Saturday, May 31, 2008

Toothless SEC-4

"Six years after a scandal first erupted over AOL allegedly inflating its revenue during its merger with Time Warner Inc., U.S. regulators have concluded their investigation and filed civil-fraud charges against eight former executives. ... Four of the former executives, including Mr. [David] Colburn, who headed AOL's business-afffairs unit, have agreed to pay a combined sum of a little more than $8 million to settle the [SEC] suit filed Monday in U.S. District Court in Manhattan, The other four, including Mr. Kelly, are contesting the SEC charges, filed in a separate suit. ... At the heart of the SEC's inquiry was an alleged scheme in which AOL made so-called round-trip transactions to inflate revenue by giving vendors money to buy online advertising they didn't need. In 2005, the SEC sued Time Warner over related allegations. .. Time Warner settled the charges, paying a $300 million fine, and restated its earnings three times to correct its reported revenue. But the SEC continued its investigation. ... The four who have settled have agreed to pay fined and return allegedly ill-gotten gains, with interest. But they haven't admitted or denied wrongdoing under the settlement", my emphasis, WSJ, 20 May 2008.

Why did the SEC continue this farce to settle charges without an admission of wrongdoing? Does anyone in Cox's SEC have a lick of sense?

California Real Estate Update-4

"California home prices tumbled 32 percent from April a year earlier as 'distressed' properties and a lack of financing cut demand, the state realtors group said. The median home price fell to $403,870, the California Association of Realtors said in a statement today",, 23 May 2008.

Be patient, it will get worse.

The Fed "Gets It"

"Back in December 2002, one dollar equaled one euro. But that exchange rate didn't last. The dollar was on its way down, a trend that had started more than a year earlier, and has lasted, with occasional oscillations, to this day. ... In Europe, the price of oil has risen by 50 euros in the past five-and-a-half years. ... The sole reason for this enormous difference is the incredible depreciaton of the dollar against the euro. From one for one at the end of 2002, it now costs nearly $1.60 to buy a euro. ... The same old solutions we have heard for years are being proposed--conservation, increased domestic exploration, manipulation of the tax on gasoline. But no one is pointing to what is by far the biggest reason for today's $50 fill-ups. The collapse of the dollar exchange rate, alone, explains at least half of the increase in the pump price of gas over the past five years. If it wasn't for the falling value of the dollar, the price of gasoline wouldn't be an issue. ... Why have we allowed the value of a dollar to fall by half? ... The fact is that the dollar exchange rate is way our of line with the fundamental strength of our economy, and even with such well-known fundamentals as inflation rates. .. We don't need gas tax holidays. We need exchange rate policy", David King (DK) at the WSJ, 23 May 2008.

"In a speech in New Orleans this week, [Donald] Kohn acknowledged soaring oil and food prices, but he blamed them on global supply and demand for corn, oil and so on. ... 'But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dolar may have played a role in the rise in the prcies of oil and other commodities, but it probably has been a small one.' If Mr. Kohn really believes this, we're in more trouble than we thought. ... When the value of the greenback falls, and especially when speculators anticipate that it will fall further, oil sellers demand more dollars for their product. That was the experience of the 1970s, the last time the Fed lost its monetary moorings, and we have been living through a sequel this decade. ... The central bankers have justified their rapid plunge down the yield curve as necessary to avoid a recession, arguing that a slowing economy would mitigate any inflationary inpact. ... As for inflation, this week's price numbers were alarming. ... With even the Fed's phony 'core inflation' rate well above the 2% federal funds rate, Mr. Kohn and company are running a negative real interest rate policy. ... Yet some at the Fed continue to insisist that inflation expectations are 'well-anchored.' Anchored on what planet? ... Voters are understandably furious because they can see that their real incomes are falling as prices rise", editoral at the WSJ, 23 May 2008.

DK gets it. DK is a "former chief of the New York Federal Reserve's Industrial Economics Division". Apparently, DK's article is the Fed's way of letting us know, the Fed understands what's going on. I await Helicopter Ben's appearing in front of Congress to explain the effects of the dollar's fall on oil's price. As to "no one" pointing to the dollar collapse, I have, see my 7 January 2008 post. Jeffrey Currie of Goldman Sachs is getting close, my 9 May 2008 post. How the US can have "an exchange rate policy" and support Wall Street at the same time is beyond me. We destroy the dollar or the banks, see my 15 December 2007 post.

The WSJ proclaims the "core inflation rate" phony. Thank you. Is Kohn stupid or venal? Is he incapable of seeing the relative increases in the dollar price of commodities compared say, to the euro price? Who is Kohn? A guy with a PhD from the University of Michigan. Aren't we impressed? Yes, but unfavorably. We are not amused either.

Friday, May 30, 2008

Broken Models

"The latest blow to the reputation of Moody's Investor Service in structured finance is the charge that it knew of a computer error that inflated the ratings of constant-proportion debt obligations, or CPDOs, and didn't disclose the problem. But Standard & Poor's gave the deal in question the same top rating--and a bit of a dodgy bit of software code wasn't to blame. The real problem is the rating companies' reliance on computer black-box models in the first place. ... Moody's, a unit of Moody's Corp., says it takes the questions about its models seriously, and has hired an outside law firm to review its CPDO ratings process. Still, the crisis of confidence in structured finance didn't stem from calculation errors. It was a reaction to the discrediting of the rating firms' overly theoretical and insufficiently critical approach--which investors blithely accepted at face value", my emphasis, WSJ, 22 May 2008.

"Moody's Investors Service's problems in rating complex debt instruments known as CPDOs show the difficulty in assessing new, untested products with the same scale that conveys the financial strength of blue-chip companies or the U.S. government. ... On Wednesday, Moody's said it retained law firm Sullivan & Cromwell LLP (S&C) to review its European CPDO-ratings process. The Financial Times reported that data errors were discovered after some of the early CPDOs were rated by Moody's, and those errors went unreported. ... Though [the SEC] can't regulate the specific methodology that a firm uses, the SEC can sanction firms for straying from their stated methodologies. ... Some former Moody's officials said data integrity has been an issue before. Sylvain Raynes, a former Moody's quantitative analyst, said he discovered during the late 1990s, a 'bug in the code' used to rate a deal backed by rental cars. In an interview, Mr. Raynes said Moody's should have downgraded the deal after discovering the error, but decided not to", my emphasis, WSJ, 22 May 2008.

I disbelieve Moody's. It "hired a law firm". Why? To review "process", not susbtance. If Moody's wants to fix its ratings, it could hire Joel Stern MBA (Chicago, 1964), a guy I believe knows something. Why did Moody's hire a law firm? Most likely: to fend off anticipated litigation. Hey Mike Garcia (MG), if Moody's knowingly and willfully let its ratings be comunicated to any third party while knowing they were wrong, can you indict it under 18 USC 1341 or 1343, mail or wire fraud? Get out "Ed McMahon's hermetically sealed mayonnaise jar", see my 14 and 28 April 2008 posts.

Does anyone remember Arthur Andersen, once auditor for Enron? I think it's time the SEC yanked Moody's and S&P's NRSRO status. This is an outrage. MG, start drafting those indictments. Now! "[D]ecided not to", how interesting. Hey MG, if we have two or more predicate acts within a ten-year period, relatedness and continuity and threats of continued criminal activity, can we state a RICO count? Remember RICO, 18 USC 1961-69? Will this Moody's and S&P outrage be left to the plaintiffs' bar to respond to with a civil RICO action? Hey Chris Cox, hey Walter Riccardi (WR), what if anything will you do about this? Oh, I'm sorry WR, you're leaving the SEC. Did you send S&C a resume and is the fix already in? Imagine, the SEC has time to harass short sellers, but will likely do nothing about this. I wonder if the SEC will harass Moody's short sellers?

IEA Discovers Supply

"The decision to rigorously survey supply--instead of just demand, as in the past--reflects an increasing fear within the agency [IEA] and elsewhere that oil-producing regions aren't on track to meet future needs. ... The IEA, employing a team of 25 analysts, is trying to shed light on some of the industry's best-kept secrets by assessing the health of major oil fields scattered from Venezeula and Mexico to Saudi Arabia, Kuwait and Iraq. The fields supply over two-thirds of daily world oil prodution. ... But the direction of the IEA's work echoes the gathering supply-side gloom articulated by some Big Oil executives in recent months. ... Any gap, it was assumed, would then be met by big OPEC producers such as Saudi Arabia, Iran or Kuwait. ... In November, [the IEA] said its analysis of projects known to be in the works suggested that the world could face a shortfall by 2015 of as much as 12.5 million barrels a day, unless there was a sharp drop in expected demand. ... 'This is very important, because the IEA is treated as the world's only serious guardian of energy data and forecasts,' says Edward Morse, chief energy economist at Lehman Brothers. ... The big OPEC producers have been raking in record profits, creating a disincentive to sink more billions into increased oil production. ... 'The IEA is always conflicted by political pressures,' says Chris Skrebowski, a London-based oil analyst", WSJ, 22 May 2008.

All such "guardians" are subject to political pressures. That said, a 12.5 million barrel a day oil production "shortfall" could double oil prices.

Thursday, May 29, 2008

The Middle East and the Dollar

"If there's one message the Bush administration has been trying to hammer home to Chinese leaders, it is this: A major country with huge trade surpluses and rising prices should let its currency strengthen with market forces. So why is the administration nearly silent about the fixed exchange rates of Saudi Arabia and other Persian Gulf oil fiefdoms? ... Gulf newspapers and financial markets are rife with speculation that the Saudis, who have kept the riyal at 3.75 to the dollar since 1986, might set a new, higher exchange rate or otherwise loosen the link between the two currencies. ... There are good reasons for the Gulf Cooperation Council countries--Saudi Arabia, the U.A.E., Bahrain, Kuwait, Oman and Qater--to move away from the dollar. Inflation is high and getting higher in the region: almost 10% in Saudi Arabia, close to 15% in the U.A.E. and 9% in Kuwait. ... Already, the U.A.E. has frozen prices for bread, rice and other staples. Saudi Arabia is cutting tariffs on imported foodstuffs. ... Still, there is no consensus among economists about whether it is a good idea for the Saudis to do unto the riyal as the U.S. would have the Chinese do unto the yuan, ... Paulson may also be concerned that a shift in the Gulf's foreign-exchange policy might persuade markets that the smart money is losing faith in the dollar, sparking an even steeper decline in the currency even as the Treasury tries to put a floor under its fall", WSJ, 19 May 2008.

"Hedge funds and other investors made bundles of money in the 1990s betting currency pegs around the world would break. They are at it again, only this time they are gambling currencies will soar, not plummet. ... Art Steinmetz, who manages a $12 billion international bond portfolio at Oppenheimer Funds, likens currencies pegged to the dollar to bouyant rafts dragged underwater by a heavy boat anchor. ... Still, the money pouring into countries in anticipation of stronger currencies is causing inflationary pressures that policy makers can't ignore", WSJ, 27 May 2008.

This is absurd. If Hank Paulson (HP), "formerly" of Goldman Sachs (GS), wants a stronger dollar he should order Helicopter Ben to stop printing them. The UAE should follow the Phillipines and end price controls. They haven't worked for 4,000 years. As for the economists, what are they waiting for? See my 13 November 2007 and 9 and 12 May 2008 posts. I wonder if HP speaks to any of his old GS associates about commodity prices?

Eventually these pegs will break no matter what the world's finance ministers may say.

Argentina and Indonesia Act

"Barely six years after Argentina committed the biggest sovereign-debt default in history and devalued its currency, locals and Wall Street investors are asking an unsettling question: Is is about to happen again? ... Nonetheless, troubling signs of financial panic have appeared. Middle-class Argentines are rushing to cash out savings accounts to buy dollars, a sign they think the government is in big trouble and the currency will plunge. ... The X-factor is Argentina's first family: President Cristina Fernandez de Kirchner, the irascible former president who many believe still calls the shots. With the government's popularity in decline amid a 23% inflation rate and a failure to end a farmers strike, concerns are mounting over the long-term sustainability of the Kirchners' populist policies. ... 'The objective probability of a crisis similar to those of the past is, in the Argentina of today, virtually nil,' Central Bank President Martin Redrado wrote in Sunday's La Nacion newspaper. ... Complicating matters, the government must still contend with the still-painful memories of the 2001 financial crisis, when a deperate government froze deposits, wipiong out the savings of many middle-class Argentines. ... 'There is no confidence in the Argentine financial system, period,' said Ernesto Bodenheimer, 59 years old, an activist who led an organization of bank account holders seeking access to savings frozen during the last crisis. 'The slightest noise and you get your money out.' ... We suspect that the authorities are under some pressure to engineer a devaluation of the peso in order to protect local industries from import competition,' Morgan Stanley economist Daviel Volberg said in a research note. 'This would of course be a high risk move'," WSJ, 19 May 2008.

"Indonesia increased fuel prices by almost 30%, a move that shows how Asian nations are grappling with the financial pressures of high fuel subsidies in an era of $130-plus oil. China, India and Malaysia face a smiliar dilemma. ... Indonesia's energy minister, Purnomo Yusgiantoro, said the government could no longer afford subsidies that have kept fuel prices here about half the level of the U.S. ... China's oil subsidy program stood at $8 billion in 2007. It was just 0.2% of gross domestic product, according to Citigroup. .. In India, fuel subsidies represent about 0.9% of GDP, according to Citigroup", WSJ, 24 May 2008.

Buy dollars? Are the Argentines nuts? Buy gold! Does anyone remember Walter Wriston, Citigroup head, 1967-84? He used to say, "Countries don't go bust". What a fool. I look at Argentina and see the US. We Americans see a commodities boom. I think it's a flight from the dollar. Congress is considering legislation to control "speculators" which some Congressmen think "unceccesarily" increase oil prices. Self righteous, arrogant fools. Are foreign exchange controls next? Does anyone remember 1963-74's Interest Equalization Tax? If you want commodity prices to stop rising, have Helicopter Ben (HB) "stop the presses!". Study the British pound devaluations, see my 27 September 2007 and 12 May 2008 posts. Argentines should ignore Redrado, just like Americans should ignore HB. US Congress take note. Why a "high risk move", Volberg? For whom? I think all US dollar denominated long-term bonds are a sell.

When all else fails, even governments act rationally. See my 22 May 2008 post. Eventually I expect most of the world's countries to end commodities subsidies. Who knows, maybe Congress will end food stamps?

Wednesday, May 28, 2008

Fed--Rating Agency Smoke and Mirrors

"Saving the nation's financial system from reckless banks and brokerage firms is an enormous job, heaven knows. But somebody's got to do it, so the [Fed], with its taxpayer-funded balance sheet, stepped in ... Together, they allow banks and financial firms to swap up to $350 billion in securities they cannot sell for cash or [US] Treasuries. ... This allows institutions to exchange their trash for cash that they can turn around and lend to corporations or individuals. ... One of those risks is that taxpayers may have to cover losses if a firm or bank fails to repay a loan. So far, the Fed's noble experiment seems to be working. ... To be sure, the Fed is fairly well protected against the possibility that a commercial bank will renege on the loans. These institutions provide excess collateral--typically 100 percent of their borrowings--when they tap the entity and the Fed can go after their other assets if need be. But deals with brokerage firms are another story entirely. And the particulars of those transactions worry Josh Rosner [JR], analyst and expert on mortgage securities at Graham-Fisher, an independent financial research company in New York. ... And look at the securities the Fed accepts in these swaps: residential and commerical mortgages and other asset-backed issues. Sure, the Fed requires that the securities must be rated triple-A to to qualify for a Treasury swap. But as we've learned over the last year and a half, such ratings are unreliable... Last month. Donald L. Kohn, vice chairman of the [Fed], addressed bankers at a credit market symposium in North Carolina. 'I think part of the worklist for the regulators is to re-examine the extent to which we ourselves are relying on these rating agencies to gauge the risks that you guys are taking,' he said. 'I think there was far, far too much reliance on credit rating all around.' ... Yet the Fed is doing precisely that when it accepts triple-A rated mortgage securities. 'This is classic "do as I say, not as I do,'' Mr. Rosner said. More worrisome, he added is the fact that the Fed doesn't examine the basis for bestowing a triple-A rating on these securities. Are they triple-A rated based on the soundness of the issuer? Or because of an insurance policy guaranteed by M.B.I.A. or Ambac Financial Group, the troubled financial guarantors? ... But as long as the guarantors carry triple-A's, the securities they guarantee carry them as well. But what if the guarantors themselves are downgraded? ... How much of the collateral posted at the Fed by brokerage firms is triple-A solely because of financial guarantors' insurance, which is known as a wrap? The Fed won't say. But Mr. Rosner said it only stands to reason that much of the mortgage and asset-backed collateral posted at the Fed falls into that catagory. 'Investment banks who are posting the collateral know if the securities are natural triple-A or only triple-A because of the wrap,' he said. 'Obviously the incentive would be for them to post triple-A collateral of lower quality to the Fed.' ... Clearly, it is in the Fed's interest to make sure that M.B.I.A. and Ambac are well capitalized and deserving of triple-A ratings. ... Henry M. Paulson, Jr., the Treasury secretary, said last week that the credit crisis was abating", Gretchen Morgenson (GM) at 18 May 2008.

GM, why must anyone "do it"? What's "noble" about it? The "Fed requires that the securities must be rated triple-A". So? Moody's, S&P, et al., understand the Fed's game. Would I be out of line to suggest Helicopter Ben and Hank Paulson, subtly, or unsubtly, let the ratings agencies (RA) know do not downgrade anything the Wall Street houses wish to dump on the Fed, lest they interfere with the Fed-Treasury bailouts? Did say, the Treasury's designated schtarke, Robert Steel tell the RA of 18 USC 1505, interference with the operations of a federal agency? Will Dudley Do-right save Nell Fenwick from the oncoming train? GM and Rosner, I do not believe the Fed relies on the RA for anything, but uses RA to justify it's already decided upon course of action. I await the RA downgrading Fed-held paper. Right! That Wall Street houses would "cherry pick" the securities they post at the Fed should surprise no one. See my 7 April and 3 and 9 May 2008 posts.

The DOJ Strikes Out, Again

"Wilbros Group, Inc., a Houston-based oil-services company, agreed to pay $32.3 million in criminal and civil penalties to settle charges that it bribed government officials in Nigeria and Ecuador to get contract, federal prosecutors said Wednesday. ... The Justice Department agreed to defer prosecution of the company under the Foreign Corrupt Practices Act for three years, citing the company's cooperation and compliance efforts". WSJ, 15 May 2008.

Another DOJ triumph. Another deferred prosecution. Feh!

Tuesday, May 27, 2008

Equal Justice?

"You can, however, wish the state of Texas had shown similar vigor in protecting the children of some other religious groups with sexual practices that seem out of touch with modern society. Say, for example, the church that prescribes celibacy for its priests. The state not only turned a blind eye for many years, but at times it actually abetted the Roman Catholic Church. ... The church quietly reached a settlement with the family. A judge ordered the terms of the settlement sealed. It was likely for a substantial amount of money, because the family told the district attorney it did not want the boy to testify against the priest. The district attorney acquiesced and dropped the charges. ... The majority's ruling meant we couldn't know for sure whether the secret agreement amounted to the family declining to prosecute the priest after receiving hush money from the church. Put another way, the sealing order may have masked the church paying money raised from the faithful to keep a child molester from going to prision", Rick Casey (RC) at the Houton Chronicle, 27 April 2008.

In some states, an agreement as RC describes would be illegal as "compounding a felony". It might be punishable under Texas Penal Code 36.05 as witness tampering. Under any circumstances, I think it bad public policy.

IEA Discovers Demand?

"Evidence is mounting that high energy prices are at least cutting into global oil consumption, but probably not yet at levels that will drain demand enough to drive down prices. In one key barometer, the International Energy Agency [IEA] on Tuesday revised downward its forecast for global oil-demand growth this year for the second month in a row. ... Oil demand will grow this year by 1.03 million barrels a day, or about 1.2% to 86.8 million barrels a day, the IEA estimates. ... The IEA's report acknowledges a major shift. For years, global oil demand has seemed impervious to the steep rise in crude prices because incomes have grown fast enough to offset the rising cost of fuel. ... The IEA also said oil demand may start to weaken in developing economies where it had been robust. Demand is still growing strongly in places like China and the Middle East, where fuel prices are kept artificially low by the state. But some emerging economies are creaking under the burden of escalating fuel subsidies--which in the case of Indonesia will reach $12 billion this year--and pressure is growing to end them. ... 'It's an open question as to how long these price subsidies in some Asian economies can be sustained,' said David Fyfe, an IEA analyast. 'But politically, removing them is a very difficult move to make.' ... The IEA's conclusions contradict the claim by some economists that oil demand remains largely impervious to the price of crude--an argument that had been voiced during other oil-price shocks", my emphasis, Guy Chazan and Neil King (C&K) at the WSJ, 14 May 2008.

C&K should learn some economics. The "economists" claim is amazing. I understand demand to mean a schedule of quantities purchased over some period of time at various prices, a curve with a negative slope. "Oil demand will grow", at what price will consumption grow? It seems the IEA and C&K confuse demand and consumption. These guys should all go to wikipedia to learn concepts like: price elasticity of demand.

Monday, May 26, 2008

GSEs and their CFOs

"Freddie Mac recorded a $151 million net loss for the first quarter as changes in accounting policies offset higher costs related to U.S. home-mortgage defaults. Without the accounting changes, the loss would have exceeded $2 billion, Buddy Piszel [BP], chief financial officer, said in an interview. But he said the accounting changes mean results better reflect the underlying business. ... Freddie also reported that the 'fair value,' or estimated market value, of its net assets was a negative $5.2 billion as of March 31, compared with a positive $12.6 billion three months earlier. ... Piszel said the negative fair value reflects current distressed prices for mortgage securities and has 'no impact' on the operations of a company like Freddie that is a long-term holder of mortgages. ... Freddie's main regulator .... Ofheo, 'is aware of all of the accounting changes and has taken no exception to them,' Mr. Piszel said. ... Joshua Ronen, an analyst of Graham Fisher & Co., a New York research firm, said the accounting changes 'put a lot of lipstick on this pig'," WSJ, 15 May 2008.

"Fannie Mae and Freddie Mac are 'a point of vulnerability for the financial system' because their capital is meager in relation to their mortgage assets and obligations, the companies' main regulator said. With that skimpy capital cushion, the government-sponsored companies 'could pose significant risk to taxpayers as well as financial institutions and other investors,' the regulator, James Lockhart, director of [Ofheo] said at a conference in Chicago. ... Fannie and Freddie each have 'core' capital equalling less than 2% of the mortgages they own or guarantee", WSJ, 17 May 2008.

I agree with Ronen. This looks like the "regulatory forbearance" that prolonged the S&L crisis of 1979-86. BP sounds like an accountant. I use that as a term of opprobrium. BP apparently doesn't understand Freddie is a highly-leveraged potential disaster area. I found out how many Freddie shares BP purchased recently: none. I found a Form 4 indicating he was awarded 12,538 shares on 31 January 2008 for services and owns 120,851 shares. Prices: $30.01 on 31 January and $25.73 per share currently. Hey, BP, if you believe Freddie is a good deal, buy say 100,000 shares with your sign on bonus. Right! Who is BP? Why did Freddie hire him? A 19 October 2006 press release indicates BP was once a Deloitte & Touche partner. My guess: Freddie hired BP to provide it "regulatory cover" with the SEC, PCAOB, etc., etc., ad nauseum. If BP's like 95% of the Big 87654 partners I've met, he's an economic ignoramus. Chuck Chaplin, CFO of MBIA wrote a letter the the WSJ, 19 May 2008, attacking "mark to market" accounting. It seems, he's another CFO who does not understand the economics of his own business.

"Could pose"? No, do pose.

Real Estate Update-2

"The share of homes vacant and for sale, an important measure of the nation's housing supply, set a record in the first quarter in a signal that the glut of homes on the market isn't improving. The homeowner vacancy rate, which measures the number of vacant homes for sale, rose to a record 2.9% in the first quarter from 2.8% in the fourth quarter, about one percentage point higher than normal, according to new Census Bureau data. ... Meanwhile, a record 4.1 million vacant homes are for rent, with the rental vacancy rate rising to 10.1% in the first quarter", WSJ, 29 April 2008.

"Home-price declines are accelerating nationwide, pushing a hoped-for turnaround in the housing market further down the road. The [S&P]/Case/Schiller index that measures home prices in 20 major metro areas dropped 12.7% in February from a year earlier--the sharpest decline in the data's two-decade history. ... 'There is no sign of a bottom in the numbers', said S&P analyst David Blitzer. ... All 20 cities in this measure showed price drops from January to February, and almost all showed year-to-year declines; the Charlotte, N.C., area showed a modest 1.5% increase. ... Home prices in the Las Vegas, Miami and Phoenix markets fell by more than 20% from a year earlier. ... Overall, the 20-city index has declined 14.8% since peaking in July 2006", WSJ, 30 April 2008.

"In the latest sign that the housing market is deflating at a record pace, the National Association of Realtors said prices declined in more metropolitan areas in the first quarter than at any time in the past three decades. ... Nationally, the median home price fell to $196,300, down 7.7% from a year ago. ... Home prices fell 12.3% to $296,300 in the West and dropped 7.5% to $164,200 in the South", WSJ, 14 May 2008.

Be patient, this will get worse.

Sunday, May 25, 2008

Welcome London Banker

"When I was a young central banker, we often spent our lunchtimes debating how best to rob our employer. ...I can now see I was a central banker of very little brain--and lacking ambition. The way to rob a central bank efficiently is to be a bank executive so skilled in financial engineering that I take my bank to the edge of extinction. I can then swap all my unpriceable, illiquid, engineered credit instruments for good central bank cash and Treasuries. That's larceny without risk, making the central bank a complicit partner in the looting of its vaults, and earning gratitude and bonuses instead of audits and indictments", London Banker (LB) at, 15 May 2008.

This is LB's first post at RGE Monitor. Read it. I love you LB. Enjoy. Laugh. Cry. LB is RGE's Spengler. I have said things like LB for years. Willie Sutton (WS), bank robber, spent about 35 of his 79 years in prison for bank robbery. When last released he was asked if he would do it again. WS said no, He would become an accountant. WS is asked why? WS responds because you can steal ten times as much with a pencil as with a gun. And if you're caught you don't go to jail, you just get fired. The bank you stole from doesn't even report what you did because it doesn't want to be publicly embarrassed.

Moody's Image

"Moody's Investors Service is clarifying its code of conduct to convince regulators and investors that its bond-rating analysts aren't too close to the companies they cover. ... Self-imposed reforms could help Moody's and rivals [S&P] and Fimalac SA's Fitch Ratings stave off a regulatory crackdown. ... The report concluded that analysts shouldn't make proposals or recommendations about the design of structured-finance products, since such consultations can been seen as compromising objectivity in rating bond deals", WSJ, 15 May 2008.

Big deal. I wouldn't put any credence in "self-imposed reforms". I've seen their history of failure in the CPA profession. See my 6 October and 28 December 2007 posts.

Saturday, May 24, 2008

Volker on the Fed

"Former [Fed] Chairman Paul Volker said the Fed's independence could be hurt by the wide variety of assets it has taken on its balance sheet to combat the credit cruch. ... It has so far not directly purchased [loans backed by subprime mortgages]. It did, however, make an unprecdented loan of $29 billion to facilitate the sale of Bear Stearns Cos. to J.P. Morgan Chase & Co. ... Volker [said] 'If its' going to be looked to as the rescuer or supporter of a particular section of the market, that is not strictly a monetary function in the way it's been interpreted in the past.' ... Volker also laid part of the blame for the current crisis at the feet of banking regulators, including the Fed. 'Why were [the banks] permitted to set up those off-balance-sheet entities that may or may not have had some formal relationship with the bank? They were not regulated and [banks] didn't hold an adequate amount of capital against them. Why did that happen after the experience of Enron?' ... In 2003 and 2004, the Fed and other regulators ruled that the new accounting standards wouldn't compel banks to hold aditional capital for such entities. But when investors refused to refinance the entities' commerical paper last year, some banks were forced to take the entities back on their own balance sheets", WSJ, 15 May 2008.

I agree with Volker, See my 6 February 2008 post on the banks QSPE accounting.

Friday, May 23, 2008

Krugman on Oil

"'The Oil Bubble: Set to Burst?' That was the headline of an October 2004 article in National Review, which argued that oil prices, then $50 a barrel, would soon collapse. Ten months later, oil was selling for $70 a barrel. 'It's a huge bubble,' declared Steve Forbes, the publisher, who warned that the coming crash in oil prices would make the popping of the technology bubble 'look like a picnic.' ... So here are two questions: Are speculators mainly, or even largely, responsible for high oil prices? And if they aren't why have so many commentators insisted, year after year, that there's an oil bubbble? ... The only way speculation can have a persistent effect on oil prices, then, is if it leads to physical hoarding--an increase in private inventories of black gunk. This actually happened in the late 1970s, when the effects of disrupted Iranian supply were amplified by widespread panic stockpiling. But it hasn't happened this time. ... Traditionally, denunciations of speculators come from the left of the political spectrum. ... After all, a realistic view of what's happened over the past few years suggests that we're heading into an era of increasingly scare, costly oil. ... Again, I wouldn't be shocked if oil prices dip in the near future--although I also take seriously Goldman's recent warning that the price could go to $200. But let's drop all the talk about an oil bubble", Paul Krugman (PK) at the Houston Chronicle, 13 May 2008.

I agree with PK. The commentators are being misled because they think in terms of dollars as opposed to other currencies.

Thursday, May 22, 2008


"Inflation is rising just about everywhere. Why is this and what can be done about it? To get some basic concepts clear: inflation is a sustained rise in the general price level. ... In a fiat money world, central banks cause inflation, or, more precisely, only central banks are responsible for inflation. Other shocks, real and nominal, can influence the general price level if the central bank does not respond swiftly and determinedly, but these non-central bank induced changes in the general price level can always be offset by the central bank, given enough time, freedom to act and courage. But, in the medium and long term (at horizons of two years and over, say--central banks choose the average rate of inflation. Not globalization; not indirect taxes; not bad harvests; not OPEC and the price of oil; not the Chinese and their exchange rate management. There is no oil inflation, food inflation or cost-push inflation. There is only inflation. Inflation may be accompanied by changes in key relative prices--in the real prices of oil, of and labor for instance. ... Sometimes the central bank is the political captive of the fiscal authority. ... But with an operationally independent, sufficiently well capitalized central bank, the monetary authorities can, on average in the medium and long term, achieve the inflation rate they want. They are responsible, no-one else. ... The die-hard core inflationists there will point out that core inflation is only 2.4%, but the only appropriate answer to that is: so what? Core inflation is of interest only to the extent that it is a superior predictor of headline inflation. ... The oil price shocks of 1973/74 and 1979/80 did not cause inflation. ... Without central bank accomodation and expansionary fiscal policy to try to uindo the negative effects of the oil price shock on non-oil production and employment, there would at most have been a one-off increase in the general price level", William Buiter (WB) at, 14 May 2008.

Thanks Yves Smith for leading me to this article. I agree with WB. I remember the 1973-74 oil shock. At Chicago we debated the significance of the Fed's "accomodating" an increase in relative prices. I take issue with one thin WB wrote, "an operationally independent ... central bank". Ain't no such animal. Fuggedaboudid.

When All Else Fails

"Phillipine President Gloria Macapagal Arroyo said she is considering rolling back government rice-import subsidies--a move proponents say could help curb corruption and free up funds to stimulate local rice production. ... Last week, the Phillipines agreed to buy more than 300,000 tons of rice from Thailiand, Vietnam and Pakistan at an average price of more than $1,100 a ton--up from $360 a ton at the beginning of the year. ... Arroyo said ... 'In the longer term, with prices being where they are now and if they continue to stay where they are, then it would be good economics to look at producing more of it ourselves.' ... [T]he Phillipines ... uses high import tarriffs of 50% on rice to protect local farmers and stimulate rice production. ... Sen. Edgardo Angara, a former secretary of agriculture, argues that if private-sector rise traders are allowed to import and sell rice without any restriction, supply and prices will stabilize. Removing subsidies will also remove opportunities for unscrupulous traders to sell subsidized rice--both imported abd locally produced--at commerical-market prices. ... In addition, Mr. Angara says that by removing subisidies, the Phillipines will have more funds to develop rice production". WSJ, 28 April 2008.

What's so hard to understand? Now if Hank Paulson talked like Angara, we might be able to resolve the 'housing crisis" quickly.

Wednesday, May 21, 2008

Government Stupidity

"A windfall profits tax would prevent oil companies from increasing supply because it would disincentivize further production. We need these companies to increase production, not decrease production if we want the supply to increase", Frank Stalzer letter to the WSJ, 8 May 2008.

"The first windfall profits tax, passed in 1980 (It was repealed in 1988), caused more devastation than a loss of 3% to 6% in domestic oil production. The industry never recovered. ... That wasn't all the devastation: the impact on the oil servicing industry was significant as it reduced that industry's investment as well. Many just closed shop never to return. There were about 2,000 active drilling rigs working in the U.S. during the 1970s. Their number dropped to around 800 during the 1980s. The rig count has returned to 1,700 now, but that's not enough for the work that needs to be, or should be, done. ... The cost of replacing reserves not only increases due to inflation but also due to drilling in more difficult places and formations. Major oil companies need to administer their businesses on the basis of true replacement costs, not historical accounting costs", David McElevain (DM) letter to the WSJ, 8 May 2008.

"Myanmar's badly conceived agricultural policies are compounding the country's already dire food situation. In recent years, Myanmanr's reclusive military rules have plowed large tracts of rice--and vegetable-growing land to plant jatrophia--an inedible plant used for making biodiesel. ... And villagers in the highland regions are often given rice strains requiring expensive fertilizers that they can't afford. ... Now the folly of such policies is becoming apparent in the wake of the cyclone that devastated the country last weekend. ... The most notorious example of errant policy making refelcts the fascination of 75-year-old junta leader Senior-Gen. Than Shwe with biodiesel as a way to break the country's dependence on expensive imported oil. ... 'This was the whitest of the junta's white elephants,' says Monique Skidmore, a professor at the Australian National University and an author of two books on Myanmar", WSJ, 9 May 2008.

Stalzer doesn't even need to be a Havard economics professor to understand this.

Boy is DM right. Politicians can never seem to understand the concept of marginal cost. In the oil industry, marginal cost is the cost of the next barrel you find, not you lift. Current reserves are a stock, not a flow number. Marginal cost is not just lifting cost of existing reserves. Don't feel too bad. Uncle Miltie blew this one in 1973. I remember. It wasn't until about 1976 that he realized it. But Uncle Miltie was an intellectually honest guy.

Myanmar should get out of the business of "managing" its economy. As should Uncle Sam.


"Federal agents raided the Office of Special Counsel, a government agency involved in several high-profile and politically sensitive investigations. The agents seized computer files and documents from its chief, Scott Bloch, and his staff. ... The [DOJ] joined the case as the inquiry was widened last year to include possible obstruction of justice, which is a criminal offense. ... The [DOJ] had no comment about Tuesday's raid. A Special Counsel spokesman said, 'we are cooperating with law enforcement.' ... In the Tuesday raid, 20 agents from the [FBI] and an inspector general's office served grand jury subpoenas on Mr. Bloch and searched his office and home. ... Among the office's recent inquiries was whether former White House political director Karl Rove and others improperly used U.S. agencies to help elect Republicans. ... Bloch's investigative role made him a target for both political parties. He was sharply criticized in Congress, even by Republican members", my emphasis, WSJ, 7 May 2008.

Bloch must be the stupidest man in Washington. Doesn't he know it is impossible for "Karl Rove and others [to have] improperly used U.S. agencies to help elect Republicans". It would only have been possible for Rove to have improperly used these agencies to help elect Democrats. If we get a Democratic administration in 2009, Rove's actions could become criminal. The thought of Bush's DOJ investigating Bloch for improper conduct is a joke. I suspect it's really investigating Bloch to continue to conceal Rove and others malfesance. "Even by Republican members"? Idiot, of course by Republican members. Apparently Bloch did not realize his real job was more "window dressing".

Tuesday, May 20, 2008

Sentencing Snipes-2

"As part of a widening probe, the U.S. has charged a former UBS AG banker and a Lichtenstein consultant with helping clients avoid taxes by opening secret bank accounts, destroying documents, using Swiss credit cards and filing false tax returns. One client was billionaire California real-estate developer Igor Olenicoff. Mr. Olenicoff set up a web of secret bank accounts in Switzerland and Lichtenstein to avoid taxes on $200 million in assets, a person familar with the U.S. case said. Mr. Olenicoff has been cooperating with investigators in the wake of his criminal guilty plea to a criminal count of filing a false 2002 U.S. tax return. He was ordered to pay $52 million. ... The Justice Department alleges that a central component of the scheme was an effort to get around a 2001 agreement between UBS and U.S. authorities that called for UBS to identify clients who received U.S. taxable income. ... The indictment alleges the scheme with Mr. Olenicoff dates to the fall of 2001 and lasted at least through 2005: The first step was setting up accounts in Swiss and Lichtenstein banks that concealed Mr. Olenicoff's control of assets with taxable U.S. income. ... According to court records from Mr. Olenicoff's December guilty plea, he controlled financial accounts through a series of firms in the United Kingdom, Switzerland, the Bahamas, and Lichtenstein", WSJ, 14 May 2008.

What's going on here? It seems Olenicoff could have been charged with tax evasion, 26 USC 7201. Compare Olenicoff's sentence with Snipes, my 4 May 2008 post. See Doug Berman's (DB) post at, 4 April 2008 which indicates Olenicoff will get one year of probation and a $3,500 fine. DB writes, "I think what irks me about this story is the idea that a defendant apparently worth $1.6 billion is going to face a fine of a few thousand dollars. Especially if he is to avoid all prison time, how about a fine say, .1% of his worth. Even letting this fellow keep 99.9% of his fortune could still produce a more fitting fine of $1.6 million". I think Olenicoff might have been charged under 18 USC 225, continuing financial crimes enterprise, or 18 USC 1344, bank fraud. Again, what's going on here? The DOJ is a joke. Jesse Jackson, where are you now that the US needs you. As you have said, "no justice no peace". The DOJ seems not to dispense justice, it dispenses injustice.

The 13th Juror Strikes Again

"A Texas state appellate court on Wednesday overturned a multimillion-dollar verdict against Merck & Co., ruling that there was insufficient evidence linking the painkiller Vioxx to a heart attack suffered by the plaintiff's spouse. ... In its opinion tossing out the verdict, the Fourth Court of Appeals wrote that the plaintiffs failed to negate, 'with reasonable certainty, Mr. Garza's pre-existing heart condiction as a plausible cause of death.' Under Texas law, the plaintiffs didn't have to prove the exact cause of the heart attack with medical certainty but were required to offer evidence excluding Mr. Garza's pre-existing heart disease as a cause", WSJ, 15 May 2008.

Judges contempt for juries leaves me numb. I thought a civil case's standard of proof was the "preponderance of evidence". "Failed to negate"? These judicial clowns seem to have improperly shifted the burden of production. If there was any credible evidence Vioxx caused Garza's heart attack, the verdict should stand. I further thought appellate courts do not: weigh evidence, consider the veracity of witnesses or overturn findings of fact except under very unusual circumstances. What's going on here? Did Merck improperly influence this court? Stay tuned.

Monday, May 19, 2008

Quotations From Chairman Steve

"Paulson repeatedly says he wants a strong U.S. dollar. ... Here's what Paulson and [Fed] Chairman Ben Bernanke should do: Soak up the excess dollars. Announce to the world that they are doing this and why. Get the G7 to intervene to prop up the buck. The Fed could simultaneously point out that the Bear Stearns operation demonstrates we can take pinpoint action to prevent the financial system from seizing up but that there is no need--if there ever was one--to throw gobs of dollars from a helicopter all over the U.S. and the world. ... Paulson ... has it backwards: The weak dollar is the fundamental problem", original emphasis, Steve Forbes (SF) at Forbes, 19 May 2008.

"But is the biggest entity of all--the U.S. government--heading toward the financial rocks? Moody's, the credit-rating agency, got publicity--for once, not negative--in January when it warned that the U.S. government may lose its triple-A rating within a decade if Uncle Sam doesn't do something drastic about the unfunded liabilities of Social Security, Medicare and Medicaid. ... and let's ignore the fact that the U.S. government can literally print the money to service Washington's Treasury debt. ... Raising the retirement age for Social Security or reducing payouts is also unneccessary. ... If younger workers had their own accounts, Social Security liabilities could be treated as sunk costs to be amortized over the next 30 or so years. ... Moody's, by the way, didn't even mention that other and very real threat to the value of U.S. Treasury's: inflation", SF at Forbes, 19 May 2008.

"Given the turmoil in the credit markets, here's an initiative the White House should adopt: busting up the credit-rating-agency cartel. For more than 30 years the SEC has taken it upon itself the task of deciding who should rate debt instruments and who shouldn't. ... The SEC should step aside and let the financial markets decide which rating agencies should get the business", SF at Forbes, 19 May 2008.

I'll say it again, is SF stupid or crazy? If Helicopter Ben (HB) wants to defend the dollar, all he has to do is nothing. Literally stop printing them. If say, Citigroup fails, so be it. SF is correct, the weak dollar is a serious problem. The Bear Stearns bailout only showed that HB will protect Wall Street at the expense of dollar holders.

What has the potential amortization of prior Social Security (SS) liabilities to do with younger workers having separate accounts? If we don't reduce SS liabilities directly, we will reduce them through inflation. What's not to understand? Inflation is no threat to the nominal value of Uncle Sam's debt.

Hooray SF, something I agree with. See my 28 December 2007 and 14 March 2008 posts.

Poetic Justice

"Massachusetts legislators, demonstrating a growing resentment against the wealth of elite universities in tight economic times, are studying a plan to levy a 2.5% annual tax on the portion of college endowments that exceed $1 billion. ... Based on the most recent size of Harvard's endowment, the university would have to shell out more than $840 million annually. ... Kevin Casey, a spokesman for Harvard ... said Harvard would have to raise money to pay the tax because so much of the university's endowment is already tied up by restrictions on gifts", WSJ, 9 May 2008.

Delicious. A liberal institution like Harvard might be hoist on its own petard. "Raise money to pay the tax", says Casey. Is he Ernest Thayer's "Mighty Casey", who struck out? Why? Do idiots run Harvard? Larry Summers, former Harvard president, what do you think? Harvard should have some HBS professors draft moving plans. To Texas. Harvard, have Exxon which moved its headquarters to Irving in 1990, plan the move. Which I'm sure Exxon will do gladly. For a fee. How much is at stake? Let's capitalize $840 million at 9%, that's $9.333 billion Harvard could lose. Let's fill those moving vans! Now.

Sunday, May 18, 2008

SEC, too little, too late

"The [SEC] will require investment banks to publicly disclose their funding levels after the second quarter, in the agency's first step to increase disclosure in the light of the collapse of Bear Stearns Cos. SEC Chairman Christopher Cox said in a speech Wednesday that the four largest investment banks overseen by the SEC will disclose 'actual capital and liquidity positions ... in terms that the market can readily understand and digest.' ... Investment banks provide liquidity information in their quarterly reports, but the SEC is looking to expand that to include capital ratios--assets minus liabilities--and what goes into that, such as regulatory capital and risk-weighted assets. ... In addition to increased disclosure on funding levels, the SEC has begun increasing stress-testing at the four largest brokerage firms it reviews under a voluntary oversight program", WSJ, 8 May 2008.

What does this mean? Will the SEC have these firms disclose under what circumstances they might have to shut down? Or is this another "smoke and mirrors dance" to conceal the investment banks financial condition? Let us not forget Cox sang Bear Stearns praises five days before JPMorgan swallowed it. See my 1 April 2008 post.

China's Challenge

"China is threatened neither by Japan, Russia, India, nor the Western powers, as it was not that long ago. ... Unlike the U.S., which governs itself almost unconsciously, reactively, and primarily for the short term, China has plotted a long course, in which with great deliberation it joins economic growth to military power. ... The crux is to raise per-capita income significantly enough that diversions for defense will go virtually unnoticed. ... As we content ourselves with the fallacy that never again shall we have to fight large, technological opponents, China is transforming its forces into a full-spectrum military capable of major operations and remote power projection. Eventually the twain shall meet. By the same token, our sharp nuclear reductions and China's acquisitions of ballistic-missle submarines and multiple-warhead mobile missles well eventually come level. ... Our reductions are not solely nuclear. Consider the F-22, the world's most capable air dominance aircraft, for which the original call for 648 has been whittled to 183, leaving, after maintenance, training, and test, approximately 125 to cover the entire world. The same story is evident without relief through our diminshed air echelons, shrinking fleets, damaged and depleted stocks, and ground forces turned from preparation for heavy battle to the work of a gendarmerie. ... We must revive our understanding of deterrence, the balance of power, and the military balance. In comparison with its recent history, American military potential is restrained. Were we to allot the average of 5.7% of GNP that we devoted annually to defense in peacetime from 1940-2000, we would have as a matter of course $800 billion each year with which to develop and sustain armies and fleets. ... And there we will be, if we are wise, not with 280 ships, but a thousand; not eleven carriers, or nine, but 40, not 183 F-22s, but a thousand, and so on. That is, the levels of military potential that traditional peacetime expenditures of GNP have provided, without strain, throughout most of our lives. ... And yet what candidate is alert to this? Who asserts that our sinews are still intact? That we can meet any challenge, especially when in can be answered with our historial strengths", my emphasis, Mark Helpirn (MH) at the WSJ, 13 May 2008.

I agree with MH. So far the 2008 presidential campaign has lacked any discussion of military affairs. See most of my previous posts on military affairs. See my 14 April and 1 May 2008 posts.

Saturday, May 17, 2008

Toothless SEC-3

"Marvell Technology Group Ltd. and one of its founders agreed to settle [SEC] charges for backdating stock-options. The Santa Clara, Calf., chip maker agreed to pay a $10 million fine for a pattern of backdating that, the SEC alleged in a complaint filed Thursday, 'allowed Marvell to overstate its income by $362 million from its fiscal years 2000 to 2006.' Weili Dai, who is married to Marvell's chief executive and had served as its chief operating officer agreed to pay a $500,000 fine, and is barred from serving as an officer at a public company for five years. ... According to the SEC's complaint, Ms. Dai didn't cooperate with the agency's investigators and invoked the Fifth Amendment right against self incrimination when asked 'substantive questions' by the SEC staff", WSJ, 9 May 2008.

Another SEC "triumph". The $10 million fine was .028 ($10 / $362) of the alleged fraud. I'm sure its imposition will have a tremendous deterrent effect on other corporate miscreants. The SEC settled another case recently on similar terms. See my 28 April 2008 post in which the SEC settled a case with Broadcom for .006 of the alleged fraud. Amazing.

Friday, May 16, 2008

Monoline Hijinks

"Back in the dot-bomb days, companies liked to guide investors to rosy variations of their stated profit. These profit figures became known as EBBS, or 'earnings before bad stuff.' ... MBIA ... prefers a metric it calls 'analytic adjusted book value' that 'provides an economic basis for investors to reach their own conclusions about the fair value of the company.' ... So MBIA's variation on book value excludes things like the $3.5 billion mark-to-market loss on derivatives that drove its $2.4 billion net loss in the first quarter. Rather, it includes management's expectations of losses, plus gains from future expected premium payments. ... Investors shouldn't forget the lessons of the Internet-stock bubble; they should stick to figures the company compiles according to generally accepted accounting principles. On the basis of that $8.70-a-share figure, the stock, even at its current level [$9.85], isn't a bargain", David Reilly (DR) at the WSJ, 13 May 2008.

"When you shop for groceries, the checkout clerk asks, 'Paper or plastic?' When your broker calls to sell you municipal bonds in the depths of the credit crisis, he should ask, 'Insured or uninsured?' Your correct answer: 'Uninsured, and what is the credit rating?' ... We who manage municipal portfolios care a lot about credit ratings and give credence to insurance from just three firms: Financial Security Assurance, which carefully managed its exposure to CDOs; Berkshire Hathaway, the new insurer on the block; and, to a lesser extent, Assured Guaranty, which just received an infusion of capital from W.L. Ross & Co. ... For months now, good-quality uninsured municipal bonds, A-rated or better, have yielded less than insured ones. The fact is, no one in the business gives any value to the insurance coverage, and you shouldn't either", my emphasis, Marilyn Cohen (MC) at Forbes, 19 May 2008.

I agree with DR, MBIA's creating its own metrics reeks of the dot-com bust. Investors, beware. MBIA CFO C. Edward Chaplin is pushing his own metric. I did a google search to see when Chaplin last filed a Form 4, it was 15 February 2007, when he bought 20,181 MBIA shares at $70.86 each or $1,430,026. Has he taken a beating. Let's take up a collection for him.

MC gets it. See my 16 February 2008 post, among others.

Arbitration in China

"Western companies doing business in China are increasingly being asked to agree to what they consider a risky--proposition--to resolve disputes through arbitration in China in the event a deal goes sour. ... But some Chinese companies, especially the state-owned, are pushing for their business contracts with Western companies to stipulate that conflicts go to arbitration in mainland China. ... Among issues worrying to Western companies are how the arbitrators are chosen and paid under the Chinese system. Raising different concerns is a particular case in which an arbitrator--at that time the head of CIETAC--who sided with PepsiCo Inc. against a Chinese bottler was later detained by the Chinese authorities. Jerome Cohen, a professor of law at New York University ... served on an arbitration panel in China. ... The arbitrators ruled 2-1 in favor of the Chinese company, with Mr. Cohen the dissenter. "I was astounded,' recalls Mr. Cohen. "I saw some of the most blatant contract violations I'd ever seen, but it was like the others had been watching a different case.' ... Still, many western lawyers remain wary of certain practices they fear can undermine fairness. ... But in China, if the parties can't agree, CIETAC chooses the third [arbitrator]. 'That's an extraordinatrily risky proposition,' says Francis Kao, a lawyer at Skadden, Arps, Slate, Meagher & Flom L.L.P. Ms. Kao advises her clients to cut down the risk by putting a requirement in their business contracts that a CIETAC-appointed arbitrator meet certain qualifications. But the strategy isn't foolproof. 'You still really don't know what you're going to get,' she says. ... In March 2006, Dr. Wang was apprehended outside CIETAC's Beijing headquarters. He has been detained ever since. ... The charges against him allege financial impropriety within CIETAC, but people in the arbitration community have feared something else was at work", Ashby Jones and Andrew Batson at the WSJ, 9 May 2008.

Kao, grow up. As the Chairman taught us, "Political power grows out of the barrel of a gun". How many guns can a Chinese company command and how many can your clients command? Face it Kao, contracts in China are virtually unenforceable. I am touched by the companies concerns over arbitration. I wonder if any of the companies in question were the subject of my 17 and 27 April 2008 posts? How much do American companies like arbitration? See my 24 December 2007 post. The Chinese arbitration system looks much like our own SEC. Kao, do your clients a favor, have them contact Joel Stern, MBA (Chicago, 1964), who among other things, is a Columbia Business School professor. Why? Have him consult with them about how much each should raise its "hurdle" rate for Chinese investments since contracts in China are virtually unenforceable. By the way, I've read a lot of Stern's stuff over the years and think he is a real smart guy.

Thursday, May 15, 2008

Model Doubts

"Statistical modelling increasingly drives decision-making in the financial system while at the same time significant questions remain about model reliability and whether market participants trust these models. If we ask practitioners, regulators, or academics what they think of the quality of the statistical models underpinning pricing and risk analysis, their response is frequently negative. ... To have numbers seems to be more important than whether the numbers are reliable. This is a paradox. How can we simultaneously mistrust models and advocate their use? ... A single asset class worth only $400 billion should not be able to cause such turmoil. And indeed, the problem lies elsewhere, with how financial institutions packaged subprime loans into SIVs and conduits and the low quality of their ratings. ... [E]ven a cursory glance at history reveals that mortgage defaults become highly correlated in downturns. Unfortunately, the data samples used to rate SIVs often were not long enough to include a recession. Ultimately this implies that the quality of SIV ratings left something to be desired. ... After all, why would a AAA-rated SIV earn 200 basis points above a AAA-rated corporate bond? Underpinning this whole process is a view that sophistication implies quality; a really complicated statistical model must be right. That might be true if the laws of physics were akin to the statistical laws of finance. However, finance is not physics. ... Taken to the extreme, I have seen banks required to calculate the risk of annual loses once every thousand years, the so-called 99.9% annual losses. However, the fact that we can get such numbers does not mean the numbers mean anything. The problem is that we cannot backtest at such extreme frequencies. ... Fundamental to the scientific process is verification, in our case backtesting. Neither the 99.9% models, nor most tail value-at-risk models can be backtested. ... If we do not understand how the system works, generating numbers may give us comfort. But the numbers do not imply understanding", Jon Danielson (JD) at, 8 May 2008.

I agree with JD. Without understanding concepts like arbitrage and discounted present value, the models are worse than worthless, they are "soma" pills. Mark Thoma has a post about JD's article at, 8 May 2008 which is worth reading.

McLean on Shorts

"'This is indeed a concern and we will tackle it.' That was SEC chairman Christopher Cox's handwritten note to a Senator worried that companies were retaliating against analysts who produced research critical of them. ... In an new book, Fooling Some of the People All of the Time, David Einhorn, who runs a $6 billion hedge fund called Greenlight Capital, recounts his multiyear battle with Allied Capital, a publicly traded private equity firm. ... But the most troubling material concerns an issue that is bigger than Allied and Einhorn's battle: It's the way criticisms of corporate behavior are received in the marketplace. Many, including the SEC, appeared inclined to shoot the messenger. ... After Einhorn gave his speech, the SEC launched an 'informal inquiry'--into Greenlight. When Einhorn testified at the SEC, the 'gist of the questions,' he writes, was 'When did you start manipulating Allied's stock?' The SEC declined to comment. ... Lawmakers have urged the SEC to investigate whether short-sellers spread rumors to bring down Bear Stearns. ... The larger point is that even if a blameless Bear Stearns was crippled by wicked short-sellers-ha!--there's a big difference between spreading rumors and publishing critical research", my emphasis, Bethany McLean (BM) at Fortune, 12 May 2008.

Way to go BM. BM has followed this story for years, see my 20 December 2007 post about the monoline insurers. The SEC has largely been a fraud. For decades. I've cited the Ray Dirks fiasco before. The SEC frequently, it not usually protects politically well-connected corporate miscreants. I never heard of the SEC investigating say, a CPA firm, finding it fired an employee who complained about a client's wrongdoing, putting the employee in a position to sue his former firm and the client in question and win millions in a wrongful termination public policy tort suit. Hey, Mark Olson, does the PCAOB regularly interview former CPA firm employees to find out what went on during an audit? What does the PCAOB do aside from beat up miniscule CPA firms? The SEC's long-held contempt for the First Amendment is appalling. Apparently the SEC only applies it to rating agencies, which no matter how bad their opinions are, use it as a shield against lawsuits. But I thought one could sue over bad "expert" opinion. Apparently the SEC conferred "sovereign immunity" on the NRSROs.

Wednesday, May 14, 2008

Intellectual Honesty and the Supremes

"Thirty-two years ago, Justice John Paul Stevens sided with the majority in a famous 'never mind' ruling by the Supreme Court, Gregg v. Georgia, in 1976, overturned Furman v. Georgia, which had declared the death penalty unconstitutional only four years earlier. The week, Justice Stevens said 'never mind' again in Baze v. Rees, which ruled the Kentucky lethal-injection procedure did not constitute 'cruel and unusual' punishment. ... He's concluded, you see, that Furman was right all along. ... There's something almost admirable in Justice Stevens intellectual honesty on this point. Baze was one in a recent campaign to euthanize the death penalty piecemeal by getting the courts to declare the method of execution, rather than the penalty itself, to be unnecessarily cruel. But then again, his was not the deciding vote in this week's case, so his concurrence, accompanied as it was by a condemnation of the death penalty itself, was a 'free vote,' of a sort. ... The death penalty, he argues, is unconstitutional today, even if was constitutional 32 years ago, because it doesn't serve a social function that justifies the sentence, and so is 'excessive'," editorial at the WSJ, 19 April 2008.

The law is whatever the Supremes think it is, until they are told in no uncertain terms, that the other branches of government will ignore their opinions.

Good Riddance

"Brian Clarkson, ... is stepping down as president and chief operating officer of the oldest bond-rating firm, [Moody's] announced Wednesday. ... 'Challenging credit-market conditions, combined with Moody's role and function in [structured-finance] markets, have created scrutiny and criticism from numerous external sources about various aspects of our business,' Moody's Corp Chief Exectuive Raymond McDaniel said in a letter to employees Wednesday", WSJ, 8 May 2008.

Brian Clarkson (BC), good bye and good riddance. Now it remains to be seen if McDaniel will do anything to improve Moody's product. I mentioned BC in my 3 May 2008 post. It remains to be seen if BC's leaving Moody's was an attempt to make him the "face" of Moody's problems, like say Mozillo at Countrywide, or will Moody's change the way it does business. Stay tuned.

Tuesday, May 13, 2008

DOJ v People of Harris County

"A federal appeals court ruled Wednesday that the rights of victims of the 2005 BP explosion in Texas City were violated by Houston federal prosecutors and a judge, but the plea bargain they object to remains on the table. ... The plea agreement must be accepted by a judge to be final and that has not yet happened. ... Judge Lee Rosenthal ... listened in a sometimes tearful February hearing where they complained the fine should be more like $1 billion, not $50 million. But Rosenthal refused to scrap the plea bargain, which is still awaiting her further consideration. ... Prosecutors have defended the plea bargain and noted that the $50 million fine was the harshest available under the Clean Air Act. 'We are ... disappointed by the appellate court's criticism of the government's good faith reliance upon a court's order approving our approach to meet our CRVA obligations,' U.S. Attorney Don DeGabrielle said in a prepared statement. ... The appellate court said it was improper for [Judge Nancy] Atlas to approve the U.S. attorney's request. Prosecutors argued that victims should not be consulted because they were numerous and a leak to the media could impair the plea negotiations and prejudice the case. ... The appellate court said the reasons to keep victims out did not 'pass muster,' and the victims had a right to be involved before a plea deal is reached. ... Victims' lawyer [David] Perry said ... 'What they wanted to do here was keep the fact that they were exploring a criminal case from the public and the victims. Under the victims' rights act, that should not be the case.' ... 'The dirty little secret is that prosecutors are happy to take advantage of victims when it serves their relatively parochial interest,' [Doug Berman, Ohio State University law professor] said. 'But they can also create a lot of headaches for prosecutors'," Mary Flood (MF) at the Houston Chronicle, 8 May 2008.

See my 6 January, 29 February and 19 March 2008 posts. I think Judge Rosenthal should be thrown off the bench. DeGabrielle, stop wasting time. Leave the DOJ for whatever job you've got lined up with whatever law firm you're going to. Do us a favor, leave. Now! Get out that crying towel for BP. $50 million? It's insignificant. I'll bet if E&Y had enough guts to respond to the question, I'm sure it would say $50 million is immaterial to BP's financial statements. DeGabrielle, I don't care about your personal convenience and future career prospects. Who are you kidding? With say a $1 billion fine, not levied, I'm positive you can find something attractive when you leave the DOJ. The DOJ looks more like an extortion racket every day.

SEC v Spitzer

"Say what you will about his personal life, but a new study finds former [NY] Attorney General Eliot Spitzer was a successful advocate for investors harmed by mutual-fund trading abuses. Investors received five to 10 times more in mutual-fund settlements that Mr. Spitzer took part in, according to a comparison of 20 settlements with federal and state regulators between December 2003 and January 2007. Regulators recovered an average of 77% of estimated investor losses in settlements when Mr. Spitzer was involved compared with 7% when he wasn't noted the study. When penalties are included, the recovery rates are 125% and 25% respectively. ... What accounts for the gap? ... [Eric Zitzewitz, an associate professor at Dartmouth College] found one difference: Mr. Spitzer was just more aggressive in pursuing and settling cases than the SEC. SEC spokesman John Nester declined to comment on the research. ... Spitzer insisted that settling funds pay hefty penalties, make restitution to harmed investors and lower fund-management fees, an aggressive approach that his critics attributed to a desire to gain publicity and advance his career, even at the expense of the SEC", my emphasis, WSJ, 30 April 2008.

Why do Spitzer's critics complain? What do SEC staffers do, if not "advance [their] careers" at the expense of investors? Spitzer appeared to seek public approval, SEC staffers appear to seek the approval of the companies they purport to regulate. Either way, Spitzer and SEC staffers each pursues private ends. I conclude the critics' problem with Spitzer is that his interests were more closely aligned with those of investors than the SEC staffers are.

Monday, May 12, 2008

Another Pension Bomb

Michael Panzer has a nice post about state and locality pension problems at, 11 May 2008. I have nothing to add to his comments.

Americocentric Analysts

"Oil's seemingly unstoppable surge has led some analysts to issue gloomier price outlooks. Goldman Sachs Group Inc, which predicted the latest run-up says the world may face a 'super-spike' in which crude ranges from $150 to $200 a barrel as early as October, up from $120 now. ... Even more unusual is that oil has maintained its upward momentum in the face of sharply diminished U.S. demand, which fell in Febuary to 19.7 million barrels a day. That was down a million barrels a day from the 2007 average. ... The world oil market has also learned to be disappointed with non-OPEC producers, as underinvestment and aging oil fields in places such as Mexico and Russia have crimped crude production. ... Many analysts now contend that oil prices will fall only following a sharp and sustained drop in demand in the U.S. and other large consuming countries", WSJ, 7 May 2008.

It's good the analysts now realize US oil consumption is only about a quarter of the world's total.

Hanke Spanks Bernanke

"U.S. Treasury Secretary Henry Paulson's blundering is becoming more breathtaking with each passing week. At the end of March he rolled out a grand plan to crown the [Fed] as the nation's new financial stabilizer. The Fed a stabilizer? That's who created the financial mess we're in. ... All the while favoring in this fashion a debasement of the U.S. currency, Paulson proclaimed that we should remain calm and confident because the economic fundamentals are sound. He reminds me of the stockbroker who performed a valuable service to his partners by always being wrong. ... As long as inflation remains at or below its target level, the Fed's modus operandi is to panic at the sight of real or perceived economic trouble and provide emergency relief. It does this by pushing interest rates below where the market would have set them. ... Austrian economists warned that price stability might be inconsistent with economic stability. ... The Austrians concluded that monetary stability should include a dimension extending to asset prices and that changes in relative prices of various groups of goods, services and assets are of utmost importance. For the Austrians a stable economy might be consistent with a monetary policy that had prices gently falling. ... A broad measure of the money supply (MZM) reported by the Federal Reserve Bank of St. Louis increased at an astounding annual rate of 37.7% from the end of January until Mar. 24. ... Until the Fed dumps inflation targeting and the U.S. abandons its weak-dollar policy, inflation will rule the day. Retain (and add to) your gold hedges", my emphasis, Steve Hanke (SH) at Forbes, 5 May 2008.

"On those awkward occasions when he is asked about his nation's currency, President George W. Bush has a simple response. 'We believe in a strong-dollar policy,' he'll say--or words to that effect. For his Treasury Secretary, Hank Paulson, the mantra is 'A strong dollar is in our nation's interest.' ... It should be pretty obvious, then, that the U.S. doesn't have a strong-dollar policy. ... So why do Bush and Paulson keep saying they're in favor of a strong dollar? ... Over time, a currency's value reflects an economy's fundamentals. .. So in that sense, a strong currency is reflective of a strong economy. ... The difficulty is that it's hard to distinguish a cyclical downswing that's clearing the way for good times ahead from the wheezing of a currency and a nation in decline. ... So what should U.S. dollar policy be? ... Menzie Chinn, a University of Wisconsin economist who is one of the nation's leading academic currency watchers [said] 'Because, frankly, I'm confused'," Justin Fox (JF) at Time, 5 May 2008.

I wonder if Steve Forbes read SH's article. If not, I suggest he do. The Los Angeles financial group I was a member of debated including asset prices in "measured inflation" for years. I gave up being a "Friedmanite" when I realized a stable economy is consistent with a falling price level. Why? In a gold-standard economy, gold holders get no "interest". However, by holding gold they forego current consumption, in effect making the rest of society a loan. A non-interest bearing loan. How is the "interest" paid? In falling gold prices of other goods. Think about it. I disagree that Hank Paulson (HP) is "blundering". Mr. "former" Goldman Sachs guy wants to increase the Fed's control over the economy so he can direct it. See my 1 March 2008 post.

JF, like Chinn is confused. I conclude Bush and HP claim to support a strong dollar because they sell dollars and are talking up their product. Would HP, world's largest bond salesman, tell us his product is defective when he has hundreds of billions of dollars of bonds to sell annually? Why care what Bush and HP say? Chinn's being "confused" is no surprise. What does "a currency's value reflects an economy's fundamentals" mean? A currency's quantity controls its value. I have a few years on Chinn and suspect, many more battle scars. Chinn graduated from Harvard in 1984, so I estimate was born in 1962. It's unlikely he remembers the 18 November 1967 British pound devaluation the way I do. See my 27 September 2007 post. Once you've lived through a devaluation like that, you will never again take anything a Finance Minister says at face value. The pound devaluation was typical in that it was done over a weekend to "surprise the speculators".

Sunday, May 11, 2008

Uncle Sam at Work

"Yesterday, the [Fed] lowered the federal funds rate to 2%, it's lowest level since 2004. In a nod to growing inflation fears, the Fed said, 'it will be necessary to continue to monitor inflation developments carefully.' But if we really want to do something about inflation, Congress should repeal the Humphrey-Hawkins Full Employment Act of 1978, which diverted the Fed from its most important job: price stability. When the Fed was created in 1913, its principal role was to maintain a sound currency with stable prices. ... Because goosing the economy in the short run and maintaining stable prices over the long run are often at odds, I'm introducing legislation that would rewrite Humphrey Hawkins and give the Fed just one mandate: price stability. ... The Fed's actions have pushed real short-term interest rates into negative territory. ... Clearly, these negative outcomes are not the intention of Fed policy", my emphasis, Paul Ryan (PR) at the WSJ, 1 May 2008.

"You may also be wondering how a higher tax on energy will lower gas prices. Normally, when you tax something you get less of it, but Mr. Obama seems to think he can repeal the laws of economics. We tried this windfall profits scheme in 1980. It backfired. ... If oil companies believe their earnings from exploring for new oil will be expropriated by government--and an excise tax on profits is pure expropriation--they will surely invest less, not more. ... This tiff over gas and oil taxes only highlights the intellectual policy confusion--or perhaps we should say cynicism--of our politicians. ... They want more oil company investment but they want to confiscate the profits from that investment. And these folks want to he President", editorial at the WSJ, 3 May 2008.

Congressman PR of Wisconsin is naive, in my opinion. The Fed's real mandate from day one was to support the Treasury's debt sales. The US price level in 1913 was about the same as it was in 1792. We never needed a Fed to maintain price stability. The negative outcomes PR decries, commodity price increases and reductions in the earnings of those on fixed incomes are exactly what the Fed intends. Remember, in criminal law a man is presumed to intend the "natural and probable consequences of his acts". Are we to believe Helicopter Ben (1590 SATs) does not know what he is doing? If PR is serious about ending inflation I have another suggestion for him: repeal the Federal Reserve Act.

Are our politicians this stupid? Why should Exxon drill more wells if it can't do it at a profit? I remember the windfall profits tax. It drove the IRS crazy trying to figure out how to compute it and collect it. It diverted IRS resources from audits. It was a fiasco. So? It was so much fun last time, let's do it again.


"Yet at a conference Thursday morning, FASB chairman Robert Hertz reminded both investors and preparers that his staff issued an unusual six-page 'reminder' back in December 2005 that warned investors that investments in subprime mortgages were risky. ... The financial vehicles into which these features were packaged become 'ticking time-bombs,' Hertz said earlier this month at a joint meeting of the FASB and the International Accounting Standards Board in London. ... At that meeting, Hertz added that the securitization of those loans had made improper use of an accounting mechanism known as a qualified special purpose entity of QSPE. Both U.S. and international accounting standards setters are now looking to eliminate QSPEs",, 1 May 2008.

I agree with Hertz. The accounting for QSPEs was improper when they were created. See my 6 February 2008 post. I bet Hank Paulson, Chris Cox, Conrad Hewitt and Mark Olson are furious with Hertz over his position. Tough.

Saturday, May 10, 2008

SEC as Idiot-2

"In the days when square-rigged galleons plied the spice route to the East, the Dutch outlawed a band of rebels that they feared might plunder their new-found riches. ... Their offense: shorting the shares of the Dutch East India Company, purportedly the first company in the world to issue stock. ... Now short sellers are drawing fire once again, this time from some unexpected quarters. ... The uproar has drwan the attention of Washington. 'This goes beyond rumors,' Senator Christopher J. Dodd said at a recent Senate hearing about Bear Stearns [BS]. 'This is about collusion.' Short sellers dismiss the idea that they killed off [BS]. They say they often get the blame when things go wrong in the markets. 'Show me the evidence,' said James S. Chanos, one of Wall Street's most prominent short sellers. 'It's always easier to blame someone else, some unnamed market force than the people responsible.' ... Market watchdogs in Iceland, meantime, are looking into whether short sellers are behind a plunge in that tiny nation's currency, the krona, whaihc has lost a quarter of its vlaue this year. ... And in the [US], concern about short sellers' growing power gained new urgency last week when the [SEC] accused a former trader of spreading rumors about a big takeover and then profiting from the ploy. ... But another reason that shorts are drawing fire in that hedge funds that specialize in this kind of trading are making money--lots of it--at a time many other investors are losing. ... In the past few years, shorts warned about the troubles brewing at Enron and Tyco and also uncovered financial shenanigans at many small companies. As the financier Bernanrd M. Baruch once said, 'A market without bears whold be like a nation without a free press.' Owen A. Lamont, a finance professor at the Yale School of Management, studied a group of companies that battled with short sellers and found that those companies' share prices fell 42 percent on average over the next three years, suggesting their share prices were inflated, just as the shorts had claimed. Other Wall Street banks have also been buffeted by short sellers this year. Shares of Lehman Brothers fell almost 40 percent the day before that investment bank reported earnings in March. ... But Wall Street deals in rumors all the time. For regulators, the challenge is proving that short sellers tried to profit by spreading false information", my emphasis,, 30 April 2008.

The SEC has been after short sellers (SS) since at least the Ray Dirks fiasco, see my 6 October 2007 and 9 and 28 April 2008 posts. Hey Cox, Riccardi & Co., (CRC), why don't you worry about all the optimistic forescasts that companies out out? The SEC's crusade against SS is insane. SS do some of the SEC's work for it. One would think the SEC could show some gratitude. Is the SEC trying to protect Citigroup and the rest of Wall Street from SS which the SEC is afraid might dredge up some damaging information about these entities that the SEC and Treasury would just as soon conceal?

The Ship is Sinking

"As a number of other commentators have written in Asia Times Online, including Julian Delasantis and the Mogambo Guru, the problem with the US is that of excessive borrowing that has fueled a consumption boom. Almost three-quarters of the US economy is consumption, compared with the more usual 50-50 mix considered 'normal' in Economics 101 texbooks. ... What many of us on this website have been writing about is that this edifice is cracking and quite likely to fall over. On Thursday (May 1), the finance minister of Kuwait, Mustafa al-Shiwali, suggested that Gulf Cooperation Council (GCC) countries were considering an idea to abandon their long-standing US dollar pegs. This is a minor news item to be tucked away in page 20 of the financial press, which it has been--but rather emblematic of a systemic shift. ... These were the same countries that considered the same action in the 1970s, and indeeed it was the Kuwati finance minister of that time who famously asked, 'Why should we sell our black gold in exchange for unguaranteed currency notes [US dollars]'? ... Despite owing a debt of gratitude for getting their country back, it is interesting that Kuwait today is concerned more about domestic inflation that has run away to absurd levels, and less about kicking the US when it is down. Call that the new world if you will. ... I however think it is more likely we will see actual selling of ... US Treasury bonds that offer yields roughly in line with official inflation and less than half of unofficial inflation figures. ... The final consequence of the decline of US power is global in nature, namely a search for an absolute value reserve. That would be physical commodities, including oil, copper and whatever have you. The easiest though would be gold", Chan Akya (CA) at, 2 May 2008.

I agree with CA and keep wondering when the Kuwaitis will pull the plug on the dollar. They may just be waiting for the next administration to take office.

Friday, May 9, 2008


"Over the last decade, Moody's and its two principal competitors, [S&P] and Fitch, played this game to perfection--putting what amounted to gold seals on mortgage securities that investors swept up with increasing elan. ... No longer did mortgage banks have to wait 10 or 20 or 30 years to get their money back from homeowners. Now they sold their loans into securitized pools and--their capital thus replenished--wrote new loans at a much quicker pace. ... Almost all of those subprime loans ended up in securitized pools; indeed, the reason banks were willing to issue so many risky loans is that they could fob them off on Wall Street. ... Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody's and [S&P] that set the credit standards that determined which loans Wall Street could repackage and, ultimately which borrowers would qualify. ... Arthur Levitt, the former chairman of the [SEC], charges that 'the credit-rating agencies suffer from a conflict of interest--perceived and apparent--that may have distorted their judgment, especially when it came to complex structured financial products. ... Moody's did not have access to the individual loan files. ... 'We aren't loan officers,' Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody's told me. 'Our expertise is as statisticians on an aggregate basis. We want to know of 1,000 individuals, based on historical performance, what percent will pay their loans?' ... Nearly half of the borrowers [in this pool], however, took out a simultaneous second loan. Most often, their two loans added up to all of their property's presumed resale value, which meant the borrowers had not a cent of equity. ... That a vehicle backed by subprime mortgages could borrow at triple-A rates seems like a trick of finance. 'People say, "How can you create triple-A out of B-rated paper?'" notes Arturo Cifuentes, a former Moody's credit analyst who now designs credit instruments. It may seem like a scam, but it's not. ... However elegant [structured finance's] models, forecasting the behavior of 2,303 mortgage holders is an uncertain business. 'Everyone assumed the credit agencies knew what they were doing,' says Joseph Mason, a credit expert at Drexel University. 'A structural engineer can predict what load a steel support will bear; in financial engineering we can't predict as well.' ... Moody's used statistical models to assess C.D.O.'s; it relied on historical patterns of default. ... Jamie Dimon, the chief executive of JPMorgan Chase ... says, 'There was a large failure of common sense' by rating agencies and also by banks like his. 'Very complex securities shouldn't have been rated as if they were easy-to-value bonds' ... The ratings are meant to be an estimate of probabilities, not a buy or sell recommendation. ... In effect, the government outsourced its regulatory function to three for-profit companies. ... As [Frank] Partnoy says, rather than selling opinions to investors, the rating agencies were now selling 'licenses' to borrowers. Indeed, whether their opinions were accurate no longer mattered so much. Just as a police officer stopping a motorist will want to see his license but not inquire how well he did on his road test, it was the rating--not its accuracy--that mattered to Wall Street. ... Nothing sent the agencies into high gear as much as the development of structured finance. ... According to Lewis Ranieri, the Salomon Brothers banker who was a pioneer in mortgage bonds, 'The whole creation of mortgage securities was involved with a rating.' What the bankers in these deals are really doing is buying a bunch of I.O.U.'s and repackaging them in a different form. Something has to make the package worth--or seem to be worth--more than the sum of its parts, otherwise there would be no point in packaging such securities, nor would there be any profits from which to pay the bankers' fees. That something is the rating. Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment grade is worth a lot more than one that just fails. As with a would-be immigrant traveling from Mexico, there is a lot of incentive to get over the line. The challenge to investment banks is to design securities that just meet the rating agencies' tests. ... 'Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,' a former Moody's expert in securitization says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime analyst at JPMorgan, 'Gaming is the whole thing.' ... The evidence on whether rating agencies bend to the bankers' will is mixed. ... But in structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody's has thousands of clients. ... No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. ...And the banks pay only if Moody's delivers the desired rating. ... If Moody's and a client bank don't see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as 'ratings shopping.' ... James Kragenbring, a money manager with Advantus Capital Management, complained to the agencies as early as 2005 that their ratings were too generous. ... Poring over the data, Moody's discovered that the size of people's first mortgages was no longer a good predictor of whether they would default; rather it was the size of their first and second loans--that its, their total debt combined. ... Amy Tobey, leader of the team that monitored XYZ, told me, 'It seems there was a shift in mentality; people are treating homes as investment assets.' Indeed. And homeowners without equity were making what economists call a rational choice: they were abandoning properties rather than make mayments on them. ... A C.D.O. operates like a mutual fund; it can buy or sell mortgage bonds and frequently does. ... 'We're structure experts,' Yuri Yoshizawa, the head of Moody's derivative group explained. 'We're not underlying-asset experts.' They were checking the math, not the mortgages. But no C.D.O. can be better than its collateral. ... The agencies have blamed the large incidence of fraud, but then they could have demanded verification of the mortgage data or refused to rate securities where the data were not provided. That was, after all, their mandate", my emphasis, Roger Lowenstein (RL) at, 27 April 2008.

RL sees the rating agencies (RA) much as I do. The RA and CPA firms are in the same business, selling third-party certifications. Like the SEC requires audited financial statements of SEC registrants, the market requires ratings to sell mortgage-backed securities. RA sell borrowers licenses, CPA firms sell SEC registrants licenses. Like CPA firms, which try to disclaim, responsibility for finding fraud, the RA blame fraud too. The RA could have asked their CPA firms what do do when faced with "insufficient evidential matter" to support a rating. Walk away. Yoshizawa's comment is telling, she's not an "underlying-asset" expert. What then? An overpaid clerk using spreadsheets she does not understand? A "handful of banks". Have we a repeat player advantage here? The RA's fees must not be contingent on their ratings. They must be paid in advance. Every mortgage-backed security sold must have an originator "certificate" that the mortgages in it were not "cherry-picked". Violations of my no "cherry-picking" rule should be securities fraud. "Ratings shopping", oh no. RA look like CPA firms. Wow, a homeowner with no equity in his property sees his "ownership" as economically equivalent to owning a call option combined with a lease. Is Moody's so stupid, it didn't understand that? Yes, a CDO operates like a mutual fund. See my 15 November 2007 post in which Allan Sloan likens investment bankers to butchers. I add, overpaid butchers selling hamburger as filet mignon. See also my 8 November and 12 December 2007 and 2 February 2008 posts.

R&R Consulting's Ann Rutledge has two good posts at her blog, on 15 March and 5 April 2008 concerning securitization economics. She describes "five preferred (often inter-related) ways to mask the true credit condition of a structured bond". Unfortunately the system was gamed for years.