also be caught up in the mess.
What's surprising is that individual consumers may
actually have benefited, at least financially, from the collusion. Not only
the central reference point for derivatives markets, LIBOR is also the rate
to which all sorts of loans--variable mortgage rates, student loans, even
car payments--may be pegged. To the extent that banks kept LIBOR
artificially low, all those other loan rates were marked down too. Unlike
the JPMorgan trading fiasco of a few weeks ago, which has resulted in a
multibillion-dollar loss, the only apparent red ink so far in the LIBOR
scandal is the $450 million in fines that Barclays will pay to the U.K. and
U.S. governments for rigging rates (though pension funds and insurance
companies on the short end of LIBOR-pegged financial transactions may have
lost a lot of money).
Either way, the truth is that LIBOR is a much, much
bigger deal than what happened at JPMorgan. Rather than one screwed-up trade
that was--whether you like it or not (and I don't)--most likely legal, it
represents a financial system that is still, four years after the crisis
began, opaque, insular and dangerously underregulated. "This is a very, very
significant event," says Gary Gensler, chairman of the U.S. Commodity
Futures Trading Commission (CFTC), which is one of the regulators
investigating the scandal. "LIBOR is the mother of all financial indices,
and it's at the heart of the consumer-lending markets. There have been
winners and losers on both sides [of the LIBOR deals], but collectively we
all lose if the market isn't perceived to be honest."
Continued in article
"Sandy Weill Still Doesn't Have the Answer The
banker-government consortium re-exposed in the Libor scandal won't
be unwound from the top," by Holman W. Jenkins, Jr., The Wall
Street Journal, July 27, 2012 ---
http://professional.wsj.com/article/SB10000872396390443931404577552913658228058.html?mg=reno64-wsj#mod=djemEditorialPage_t
Sandy Weill was impressive as a
scrambler, a dealmaker, a man who could catch a wave. He's come
out of retirement now, a decade after creating the Citigroup
oligopolist, to catch a new wave, declaring on CNBC that
investment banking and commercial banking should be
re-separated.
He explains that bank bailouts and too
big to fail would no longer be necessary, without explaining
how, since both bank bailouts and too big to fail predated the
repeal of Glass-Steagall.
Mr. Weill finds himself suddenly
welcome in the company of editorialists who, since the Libor
scandal, have been renewing their clamor for bankers to be
imprisoned, if not executed. He's become their new hero.
The inherent Stalinism of those who
crave to put bankers in jail for things that aren't crimes is
not unlike that of the original Stalinist—who understood that
nothing of substance has to change if you've got enough
scapegoats. Likewise, Mr. Weill's proposal to restore Glass-Steagall
would also change nothing.
Even too big to fail is too small a
phrase. Do not interpret the following conspiratorially: The
total coalescence of the financial elite with the governing
elite in our and other countries is a natural pattern. It may be
corrupting. It may be counterproductive. But it's the natural
outcome of the giant, almost inconceivable amounts of debt the
U.S. and other governments ask the financial system to market
and hold on their behalf.
If you owe the bank $1 million, the
bank owns you. If you owe $1 billion, you own the bank. If you
owe several trillion, you are the financial system. Libor is
called a key underpinning of global finance. But that's far more
true of IOUs issued by the U.S. government and its major
counterparts. The global financial system is built on a mountain
of government debt, and in turn banks and their governments are
bedfellows of a highly incestuous order.
That's why, in every transcript and
phone memorandum that has come to light, in talking about Libor,
regulators and bankers talk to each other as if they were all
just bankers talking amongst themselves.
That's why, when a high British
official suggested that Barclays lowball its Libor submission
during the financial crisis, Barclays didn't hesitate because,
as one banker testified to the British Parliament, these were
government instructions "at a time when governments were
tangibly calling the shots."
It's ironic to think that some who
championed the euro saw it as way to break free of rule by
bankers. Europe's new monetary authority would be focused on a
producing a stable currency; Europe's national governments would
have no choice but to live within their means.
This experiment failed because the
European Central Bank quickly adopted policies designed to
induce banks not to distinguish between the debts of disciplined
and undisciplined governments. That is, the euro was immediately
corrupted by the need to help governments keep financing
themselves.
Now the world is Europe. Under the
current regime of financial repression, banks and states are
even more annexes of each other. Notice Japan's central bank
explicitly stating plans to erode the value of the government's
debt in the hands of Japanese savers. Notice the European
Central Bank again hinting at readiness to buy the debt of
countries no longer able to find voluntary buyers in the market.
In the U.S., how long before the Treasury issues a perpetual
bond yielding zero percent for direct sale to the Fed?
The banker-government consortium
re-exposed in the Libor scandal won't be unwound from the top,
not when governments are more dependent than ever on a captive
financial system to give their debt the illusion of viability.
And yet there's still a possibility of unwinding it from the
bottom, by giving large numbers of bankers an incentive to get
out of the government-insured sector and go back to a world in
which they live by their own profits and losses.
The solution begins with
deposit-insurance reform. The FDIC would stop insuring deposits
that are invested in anything other than U.S. Treasury paper.
The FDIC would be charged solely with seizing these assets when
a bank gets in trouble so the claims of insured depositors can
be satisfied. There'd be no call to bail out other creditors or
shareholders to minimize the cost to the deposit insurance fund.
Yes, the threat might be only
semi-credible. But such a law could be got through Congress and
risk-averse lenders would become less interested in holding
uninsured credit against banks that are too big to manage and
too opaque to be viable without a government backstop.
Continued in article
Bob Jensen's threads on banking frauds---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking
2012
View from the Left
"Barclays and the Limits of Financial Reform," by Alexander Cockburn,
The Nation, July 30, 2012 ---
http://www.thenation.com/article/168834/barclays-and-limits-financial-reform
"Execs to Cash In Despite Market Woes: Even companies whose
investors received a negative return this year expect to fund at least
100% of formula-based annual bonus plans," David McCann, CFO.com,
December 9, 2011 ---
http://www3.cfo.com/article/2011/12/compensation_executive-bonus-larre-towers-watson-
Are companies in denial when it comes to
executives' annual bonuses for 2011? Judge for yourself.
Among 265 companies that participated in a
newly released Towers Watson survey, 42% said their shareholders'
total returns were lower this year than in 2010. No surprise there,
given the stock markets' flat performance in 2011.
Yet among those that reported declining
shareholder value, a majority (54%) said they expected their bonus
plan to be at least 100% funded, based on the plan's funding
formula. That wasn't much behind the 58% of all companies that
expected full or greater funding (see chart).
"It boggles the mind. How do you articulate
that to your investors?" asks Eric Larre, consulting director and
senior executive pay consultant at Towers Watson. Noting that stocks
performed excellently in 2010 while corporate earnings stagnated —
the opposite of what has happened this year — he adds, "How are you
going to say to them, 'We made more money than we did last year, but
you didn't'?"
In particular, companies would have to
convincingly explain that annual bonus plans are intended to
motivate executives to achieve targets for short-term, internal
financial metrics such as EBITDA, operating margin, or earnings per
share, and that long-term incentive programs — which generally rest
on stock-option or restricted-stock awards, giving executives, like
investors, an ownership stake in the company — are more germane to
investors.
But such arguments may hold little sway
with the average investor, who "doesn't bifurcate compensation that
discretely," says Larre. Rather, investors simply look at the pay
packages as displayed in the proxy statement to see how much top
executives were paid overall, and at how the stock performed.
Larre attributes much of the current,
seeming generosity to executives to complacence within corporate
boards. This year, the first in which public companies were required
to give shareholders an advisory ("say on pay") vote on
executive-compensation plans, 89% received a thumbs-up. But that
came on the heels of 2010, when the S&P 500 gained some 13% and
investors were relatively content with their returns. "They may not
be as content now," Larre observes. "I think the number of 'no'
say-on-pay votes will be larger during the 2012 proxy season."
Continued in article
Compounding the Felony
"Libor problems haven't been fixed, regulators say," by Ben Protess and
Mark Scott, The New York Times, July 17, 2012 ---
http://dealbook.nytimes.com/2012/07/17/after-barclays-scandal-regulators-say-rates-remain-flawed/?ref=business
Federal authorities cast further doubt on Tuesday
about the integrity of a key interest rate that is the subject of a growing
investigation into wrongdoing at big banks around the globe.
In Congressional testimony, the chairman of the
Federal Reserve and the head of the Commodity Futures Trading Commission
expressed concern that banks had manipulated interest rates for their own
gain. They also indicated that flaws in the system — which were highlighted
in a recent enforcement case against Barclays — persist.
“If these key benchmarks are not based on honest
submissions, we all lose,” Gary Gensler, head of the trading commission,
which led the investigation into Barclays, said in testimony before the
Senate Agriculture Committee.
In separate testimony before the Senate Banking
Committee, Ben S. Bernanke, the Federal Reserve chairman, said he lacked
“full confidence” in the accuracy of the rate-setting process.
The Fed faces questions itself over whether it
should have reined in the rate-manipulation scheme, which took place from at
least 2005 to 2010.
Documents released last week show that the New York
Fed was well aware of potential problems at Barclays in 2008. At a hearing
in London on Tuesday, British authorities said the New York Fed never told
them Barclays was breaking the law.
Continued in article
Bob Jensen's threads on interest rate swaps and LIBOR ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Search for LIBOR or swap.
Timeline of Financial Scandals, Auditing
Failures, and the Evolution of International Accounting Standards ----
http://faculty.trinity.edu/rjensen/FraudCongress.htm#DerivativesFrauds
Timeline of Financial Scandals, Auditing Failures, and the Evolution of
International Accounting Standards ----
http://faculty.trinity.edu/rjensen/FraudCongress.htm#DerivativesFrauds
(to view on a new page)
Bob Jensen's threads on corporate governance are at
http://faculty.trinity.edu/rjensen/fraud001.htm#Governance
Timeline of Financial Scandals, Auditing
Failures, and the Evolution of International Accounting Standards ----
http://faculty.trinity.edu/rjensen/FraudCongress.htm#DerivativesFrauds
Timeline of Financial Scandals, Auditing Failures, and the
Evolution of International Accounting Standards ----
http://faculty.trinity.edu/rjensen/FraudCongress.htm#DerivativesFrauds
(to view on a new page)
2012
Teaching Case from The Wall Street Journal Accounting Weekly
Review on September 20, 2012
Trial Puts UBS in Spotlight
by: Dana Cimilluca
Sep 15, 2012
Click here to view the full article on WSJ.com
Click here to view the video on WSJ.com ![WSJ Video]()
TOPICS: Internal Controls, Management Controls
SUMMARY: The trial against former UBS trader
Kweku Adoboli began on Monday. "The U.K. prosecutors opened
their case...by casting the 32-year-old as the lone perpetrator
of an illegal scheme that shook the Swiss bank last year." The
related video comments on the reputational impact of the $2.3
billion trading loss generated by one "desk" being indicative of
insufficient internal controls. "Mr. Adoboli sat on a desk
trading exchange traded funds...his fraudulent activity began in
2008 when he suffered a $400,000 loss on a legitimate trade and
subsequently booked a false trade to hide it."
CLASSROOM APPLICATION: The article may be used
to discuss internal control and material weaknesses, fraudulent
accounting and reporting, and ethics.
QUESTIONS:
1. (Introductory) For how long did Mr. Kweku Adoboli
book false trades to cover losses he did not want exposed? What
was his apparent reason for these actions?
2. (Introductory) How was Mr. Adoboli able to avoid
detection of his false accounting? In your answer, define the
term "umbrella" account.
3. (Advanced) Identify one internal control that should
catch false entries such as those made by Mr. Adoboli.
4. (Advanced) What was the impact on the UBS AG stock
price when the scandal about Mr. Adoboli broke in 2011? Does
this reaction merely reflect the losses incurred by Mr. Adoboli
or something more? Explain.
Reviewed By: Judy Beckman, University of Rhode Island
RELATED ARTICLES:
UBS: Rogue Trader Hit Firm
by Deborah Ball, Paul Sonne and Carrick Mollenkamp
Sep 16, 2011
Page: A1
"Trial Puts UBS in Spotlight," by Dana Cimilluca, The Wall
Street Journal, September 15, 2012 ---
http://professional.wsj.com/article/SB10000872396390444023704577651410986775918.html?mod=djem_jiewr_AC_domainid&mg=reno-wsj
U.K. prosecutors opened their case in
the trial of Kweku Adoboli, the former UBS AG trader accused of
a $2.3 billion fraud, by casting the 32-year-old as the lone
perpetrator of an illegal scheme that shook the Swiss bank last
year.
One year to the day after the scandal
began to erupt, Mr. Adoboli sat in a packed London courtroom as
Sasha Wass of the Crown Prosecution Service depicted him as a
reckless and greedy fraudster bent on boosting "his bonus, his
status, his job prospects and his ego."
The defense didn't provide any
indication of its arguments in court, but Ms. Wass said Mr.
Adoboli will claim that three of his colleagues on his trading
desk were aware of his illegal activity before it surfaced.
Mr. Adoboli, who faces two counts each
of false accounting and fraud, has pleaded not guilty. If
convicted, he faces up to 10 years in jail on each fraud charge
and seven years on each accounting charge. He is currently free
on bail.
For UBS, the trial could shed an
uncomfortable light on how a relatively junior trader could have
caused the largest unauthorized trading loss in U.K. history,
despite the giant bank's sophisticated risk controls.
The case comes on the heels of a series
of scandals across the financial sector that have inflamed
public opinion, particularly in Europe.
Beginning in 2006, Mr. Adoboli sat on a
desk at UBS focused on trading exchange-traded funds, which are
mutual-fund-like investments, often tied to well-known indexes
like the Standard & Poor's 500-share index, but which trade on
exchanges throughout the day. According to prosecutors, Mr.
Adoboli's fraudulent activity began in 2008, when he suffered a
$400,000 loss on a legitimate trade, and subsequently booked a
false trade to hide it.
He was able to hide his unauthorized
trades for years, using hundreds or thousands of fake accounting
entries and so-called "umbrella" accounts where he stowed funds,
until market turmoil last summer caused his losses to balloon
and ultimately tripped internal compliance alarms, according to
the picture painted by the prosecution.
The unauthorized trades eventually cost
the bank $2.3 billion.
The contours of the positions that the
prosecution and defense will likely stake out in the eight-week
trial began to come into focus on the first day of the
proceedings. The prosecution will begin calling witnesses on
Monday, starting with an expert on bank trading.
Ms. Wass, the prosecutor, argued that
Mr. Adoboli acted alone, apparently trying to pre-empt an
argument that others knew of his illegal actions.
She repeatedly read from a lengthy
email Mr. Adoboli allegedly sent to colleagues on Sept. 14,
2011, the day before UBS disclosed the unauthorized trading
loss. In that email, he allegedly said: "It is with great stress
that I write this mail. First of all the ETF trades that you see
on the ledger are not trades that I have done with a
counterparty as I previously described."
The prosecution played recordings of
conversations between Mr. Adoboli and colleagues who quizzed him
on his trades in August and September of last year, in which the
former trader attempts to explain them.
Mr. Adoboli, dressed in a grey suit,
white shirt and maroon patterned tie, sat impassively as Ms.
Wass laid out the prosecution's case, at times playing with a
pen and at others conferring with his lawyer.
The prosecution depicted an ambitious
young banker who started out in UBS's so-called "back office"
processing trades, and later moved to the more lucrative and
prestigious trading floor, using knowledge he gained from his
prior job to obfuscate his alleged illegal activity. He went
from earning Ł40,500 ($65,788) in salary and bonus in 2005 to
Ł360,000 in 2010, which included a Ł250,000 bonus that
prosecutors said was boosted by his illegally inflated results.
"Like most gamblers, he believed he had
the magic touch. Like most gamblers, when he lost, he caused
chaos and disaster to himself and all of those around him," Ms.
Wass said.
The trading loss proved devastating for
UBS. The bank was already under pressure because of a massive
credit loss it suffered at the height of the financial crisis
that resulted in the need for government aid as well as from
persistently weak business conditions in the securities industry
since then.
The scandal initially knocked 10% off
the bank's already beleaguered stock, ate into its bonus pool
and forced the resignation of its chief executive, Oswald Grübel.
Continued in article
"Ex-UBS Trader Kweku Adoboli’s E-Mail to Accountant: Full Text," by
Edward Robinson, Bloomberg, September 14, 2012 ---
http://www.bloomberg.com/news/2012-09-14/ex-ubs-trader-kweku-adoboli-s-e-mail-to-accountant-full-text.html
Below is the text of an e-mail former UBS AG (UBSN)
trader Kweku Adoboli sent to bank accountant William Steward on Sept. 14,
2011, describing how he accrued trading losses.
The e-mail was read out by prosecutor Sasha Wass at
Adoboli’s fraud trial in London today.
The subject line for the e-mail, sent from
Adoboli’s home e-mail account, was: “An explanation of my trades.”
Dear Will,
It is with great stress that I write this mail.
First of all the ETF (Exchange Traded Funds) trades that you see on the
ledger are not trades that I have done with a counterparty as I
previously described.
I used the bookings as a way to suppress the
PnL losses that I have accrued through off-book trades that I made.
Those trades were previously profit making, became loss making as the
market sold off aggressively though the aggressive sell-off days of July
and early August.
Initially, I had been short futures through
June and those lost money when the first Greek confidence vote went
through in mid-June. In order to try and make the money back I flipped
the trade long through the rally.
Although I had a couple of opportunities to
unwind the long trade for a negligible loss, I did not move quickly
enough for the market weakness on the back of the first back macro data
and then an escalation Eurozone crisis cost me the losses you will see
when the ETF bookings are cancelled. The aim had been to try and make
the money back before the September expiry date came through but I
clearly failed.
These are still live trades on the book that
will need to be unwound. Namely a short position in DAX futures [which
had been rolled to December expiry] and a short position in S and P 500
futures that are due to expire on Friday.
I have now left the office for the sake of
discretion. I will need to come back in to discuss the positions and
explain face to face, but for reasons that are obvious, I did not think
it wise to stay on the desk this afternoon.
I will expect that questions will be asked as
to why nobody else was aware of these trades. The reality is that I have
always maintained that these were EFP trades to the member of my team,
BUC, trade support and John Di Bacco (Adoboli’s manager).
I take full responsibility for my actions and
the stilt storm that will now ensue. I am deeply sorry to have left this
mess for everyone and to have put my bank and my colleagues at risk.
Thanks,
Kweku.
Jensen Comment
Derivatives trading is not a St. Petersburg Paradox Game ---
http://en.wikipedia.org/wiki/St._Petersburg_paradox
2012
LIBOR ---
http://en.wikipedia.org/wiki/Libor
Interest Rate Swap ---
http://en.wikipedia.org/wiki/Interest_Rate_Swap
How to Value and Interest Rate Swap ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133swapvalue.htm
"Rigged Libor Hits States-Localities With $6 Billion: Muni
Credit," by Darrell Preston, Bloomberg News, October 9,
2012 ---
http://www.bloomberg.com/news/2012-10-09/rigged-libor-hits-states-localities-with-6-billion-muni-credit.html
The Libor bid-rigging scandal is poised
to more than double the losses suffered by U.S. states and
localities that bought $500 billion in
interest-rate swaps before the
financial crisis.
Manipulation of the London interbank
offered rate cost issuers in the $3.7 trillion municipal-bond
market at least $6 billion, according
Peter Shapiro,
managing director of Swap Financial Group in South Orange,
New Jersey. Shapiro, a muni adviser
for more than 20 years, specializes in the contracts.
Any taxpayer losses on derivative deals
linked to Libor would add to at least $4 billion in payments
that localities have already made to unwind backfiring
interest-rate swaps sold by Wall Street banks as hedges to cut
borrowing costs, data compiled by Bloomberg show.
“This number shows that banks can’t be
trusted in this market,” said Marcus Stanley, policy director
for Americans for Financial Reform, a Washington group that has
pushed for stronger regulation of lenders. “Municipalities would
be the group most likely victimized by the abuse of Libor.”
Issuers from
New York to
California have entered swap
agreements, which are bets on the direction of
interest rates. They attempted to
lower borrowing costs while guarding against increasing rates by
exchanging variable-rate loans for fixed ones. The strategy went
awry when the
Federal Reserve lowered its
benchmark rate almost to zero to
counter the 18-month recession that began in December 2007.
$500 Billion
Banks sold as much as $500 billion of
swaps to municipalities before the credit crisis, according to a
report by Randall Dodd, a researcher
on the U.S. Financial Crisis Inquiry Commission. Shapiro based
his calculation of losses on his estimate that $200 billion of
the derivatives were tied to Libor and that banks suppressed the
rate by 0.30 percentage points for three years.
Some U.S. municipal interest-rate swap
payments were tied to Libor, the basis for more than $300
trillion in securities and loans worldwide, which is supposed to
represent what banks pay each other for short-term loans. While
traders have said for years that the benchmark was rigged, the
suspicions were confirmed in June when
Barclays Plc (BARC), Britain’s
second-biggest lender by assets, paid a record 290 million-pound
($468 million) fine for manipulating the rate.
Raised Cost
Three-month dollar Libor, the most
commonly used of the rates overseen by the British Bankers’
Association, was at 0.35025 percent yesterday, down from 0.58250
percent at the start of the year.
In the
derivatives market, setting Libor too
low raised what issuers had to pay to their swap counterparties.
That drove up their costs and boosted the price of ending the
arrangements.
Libor losses may spawn “a wave of
lawsuits,” said
Michael Greenberger, who studies
derivatives at the University of
Maryland’s law school in Baltimore. He
said civil complaints, settlements with more banks, and,
possibly, criminal indictments lie ahead.
“Libor was a bid-rigged rate,” said
Greenberger. “Almost all interest-rate swaps begin with Libor.”
Five-State Probe
Since the Barclays settlement,
governments around the U.S. have started their own probes,
including attorneys general of at least five states, including
Florida and Connecticut. Jaclyn Falkowski, spokeswoman for
Connecticut Attorney General George Jepsen, and Jennifer Meale,
spokeswoman for Florida Attorney General
Pam Bondi, each confirmed the
investigations. They declined to comment further.
“I have a board and they want to know
what Libor is doing to us,” Brian Mayhew, chief financial
officer of the San Francisco Bay area’s Metropolitan
Transportation Commission, which finances roads and bridges,
said in an interview.
The Libor investigations have
implications for states and cities that are still contending
with the fiscal legacy of the recession, which left them
grappling with falling tax revenue and rising costs. States have
had to deal with combined deficits of more than $500 billion
since fiscal 2009, according to the Washington-based Center on
Budget & Policy Priorities.
Baltimore, Maryland, and the New
Britain Firefighters’ Benefit Fund, a pension for workers in the
Connecticut city, had already sued
more than a dozen banks before the Barclays settlement, alleging
Libor was artificially suppressed as part of a conspiracy.
Rates Diverge
Baltimore claimed that Libor’s
divergence from its historical correlation to overnight swaps
showed manipulation. Since the financial crisis, the spread
between three-month Libor and three-month swap rates has
increased by 95 percent, data compiled by Bloomberg show.
Hilary Scherrer, a lawyer for the
plaintiffs at Washington- based Hausfeld LLP, didn’t return a
phone call seeking comment.
North Carolina is among states waiting
for findings from federal investigations into the abuse of
Libor, Treasurer Janet Cowell said in a Sept. 28 interview on
Bloomberg Television.
“We don’t know what the manipulation
was at this point,” Cowell said. “It’s a lot of analytics and
data collection.”
Because each swap is unique in its
pricing and structure, it is possible that not all issuers were
harmed by the Libor rigging.
Libor Theory
“There’s a theory that the Libor
manipulation lowered the interest rate we got paid on our
swaps,” said Mayhew. “But the inverse of that is it also then
lowered what we were paying on the variable-rate debt.”
Mayhew said he doesn’t expect a quick
resolution.
“This is one of those things that won’t
be solved in court, it won’t be solved by lawsuits,” said
Mayhew. “This is going to be a global settlement where whoever
is guilty of whatever gets in a room, makes a global settlement,
and then that’s it.”
In muni trading last week, the
yield on 10-year munis rated AAA
dropped about 0.07 percentage point to 1.65 percent, data
compiled by Bloomberg show. The index touched 1.63 percent on
July 27, the lowest since at least January 2009, when data
collection began. The U.S. bond market was closed yesterday for
the Columbus Day holiday.
Following are pending sales:
Continued in article
Bob Jensen's Fraud Updates ---
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
2013
Bigger Than Enron
"Libor Lies Revealed in Rigging of $300 Trillion Benchmark," by Liam
Vaughan & Gavin Finch, Bloomberg News, January 28, 2013 ---
http://www.bloomberg.com/news/2013-01-28/libor-lies-revealed-in-rigging-of-300-trillion-benchmark.html
"The LIBOR Mess: How Did It Happen -- and What Lies Ahead?"
Knowledge@Wharton, July 18, 2012 ---
http://knowledge.wharton.upenn.edu/article.cfm?articleid=3056
"Lies, Damn Lies and Libor: Call it one more improvisation in 'too
big to fail' crisis management," by Holman W. Jenkins Jr., The Wall
Street Journal, July 6, 2012 ---
http://professional.wsj.com/article/SB10001424052702304141204577510490732163260.html?mod=djemEditorialPage_t&mg=reno64-wsj
Jensen Comment
Crime Pays: The good news for banksters is that they rarely, rarely,
rarely get sent to prison ---
http://faculty.trinity.edu/rjensen/FraudConclusion.htm#CrimePays
2013
Interest-Rate Swaps Scream "Buyer Beware"
The Financial Services Authority found that some U.K. banks misled
corporate customers in the sales of interest-rate swaps, but the
problem is not confined to one country.
by Vincent Ryan
CFO.com, February 1, 2013
http://www3.cfo.com/article/2013/2/credit_interest-rate-swaps-fsa-otc-overhedging-break-cost-cftc-sec
Jensen Comment
FAS 133 and IAS 39 generally assume that interest rate swaps have no
front-end costs or coercion. That appears to be no longer the case.
Banks have such a penchant for ruining good things.
Anti-Fraud Collaboration Launches Website with Access to Anti-Fraud Tools
Center for Audit Quality
January 24, 2013
News Release ---
http://www.thecaq.org/newsroom/release_01242013.htm
Anti-Fraud Collaboration Site ---
http://www.antifraudcollaboration.org/
Bob Jensen's threads on fraud ---
http://faculty.trinity.edu/rjensen/Fraud.htm
2013
Dilbert Cartoons on Market Manipulations
"Scott Adams Discovers Market Manipulation," by Barry
Ritholtz, Ritholtz Blog, March 2013 ---
http://www.ritholtz.com/blog/2013/03/scott-adams-manipulators/
Regular readers know I am a fan of
Scott Adams, creator of the comic
Dilbert
and occasional commentator on a variety of
matters.
He has a somewhat odd blog post up,
titled,
Here Come the Market Manipulators.
In it, he makes two interesting
suggestions: The first is to decry “market manipulators,” who do
what they do for fun and profit to the detriment of the rest of
us. The second is to say that these manipulators are likely to
cause “a 20% correction in 2013.”
Let’s quickly address both of these
issues: First off, have a look at the frequency of 20%
corrections in markets. According to
Fidelity
(citing research from Capital Research and Management Company),
over the period encompassing 1900-2010, has seen the following
corrections occur:
Corrections During
1900 – 2010
5%: 3 times per year
10%: Once per year
20%: Once every 3.5 years
Note that Fido does not specify which
market, but given the dates we can assume it is the Dow
Industrials. (I’ll check on that later).
Note that US market’s have not had a
20% correction since the lows in March 2009. I’ll pull up the
relevant data in the office, but a prior corrective action of
19% is the closest we’ve come, followed by a ~16% and ~11%.
As to the manipulators of the market, I
can only say: Dude, where have you been the past 100 years
or so?
Yes, the market gets manipulated.
Whether its tax cuts or interest rate cuts or federal spending
or wars or QE or legislative rule changes to FASB or even the
creation of IRAs and 401ks, manipulation abounds.
In terms of the larger investors who
attract followers — I do not see the same evidence that Adams
sees. Sure, the market is often driven by large investors. Yes,
many of these people have others who follow them. We need only
look at what Buffet, Soros, Dalio, Icahn, Ackman, Einhorn and
others have done to see widely imitated stock trades. But that
has shown itself to be a
bad idea, and I doubt anyone
is making much money attempting to do so. And, it hardly leads
to the conclusion that any more than the usual manipulation is
going on.
Will be have a 20% correction? I
guarantee that eventually, we will. Indeed, we are even overdue
for it, postponed as it is by the Fed’s manipulation.
But I have strong doubts it is going to
be caused by a cabal manipulating markets for fun & profit. It
will occur because
that’s what markets do . . .
Previously:
Dilbert’s Unified Theory of Everything Financial’ (October
15th, 2006)
7 Suggestions for Scott Adams (November 27th, 2007)
Don’t Follow Wealthy Investors, Part 14 (February 17th,
2008)
"What’s Wrong with the Financial Services Industry?" by Barry Ritholtz,
Ritholtz Blog, February 21, 2013 ---
http://www.ritholtz.com/blog/2013/02/whats-wrong-with-the-financial-services-industry/
Jensen Comment
You can also see a Dilbert cartoon about making up data ---
http://faculty.trinity.edu/rjensen/Theory01.htm
Bob Jensen's Rotten to the Core threads ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm
2013
"Ex-Goldman Trader Pleads Guilty to Fraud," by Chad Bray
and Justin Baer, The Wall Street Journal, April 3, 2013 ---
http://online.wsj.com/article/SB10001424127887324600704578400332210938670.html
In late 2007, with a seven-figure bonus
and his reputation at Goldman Sachs Group Inc. GS -2.28% on the
line, Matthew Taylor placed an $8.3 billion futures bet and hid
it from his bosses. Now, he faces a possible long prison
sentence.
On Wednesday, Mr. Taylor pleaded guilty
to a single count of wire fraud for concealing the trades, which
cost Goldman $118.4 million to unwind. He told a federal judge
he made the big bets to boost his reputation and bonus at the
bank.
"I accumulated this trading position
and concealed it for the purpose of augmenting my reputation at
Goldman and increasing my performance-based compensation," Mr.
Taylor said at a hearing in Manhattan federal court on
Wednesday. "I am truly sorry for my actions." Related
U.S. Attorney's Case Against Taylor
Plea Agreement CFTC Complaint Against Trader Taylor's Response
to CFTC Complaint Ex-Trader's Gambit Bites Goldman CFTC Charges
Trader With Concealing $8.3 Billion Trade
Prosecutors recommended a
sentencing-guidelines range of two years and nine months to
three years and five months in prison. The range was based in
part on Mr. Taylor's compensation for 2007—$150,000 in salary
and an expected $1.6 million bonus—rather than the loss suffered
by Goldman.
But the judge in the case sent a signal
that the ex-trader might face an even stiffer sentence. U.S.
District Judge William Pauley III questioned why prosecutors, in
negotiating a plea agreement, didn't seek a longer potential
sentence. "He cooked the books," the judge said.
Sentencing is set for July 26.
Wednesday's plea is the latest twist in
the case of a young trader whose career went off track in the
final days of 2007, just as the securities industry was bracing
for the looming crisis.
It also comes as time is running out
for prosecutors and regulators to bring actions related to the
events that occurred in the months leading up to and during the
downturn.
Mr. Taylor attended high school in
suburban Boston, where his guidance counselor, Adelaide Greco,
remembers him as the class valedictorian once named "most likely
to succeed." While enrolled at the Massachusetts Institute of
Technology, he returned to his high school to talk to students
about achieving one's dreams, Ms. Greco said. "Kids looked up to
him," she said.
From MIT, Mr. Taylor headed to Wall
Street. He worked for Morgan Stanley MS -2.72% from 2001 until
2005, then landed at Goldman.
By November 2007, Mr. Taylor was an
equity-derivatives trader on Goldman's Capital Structure
Franchise Trading desk and had lost a "significant portion" of
the trading profits he had accumulated earlier that year,
according to criminal charging documents filed by prosecutors
Wednesday.
Because of his lost profits and the
general market conditions, his supervisors ordered him to rein
in the risks he was taking. By December, they had told him his
annual bonus would decline "significantly," according to the
document.
In mid-December, Mr. Taylor ratcheted
up the size of his bet on electronic futures contracts tied to
the Standard & Poor's 500-Stock Index, accumulating a position
with a face value of $8.3 billion.
That figure, court records show,
exceeded the risk limits for his entire desk at Goldman, a group
of about 10 traders.
At the same time, Mr. Taylor also made
false trade entries that appeared to take the opposite side of
that bet. The purpose, according to court records: "to conceal
and understate the true size" of his long position on so-called
S&P 500 E-mini futures.
Goldman fired Mr. Taylor on Dec. 21,
2007, for "alleged conduct related to inappropriately large
proprietary futures positions in a firm trading account," the
bank wrote in a filing submitted to the Financial Industry
Regulatory Authority, which oversees broker-dealers.
Goldman agreed to pay $1.5 million in
December to settle civil charges by the CFTC that it failed to
supervise Mr. Taylor. The agency also said in its complaint
against the bank that it wasn't fully forthcoming with
regulators when Mr. Taylor was fired. Goldman settled the
charges without admitting or denying wrongdoing.
The bank cooperated in the probe,
according to a person familiar with the investigation. "We are
very disappointed by Mr. Taylor's unauthorized conduct and
betrayal of the firm's trust in him," a Goldman spokeswoman said
Wednesday.
The episode didn't bring an immediate
end to Mr. Taylor's Wall Street career. In March 2008, he
returned to Morgan Stanley as trader in the firm's equities
division. He left Morgan Stanley a second time last August,
according to Finra.
Continued in article
Banking and investment banking have become rotten to the core
---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking
Bob Jensen's Fraud Updates ---
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
2013
Wunderbar: USA Auditors Don't Have a Monoply on
Incompetence When Valuting Derivative Financial Instruments
"German regulators probe Deutsche Bank accounting - sources," Fox
Business, April 4, 2013 ---
http://www.foxbusiness.com/news/2013/04/04/german-regulators-probe-deutsche-bank-accounting-sources/
Bob Jensen's Timeline on Derivative Financial Instruments
Scandals ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
2013
From the CFO Journal's Morning Ledger on June 4, 2013
Ex-Porsche CFO
convicted of credit fraud
Former Porsche
CFO Holger Härter was convicted by a German court of credit
fraud in a case over the refinancing of a €10 billion loan
during the 2009 failed
Volkswagen
takeover bid,
Bloomberg reports.
Mr. Härter downplayed the company’s
liquidity needs and failed to disclose the correct number of put
options on VW shares Porsche held when negotiating with BNP
Paribas about the lender’s €500 million share of the syndicated
loan, presiding Judge Roderich Martis said when delivering the
verdict. Mr. Härter, who doesn’t face jail, will be fined, the
judge said.
Bob Jensen's Fraud Updates are at
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
2013
Teaching Case
From The Wall Street Journal Accounting Weekly Review on June 14,
2013
CRU, After LIBOR Scandal, Audits Steel Prices
Index
by: John W. Miller
Jun 05, 2013
Click here to view the full article on WSJ.com
TOPICS: Assurance Services, Auditing, Auditing
Services
SUMMARY: CRU Group compiles steel prices and
issues a report every
Wednesday. "The compiler...said
an auditor will conduct on-site inspections of steel companies
that provide pricing data and will gather more information about
how the prices are collected for four major types of steel
product, which go into four different indexes. The move is
believed to be a first by a commodity-price-index firm to audit
information provided to it."
CLASSROOM APPLICATION: The article may be used
in an auditing or other assurance services class to discuss
non-audit services, audit planning for a first-of-its-kind
engagement, and determination of materiality in such a setting.
QUESTIONS:
1. (Introductory) What does Commodity Research Unit
Group (CRU) do? Who uses the information that the group
prepares?
2. (Advanced) What service has CRU hired KPMG LLP to
conduct? Be specific in stating a type of service to be provided
and the type of report that you think may be issued under U.S.
assurance service requirements.
3. (Advanced) What is the significance for assurance
work planning of the fact that this engagement is apparently the
first by a commodity-price-index firm to audit information
provided to it?
4. (Advanced) Suppose you are an audit manager planning
an engagement for KPMG to examine steel prices. What factors
will you consider in deciding on materiality of amounts to
examine?
Reviewed By: Judy Beckman, University of Rhode Island
"CRU, After LIBOR Scandal, Audits Steel Prices Index," by John W.
Miller, The Wall Street Journal, June 5, 2013 ---
http://online.wsj.com/article/SB10001424127887324069104578527632400988350.html?mod=djem_jiewr_AC_domainid
A key price compiler in the global
steel industry said it will begin auditing its data providers,
part of an effort to address concerns about transparency in
price indexes following the Libor rate-fixing scandal.
The compiler, Commodity Research Ltd.,
said an auditor will conduct on-site inspections of steel
companies that provide pricing data and will gather more
information about how the prices are collected for four major
types of steel product, which go into four different indexes.
Much of these steel types are destined for the U.S automotive
market.
The move is believed to first by a
commodity-price-index firm to audit information provided to it.
CRU, based in London and Pittsburgh, has hired KPMG LLP to
conduct the audits, according to a person familiar with the
matter. KPMG didn't respond to a request for comment.
Glenn Cooney, London-based head of
operations for CRU Indices, which publishes price data on 75
commodities in metals, mining and fertilizers, said it would
look at auditing other data providers in other sectors to
bolster industry transparency.
Currently, CRU collects price and
volume data on spot transactions from steel producers and
buyers, who submit their prices voluntarily to a CRU website.
CRU publishes an index price based on the submissions every
Wednesday.
CRU officials say they hope the move
will lend it added credibility at a time of concern about
indexes. Three banks in Europe have agreed to pay over $2
billion in settlement fees to U.S. and U.K. regulators after
they were caught manipulating the London interbank offered rate,
or Libor, the interest rate banks charge to borrow from each
other. Josh Spoores, a Pittsburgh-based steel analyst for CRU,
said the company started receiving more requests for improved
transparency after the Libor scandal.
The company also hopes it will be able
to reassure several major U.S. steel mills, which in April said
they would no longer link some contracts to CRU's steel indexes
because they felt prices quoted weren't an accurate reflection
of the market. The steelmakers that stopped using the indexes
include ArcelorMittal, MT +3.34% U.S. Steel Corp. X +5.23% and
Nucor Corp. NUE +3.01%
Grant Davidson, general manager for
sales at ArcelorMittal's Dofasco mill in Canada, said big steel
companies would welcome more transparency. "We're for what's
most accurately reflecting the price in the market," he said.
Michael Steubing, vice president of
global procurement for Mauser USA LLC, which makes steel drums
and barrels, said an audited index would help guarantee that he
can sell his product at a competitive price. He sells barrels to
big chemical companies that use CRU to help determine how much
they will pay for the barrels. "So we'd like that (CRU) to be as
accurate as possible," he said.
CRU, which is used by the Chicago
Mercantile Exchange and says its prices are used to settle steel
contracts with an annual global value of over $20 billion, faces
more competition from Platts, a division of McGraw Hill
Financial Inc., MHFI +0.97% which two years ago bought price
compiler The Steel Index.
Joe Innace, Platts's editorial director
for metals, said Platts would continue its phone survey for its
Platts industry newsletter independently of The Steel Index and
wouldn't use audits because he said it has enough verifications,
such as checking that prices match the types and volumes of
steel appropriate to the index, in place.
Steve Randall, who founded The Steel
Index in 2006, said it had no plans to audit data providers. "We
run all our data through a series of screenings," he said. He
declined to provide details about the screening procedure.
Continued in article
"Everything Is Rigged: The Biggest Price-Fixing Scandal Ever:
The Illuminati were amateurs. The second huge financial scandal of the year
reveals the real international conspiracy: There's no price the big banks can't
fix," by Matt Taibbi, Rolling Stone, April 25, 2013 ---
http://www.rollingstone.com/politics/news/everything-is-rigged-the-biggest-financial-scandal-yet-20130425
Bob Jensen's LIBOR fraud threads ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking
Bob Jensen's threads on LIBOR are under the C-terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Bob Jensen's threads on LIBOR and other derivative financial
instruments frauds (timeline) ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
This is so huge it's better to do a word search for LIBOR
2013
LIBOR ---
http://en.wikipedia.org/wiki/LIBOR
From the CFO Journal's Morning Ledger on June 21, 2013
Libor case
ensnares more banks
Employees of some of the world’s
largest financial institutions conspired with a former bank
trader to rig benchmark interest rates, British prosecutors
alleged, a sign authorities have their sights on an array of
banks and brokerages. The U.K.’s Serious Fraud Office charged
former UBS and Citigroup trader Tom Hayes with eight counts of
“conspiring to defraud” in an attempt to manipulate Libor,
the WSJ reports.
The charges read in court
Thursday accuse Mr. Hayes of
conspiring with employees of eight banks and interdealer
brokerage firms, as well as with former colleagues at UBS and
Citigroup. Mr. Hayes, who was charged with similar offenses by
the U.S. last December, hasn’t entered a plea in either country.
"Libor Case Ensnares More Banks U.K. Prosecutors Allege Staff
From J.P. Morgan, Deutsche Bank and Others Tried to Fix Rates,"
by David Enrich, The Wall Street Journal, June 20, 2013 ---
http://online.wsj.com/article/SB10001424127887323893504578556941091595054.html?mod=djemCFO_h
Employees of some of the world's
largest financial institutions conspired with a former bank
trader to rig benchmark interest rates, British prosecutors
alleged Thursday, a sign authorities have their sights on an
array of banks and brokerages.
The U.K.'s Serious Fraud Office this
week charged former UBS AG UBSN.VX +0.43% and Citigroup Inc. C
-3.40% trader Tom Hayes with eight counts of "conspiring to
defraud" in an alleged attempt to manipulate the London
interbank offered rate, or Libor. Mr. Hayes appeared in a London
court Thursday, where prosecutors for the first time detailed
their allegations against him, including a list of institutions
whose employees Mr. Hayes allegedly conspired with.
Mr. Hayes, who was charged with similar
offenses by the U.S. last December, hasn't entered a plea to
either country's charges. He wrote in a January text message to
The Wall Street Journal that "this goes much much higher than
me."
The charges read in court Thursday
accuse Mr. Hayes of allegedly conspiring with employees of eight
banks and interdealer brokerage firms, as well as with former
colleagues at UBS and Citigroup. Each of the eight charges
accused Mr. Hayes of "dishonestly seeking to manipulate
[Libor]…with the intention that the economic interests of others
would be prejudiced and/or to make personal gain for themselves
or another."
The banks include New York-based J.P.
Morgan Chase JPM -2.04% & Co.; Germany's Deutsche Bank DBK.XE
+0.78% AG; British banks HSBC Holdings HSBA.LN +1.34% PLC and
Royal Bank of Scotland Group RBS.LN -3.06% PLC; and Dutch lender
Rabobank Groep NV. Prosecutors alleged Mr. Hayes also worked
with employees of ICAP IAP.LN +4.74% PLC, Tullett Prebon TLPR.LN
-0.07% PLC and R.P. Martin Holdings Ltd., which are London-based
interdealer brokers that serve as middlemen between bank
traders.
An ICAP spokeswoman said the firm has
provided information to British prosecutors and continues to
cooperate. A Rabobank spokesman said the bank continues to
cooperate with investigators and is likely to eventually reach a
settlement. In a statement, Tullett said it is "cooperating
fully" with prosecutors' requests for information.
Representatives for the rest of the named institutions declined
to comment.
The list of banks and brokerages named
at Thursday's court hearing underscores the breadth of
institutions that remain under government scrutiny. So far, only
three banks—UBS, RBS and Barclays BARC.LN +0.30% PLC—have
reached settlements with U.S. and British authorities.
Authorities hope to hammer out settlements with additional
institutions, including Rabobank, in coming months, according to
a person familiar with the investigation.
The list that prosecutors read Thursday
included at least one institution that has said it wasn't
involved in the Libor scandal. After UBS settled rate-rigging
allegations last December, Tullett Prebon spokeswoman Charlotte
Kirkham said the firm didn't help UBS manipulate rates and that
no Tullett employees had been disciplined in connection with
Libor. In April, Tullett said it stood by that statement.
In a statement Thursday, Tullett
disclosed for the first time that it has been asked to provide
information to various regulators and government agencies in
connection with Libor investigations. In addition to saying it
is cooperating with the requests, the firm reiterated it hasn't
been informed that it or its brokers are under investigation in
relation to Libor. A spokesman declined to comment further.
The interdealer brokers' alleged
involvement in attempts to rig Libor has rocked the industry in
recent months. Two R.P. Martin employees were arrested along
with Mr. Hayes in December but not charged. The U.S. Justice
Department and the Commodity Futures Trading Commission also are
investigating brokers as part of their Libor probes, according
to people familiar with those investigations.
Mr. Hayes, a 33-year-old British
citizen, was a derivatives trader in Tokyo from 2006 through
2010, the period during which prosecutors allege he attempted to
manipulate Libor. He is the only person the Serious Fraud Office
has charged in their nearly yearlong Libor investigation,
although an agency spokesman said this week that more arrests
and charges are possible.
Mr. Hayes, wearing beige trousers and
an untucked, navy dress shirt, didn't respond to the charges at
court Thursday. Standing behind a glass partition in the
courtroom, he was mostly silent aside from telling the judge his
name, address and date of birth. At one point, the judge asked
him to take his hands out of his pockets.
Continued in article
Bigger than Enron and Rotten to the Core: The LIBOR
Scandal
Bob Jensen's threads on the LIBOR Scandal ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking
Teaching Case
From The Wall Street Journal Accounting Weekly Review on June 14,
2013
CRU, After LIBOR Scandal, Audits Steel Prices Index
by:
John W. Miller
Jun 05, 2013
Click here to view the full article on WSJ.com
TOPICS: Assurance Services, Auditing, Auditing Services
SUMMARY: CRU Group compiles steel prices and issues a report every
Wednesday. "The compiler...said an auditor
will conduct on-site inspections of steel companies that provide pricing
data and will gather more information about how the prices are collected for
four major types of steel product, which go into four different indexes. The
move is believed to be a first by a commodity-price-index firm to audit
information provided to it."
CLASSROOM APPLICATION: The article may be used in an auditing or
other assurance services class to discuss non-audit services, audit planning
for a first-of-its-kind engagement, and determination of materiality in such
a setting.
QUESTIONS:
1. (Introductory) What does Commodity Research Unit Group (CRU) do?
Who uses the information that the group prepares?
2. (Advanced) What service has CRU hired KPMG LLP to conduct? Be
specific in stating a type of service to be provided and the type of report
that you think may be issued under U.S. assurance service requirements.
3. (Advanced) What is the significance for assurance work planning
of the fact that this engagement is apparently the first by a
commodity-price-index firm to audit information provided to it?
4. (Advanced) Suppose you are an audit manager planning an
engagement for KPMG to examine steel prices. What factors will you consider
in deciding on materiality of amounts to examine?
Reviewed By: Judy Beckman, University of Rhode Island
"CRU, After LIBOR Scandal, Audits Steel Prices Index," by John W. Miller,
The Wall Street Journal, June 5, 2013 ---
http://online.wsj.com/article/SB10001424127887324069104578527632400988350.html?mod=djem_jiewr_AC_domainid
A key price compiler in the global steel industry
said it will begin auditing its data providers, part of an effort to address
concerns about transparency in price indexes following the Libor rate-fixing
scandal.
The compiler, Commodity Research Ltd., said an
auditor will conduct on-site inspections of steel companies that provide
pricing data and will gather more information about how the prices are
collected for four major types of steel product, which go into four
different indexes. Much of these steel types are destined for the U.S
automotive market.
The move is believed to first by a
commodity-price-index firm to audit information provided to it. CRU, based
in London and Pittsburgh, has hired KPMG LLP to conduct the audits,
according to a person familiar with the matter. KPMG didn't respond to a
request for comment.
Glenn Cooney, London-based head of operations for
CRU Indices, which publishes price data on 75 commodities in metals, mining
and fertilizers, said it would look at auditing other data providers in
other sectors to bolster industry transparency.
Currently, CRU collects price and volume data on
spot transactions from steel producers and buyers, who submit their prices
voluntarily to a CRU website. CRU publishes an index price based on the
submissions every Wednesday.
CRU officials say they hope the move will lend it
added credibility at a time of concern about indexes. Three banks in Europe
have agreed to pay over $2 billion in settlement fees to U.S. and U.K.
regulators after they were caught manipulating the London interbank offered
rate, or Libor, the interest rate banks charge to borrow from each other.
Josh Spoores, a Pittsburgh-based steel analyst for CRU, said the company
started receiving more requests for improved transparency after the Libor
scandal.
The company also hopes it will be able to reassure
several major U.S. steel mills, which in April said they would no longer
link some contracts to CRU's steel indexes because they felt prices quoted
weren't an accurate reflection of the market. The steelmakers that stopped
using the indexes include ArcelorMittal, MT +3.34% U.S. Steel Corp. X +5.23%
and Nucor Corp. NUE +3.01%
Grant Davidson, general manager for sales at
ArcelorMittal's Dofasco mill in Canada, said big steel companies would
welcome more transparency. "We're for what's most accurately reflecting the
price in the market," he said.
Michael Steubing, vice president of global
procurement for Mauser USA LLC, which makes steel drums and barrels, said an
audited index would help guarantee that he can sell his product at a
competitive price. He sells barrels to big chemical companies that use CRU
to help determine how much they will pay for the barrels. "So we'd like that
(CRU) to be as accurate as possible," he said.
CRU, which is used by the Chicago Mercantile
Exchange and says its prices are used to settle steel contracts with an
annual global value of over $20 billion, faces more competition from Platts,
a division of McGraw Hill Financial Inc., MHFI +0.97% which two years ago
bought price compiler The Steel Index.
Joe Innace, Platts's editorial director for metals,
said Platts would continue its phone survey for its Platts industry
newsletter independently of The Steel Index and wouldn't use audits because
he said it has enough verifications, such as checking that prices match the
types and volumes of steel appropriate to the index, in place.
Steve Randall, who founded The Steel Index in 2006,
said it had no plans to audit data providers. "We run all our data through a
series of screenings," he said. He declined to provide details about the
screening procedure.
Continued in article
"Everything Is Rigged: The Biggest Price-Fixing Scandal Ever:
The Illuminati were amateurs. The second huge financial scandal of the year
reveals the real international conspiracy: There's no price the big banks can't
fix," by Matt Taibbi, Rolling Stone, April 25, 2013 ---
http://www.rollingstone.com/politics/news/everything-is-rigged-the-biggest-financial-scandal-yet-20130425
Bob Jensen's LIBOR fraud threads ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking
Bob Jensen's threads on LIBOR are under the C-terms at
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Bob Jensen's threads on LIBOR and other derivative financial instruments
frauds (timeline) ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
This is so huge it's better to do a word search for LIBOR
2013
"Who's Manipulating Derivative Indexes and Why: How to
think about the Libor scandal and its astonishingly proliferating
offspring," by Holman W. Jenkins Jr., The Wall Street
Journal, June 21, 2013 ---
http://online.wsj.com/article/SB10001424127887323893504578559282047415410.html?mod=djemEditorialPage_h
Is Ewan McGregor, who played Nick
Leeson in the movie about the Barings bank bust, available for a
sequel? He would find an oddly similar character in Tom Hayes,
the former UBS UBSN.VX -1.93% and Citibank employee charged in
this week's latest financial scandal of the century.
Let's try to sort it out. As with
Libor, or the London interbank offered rate, a benchmark for
loans world-wide, allegations are floating that traders
manipulated other widely used benchmarks. Three big
banks—Barclays, BARC.LN -2.26% UBS and Royal Bank of Scotland
RBS.LN -7.24% —have already paid $2.5 billion in fines and
penalties in the Libor caper. Now the focus has turned to
suspected manipulation of fuel-market indexes, loan-market
indexes in Japan and Singapore, and indexes used in pricing
interest-rate swaps.
Said Europe's Competition Commissioner
Joaquin Almunia last month: "Huge damages for consumers and
users would have been originated by this."
Well, maybe. A basic schematic would go
like this: Some enterprising soul decides it would be useful to
publish a daily price benchmark by surveying market participants
about certain transactions that don't take place on a central
exchange. Somebody else decides it would be useful to create
tradable derivatives whose price would vary based on changes in
these benchmarks—that is, would let participants bet on how a
survey of themselves in the future will come out.
Libor involved questioning bank traders
about the pricing of loans—and Libor derivatives let these same
traders bet on the answers they would give in the future. The
invitation here now seems rather obvious. Mr. Hayes, a
baby-faced yen-derivatives trader in Tokyo at the time, is
charged with orchestrating attempts to rig a similar Tokyo-based
benchmark called Tibor.
All this proves one thing: Financial
professionals can't be counted on to do the right thing when
self-interest beckons so we must turn power over to government
officials who always do the right thing regardless of
self-interest.
Or maybe not. The Libor scandal broke
only because London banks, in cahoots with regulators, put out
transparently fake reports about their borrowing costs during
the 2008 panic. That led to the discovery of a long history of
everyday manipulation of their Libor borrowing costs. Traders
now fessing up say they learned the practice from their
predecessors who learned it from their predecessors, and so on.
As they drain this swamp, investigators
like to allege enormous damage to the public by multiplying
small discrepancies by the number of transactions in the market.
Treat these claims with skepticism. Whatever the extent of
mispricing in downstream transactions, it is a smidgeon compared
to the rake-off brokers used to earn in pre-electronic days. It
is a smidgeon compared to the margins that middlemen could
extract before published surveys were available to shed light on
transactions previously invisible to most market participants.
It is also a smidgeon compared to the
margins that would have to be built into prices if not for Libor
hedges and other risk-sharing inventions.
A kick in the pants has been delivered
to publishers of price indexes. They need to make their products
more manipulation-proof. Where markets are thin and surveys are
the only way to glean market intelligence, publishers already
exercise a visible hand to expel questionable or anomalous data.
A further solution might be to poll a larger number of traders
and randomly exclude most of their answers so no trader would
have any certainty of influencing the index.
To understand why such opportunities
exist in the first place is to understand something about a
generic condition of our world, in which technology has
drastically reduced transaction costs and cheap money has vastly
increased leverage available even to low-ranking bank employees,
magnifying the return to small bits of illicit or licit
information, including insider information.
Continued in article
Bigger than Enron and Rotten to the Core: The LIBOR Scandal
Bob Jensen's threads on the LIBOR Scandal ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking
2013
"Everything Is Rigged: The Biggest Price-Fixing Scandal Ever:
The Illuminati were amateurs. The second huge financial scandal of the year
reveals the real international conspiracy: There's no price the big banks can't
fix," by Matt Taibbi, Rolling Stone, April 25, 2013 ---
http://www.rollingstone.com/politics/news/everything-is-rigged-the-biggest-financial-scandal-yet-20130425
"NYSE Euronext to Take Over Libor British Authorities Started
Looking for New Owner Last Year," by David Enrich, Jacob Bunge,
and Cassell Brian-Lo, The Wall Street Journal, July 10, 2013
---
http://online.wsj.com/article/SB10001424127887324507404578595243333548714.html?mod=djemCFO_h
Libor, the scandal-tarred benchmark owned
by a British banking organization, is being sold to
NYSE Euronext,
NYX -0.61%
the U.S. company that runs the New York Stock Exchange. The deal
is the British government's latest attempt to salvage Libor's
integrity, after multiple banks acknowledged trying to profit by
rigging the rate.
While Libor underpins trillions of dollars in financial
contracts and generates about Ł2 million a year in revenue, a
person familiar with the deal said the benchmark rate was sold
to NYSE for a token Ł1—a sign of the heavy toll inflicted by the
rate-rigging scandal.
Libor: What You Need to Know
What it is:
Libor—the London interbank offered rate benchmark—is supposed to
measure the interest rates at which banks borrow from one
another. It is based on data reported daily by banks. Other
interest rate indexes, like the Euribor (euro interbank offered
rate) and the Tibor (Tokyo interbank offered rate), function in
a similar way.
Why it's important:
More than $800 trillion in securities and loans are linked to
the Libor, including $350 trillion in swaps and $10 trillion in
loans, including auto and home loans, according to the Commodity
Futures Trading Commission. Even small movements—or
inaccuracies—in the Libor affect investment returns and
borrowing costs, for individuals, companies and professional
investors.
MoneyBeat
The deal means that the City of London will lose one of the
institutions most closely associated with its rise as a global
financial hub in recent decades. The new owner will be the
institution that is most closely associated with Wall Street.
For NYSE, the deal is part of a recent
effort by exchanges to take over benchmarks like Libor in the
hopes of converting them into new business opportunities in the
derivatives markets. NYSE itself is in the process of being
acquired by
IntercontinentalExchange
Inc.,
ICE -1.14%
an Atlanta-based company that is one of
the world's largest operators of derivatives exchanges. Libor
and similar benchmarks are components of interest-rate
derivatives that are heavily traded on exchanges in the U.S. and
Europe.
British authorities last year started looking for a new owner
for Libor, after concluding that the British Bankers'
Association shouldn't be responsible for administering a key
benchmark. After a competitive bidding process, a
government-appointed commission picked NYSE, which will formally
take over Libor early in 2014.
Sarah Hogg, who headed the U.K. commission that ran the Libor
sale process, said Tuesday that handing the benchmark to NYSE
"will play a vital role in restoring the international
credibility of Libor." While Libor's new parent company will be
American, the rate will be administered by a British subsidiary
that will be regulated by the U.K.'s Financial Conduct
Authority.
The deal immediately encountered
criticism. It is "far from ideal," said
Bart Chilton,
one of the commissioners who runs U.S.
regulator the Commodity Futures Trading Commission. "Whenever
there's a profit motive involved in setting [these benchmarks],
I get suspicious."
Mr. Chilton, who added he would have preferred a "neutral third
party" to take over Libor, said it would be misleading to
suggest the deal would resolve all the problems that have
bedeviled Libor. "I'm not swallowing that."
Some British officials decried the loss of an important
institution to a rival financial center. Following the Libor
sale, "the French and the Germans will be rubbing their hands
with glee at the prospect of stealing other financial markets
from the U.K.," said John Mann, a Labour Party lawmaker.
The BBA launched Libor in the 1980s as a way for banks to set
interest rates on syndicated corporate loans. The rate is based
on daily estimates by banks about how much it would cost them to
borrow from other banks. Libor eventually morphed into a
ubiquitous cog in the financial system, and today serves as the
basis for rates on everything from residential mortgages to
derivatives.
Doubts about Libor's reliability
surfaced in 2008 after a series of Wall Street Journal articles
highlighted apparent problems with the rate. But governments and
central banks balked at regulating Libor, and the BBA failed to
stop banks from continuing to skew the rate. Only last summer,
after Barclays BARC.LN +0.31% PLC admitted trying to rig Libor,
did British authorities launch a process to overhaul the
benchmark.
Part of that process involved finding a
new home for Libor. In addition, following a U.K. regulatory
panel's recommendation, the BBA earlier this year phased out
certain variations of Libor that were especially vulnerable to
manipulation. Also, the British government recently made it a
crime to rig Libor.
Martin Wheatley, head of the Financial
Conduct Authority, said he expects NYSE "to develop further the
oversight and governance of Libor." The chief executive of the
NYSE Liffe derivatives exchange, Finbarr Hutcheson, said the
company would continue "the process of restoring credibility,
trust and integrity in Libor as a key global benchmark."
At least initially, NYSE is expected to
continue the current process for calculating Libor, according to
a U.K. Treasury official. That will be supplemented by
cross-checking those submissions against market transactions,
the official said.
The new owner plans to work with market
participants and regulators to "evolve how Libor is calculated"
to bring it in line with recommendations last year from another
U.K. commission, the official said.
Among other bidders for Libor were
Thomson Reuters, which currently compiles Libor every day on the
BBA's behalf, and Markit, a data provider specializing in
derivatives, said people briefed on the process.
NYSE plans to continue licensing Libor
to other parties for use in financial products, according to a
person familiar with the deal. The benchmark is expected to keep
its current name.
Analysts said the deal will give NYSE
bragging rights as owner of a benchmark that is central to the
market for a variety of derivatives. Exchanges in recent years
have gravitated toward derivatives trading because the markets
bring higher fees than trading in stocks.
But NYSE could face years of
regulatory, legal and political scrutiny as it tries to repair
Libor's battered reputation.
Continued in article
Bigger Than Enron: Bob Jensen's Threads on the LIBOR
Scandal ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#InvestmentBanking
Search for LIBOR
2015
That some bankers have
ended up in prison is not a matter of scandal, but what is
outrageous is the fact that all the others are free.
Honoré de Balzac
Bankers bet with their
bank's capital, not their own. If the bet goes right, they get a
huge bonus; if it misfires, that's the shareholders' problem.
Sebastian Mallaby. Council on Foreign Relations, as
quoted by Avital Louria Hahn, "Missing: How Poor Risk-Management
Techniques Contributed to the Subprime Mess," CFO Magazine,
March 2008, Page 53 ---
http://www.cfo.com/article.cfm/10755469/c_10788146?f=magazine_featured
Now that the Fed is
going to bail out these crooks with taxpayer funds makes it all the
worse.
Wall Street Remains Congress
to the Core
The boom in
corporate mergers is creating concern that illicit trading ahead of
deal announcements is becoming a systemic problem. It is against the
law to trade on inside information about an imminent merger, of
course. But an analysis of the nation’s biggest mergers over the
last 12 months indicates that the securities of 41 percent of the
companies receiving buyout bids exhibited abnormal and suspicious
trading in the days and weeks before those deals became public. For
those who bought shares during these periods of unusual trading,
quick gains of as much as 40 percent were possible.
Gretchen Morgenson, "Whispers of Mergers Set Off Suspicious
Trading," The New York Times, August 27, 2006 ---
Click Here
"Why Are Some Sectors (Ahem, Finance) So
Scandal-Plagued?" by Ben W. Heineman, Jr., Harvard Business
Review Blog, January 10, 2013 ---
Click Here
http://blogs.hbr.org/cs/2013/01/scandals_plague_sectors_not_ju.html?referral=00563&cm_mmc=email-_-newsletter-_-daily_alert-_-alert_date&utm_source=newsletter_daily_alert&utm_medium=email&utm_campaign=alert_date
Jensen Comment
The Big Banks and Wall Street in general will not learn until people
are sent to jail. Until then the fines are just company money.
From the CFO Journal's Morning Ledger on May 21, 2015
Banks to pay $5.6 billion in probes
http://www.wsj.com/articles/global-banks-to-pay-5-6-billion-in-penalties-in-fx-libor-probe-1432130400?mod=djemCFO_h
The five big banks will plead guilty to
criminal charges to resolve a U.S. investigation into whether
traders colluded to move foreign-currency rates for their own
benefit. Four of the banks, Barclays PLC, Citigroup
Inc., J.P. Morgan Chase & Co. and Royal
Bank of Scotland Group PLC, pleaded guilty
on Wednesday to conspiring to
manipulate prices in the $500 billion-a-day market for U.S.
dollars and euros, authorities said. The fifth bank, UBS AG, received
immunity in the antitrust case but pleaded guilty to
manipulating the London interbank offered rate, or Libor. It
will pay a fine for violating an earlier accord meant to resolve
those allegations of misconduct.
From the CFO Journal's Morning Ledger on May 21, 2015
Barclays fined for alleged manipulation of ISDAfix.
Barclays PLC
was fined $115 million by the Commodity Futures Trading
Commission, which said in a statement that Barclays’s U.S.
traders attempted to manipulate the U.S. dollar iteration of
ISDAfix, or the International Swaps and Derivatives Association
Fix, between 2007 and 2012. A group of other financial
institutions including interdealer broker ICAP PLC
have said they are under investigation for alleged manipulation
of the ISDAfix rate.
From the CFO Journal's Morning Ledger on May 21, 2015
SEC votes to propose new asset-manager reporting rules
http://www.wsj.com/articles/sec-votes-to-propose-new-mutual-fund-reporting-requirements-1432136458?mod=djemCFO_h
The Securities and Exchange Commission
voted 5-0 to significantly boost the volume of data the agency
collects from the $60 trillion asset-management industry. The
proposal includes requirements that funds report on their use of
complex and potentially risky derivatives products, data that
aren’t frequently or consistently captured by the SEC.
2016
Insider Trading ---
https://en.wikipedia.org/wiki/Insider_trading
"How the Feds Pulled Off the Biggest Insider-Trading Investigation in U.S.
History." by Patricia Hurtado & Michael Keller, Bloomberg, June 1,
2016 ---
http://www.bloomberg.com/graphics/2016-insider-trading/?cmpid=BBD060116_BIZ&utm_medium=email&utm_source=newsletter&utm_campaign=
For more than seven years, the U.S.
government has relentlessly prosecuted Wall Street traders who
used inside information to rake in hundreds of millions of
dollars in profits.
Federal prosecutors in New York have
racked up 91 convictions and collected almost $2 billion in
fines. In the latest action on May 19, the government looked
beyond Wall Street, accusing a legendary Las Vegas gambler of
profiting from insider tips.
Here's a by-the-numbers look at what
happens when the Feds get serious about insider trading.
The suspects worked in what prosecutors
described as rings — loose and sometimes overlapping groups of
insiders, traders, and facilitators.
This arrangement, however, was also
their undoing. Adopting tactics used against mobsters and
narcoterrorists, the FBI infiltrated these rings using wiretaps
and informants to work their way further up the chain.
Continued in article
Bob Jensen's
Fraud Updates
---
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
Bob
Jensen's Rotten to the Core Threads ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm
They say that patriotism is the last refuge
To which a scoundrel clings.
Steal a little and they throw you in jail,
Steal a lot and they make you king.
There's only one step down from here, baby,
It's called the land of permanent bliss.
What's a sweetheart like you doin' in a dump like this?
Lyrics of a Bob Dylan song forwarded by Amian Gadal
[DGADAL@CI.SANTA-BARBARA.CA.US]
End of Timeline
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Selected works of FRANK
PARTNOY
Bob Jensen at Trinity University
1.
Who is Frank Partnoy?
Cheryl
Dunn requested that I do a review of my
favorites among the “books that have
influenced [my] work.” Immediately the
succession of FIASCO books by Frank
Partnoy came to mind. These particular
books are not the best among related books
by Wall Street whistle blowers such as
Liar's Poker: Playing the Money Markets
by Michael Lewis in 1999 and Monkey
Business: Swinging Through the Wall Street
Jungle by John Rolfe and Peter Troob in
2002. But in1997. Frank Partnoy was the
first writer to open my eyes to the enormous
gap between our assumed efficient and fair
capital markets versus the “infectious
greed” (Alan Greenspan’s term) that had
overtaken these markets.
Partnoy’s succession of FIASCO books,
like those of Lewis and Rolfe/Troob are
reality books written from the perspective
of inside whistle blowers. They are
somewhat repetitive and anecdotal mainly
from the perspective of what each author saw
and interpreted.
My
favorite among the capital market fraud
books is Frank Partnoy’s latest book
Infectious Greed: How Deceit and Risk
Corrupted the Financial Markets (Henry
Holt & Company, Incorporated, 2003, ISBN:
080507510-0- 477 pages). This is the most
scholarly of the books available on business
and gatekeeper degeneracy. Rather than
relying mostly upon his own experiences,
this book drawn from Partnoy’s interviews of
over 150 capital markets insiders of one
type or another. It is more scholarly
because it demonstrates Partnoy’s evolution
of learning about extremely complex
structured financing packages that were the
instruments of crime by banks, investment
banks, brokers, and securities dealers in
the most venerable firms in the U.S. and
other parts of the world. The book is
brilliant and has a detailed and helpful
index.
What did
I learn most from Partnoy?
I
learned about the failures and complicity of
what he terms “gatekeepers” whose fiduciary
responsibility was to inoculate against
“infectious greed.” These gatekeepers
instead manipulated their professions and
their governments to aid and abet the
criminals. On Page 173 of Infectious
Greed, he writes the following:
Page #173
When Republicans captured the House of
Representatives in November 1994--for the
first time since the Eisenhower
era--securities-litigation reform was
assured. In a January 1995 speech, Levitt
outlined the limits on securities regulation
that Congress later would support: limiting
the statute-of-limitations period for filing
lawsuits, restricting legal fees paid to
lead plaintiffs, eliminating
punitive-damages provisions from securities
lawsuits, requiring plaintiffs to allege
more clearly that a defendant acted with
reckless intent, and exempting "forward
looking
statements"--essentially, projections about
a company's future--from legal liability.
The Private Securities Litigation Reform Act
of 1995 passed easily, and Congress even
overrode the veto of President Clinton, who
either had a fleeting change of heart about
financial markets or decided that trial
lawyers were an even more
important constituency than Wall Street. In
any event, Clinton and Levitt disagreed
about the issue, although it wasn't fatal to
Levitt, who would remain SEC chair for
another five years.
He later
introduces Chapter 7 of Infectious Greed
as follows:
Pages 187-188
The regulatory changes of 1994-95 sent three
messages to corporate CEOs. First, you are
not likely to be punished for "massaging"
your firm's accounting numbers. Prosecutors
rarely go after financial fraud and, even
when they do, the typical punishment is a
small fine; almost no one goes to prison.
Moreover, even a fraudulent scheme could be
recast as mere earnings management--the
practice of smoothing a company's
earnings--which most executives did, and
regarded as perfectly legal.
Second, you should use new financial
instruments--including options, swaps, and
other derivatives--to increase your own pay
and to avoid costly regulation. If complex
derivatives are too much for you to
handle--as they were for many CEOs during
the years immediately following the 1994
losses--you should at least pay yourself in
stock options, which don't need to be
disclosed as an expense and have a greater
upside than cash bonuses or stock.
Third, you don't need to worry about whether
accountants or securities analysts will tell
investors about any hidden losses or
excessive options pay. Now that Congress
and the Supreme Court have insulated
accounting firms and investment banks from
liability--with the Central Bank decision
and the Private Securities Litigation Reform
Act--they will be much more willing to look
the other way. If you pay them enough in
fees, they might even be willing to help.
Of course, not every corporate executive
heeded these messages. For example, Warren
Buffett argued that managers should ensure
that their companies' share prices were
accurate, not try to inflate prices
artificially, and he criticized the use of
stock options as compensation. Having been
a major shareholder of Salomon Brothers,
Buffett also criticized accounting and
securities firms for conflicts of interest.
But for every Warren Buffett, there were
many less scrupulous CEOs. This chapter
considers four of them: Walter Forbes of CUC
International, Dean Buntrock of Waste
Management, Al Dunlap of Sunbeam, and Martin
Grass of Rite Aid. They are not all
well-known among investors, but their
stories capture the changes in CEO behavior
during the mid-1990s. Unlike the "rocket
scientists" at Bankers Trust, First Boston,
and Salomon Brothers, these four had
undistinguished backgrounds and little
training in mathematics or finance.
Instead, they were hardworking, hard-driving
men who ran companies that met basic
consumer needs: they sold clothes, barbecue
grills, and prescription medicine, and
cleaned up garbage. They certainly didn't
buy swaps linked to LIBOR-squared.
The book
Infectious Greed has chapters on
other capital markets and corporate
scandals. It is the best account that I’ve
ever read about Bankers Trust the Bankers
Trust scandals, including how one trader
named Andy Krieger almost destroyed the
entire money supply of New Zealand. Chapter
10 is devoted to Enron and follows up on
Frank Partnoy’s invited testimony before the
United States Senate Committee on
Governmental Affairs, January 24, 2002 ---
http://www.senate.gov/~gov_affairs/012402partnoy.htm
The
controversial writings of Frank Partnoy have
had an enormous impact on my teaching and my
research. Although subsequent writers wrote
somewhat more entertaining exposes, he was
the one who first opened my eyes to what
goes on behind the scenes in capital markets
and investment banking. Through his early
writings, I discovered that there is an
enormous gap between the efficient financial
world that we assume in agency theory
worshipped in academe versus the dark side
of modern reality where you find the
cleverest crooks out to steal money from
widows and orphans in sophisticated ways
where it is virtually impossible to get
caught. Because I read his 1997 book early
on, the ensuing succession of enormous
scandals in finance, accounting, and
corporate governance weren’t really much of
a surprise to me.
From his
insider perspective he reveals a world where
our most respected firms in banking, market
exchanges, and related financial
institutions no longer care anything about
fiduciary responsibility and professionalism
in disgusting contrast to the honorable
founders of those same firms motivated to
serve rather than steal.
Young
men and women from top universities of the
world abandoned almost all ethical
principles while working in investment banks
and other financial institutions in order to
become not only rich but filthy rich at the
expense of countless pension holders and
small investors. Partnoy opened my eyes to
how easy it is to get around auditors and
corporate boards by creating structured
financial contracts that are
incomprehensible and serve virtually no
purpose other than to steal billions upon
billions of dollars.
Most
importantly, Frank Partnoy opened my eyes to
the psychology of greed. Greed is rooted in
opportunity and cultural relativism. He
graduated from college with a high sense of
right and wrong. But his standards and
values sank to the criminal level of those
when he entered the criminal world of
investment banking. The only difference
between him and the crooks he worked with is
that he could not quell his conscience while
stealing from widows and orphans.
Frank
Partnoy has a rare combination of
scholarship and experience in law,
investment banking, and accounting. He is
sometimes criticized for not really
understanding the complexities of some of
the deals he described, but he rather freely
admits that he was new to the game of
complex deceptions in international
structured financing crime.
2.
What really happened at Enron? ---
http://faculty.trinity.edu/rjensen/FraudEnron.htm#FrankPartnoyTestimony
3.
What are some of Frank Partnoy’s best-known
works?
Frank
Partnoy, FIASCO: Blood in the Water on
Wall Street (W. W. Norton & Company,
1997, ISBN 0393046222, 252 pages).
This is the first of a
somewhat repetitive succession of Partnoy’s
“FIASCO” books that influenced my life. The
most important revelation from his insider’s
perspective is that the most trusted firms
on Wall Street and financial centers in
other major cities in the U.S., that were
once highly professional and trustworthy,
excoriated the guts of integrity leaving a
façade behind which crooks less violent than
the Mafia but far more greedy took control
in the roaring 1990s.
After selling a succession of
phony derivatives deals while at Morgan
Stanley, Partnoy blew the whistle in this
book about a number of his employer’s shady
and outright fraudulent deals sold in rigged
markets using bait and switch tactics.
Customers, many of them pension fund
investors for schools and municipal
employees, were duped into complex and
enormously risky deals that were billed as
safe as the U.S. Treasury.
His books have received mixed
reviews, but I question some of the
integrity of the reviewers from the
investment banking industry who in some
instances tried to whitewash some of the
deals described by Partnoy. His books have
received a bit less praise than the book
Liars Poker by Michael Lewis, but
critics of Partnoy fail to give credit that
Partnoy’s exposes preceded those of Lewis.
Frank
Partnoy, FIASCO: Guns, Booze and
Bloodlust: the Truth About High Finance
(Profile Books, 1998, 305 Pages)
Like his earlier books, some
investment bankers and literary dilettantes
who reviewed this book were critical of
Partnoy and claimed that he misrepresented
some legitimate structured financings.
However, my reading of the reviewers is that
they were trying to lend credence to highly
questionable offshore deals documented by
Partnoy. Be that as it may, it would have
helped if Partnoy had been a bit more
explicit in some of his illustrations.
Frank
Partnoy, FIASCO: The Inside Story of a
Wall Street Trader (Penguin, 1999, ISBN
0140278796, 283 pages).
This
is a blistering indictment of the
unregulated OTC market for derivative
financial instruments and the million
and billion dollar deals conceived in
investment banking. Among other things,
Partnoy describes Morgan Stanley’s
annual drunken skeet-shooting
competition organized by a “gun-toting
strip-joint connoisseur” former combat
officer (fanatic) who loved the motto:
“When derivatives are outlawed only
outlaws will have derivatives.” At that
event, derivatives salesmen were forced
to shoot entrapped bunnies between the
eyes on the pretense that the bunnies
were just like “defenseless animals”
that were Morgan Stanley’s customers to
be shot down even if they might
eventually “lose a billion dollars on
derivatives.”
This book has one of the best accounts
of the “fiasco” caused almost entirely
by the duping of
Orange
County ’s Treasurer (Robert Citron)
by the unscrupulous Merrill Lynch
derivatives salesman named Michael
Stamenson.
Orange
County eventually lost over a billion
dollars and was forced into bankruptcy.
Much of this was later recovered in
court from Merrill Lynch.
Partnoy
calls Citron and
Stamenson “The Odd Couple,” which
is also the title of Chapter 8 in the
book.Frank Partnoy, Infectious Greed:
How Deceit and Risk Corrupted the
Financial Markets (Henry Holt &
Company, Incorporated, 2003, ISBN:
080507510-0, 477 pages)Frank Partnoy,
Infectious Greed: How Deceit and Risk
Corrupted the Financial Markets
(Henry Holt & Company, Incorporated,
2003, ISBN: 080507510-0, 477 pages)
Partnoy shows how
corporations gradually increased financial
risk and lost control over overly complex
structured financing deals that obscured the
losses and disguised frauds pushed
corporate officers and their boards into
successive and ingenious deceptions." Major
corporations such as Enron, Global Crossing,
and WorldCom entered into enormous illegal
corporate finance and accounting. Partnoy
documents the spread of this epidemic stage
and provides some suggestions for
restraining the disease.
"The
Siskel and Ebert of Financial Matters: Two
Thumbs Down for the Credit Reporting
Agencies" by Frank Partnoy, Washington
University Law Quarterly, Volume 77, No. 3,
1999 ---
http://ls.wustl.edu/WULQ/
4.
What are examples of related books that are
somewhat more entertaining than Partnoy’s
early books?
Michael
Lewis, Liar's Poker: Playing the Money
Markets (Coronet, 1999, ISBN 0340767006)
Lewis writes in Partnoy’s
earlier whistleblower style with somewhat
more intense and comic portrayals of the
major players in describing the double
dealing and break down of integrity on the
trading floor of Salomon Brothers.
John
Rolfe and Peter Troob, Monkey Business:
Swinging Through the Wall Street Jungle
(Warner Books, Incorporated, 2002, ISBN:
0446676950, 288 Pages)
This is a hilarious
tongue-in-cheek account by Wharton and
Harvard MBAs who thought they were
starting out as stock brokers for
$200,000 a year until they realized that
they were on the phones in a bucket shop
selling sleazy IPOs to unsuspecting
institutional investors who in turn
passed them along to widows and
orphans. They write. "It took us
another six months after that to realize
that we were, in fact, selling crappy
public offerings to investors."
There are other books
along a similar vein that may be more
revealing and entertaining than the
early books of Frank Partnoy, but he was
one of the first, if not the first, in
the roaring 1990s to reveal the high
crime taking place behind the concrete
and glass of Wall Street. He was the
first to anticipate many of the scandals
that soon followed. And his testimony
before the U.S. Senate is the best
concise account of the crime that
transpired at Enron. He lays the blame
clearly at the feet of government
officials (read that Wendy Gramm) who
sold the farm when they deregulated the
energy markets and opened the doors to
unregulated OTC derivatives trading in
energy. That is when Enron really began
bilking the public.
Some of the
many, many lawsuits settled by auditing
firms can be found at
http://faculty.trinity.edu/rjensen/Fraud001.htm
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The End of Wall Street?
Liars Poker II is called "The End"
The Not-Funny Punch Line is Not Until Page 9 of This Tongue in Cheek
Explanation of the Meltdown on Wall Street!
Now I asked
Gutfreund about his biggest decision. “Yes,” he said.
“They—the heads of the other Wall Street firms—all said what an
awful thing it was to go public
(beg for a government bailout)
and how could you do such a thing. But when the temptation
arose, they all gave in to it.” He agreed that the main effect
of turning a partnership into a corporation was to transfer the
financial risk to the shareholders. “When things go wrong, it’s
their problem,” he said—and obviously not theirs alone. When a
Wall Street investment bank screwed up badly enough, its risks
became the problem of the U.S. government. “It’s laissez-faire
until you get in deep shit,” he said, with a half chuckle. He
was out of the game.
This is a must read to understand what went wrong on Wall Street
--- especially the punch line!
"The End," by Michael Lewis December 2008 Issue The era that defined
Wall Street is finally, officially over. Michael Lewis, who
chronicled its excess in Liar’s Poker, returns to his old haunt to
figure out what went wrong.
http://www.portfolio.com/news-markets/national-news/portfolio/2008/11/11/The-End-of-Wall-Streets-Boom?tid=true
To this day, the willingness of a Wall
Street investment bank to pay me hundreds of thousands of
dollars to dispense investment advice to grownups remains a
mystery to me. I was 24 years old, with no experience of, or
particular interest in, guessing which stocks and bonds would
rise and which would fall. The essential function of Wall Street
is to allocate capital—to decide who should get it and who
should not. Believe me when I tell you that I hadn’t the first
clue.
I’d never taken an accounting course,
never run a business, never even had savings of my own to
manage. I stumbled into a job at Salomon Brothers in 1985 and
stumbled out much richer three years later, and even though I
wrote a book about the experience, the whole thing still strikes
me as preposterous—which is one of the reasons the money was so
easy to walk away from. I figured the situation was
unsustainable. Sooner rather than later, someone was going to
identify me, along with a lot of people more or less like me, as
a fraud. Sooner rather than later, there would come a Great
Reckoning when Wall Street would wake up and hundreds if not
thousands of young people like me, who had no business making
huge bets with other people’s money, would be expelled from
finance.
When I sat down to write my account of
the experience in 1989—Liar’s Poker, it was called—it was in the
spirit of a young man who thought he was getting out while the
getting was good. I was merely scribbling down a message on my
way out and stuffing it into a bottle for those who would pass
through these parts in the far distant future.
Unless some insider got all of this
down on paper, I figured, no future human would believe that it
happened.
I thought I was writing a period piece
about the 1980s in America. Not for a moment did I suspect that
the financial 1980s would last two full decades longer or that
the difference in degree between Wall Street and ordinary life
would swell into a difference in kind. I expected readers of the
future to be outraged that back in 1986, the C.E.O. of Salomon
Brothers, John Gutfreund, was paid $3.1 million; I expected them
to gape in horror when I reported that one of our traders, Howie
Rubin, had moved to Merrill Lynch, where he lost $250 million; I
assumed they’d be shocked to learn that a Wall Street C.E.O. had
only the vaguest idea of the risks his traders were running.
What I didn’t expect was that any future reader would look on my
experience and say, “How quaint.”
I had no great agenda, apart from
telling what I took to be a remarkable tale, but if you got a
few drinks in me and then asked what effect I thought my book
would have on the world, I might have said something like, “I
hope that college students trying to figure out what to do with
their lives will read it and decide that it’s silly to phony it
up and abandon their passions to become financiers.” I hoped
that some bright kid at, say, Ohio State University who really
wanted to be an oceanographer would read my book, spurn the
offer from Morgan Stanley, and set out to sea.
Somehow that message failed to come
across. Six months after Liar’s Poker was published, I was
knee-deep in letters from students at Ohio State who wanted to
know if I had any other secrets to share about Wall Street.
They’d read my book as a how-to manual.
In the two decades since then, I had
been waiting for the end of Wall Street. The outrageous bonuses,
the slender returns to shareholders, the never-ending scandals,
the bursting of the internet bubble, the crisis following the
collapse of Long-Term Capital Management: Over and over again,
the big Wall Street investment banks would be, in some narrow
way, discredited. Yet they just kept on growing, along with the
sums of money that they doled out to 26-year-olds to perform
tasks of no obvious social utility. The rebellion by American
youth against the money culture never happened. Why bother to
overturn your parents’ world when you can buy it, slice it up
into tranches, and sell off the pieces?
At some point, I gave up waiting for
the end. There was no scandal or reversal, I assumed, that could
sink the system.
The New Order The crash did more than
wipe out money. It also reordered the power on Wall Street. What
a Swell Party A pictorial timeline of some Wall Street highs and
lows from 1985 to 2007. Worst of Times Most economists predict a
recovery late next year. Don’t bet on it. Then came Meredith
Whitney with news. Whitney was an obscure analyst of financial
firms for Oppenheimer Securities who, on October 31, 2007,
ceased to be obscure. On that day, she predicted that Citigroup
had so mismanaged its affairs that it would need to slash its
dividend or go bust. It’s never entirely clear on any given day
what causes what in the stock market, but it was pretty obvious
that on October 31, Meredith Whitney caused the market in
financial stocks to crash. By the end of the trading day, a
woman whom basically no one had ever heard of had shaved $369
billion off the value of financial firms in the market. Four
days later, Citigroup’s C.E.O., Chuck Prince, resigned. In
January, Citigroup slashed its dividend.
From that moment, Whitney became E.F.
Hutton: When she spoke, people listened. Her message was clear.
If you want to know what these Wall Street firms are really
worth, take a hard look at the crappy assets they bought with
huge sums of borrowed money, and imagine what they’d fetch in a
fire sale. The vast assemblages of highly paid people inside the
firms were essentially worth nothing. For better than a year
now, Whitney has responded to the claims by bankers and brokers
that they had put their problems behind them with this
write-down or that capital raise with a claim of her own: You’re
wrong. You’re still not facing up to how badly you have
mismanaged your business.
Rivals accused Whitney of being
overrated; bloggers accused her of being lucky. What she was,
mainly, was right. But it’s true that she was, in part,
guessing. There was no way she could have known what was going
to happen to these Wall Street firms. The C.E.O.’s themselves
didn’t know.
Now, obviously, Meredith Whitney didn’t
sink Wall Street. She just expressed most clearly and loudly a
view that was, in retrospect, far more seditious to the
financial order than, say, Eliot Spitzer’s campaign against Wall
Street corruption. If mere scandal could have destroyed the big
Wall Street investment banks, they’d have vanished long ago.
This woman wasn’t saying that Wall Street bankers were corrupt.
She was saying they were stupid. These people whose job it was
to allocate capital apparently didn’t even know how to manage
their own.
At some point, I could no longer
contain myself: I called Whitney. This was back in March, when
Wall Street’s fate still hung in the balance. I thought, If
she’s right, then this really could be the end of Wall Street as
we’ve known it. I was curious to see if she made sense but also
to know where this young woman who was crashing the stock market
with her every utterance had come from.
It turned out that she made a great
deal of sense and that she’d arrived on Wall Street in 1993,
from the Brown University history department. “I got to New
York, and I didn’t even know research existed,” she says. She’d
wound up at Oppenheimer and had the most incredible piece of
luck: to be trained by a man who helped her establish not merely
a career but a worldview. His name, she says, was Steve Eisman.
Eisman had moved on, but they kept in
touch. “After I made the Citi call,” she says, “one of the best
things that happened was when Steve called and told me how proud
he was of me.”
Having never heard of Eisman, I didn’t
think anything of this. But a few months later, I called Whitney
again and asked her, as I was asking others, whom she knew who
had anticipated the cataclysm and set themselves up to make a
fortune from it. There’s a long list of people who now say they
saw it coming all along but a far shorter one of people who
actually did. Of those, even fewer had the nerve to bet on their
vision. It’s not easy to stand apart from mass hysteria—to
believe that most of what’s in the financial news is wrong or
distorted, to believe that most important financial people are
either lying or deluded—without actually being insane. A handful
of people had been inside the black box, understood how it
worked, and bet on it blowing up. Whitney rattled off a list
with a half-dozen names on it. At the top was Steve Eisman.
Steve Eisman entered finance about the
time I exited it. He’d grown up in New York City and gone to a
Jewish day school, the University of Pennsylvania, and Harvard
Law School. In 1991, he was a 30-year-old corporate lawyer. “I
hated it,” he says. “I hated being a lawyer. My parents worked
as brokers at Oppenheimer. They managed to finagle me a job.
It’s not pretty, but that’s what happened.”
He was hired as a junior equity
analyst, a helpmate who didn’t actually offer his opinions. That
changed in December 1991, less than a year into his new job,
when a subprime mortgage lender called Ames Financial went
public and no one at Oppenheimer particularly cared to express
an opinion about it. One of Oppenheimer’s investment bankers
stomped around the research department looking for anyone who
knew anything about the mortgage business. Recalls Eisman: “I’m
a junior analyst and just trying to figure out which end is up,
but I told him that as a lawyer I’d worked on a deal for the
Money Store.” He was promptly appointed the lead analyst for
Ames Financial. “What I didn’t tell him was that my job had been
to proofread the documents and that I hadn’t understood a word
of the fucking things.”
Ames Financial belonged to a category
of firms known as nonbank financial institutions. The category
didn’t include J.P. Morgan, but it did encompass many
little-known companies that one way or another were involved in
the early-1990s boom in subprime mortgage lending—the lower
class of American finance.
The second company for which Eisman was
given sole responsibility was Lomas Financial, which had just
emerged from bankruptcy. “I put a sell rating on the thing
because it was a piece of shit,” Eisman says. “I didn’t know
that you weren’t supposed to put a sell rating on companies. I
thought there were three boxes—buy, hold, sell—and you could
pick the one you thought you should.” He was pressured generally
to be a bit more upbeat, but upbeat wasn’t Steve Eisman’s style.
Upbeat and Eisman didn’t occupy the same planet. A hedge fund
manager who counts Eisman as a friend set out to explain him to
me but quit a minute into it. After describing how Eisman
exposed various important people as either liars or idiots, the
hedge fund manager started to laugh. “He’s sort of a prick in a
way, but he’s smart and honest and fearless.”
“A lot of people don’t get Steve,”
Whitney says. “But the people who get him love him.” Eisman
stuck to his sell rating on Lomas Financial, even after the
company announced that investors needn’t worry about its
financial condition, as it had hedged its market risk. “The
single greatest line I ever wrote as an analyst,” says Eisman,
“was after Lomas said they were hedged.” He recited the line
from memory: “ ‘The Lomas Financial Corp. is a perfectly hedged
financial institution: It loses money in every conceivable
interest-rate environment.’ I enjoyed writing that sentence more
than any sentence I ever wrote.” A few months after he’d
delivered that line in his report, Lomas Financial returned to
bankruptcy.
Continued in article
Michael Lewis, Liar's Poker: Playing the Money Markets (Coronet,
1999, ISBN 0340767006)
Lewis writes in Partnoy’s earlier
whistleblower style with somewhat more intense and comic
portrayals of the major players in describing the double dealing
and break down of integrity on the trading floor of Salomon
Brothers.
Continued at
http://faculty.trinity.edu/rjensen/FraudRotten.htm
Bob Jensen's threads on the Lehman Examiner's Report ---
http://faculty.trinity.edu/rjensen/fraud001.htm#Ernst
2012"MF Global Mystery: The Beginning of the End or the End of The Beginning?"
by Francine McKenna, re:TheAuditors, January 10, 2011 ---
http://retheauditors.com/2012/01/10/mf-global-mystery-the-beginning-of-the-end-or-the-end-of-the-beginning/
Yesterday I wrote a
long and detailed column for Forbes about the
conscious dodging by regulators and the trustees in the MF Global case.
Continued in article
Teaching Case on the MF Global Scandal
From The Wall Street Journal Weekly Accounting Review on January 6,
2012
The Unraveling of MF Global
by:
Aaron Lucchetti and Mike Spector
Dec 31, 2011
Click here to view the full article on WSJ.com
TOPICS: Accounting Information Systems, Auditing, Disclosure
SUMMARY: "The article is based on interviews with traders,
executives and other employees...as more details emerge about MF Global's
ruin..." from the bankruptcy process, Congressional hearings, and other
inquiries into the process behind the firm's demise. The article provides a
description of the background of MF Global and the significant change effort
led by John Corzine. MF Global had faced declining interest revenue it once
earned as interest rates in the U.S. have fallen to near zero. "As soon as
Mr. Corzine arrived in March 2010, Moody's Investors Service, Standard &
Poor's and Fitch ratings told Mr. Corzine he needed to rev up profits or
face downgrades on the securities firm's debt." Corzine increased revenues
by executing trades in European sovereign debt, but structured the
transactions as "repurchase to maturity." As a result, the investments in
European sovereign debt totaling $6.3 billion were removed from the
company's balance sheet; there was an obligation to repay under these
agreements that was excluded from the balance sheet as well. The demise of
the firm came after MF Global disclosed the huge $6.3 billion sum total of
these trades; regulators asked for additional collateral, squeezing cash
available and then a run on the bank began, securing the demise.
CLASSROOM APPLICATION: The article is useful to cover this case in
an auditing or systems controls class.
QUESTIONS:
1. (Introductory) What was the background of MF Global prior to the
arrival of Jon Corzine as the company's leader?
2. (Introductory) What operating changes occurred at MF Global
during the time of Mr. Corzine's tenure there?
3. (Advanced) What is the significance of the statements in the
article that Mr. Corzine roamed the company's trading floor encouraging
"...traders to make larger bets...but...spent little time on the firm's back
offices and record-keeping, several former employees say." Are these
statements necessarily accurate because they are reported in this newspaper?
4. (Advanced) Refer again to the question above. Regardless of
whether the statements are accurate in this case, would observing these
behaviors influence your plan to audit MF Global? Explain your answer.
5. (Introductory) Refer to the graphic at the beginning of the
article entitled "The Corzine Trade." Summarize in words the impact of the
"estimated revenue from trade" on total net revenue. Based on discussion in
the article, would these trades have increased costs at the firm? Explain
your answer.
6. (Advanced) How large was the company's trading activity in
European Sovereign debt? Was this an unprofitable series of transactions for
the firm?
7. (Advanced) What was the reaction by creditors and regulators
when MF Global disclosed its "sovereign-debt trades...on pages 77 and 78 of
the company's annual report..."? In your answer, define the term "run on the
bank."
8. (Advanced) Based on the activities described in this article,
what are possible ways you would consider as an auditor to trace or recover
the lost $1.2 billion in missing client funds? In your answer, comment on
the propriety of trading with funds from customer accounts and goal of
accounting controls you believe should be present in an operation such as MF
Global's.
Reviewed By: Judy Beckman, University of Rhode Island
"The Unraveling of MF Global," by: Aaron Lucchetti and Mike Spector,
The Wall Street Journal, December 31, 2011 ---
http://online.wsj.com/article/SB10001424052970203686204577117114075444418.html?mod=djem_jiewr_AC_domainid
In September, MF Global Holdings Ltd.'s management
sent a memo to the securities firm's 2,800 employees: Start printing on both
sides of paper.
The unusual request was a sign that executives at
the New York company then led by Jon S. Corzine, a former New Jersey
governor and Goldman Sachs Group Inc. chairman, saw tougher times ahead.
They were right.
Less than two months later, MF Global collapsed
into bankruptcy, undone by a huge bet by Mr. Corzine on European sovereign
bonds that was part of his ambition to transform a sleepy commodities broker
into a Goldman-like investment-banking powerhouse.
MF Global filed for Chapter 11 bankruptcy
protection on Oct. 31. An estimated $1.2 billion in customer funds remain
missing, according to the bankruptcy trustee of MF Global's brokerage unit,
and there are few solid clues about where the money went. The shortfall has
snarled the finances of thousands of traders, farmers and other commodities
customers at MF Global.
Mr. Corzine, who turns 65 years old on Jan. 1, has
testified before Congress that he never intended for anyone at MF Global to
misuse customer funds. He and other MF Global executives face intensifying
probes from regulators and law-enforcement officials into the firm's demise.
For employees who worked at MF Global after Mr.
Corzine's tenure began in March 2010, the past two months have been filled
with anger, sadness, confusion and reflection about how a Wall Street firm
that seemed to have so much promise could unwind so quickly.
Some say they saw red flags that worried them as
Mr. Corzine ramped up risk-taking and tried to return MF Global to
profitability. This article is based on interviews with traders, executives
and other employees, many of whom declined to be identified because they are
looking for new jobs and are leery about being dragged into the
investigations.
As more details emerge about MF Global's ruin, the
reasons for Mr. Corzine's decision to bet $6.3 billion on bonds from shaky
European countries are becoming clearer.
Some of those who saw Mr Corzine in action at the
time reject the oft-repeated narrative that the bet was simply a reckless
gamble by an overconfident trader. Instead, they say the unusual trade was
driven as much by desperation as self-assurance. Read More
Weekend Investor: Are Brokerage Accounts Safe?
One big reason for the bet: It instantly boosted
revenue at a time when Mr. Corzine wanted to appease anxious credit-rating
firms and shareholders, said two executives familiar with his thinking. Mr.
Corzine declined to comment for this article.
As soon as Mr. Corzine arrived in March 2010,
Moody's Investors Service, Standard & Poor's and Fitch Ratings told Mr.
Corzine he needed to rev up profits fast or face downgrades on the
securities firm's debt.
The European bet was "a way to answer the...demands
while buying time to transform the business," one MF Global executive
recalls Mr. Corzine telling him.
In the end, he ran out of time. 1,100 New Faces
Mr. Corzine, a Democrat, wouldn't have gone back to
work on Wall Street had he been re-elected as governor in 2009. But after
his narrow loss to Republican Chris Christie, private-equity investor J.
Christopher Flowers, an MF Global shareholder and close friend of Mr.
Corzine, persuaded him to run the company. Mr. Corzine was intrigued by the
opportunity to turn around the struggling firm, declining another job offer
to be a high-ranking executive at a hedge fund.
Mr. Corzine arrived at MF Global with a plan to
reinvigorate the firm by introducing the kind of risk-taking that made him a
bond-trading star at Goldman in the 1980s and 1990s. He moved quickly at MF
Global, cutting hundreds of employees and hiring 1,100 new traders and other
employees.
In all, 1,400 employees, or 40% of the firm's work
force, eventually left between his arrival and the company's bankruptcy
filing, according to a company presentation shortly before the bankruptcy.
The move to become a full-fledged banking firm was
an extraordinary change for MF Global, whose roots go back more than 225
years to a sugar broker in London. MF Global spent most of its history as a
middleman between farmers, traders and companies that liked to hedge or bet
on the direction of commodity prices. 'Take More Risk'
Roaming MF Global's trading floor, Mr. Corzine
encouraged traders to make larger bets, without fear of losing money. He
added new, riskier businesses that wagered the firm's own money, creating a
proprietary-trading desk and increasing the emphasis on higher-risk products
like mortgage-backed securities and stock-index derivatives.
Continued in article
"MF Global : 99 Problems And Auditor PwC Warned About None," by
Francine McKenna, re:The Auditors, October 28, 2011 ---
http://retheauditors.com/2011/10/28/mf-global-99-problems-and-pwc-warned-about-none-of-them/
Update October 31: I’m
putting updates over at Forbes.
My latest column is up at
American Banker, “Are Cozy Ties Muzzling S&P on MF Global Downgrade?”
You may recall the last time
I wrote about MF Global. That story was about the “rogue” trader that cost
them $141 million. In the meantime we’ve seen another “rogue” trader scandal
and PwC has given MF Global clean opinions on their financial statements and
internal controls over financial reporting since the firm went public in
mid-2007.
I’m sure PwC thought
everything was peachy as recently as this past May when the annual report
came out for their year end March 30. Instead we’re seeing another sudden,
unexpected, calamitous, black-swan event that no one could have predicted
let alone warn investors about.
Right….
Also see
http://www.forbes.com/sites/francinemckenna/2011/10/30/mf-global-99-problems-and-auditor-pwc-warned-about-none/
Jensen Comment
I prefer "Yeah right!" to just plain "Right!"
MF Global also has some ocean front property for sale in Arizona that's been
attested to by PwC.
"MF Global Shares Halted; News Pending," The Wall Street Journal,
October 31, 2011 ---
http://blogs.wsj.com/deals/2011/10/31/mf-global-shares-halted-news-pending/
As stock markets open in New
York on Monday, MF Global shares remain halted. The only news the company
has released so far is a one-line press release confirming the suspension
from the Federal Reserve Bank of New York.
Pre-market trading in MF
Global Holdings has been halted since about 6 a.m. ET as news is expected to
be released about Jon Corzine’s ailing brokerage.
Meanwhile, the global
exchange and trading community is moving to lock-down mode on MF Global as
the U.S. broker continues efforts to forge a restructuring that could
include a sale and bankruptcy filing.
The U.S. clearing unit of
ICE said it is limiting MF Global to liquidation of transactions, while the
Singapore Exchange won’t enter into new trades. Floor traders said Nymex has
halted all MF Global-created trading. Some MF traders are restricted from
the entering the floor of the Chicago Board of Trade, and the Federal
Reserve Bank of New York said it had suspended doing business with MF
Global.
The New York Fed said in its
brief statement: “This suspension will continue until MF Global establishes,
to the satisfaction of the New York Fed, that MF Global is fully capable of
discharging the responsibilities set out in the New York Fed’s policy…or
until the New York Fed decides to terminate MF Global’s status as a primary
dealer.”
The Wall Street Journal
reported Sunday night that MF Global is working on a deal to push its
holding company into bankruptcy protection as soon as Monday, and to sell
its assets to Interactive Brokers Group in a court-supervised auction.
Continued in article
Jensen Comment
Francine may be singing
'99 bottles of negligence on the wall, 99 bottles of negligence, if one of the
bottles should happen to fall, 98 bottles of negligence on the wall, . . . "
"MF GLOBAL GOES BELLY UP, SO WHERE WAS THE GOING CONCERN OPINION?" by
Anthony H. Catanach Jr. and J. Edward Ketz, Grumpy Old Accountants, November 1,
2011 ---
http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/368
"MF Global: Where Is The Missing Money?" by Francine McKenna,
re:TheAuditors, November 10, 2011 ---
http://retheauditors.com/2011/11/10/mf-global-where-is-the-missing-money/
"MF Global : 99 Problems And Auditor
PwC Warned About None," by Francine McKenna, re:The Auditors, October
28, 2011 ---
http://retheauditors.com/2011/10/28/mf-global-99-problems-and-pwc-warned-about-none-of-them/
"MF GLOBAL GOES BELLY UP, SO WHERE
WAS THE GOING CONCERN OPINION?" by Anthony H. Catanach Jr. and J. Edward
Ketz, Grumpy Old Accountants, November 1, 2011 ---
http://blogs.smeal.psu.edu/grumpyoldaccountants/archives/368
"Deloitte: MF Global’s Former Clients Overstating Claims," by Michael
Foster, Big Four Blog, November 13, 2011 ---
http://www.big4.com/deloitte/deloitte-mf-globals-former-clients-overstating-claims
Question
Where did the missing MF Global funds end up?
Hint:
The the word "repo" sound familiar?
http://en.wikipedia.org/wiki/Repurchase_agreement
"MF Global and the great Wall St re-hypothecation scandal," by
Chrisopher Elias, Reuters, December 7, 2011 ---
http://newsandinsight.thomsonreuters.com/Securities/Insight/2011/12_-_December/MF_Global_and_the_great_Wall_St_re-hypothecation_scandal/
.
"Fixing the Futures Market in the Wake of MF Global: To restore
investor faith in the futures market, the CFTC may need to do more than just
update the rules that govern the investing of customer cash," by Larry Tabb,
Wall Street Technology, January 17, 2012 ---
http://www.wallstreetandtech.com/regulatory-compliance/232400305
The MF Global debacle has shown that the way
Futures Commission Merchants (FCMs) manage client assets can be -- how
should I say this -- somewhat lacking. Given the unsound practices, lack of
internal controls and poor oversight displayed throughout the MF Global
mess, I'm not sure if we need to rethink regulatory practices governing how
FCMs manage client money or scratch the system altogether and start anew.
Until the CFTC updated the rules that govern the
investing of customer cash, Regulation 1.25, FCMs had fairly flexible reign
in how they "invested" client assets (the new rules go into effect Feb. 17).
As long as relatively safe assets were pledged as collateral, FCMs lent
client funds to internally owned broker-dealers, which used it as
inexpensive funding. Practically, MF Global clients were engaged in "hold in
custody" repurchase agreements, or repo, theoretically collateralized
against some "relatively safe" dealer inventory. While collateral was
supposed to be segregated, however, dealers were never required to inform
the client of what collateral was pledged against their cash,
Years ago securities dealers also could
collateralize internal institutional repo without letting the client know
what was being used as the collateral. It was done on the dealer's word and
no third parties were involved. No one even checked to confirm that the same
collateral wasn't allocated multiple times. Internally, we called these
"Trust Me" repos. Thankfully, "Trust Me" repos stopped in the late '80s for
institutional clients with the advent of tri-party repo, in which the
collateral was physically segregated to a third-party custodian that also
valued and verified these transactions.
Under the new Regulation 1.25 rules, internal repo
transactions also will be a thing of the past. FCMs will need to physically
move clients' excess cash to a third party for overnight investment. To
avoid excess concentration of risk, this cash must be placed with at least
four unaffiliated dealers, with no single dealer getting more than 25
percent. The cash only will be allowed to be invested in very safe
investments that can lose no more than 1 percent of their value overnight.
The approved list of investments is very short; it includes U.S.
government-guaranteed debt and debt issued by organizations that the U.S.
government has backed through secured lending programs, as well as
short-term commercial paper, certificates of deposit and high-quality
municipal bonds, or munis. Foreign sovereign debt is, as its name suggests,
excluded from the list of acceptable investment opportunities.
While this is a step in the right direction, it is
not without its challenges. Perhaps the biggest questions are: Where will we
get access to so much U.S. guaranteed debt? And which banks will take the
money? Obtaining access to vast amounts of U.S. Treasuries will be
difficult, as most Treasuries are pledged against institutional financings.
Even if all guaranteed U.S. debt is allowable, there may not be that much
excess collateral available -- especially given the collateral demands
required to back the central clearing of OTC derivatives as mandated by
Dodd-Frank.
Unless the new Regulation 1.25 rules are repealed,
which is unlikely, we can expect a very significant squeeze on U.S.
government-guaranteed debt, pushing yields lower and prices higher,
initiating the repatriation of U.S. debt from around the globe. It also is
likely to push short-term yields into the negative territory, especially for
futures clients.
Another problem with investing so much overnight
cash is the possibility that banks may not want it. Under new Basel III
liquidity requirements, banks accepting short-term money will need a greater
supply of longer-term, less-flight-prone deposits. This will increase banks'
funding costs, which most likely will be pushed back on clients that hold
cash balances in futures margin accounts. As a result, banks may shy away
from taking this cash, or they may be forced to charge a fee for holding it
instead of paying the FCM client interest.
Continued in article
Bob Jensen's threads on derivatives financial instruments scandals ---
http://faculty.trinity.edu/rjensen/FraudRotten.htm#DerivativesFrauds
Bob Jensen's threads on the Bankruptcy Examiner's Report in the Lehman
Brothers Repo 105/108 scandals --- |
www.trinity.edu/rjensen/Fraud001.htm
Bob Jensen's threads on MF Global ---
http://faculty.trinity.edu/rjensen/Fraud001.htm
2012
LIBOR ---
http://en.wikipedia.org/wiki/LIBOR
"UBS, Credit Suisse Among Banks in Swiss Libor-Fixing Probe," by Elena
Logutenkova, Bloomberg News, February 3, 2012 ---
http://www.bloomberg.com/news/2012-02-03/switzerland-s-comco-opens-investigation-into-ubs-credit-suisse.html
UBS AG (UBSN) and Credit Suisse Group AG (CSGN) are
among 12 banks facing a Swiss inquest into possible manipulation of the
London interbank offered rate, the latest probe into how the benchmark for
$350 trillion of financial products is set.
“Collusion between derivative traders might have
influenced” Libor and its Japanese equivalent, Tibor, the Swiss competition
watchdog, Comco, said in an e-mailed statement today. “Market conditions
regarding derivative products based on these reference rates might have been
manipulated too.”
Comco said it opened the investigation after
receiving an application for its “leniency program,” which indicated that
traders from various banks might have influenced the rate. Libor is set
daily by the British Bankers’ Association based on data from banks, which
report how much it would cost them to borrow from each other for various
periods of time. Regulators in the U.S., U.K. and European Union have been
examining how Libor is set, while Japan’s securities watchdog has probed
Tibor.
“We are taking these investigations very seriously
and are fully cooperating with the authorities,” said Yves Kaufmann, a
spokesman for UBS in Zurich. UBS, the biggest Swiss bank, said in July that
it was granted conditional immunity from some agencies, including the U.S.
Department of Justice.
A spokesman for Credit Suisse said the bank is “not
in the position” to comment at the moment.
Jensen Comment
This could be really huge since hundreds of thousands of derivatives financial
instruments and hedging contracts use LIBOR as an underlying. Although LIBOR is
not technically a risk free interest rate, it fundamentally assumes that traders
are not manipulating the rate for devious purposes. It's probably the most
popular interest rate underlying in derivatives financial instruments contracts.
Bob Jensen's helpers in accounting for derivative financial instruments
and hedging activities ---
http://faculty.trinity.edu/rjensen/caseans/000index.htm
Bob Jensen's fraud updates ---
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
2012
LIBOR ---
http://en.wikipedia.org/wiki/LIBOR
Note that LIBOR is a global index used in hundreds of millions of contracts
around the world as an underlying for interest rate movements. Nobody ever
argued that LIBOR was as risk free as the U.S. Treasury Rate, but globally the
U.S. Treasury rate paled relative to LIBOR as a market index for interest rates,
especially hundreds of trillions of dollars in interest rate swaps.
Hence when LIBOR becomes manipulated by traders it affects worldwide
settlements. This is why pension funds of small U.S. towns, labor unions, and
banks of all sizes are now suing Barclays and the other U.K banks that allegedly
manipulated the LIBOR market rates for their own personal agenda.
"Lies, Damn Lies and Libor: Call it one more improvisation in 'too
big to fail' crisis management," by Holman W. Jenkins Jr., The Wall
Street Journal, July 6, 2012 ---
http://professional.wsj.com/article/SB10001424052702304141204577510490732163260.html?mod=djemEditorialPage_t&mg=reno64-wsj
Ignore the man behind the curtain, said the Wizard
of Oz. That advice doesn't pay in the latest scandal of the century, over
manipulation of Libor, or the London Interbank Offered Rate. The mess is one
more proof of the failing wizardry of the First World's monetary-cum-banking
arrangements.
Libor is a reference point for interest rates on
everything from auto loans and mortgages to commercial credit and complex
derivatives. Major world banks are accused of artificially suppressing their
claimed Libor rates during the 2007-08 financial crisis to hide an erosion
of trust in each other.
Did the Bank of England or other regulators
encourage and abet this manipulation of a global financial indicator?
We are talking about TBTF banks—too big to fail
banks. Banks that, by definition, become suspect only when creditors begin
to wonder if regulators might seize them and impose losses selectively on
creditors. Their overseers could not have failed to notice that interbank
liquidity was drying up and the banks nevertheless were reporting Libor
rates that suggested all was well. The now-famous nudging phone call from
the Bank of England's Paul Tucker to Barclays's Bob Diamond came many months
after Libor manipulation had already been aired in the press and in meetings
on both sides of the Atlantic. That call was meant to convey the British
establishment's concern about Barclays's too-high Libor submissions.
Let's not kid ourselves about something else:
Central banks everywhere at the time were fighting collapsing confidence by
cutting rates to stimulate retail lending. Their efforts would have been
thwarted if Libor flew up on panic about the solvency of the major banks.
Of all the questionably legal improvisations
regulators resorted to during the crisis, then, the Libor fudge appears to
be just one more. Regulators everywhere gamed their own capital standards to
keep banks afloat. The Fed's bailout of AIG, an insurance company, hardly
bears close examination. And who can forget J.P. Morgan's last-minute
decision to pay Bear Stearns shareholders $10 a share, rather than the $2
mandated by Treasury Secretary Hank Paulson, to avoid a legal test of the
Fed-orchestrated takeover? Even today, the European Central Bank continues
to extend its mandate in dubious ways to fight the euro crisis.
There has been little legal blowback from any of
this, but apparently there will be a great deal of blowback from the Libor
fudge. Barclays has paid $453 million in fines. Half its top management has
resigned. A dozen banks—including Credit Suisse, Deutsche Bank, Citigroup
and J.P. Morgan Chase—remain under investigation. Private litigants are
lining up even as officialdom seemingly intends to wash its hands of its own
role.
Yet the larger lesson isn't that bankers are moral
scum, badder than the rest of us. The Libor scandal is another testimony (as
if more were needed) of just how lacking in rational design most human
institutions inevitably are.
Libor was flawed by the assumption that the banks
setting it would always be seen as top-drawer credit risks. The Basel
capital-adequacy rules were flawed because they incentivized banks to
overproduce "safe" assets, like Greek bonds and U.S. mortgages. The ratings
process was flawed eight ways from Sunday, including the fact that many
fiduciaries, under law, were required to invest in securities blessed by the
rating agencies.
Some Barclays emails imply that traders, even
before the crisis, sought to influence the bank's Libor submissions for
profit-seeking reasons. This is puzzling and may amount to empty chest
thumping. Barclays's "submitters" wouldn't seem in a position to move Libor
in ways of great use to traders. Sixteen banks are polled to set Libor and
any outlying results are thrown out. Plus each bank's name and submission
are published daily. But let's ask: Instead of trying to manipulate Libor in
a crisis, what would have been a more straightforward way of dealing with
its exposed flaws, considering the many trillions in outstanding credit tied
to Libor?
Continued in article
Bob Jensen's fraud updates ---
http://faculty.trinity.edu/rjensen/FraudUpdates.htm
Bob Jensen's threads on interest rate swaps and LIBOR ---
http://faculty.trinity.edu/rjensen/acct5341/speakers/133glosf.htm
Search for LIBOR or swap.
Timeline of Financial Scandals, Auditing
Failures, and the Evolution of International Accounting Standards ----
http://faculty.trinity.edu/rjensen/FraudCongress.htm#DerivativesFrauds
END OF TIMELINE TO
DATE
