Saturday, December 29, 2007

Monolines Death Watch

"'The new triple-A-rated player will take business from Ambac, MBIA and others because their own triple-A ratings are suspect,' said Ed Grebeck, chief executive of Tempus Advisors, in Stamford, Conn. ... The risk to Mr. Buffett's new business is that municipal governments decide that its prices are too high and opt to issue debt without insurance instead. ... Bond insurers help municipalities keep their borrow costs low. At least until recently, the fee paid to the insurer effectively extended its triple-A rating to the borrower. That allowed governments to pay lower interest rates on the bonds they issued, saving taxpayers money. ... Few such bonds ended up in default over ther past 30 years, making the business highly profitable. ... Buffett said his new company will charge more than other bond insurers because of what he calls the 'moral hazard' inherent in bond insurance. That is, governments that have insurance could take advantage of it by borrowing and spending far beyond their means to repay the debt, and simply default, leaving the insurer on the hook", WSJ, 28 December.

"Bond insurers put on a brave face in welcoming a new rival backed by Warren Buffett [WB], even as investors dumped their shares on fears that a well-financed competitor would cripple their beleagured business. ... Buffett's entry 'is a significant validation of the valuable role our industry plays in helping public entities issue debt,' said Williard Hill, chief marketing officer for MBIA. ... Buffett's company won't insure structured-finance products such as collateralized debt obligations or asset-backed securities which require more capital", WSJ, 29 December.

If monolines muni bond insurance business was profitable, how did it lower municipalities borrowing costs? This business required municipalities having stupid financial officers, and was supported by the rating agencies, like Moody's, 19% owned by WB. WB has a key point applying "moral hazard" to governments. Apply it to California, see my 28 December post. Better still, Uncle Sam. How will Unc repay the national debt? Easy, inflation; that's Helicopter Ben's job, to reduce the real value of Unc's debt. "But I thought it was to stabilize the economy". No. Did you ever hear of the "period of the peg", 1942-46? No? See my 17 September post. "The Humphrey-Hawkins bill said the Fed was to ... ". So?

I disagree with Hill; WB's entry into the muni bond insurance business shows it lacks economic value for bond issuers. Why? WB is smart. His company will only sell insurance that is expected to be profitable. Ex ante, municipalities buying this insurance will lose discounted present value. If not, how will WB profit? This is a zero-sum game. Mike Shedlock has a nice post on this at, 28 December.

Friday, December 28, 2007

California Municipal Bonds

"In the contest to be America's most spendthrift state, New York and California are typically ahead of the pack. But here comes the not-so-Golden State charging back into the lead. Last week, Governor Arnold Schwartznegger announced he will declare a 'fiscal emergency' in January, which he said has become a 'common thing in California'. ... The bean counters in Sacramento are now projecting the state's budget deficit at $14 billion, and climbing. ... State outlays have nearly tripled to $142 billion this year from $51 billion in the early 1990s. ... California is also losing many of its most productive workers. Over the past decade nearly 1.5 million more Americans fled California than arrived; 275,000 left last year alone, according to Census Bureau data. An influx of foreign immigrants has maintained the state's overall population, but those departing include upwardly mobile middle-class families moving to lower-tax states with more affordable housing", WSJ, 28 December.

How nice of the WSJ to tell us Californians follow Lenin's dictum and "voted with their feet". At its current rate in 15-20 years no one will live in California except: venture capitalists, movie stars and illegal aliens. This shouldn't bother the "open borders" WSJ. Who does the WSJ think uses California's government services? Fortunately, California does not have its own: currency and Helicopter Ben, yet, to balance the budget, with inflation.

31 More Years?

"That spasm of reformist zeal resulted in the 2006 Credit Agency Reform Act--but the law clearly didn't go far enough. That's why Barron's now proposes some fresh and far-reaching measures to fix the rating system, starting with steps to greatly increase competition. ... Fatefully, the rating agencies decided to allow securitizers to slice these CDOs into a new capital structure that transmogrified 80% of the bonds into triple-A credits. ... But the rating agencies unquestionably were key enablers, by countenancing and legitimizing lethal capital structures. ... Most importantly, the SEC should promote more competition in the industry by speeding up its approval of new agencies, designating them 'nationally recognized statistical rating organization(s)'. ... The two top dogs preside over what the Justice Department terms a partner monopoly, as opposed to an oligopoly. ... This duopoly has proven inordinately profitable, which perhaps explains why Warren Buffet is Moody's top shareholder with a nearly 19% stake. ... True, the rating agencies have long escaped any legal liabaility for issuing errant ratings by asserting that their actions constitute free speech protected by the First Amendment. In essence, they portray their ratings as nothing more than editorial opinion. ... [John] Coffee argues, the SEC should discipline miscreant agencies by temporarily yanking their registration in areas where their ratings have been notably wrong. ... Robert Reich writes on his blog that the system is tantamount to movie studios hiring critics to review their films and paying them only 'if the reviews are positive enough to get lots of people to see the movie.' ... [E]conomists Joseph Mason and Charles Calomiris reported recently, using Moody's own data, ... the five-year cumulative default rate between 1993 and 2005 was 24% for CDOs receiving Moody's lowest investment-grade rating of Baa. This compares with a five-year default rate of 2.2% on corporate bonds similarly rated from 1983 through 2005. ... Jeffrey Grundlach chief investment officer at TCW ... has an excellent suggestion for reforming the rating industry that he has made to several agency executives. 'Just Say No' when Wall Street asks them to rate securities that lack historically relevant data", Jonathan Laing at Barron's, 24 December.

If the SEC couldn't "fix" the auditing business in 31 years, why believe it can "fix" the rating agencies? The SEC should end the "NRSRO" designation. Anyone who wants to rate, rate. I have another idea: a rating agency accepting a fee from an issuer to rate a security assumes underwriter's liability. Further, the rating agency should be denied any "privity" defense with regard to holders of the security. Then it's: sue away and let the plaintiffs' bar discipline the agencies. I wonder how quickly the rating agencies will tell underwriters they can't afford to give unduly high ratings. I think the rating agencies would be afraid to rate securities "that lack historically relevant data" if they knew they would get sued over their ratings. See my 6 October post.

"So how can we increase transparency in a complex market where everyone involved profits by keeping the investor in the dark? One way would be 'a large lawsuit by a well-capitalized institution.' says Sylvain Raynes [SR], a principal at R&R Consulting, a structured valuation boutique in New York. Another way would be to utilize 'cybernetics, or the theory of feedback control, in both primary and secondary markets,' he says. (Here I thought the structures were incomprehensible. Now I find out that cybernetics is the key to enlightenment.) ... For our purposes here, the issue is the 'need to introduce secondary market monitoring in a meaningful way,' Raynes says. The primary market needs to develop 'valuation standards,' which 'could have avoided 90 percent of the problems,' he says. 'It is possible to know a priori that a deal does not work, that the amount of securities in the transaction is too high'," Caroline Baum at, 24 August.

I agree in part with SR, a "large lawsuit by a well-capitalized institution" would help. Still better might be an indictment of a rating agency and an underwriter under say, 18 USC 225, continuing financial crimes enterprise. Mike Garcia (MG), wake up! You might become New York State's next governor! Needing "secondary market monitoring" may be SR's way of saying our old friend is back, the classical agency problem. I can't see how developing "valuation standards ... could have avoided 90 percent of the problem". If SR could explain this to me I would appreciate it. Having been a CPA for many years, I've concluded in many instances, "standards" just protect the "professional" from malpractice lawsuits. Nor do I understand the phrase "the amount of securities in the transaction is too high". Too high for what?

18 USC 225 requires "a series of violations under section ... 1014 ... of this title". 18 USC 1014 states, "Whoever knowingly makes any false statement or report, or willfully overvalues any land, property or security, for the purpose of influencing in any way the action of ... any institution the accounts of which are insured by the Federal Deposit Insurance Corporation [FDIC], the Office of Thrift Supervision, ... the [FDIC], ... upon any application, advance, discount, purchase, purchase agreement, repurchse agreement, commitment, or loan, or any change or extension of the same, by renewal, deferment of action or otherwise, or the acceptance, release, or substitution of security therefor, shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both". Good authority indicates the rating agencies did this, i.e., Ann Rutledge told us; see my 27 December post. What makes 18 USC 1014 so juicy, is: willfull overvalution of almost anything to influence a financial institution is a felony. I wonder if Hank Paulson's Treasury Department attorneys knew this before he tried to float MLEC? Under any circumstances, MG, hop on this. Your governorship awaits.

Thursday, December 27, 2007

The Injustice Department Goes Hollywood

"At all times relevant to this Indictment, Refco was represented by a large well-known law firm (the 'Law Firm'). At all times relevant to this Indictment, the Law Firm maintained offices throughout the United States and the world, including New York, New York", P 3.

"At all times relevant to this indictment, JOSEPH P. COLLINS, the defendant, was a partner at the Law Firm. ... At all times relevant to this Indictment, Refco was the most significant client of JOSEPH P. COLLINS, the defendant. ... From in or about 1997 through in or about 2005, COLLIN's relationship with Refco resulted in at least approximately $40 million in fees being invoiced by the Law Firm to Refco", P 4.

"In connection with the LBO transaction, JOSEPH P. COLLINS, the defendant, and other attorneys at the Law Firm represented both Refco and RGHI", P 30.

"COLLINS and others made representations and drafted documents (or caused other Law Firm attorneys to draft documents), and negotiated contract terms that concealed from Thomas H. Lee Partners and its representatives the following related party transactions, among others", P 36.

The P's are Indictment paragraph numbers. Michael Garcia (MG) likely has a promising career ahead of him as a Hollywood script writer. I read Collins's 55-page indictment and noticed the "Law Firm" was not named. The Indictment reads like a John Grisham novel. The Indictment may help the "Law Firm". It may be used in "Law Firm" recruiting literature to help attract new law school graduates. The "Law Firm" can say, "We're famous. The US's most famous law firm. We were the subject of a best selling novel and movie that got two Academy Award nominations. If you join us, you can become famous too. We even have our own Law Firm dance, the 'Perp Walk'." Seriously, since Collins and "other attorneys at the Law Firm" apparently knew of the transactions in question, why wasn't the "Law Firm" indicted? Or is that coming in MG's next "novel"?

Saving "Sergeant Dollar"

"Contrary to what the inflation doves have been telling us, inflation and inflation expectations are not well contained. The dollar's sinking exchange value signaled long ago that monetary policy was too loose, and that inflation would eventually rear its ugly head. ... So what should be done? It's time for the Bush adminstration to put some teeth in its 'strong' dollar rhetoric by encouraging a coordinated, joint intervention by leading central banks to strengthen and put a floor under the U.S. dollar. ... The current weakness in the dollar is cyclical. ... This brings us to China, and all the misplaced concern over its exchange rate. Given the need to make a strong dollar policy credible, it is perverse to bash the one country that has done the most to prevent a dollar free fall". Ronald McKinnon (RM) and Steve Hanke (SH) in the WSJ, 27 December.

How do RM and SH know the "current weakness in the dollar is cyclical"? Are they short say Euros on margin? I have long been a fan of SH, who writes for Forbes. Here, I disagree. The one thing which will strengthen the dollar, is for Helicopter Ben to stop printing more of them. I agree it is perverse to hector China about the renmibi's value when China is the dollar's largest support. That the dollar needs to be rescued shows how weak it is.

Housing Prices

"Home prices in 10 major metropolitan areas in October were down 6.7% from a year earlier, according to the S&P/Case-Schiller home-price indexes. ... The market is working its way 'back to reality,' says David Seiders, chief economist of the National Association of Home Builders. He thinks house prices will bottom out early 2009. ... The S&P/Case-Schiller index showed that some of the fastest declines in home prices are in metropolitan areas that were among the hottest during the housing boom. ... As measured by the S&P/Case-Schiller national index, home prices jumped 74% in the six years through 2006. During the same period, median household income rose 15%", WSJ, 27 December.

I expect house prices will fall after early 2009, possibly for another 12-18 months.

Wall Street Wizardry

"Instead of spreading the risk of a global home-finance boom, the instruments have magnified and concentrated the effects of the subprime-mortgage bust. ... Norma ... was also part of a chain of mortgage-linked investments that took stakes in one another. The practice generates fees for a handful of big banks. But, say critics, it created little of value for investors or the broader economy. 'Everyone was passing the risk to the next deal and keeping it within a closed system,' says Ann Rutledge [AR], a principal of R&R Consulting, a New York structured-finance consultancy. 'If you hold my risk and I hold yours, we can say whatever we think it's worth and generate fees from that. It's like ... creating artificial value.' ... 'It is a tangled hairball of risk', Janet Tavakoli, a Chicago consultant who specializes in CDOs said of Norma. In March of 2007, any savvy investor would have thrown this ... in the trash bin.' ... But the system only works if the securities in the CDO are uncorrelated--that is, they are unlikely to go bad all at once. Corporate bonds, for example, tend to have low correlation. ... Mortgage securities, by contrast, have turned out to be very similar to one another. ... Yuri Yoskizawa, group managing director at Moody's Investors Service, says the firm figured some of these mortgage sevicers would be better than others at handling problem loans", WSJ, 27 December.

Yves Smith at, is critical of this article. I am not. While 98 column inches, it has a few gems. That Moody's thought the loan servicers identity was important is amazing. If I have two mutual funds: one 80% IBM and 20% MSFT, the other 75% IBM and 25% MSFT, no matter who manages them, they will have highly correlated returns. Welcome back AR, I couldn't have said it better. It is creating artificial value. All valuation is in the mind. Jim Grant, who writes for Forbes, wrote Money of the Mind, 1994, a good read.

Monday, December 24, 2007

The Fed and the four-letter word, GOLD!

"But it just goes to show you, the subprime thing is giving everyone the willies, because it's signalling the unraveling of the monetary ponzi scheme. Like any ponzi scheme, you have to keep new people paying in. The prevalence of subprime lending, almost all of it very recent, merely indicates that there's no one left to dupe; the system has had to tap individuals that plainly cannot ever pay, just to keep the game going a little while longer. ... If you had asked me two years ago how long the whole drama could go on, I would have said 'indefinitely'. ... Similarly, the 'money' power of the [Fed] ... is both profound and seemingly limitless, but yet somehow still mundane and weak. It is the heart of a wretched and lawless system that nevertheless has a few fundamental rules. Such as this one: the banks are all insolvent, but the insolvency has to be manageable. ... Somebody is going to be left holding the bag, they all know it, and they're all scrambling around, pointing fingers, trying to make sure it isn't them. ... [T]he dollar must be redefined in gold terms based on what is currently on hand at the Treasury and the [Fed], so as to cover deposits in the banking system and avoid a collapse of activity in the 'real economy'. ... When Murray Rothbard wrote about a similar solution in 1995,, he estimated that gold would have to be valued at about $7500 per ounce. ... I wouldn't be surprised if today's figure was more like $20,000 per ounce. ... The real reason banking disasters cause so much pain and suffering is that the bankers and the rulers, though having plainly screwed up everything so royally, fight to retain their position at everyone else's expense. ... It is [bankers] who deserve to suffer, at least to the extent of losing their privileged position and having to provide something of value for their living. ... But somebody has to get stiffed to fix all this, and in justice it should be them for a change", John Regan (JR) at, 22 December.

American have fought over banking policy since Jefferson said, "Banking establishments are more dangerous than standing armies". Banking policy was the major issue in 1832's election, "Jackson and no bank or bank and no Jackson" was Andrew Jackson's (AJ) 1832 campaign slogan. Jackson called the Second Bank of the United States (SBUS) a "Monster". If interested, read Remini, Robert, Andrew Jackson and the Bank War, 1967. Will Bush call the Fed a "monster? See my 13 August post.

"Every monopoly and all exclusive privileges are granted at the expense of the public, which ought to receive a fair equivalent. ... To the extent of [the SBUS] practical effects it is a bond of union among the banking establishments of the nation, erecting them into an interest separate from that of the people, and its necessary tendency is to unite the [SBUS] and the State Banks in any measure which may be thought conducive to their common interest. ... Under such circumstances the bank comes forward and asks for a renewal of its charter for a term of fifteen years upon conditions which not only operate as a gratuity to the stockholders of many millions of dollars, but will sanction any abuses and legalize any encroachments. ... It is to be regretted that the rich and powerful too often bend the acts of government to their selfish purposes. ... In the full enjoyment of the gifts of Heaven and the fruits of superior industry, economy, and virtue, every man is equally entitled to protection by law; but when the law undertakes to add to these natural and just advantages artificial distinctions, to grant titles, gratuities, and exclusive privileges, to make the rich richer and the potent more powerful, the humble members of society-the farmers, mechanics, and laborers-who have neither the time nor the means of securing like favors to themselves, have a right to complain of the injustice of their Government. ... Many of our rich men have not been content with equal protection and equal benefits, but have besought us to make them richer by act of Congress. By attempting to gratify their desires we have in the results of our legislation arrayed section against section, interest against interest, and man against man, in a fearful commotion which threatens to shake the foundations of our Union", AJ's SBUS recharter veto message at, 10 July 1832 It is inconceivable we could elect an AJ today.

I've said since January 1980 with gold at $875, $2,300 today, in official CPI terms, $3,500 by my estimates, that the US will remonitize gold. What happened in 1980? I assumed gold was "just" a commodity, like wheat or soybeans. Then I realized: the Fed didn't sell at $875! Why not? If the Fed is just another speculator in the market, it believed gold was worth more than $875! I can't explain it any other way.

"On June 22, according to the Federal Reserve Bulletin, the notes issued were covered by gold to the extent of 72.4; while the ratio of gold reserve ... to notes in actual circulation ... was 79.8 per cent", NYT, 17 February 1918. 1918? Gold "cover"? Percentage? What? Once upon a time the Fed needed gold to "cover" Federal Reserve Note (FRN) redemption. You could exchange 20 FRNs at a bank for a "double eagle" containing .9675 of an ounce of gold, which meant the "gold price" was $20.67 per ounce, or a dollar was .048379 ounce of gold. So? Today: the US has 261.5 million ounces of gold, M1 is $820 billion, M2 $7,457 billion and M3, no longer published, about $12,000 billion. If the Fed needs a 100% "gold cover" for M1, M2 and M3, we get "prices" of $3,136; $28,516 and $45,889 per ounce. JR's $20,000 estimate is in this range.

A "repectable" person suggested a 100% gold reserve, Graham, Frank, American Economics Review, 428-440, (September, 1936), "Partial Reserve Money And The 100 Per Cent Proposal". What, 1936? A Princeton professor? Yes. After Ludwig Von Mises, Murray Rothbard (MR) is my favorite economist. I highly recommend MR's Mystery of Banking, 1983, available at

Improper Judicial Influence?

"As it has every year for six years now, the American Tort Reform Association released its list of 'judicial hellholes' last week. ... The report was prepared by a business-oriented group that dislikes perosonal-injury lawsuits and big class-action awards. ... But just because the business lobby has a stake in the civil justice system does not disqualify it from speaking about it. The question is whether the report's arguments make sense, are supported by evidence and are applied evenhandedly. ... It is, for starters, a collection of anecdotes based largely on newspaper accounts. It has no apparent methodology. ... 'We have never claimed to be an empirical study', said Darren McKinney, a spokesman for the association. ... The report often makes sound but incomplete points. It assails, for instance, the practice of allowing plaintiffs' lawyers to make campaign contributions to the judges they appear before. ... But the poll did not ask about contributions from plaintiff's lawyers. It concerned all contributions, including those from business groups. And in many states these days, contributions from business groups are much larger than those from plaintiffs' lawyers and labor unions. ... In November, [West Virginia's] highest court threw out a jury verdict for more than $50 million in a fraud case against Massey Energy, a coal-mining company. The vote was 3 to 2. Voting with the majority was Justice Brent D. Benjamin, who was elected to the court in 2004 with the help of about $3 million in advertisements and other support from Don L. Blankenship, Massey's chief executive officer. ... But a new study, to be published in the University of Michigan Journal of Law Reform next year, found that businesses use arbitration clauses in major contracts with other businesses less than 10 percent of the time. By contrast, more than three-quarters of consumer contracts make arbitration mandatory. That suggests, the Michigan study said, that corporation's real motive in insisting on arbitration clauses in consumer contracts is to gain a strategic advantage, particularly by avoiding class actions", Adam Liptak (AL) in the NYT, 24 December.

AL isn't suggesting some improper influence by Massey on the West Virginia courts is he? It's not for nothing many people have contempt for the courts.

Oil Costs and the Price System

"But there's a potential obstacle to [ConocoPhillips] vision: not enough people to get the work done. Half of Conoco's employees are eligible for retirement within five years. ... The oil industry is suffering from massive layoffs that took place during the oil bust. More than 500,000 petroleum-related jobs were lost between 1982 and 2000 in the U.S. ... Enrollment in petroleum-related undergraduate programs fell 85% from 1982 to 2003", BusinessWeek, 24 December.

As long as the price of oil stays high, salaries in the oil sector will increase. It's price that drives cost, not vice versa. High prices draw more resources into a sector.

Sunday, December 23, 2007

Three Countries "Fight" Inflation

"But on Jan. 1, the Venezuelan government will start phasing out the bolivar and phasing in a new currency with a muscular name: the strong bolivar. The freshly minted bank notes and coins are designed to boost consumer confidence and bring down the 20 percent annual inflation rate. ... But massive government spending has pushed up the inflation rate. Meanwhile, Chavez's move to nationalize some utilities and parts of the oil industry has sparked capital flight, causing the bolivar to fall even further against the dollar. The switch to the strong bolivar 'will close a cycle of instability that Venezuela has suffered from the past 25 years and generate positive expectations', Finance Minister Rodrigo Cabezas told the Caracas daily El National. But the currency makeover won't make much difference unless the policy is combined with other measures to cut inflation, such as a slowdown in government spending, said Domingo Maza Zavala, a former director of Venezeula's Central Bank. ... Oscar Trejo, co-owner of a Caracas construction company, called the strong bolivar 'a way of cheating the people into thinking that inflation is down and the value of their money is up'," Houston Chronicle, 23 December.

"The central bank of [Zimbabwe] unveiled new currency notes Thursday with denominations as high as 750,000 dollars as the government tries to ease chronic shortages of cash in a hyperinflationary economy. ... President Robert Mugabe, 83, who has ruled Zimbabwe for 27 years, blames the crisis on Western sanctions", Houston Chronicle, 21 December.

"Over the past five years, Turkey's government has pushed through changes that have increased growth to 7% a year and brought inflation down to the single digits. The changes involved cuts in government spending, an overhaul of the banking sector, strengthening the independence of the central bank and selling state-owned companies. ... Guven Sak, a former member of the monetary-policy committee at Turkey's central bank [said] 'Turkey ... will have to transform its institutional structure, demanding change from various parts of society, which may be more difficult to manage.' The first priority is to cut spending on the country's social security system, Economics Minister Mehmet Simsek said", WSJ, 24 December.

What "suffered from for the past 25 years"? Is inflation a disease, like polio, or a conscious government policy, as My Weekly Reader taught in the late 1950s? Eliot Janeway once wrote, "War is bearish on money". Any war: Iraq, drugs, you name it. This story reminds me of Germany, 1922-23. If interested read Bresciani-Turroni, Constantino's, The Economics of Inflation, 1937, to understand what's driving Venezuela's inflation today. The external value of a currency usually falls faster than its internal value. Why anyone would listen to a Finance Minister about a currency's value, even our own Hank Paulson (HP), is beyond me. Lopping three zeros off the bolivar does nothing. Cutting government spending will. I wonder if Oscar Trejo wants a new job. As Helicopter Ben's (HB) replacement.

Mugabe blames outsiders for the problems he created. Turkey apparently recognizes what it must do to curb inflation. Now if HB and HP understood this, the US might make some progress in this regard.

Subprime SEC Investigations

"Regulatory investigations into mortgage-securities pricing are examining whether financial firms should have told the public earlier about the declining value of such securities and how they priced them on their books, people close to the matter say. ... The probes are among the roughly three dozen investigations opened by the SEC tied to the downturn of the subprime market, which primarily is tied to low-end borrowers. ... These days, far fewer than half of all securities trade on exchanges with readily avaliable price information, according to Goldman Sachs Group Inc., while more securities than ever are priced by dealers who don't publish quotes. ... Financial firms often use mathematical models with built-in assumptions in determining value, or 'marks' which might differ if they had to sell the securities. ... The SEC is asking questions specifically about whether financial firms were valuing mortgage-related securities differently on their own books compared to the valuations they applied to the holdings of customers such as hedge funds. ... In the current environment, investigators will be looking at whether a firm changed its valuation methodology to one that was more favorable in order to avoid or forestall taking big losses", WSJ, 21 December.

May individuals accused of mortgage fraud against banks use their "marks" to determine what the houses they borrowed on were "worth"? What will the SEC do if it finds financial institutions used different valuations for the securities in question? Will anyone "important" be indicted by the SDNY US Attorney's office? Don't hold your breath. Hey, Michael Garcia, are you following this?

Saturday, December 22, 2007

US Injustice System at Work

"In a rare case of a lawyer being charged in connection with the alleged wrongs of a client, an Illinois attorney was indicted on fraud and other charges in connection with the 2005 collapse of commodities and derivatives firm Refco Inc. Federal prosecutors in Manhattan yesterday announced 11 counts against Joseph Collins [JC], now on leave from the law firm Mayer Brown [MB], LLP, in connection with his legal work for Refco, including documenting a series of 'round-trip loans' between related entities and outside investors that allegedly were designed to shift bad debt off Refco's books from 2000 to 2005. ... [MB] wasn't named in the indictment. Lawyers are rarely charged criminally in connection with a client's alleged fraud. In the collapse of Enron Corp. for example, outside lawyers weren't charged. ... Michael Garcia, U.S. Attorney for the Southern District of New York [SDNY] [said] ... 'No lawyer will be prosecuted unless that lawyer knows about the client's fraud and agrees to join in it, understanding its unlawful nature'," WSJ, 19 December.

"Fewer than 2% of civil cases went to trial in 2002, down from 11% 40 years earlier. The decline has come as busy courts increasingly emphasize efficiency in resolving claims, often at the expense of a just result says [Neal] Ellis. ... Underlying those factors says Mr. Ellis, is a bigger problem: The growing fear that jurors are too unsophisticated and too easily swayed by emotion to render fair verdicts in increasingly complex cases. ... Without reform he warns, Americans' confidence in the judicial system, including the right to trial by jury enshrined in the Seventh Amendment, will be dangerously undermined", WSJ, 20 December.

"With the recent announcement by federal authorities that they would not pursue a criminal investigation of police and prosecutors in the Duke Non-Rape, Non-Kidnapping, and Non-Sexual Assault Case, we pretty much have come to a dead end in the sorry aftermath of this affair. As one who has been immensely critical of the federal criminal system in general, I must say that while I am not surprised at the outcome, nonetheless the pure cynicism that came from the U.S. Department of (In)Justice was shocking even to someone as jaded as I have become. ... [T]he feds made the following announcement: 'We believe the State of North Carolina has the primary interests in this matter: protecting the integrity of its judicial proceedings, holding Mr. Nifong accountable for his actions as an officer of the courts, and vindicating the principles of justice under state law." ... This comes from the same DOJ(In) that saw no problem in prosecuting and convicting Michael Vick despite the fact that there are no specific federal statutes regarding dog fighting, but that such statutes exist in Virginia law. Now, there are specific federal statutes for obstruction of justice, and for misusing federal funds. ... In most circumstances, ... I ordinarily would welcome such 'restraint' from the feds. ... I realize more than ever that the [US] has become a country that is run by political rogues, and no more is that apparent than with federal and state prosecutors, and 'law enforcement' officials. Indeed, if one wishes to be a lifelong criminal--and get away with it--I would strongly recommend going to work in a prosecutor's office or become a member of a federal, state, or local law enforcement agency. ... So, we have one more example of police and prosecutors committing real crimes and being able to walk away without a scratch", William Anderson at, 14 December.

JC's indictment is rare as he is a major law firm partner. Michael Garcia (MG) may still work for MB when he leaves government service; why wasn't MB indicted? I presume because MG wants "to keep his options open". Hey, MG have you heard of a "wilful blindness" or "ostrich" jury instruction? I believe it's West's criminal law key 785. Study up, Mike. You need not show the lawyer" knew" anything. MG, must you have the lawyer's affidavit written while drafting the client's documents that the client said the documents were being prepared to further a fraud in progress, for the Second Circuit Court of Appeals to sustain his conviction? The jury may infer knowledge from actions. Or his choosing not to know, by ignoring what was plainly to be seen? What do law schools teach anyway? Hey MG, do you get practice pointers from Mary Jo White? See my 10 August and 12 September posts. Also see my 24 October post mentioning Graffam v. Burgess. MG, as far as I know, Graffam is still good law. It's a Supreme Court Case, ergo it's good law. Even in the SDNY.

I have little confidence in the judicial system. That many lawyers lack confidence in juries is a result of their elitism and fear. I lack confidence in lawyers and judges. Many are innumerate and scientific ignoramuses. I remember when the Supreme Court came down with Daubert, thinking: do the Supremes think Federal District Court Judges are budding Richard Feynmans, who will smoke out scientifically questionable claims? One reason for the decrease in jury trials is summary judgment abuse by judges who grant it to clear their calendars. Further, jurors don't want to sit. Why should they, if the judge can grant JNOV on a whim? Who needs it? Fear?

I agree with Anderson about the Vick prosecution. As to federal prosecutors discretion, see my 30 November post about Robert Morgenthau.

"In fact, after three years of law school and another seven years of actually working with lawyers, I can say that a lot of them actually fear numbers. ... I've watched managing partners spend thousands on consultants, apparently believing that some kind of black magic was involved, when those consultants' studies could have been assembled by any self-respecting MBA at a fraction of the cost", Take the Bar and Beat Me, Woodcock, Raymond, 1991, p 46. "I wouldn't say that math is beyond the grasp of those attorneys who fear it. ... They remain ignorant of quantitative procedures, and tend to forget even the math they used to know. But that doesn't stop them from thinking that they're brilliant, nor from handling highly numeric problems when perhaps they shouldn't", 47. "You don't philosophize, anymore, when you want to know something about the real world. ... If you're as non-scientific as the most muddled philosopher, and if you don't want scientists telling you to butt out because you don't know what you are talking about, my advice is this: Don't go into philosophy. Go instead into law. Law is perhaps the last refuge in our world for those who, knowing nothing, wish to assume that they know more than enough", 48. What's the problem: lawyers can't assemble cases because they can't get to the substantive issues. They can't evaluate evidence.

An "OJ" murder case incident illustrates. A prosecution "DNA expert" said the odds against a DNA sample match were: 57 billion to one! The "expert", who Marcia Clark and Chris Darden (MC&CD) put in front of the much maligned OJ jury, helped acquit OJ. Why? The jurors, those racist ignoramuses, realized the earth's population was 6.2 billion. Ergo, if everyone on earth got a DNA test, the odds against a match could not exceed 6.2 billion to one! The jurors came up with the "statistical independence" concept by themselves! But none had say, a Princeton mathematics degree. So? I followed the OJ case. I believe MC&CD's case was a mess. I would have acquitted OJ! Whaaaat? But "the blood"! MC&CD spent seven months proving OJ was an accessory after the fact to murder! Whether one drop of blood or a hundred, the blood went to one issue: OJ's presence at the crime scene, not what he did there. OJ was not charged as an accessory. A jury can consider what: it saw and failed to see. There was no: weapon, theory of the crime or motive presented. A wonderful case. The mythical Hamilton Burger of Perry Mason, 1957-66, would not have tried the OJ case. See also my 12 November post.


"One of the federal government's signature efforts to ease financial instability caused by the subprime-mortgage crisis collapsed as the nation's three biggest banks gave up on a fund intended to bail out tens of billions of dolars in troubled investments. ... Benn Steil, senior fellow at the Council on Foreign Relations, a nonpartisan think tank, said the plan was based on the flawed notion that the fund would pay more for tainted securities than would the banks themselves. 'I'm not surprised that this didn't happen,' he said. 'I never believed the proposal made much sense.' ... One reason for the plan's downfall was that it would only buy the highest-quality assets from the SIVs. That gave banks with SIVs less motivation to create a super-SIV, because the assets they wanted most to unload were those backed by more-troubled slices of mortgage debt", WSJ, 22 December.

"Also good riddance to the entire SIV schemes or scams--$350 billion of them--that are now comatose and dying an undiginified and well deserved death. .. [B]anks decided to ... bring back the junk from off-balance sheet to on-balance sheet. The reason is simple: given massive credit enhancement provided by the banks to the SIV dumping the losses on the investors was not feasible. ... So at the end the banks did the rational and unavoidable thing given that no investors was foolish enough to fork money into this Super-SIV turkey that could not fly in spite of the full support of Treasury and given that letting the roll-off of the ABCP destroy the SIVs and force a fire sale of assets would have triggered even bigger losses than the alternative of parking the assets on the balance sheet of the banks. ... This is the pathetic conclusion to the entire SIVs scam, as these were scams in the first place. The banks went to extreme length to create off balance sheet vehicles to exploit regulatory arbitrage ... and to provide tax avoidance ... to investors. ... So the SIVs were part and parcel of a securitization food chain that produced Frankenstein toxic food to be disposed of and shoved off the banks' tables. Thus, the SIV should have been banned in the first place by regulators; or be subject to the same regulations and supervision ... as the assets on the balance sheet of banks. Instead a bunch of clueless and incompetent regulators ... allowed these monsters to be created in the first place; these are the same folks that allowed the Enron SPV's--a close cousins of the SIVs--to be created and create a cancer that destroyed Enron. ... Will U.S. regulators learn their lesson and ban these off balance sheet scams or force them to have the same regulatory framework of on balance sheet assets and liabilities?", Nouriel Roubini (NR) at, 22 December.

I disagree with the WSJ. MLEC failed because Hank Paulson (HP) and the banks did not find enough "greater fools" to dump the worthless assets on. If the banks intended to put fairly valued assets into MLEC, it could have succeeded. As it is, Helicopter Ben will buy the junk through his TAF. MLEC, RIP. Better luck next time, HP.

Way to go NR! That's banging one out of the park, like the "Mick" did in old Yankee Stadium (YS). A 520-footer, right over the 461 sign in the left-center "bulge". What to do with our financial engineers now? Let's see if Communist China still has reeducation camps to send them to.

Friday, December 21, 2007

Mortgage Fraud, Whose?

"Skyrocketing foreclosures are a testament to how easy it was to borrow from mortgage lenders in recent years. It may also have been easy to steal from them, to judge from a multimillion-dollar fraud scheme that federal prosecutors unraveled here in Atlanta. The criminals obtained $6.8 million in mortgages from Bear Sterns Cos., including a $1.8 million mortgage to Calvin Wright, a New Yorker who told the investment bank that he and his wife earned more than $50,000 a month. ... Fraud goes a long way to explaining why mortgage defaults and foreclosures are rocking financial institutions, Wall Street and the economy. The [FBI] says the share of its white-collar agents and analysts devoted to prosecuting mortgage fraud has risen to 28% from 7% in 2003. ... It didn't take a rocket scientist to steal a fortune from mortgage lenders in recent years. ... In an unrelated case, an Atlanta attorney with no criminal record was sentenced in August 2005 to 30 years in prison on a mortgage-fraud conviction. ... Bear Stearns says falsified income and asset documents are difficult to detect 'if they are part of a sophisticated fraud ring'," WSJ, 21 December.

I say again, "Round up the usual suspects", Captain Renault in "Casablanca", 1942. $6.8 million? That's 10% of Goldman Sachs Lloyd Blankfein's $67.9 million bonus. What's going on? Why is the FBI chasing these peanuts? Why not investigate major banks, monolines and Wall Street houses SEC reports?

As the S&L crisis unfolded, 1979-86, the Feds tried to make it seem the result of "fraud" as opposed to a more innocent explanation: mismatched maturities. It's good "guerrilla theater" to see a few miscreant "perp walks". Most people are not interested in bad lending practices. In the end, only about 3% of S&L industry losses arose from fraud as opposed to bad lending.

Now the Feds are trying to garner public sympathy for the banks by portraying them as victims of unscrupulous fraudsters as opposed to their having victimized whoever bought recent bank products like CDOs. Banks as Katrina victims!

On 21 January 1990, Ben Stein (BS) wrote in the NYT, "The New Organized Crime". "John Gotti, you poor, obsolete loser. You've missed the boat. You forgot Willie Sutton's lesson-go where the money is. ... Breathlessly, the announcer talked about how the take was in the tens of thousands of dollars, and how the raid [on a gambling bank] marked a major coup in the war on organized crime in [NYC]. If it's true, it's a joke. 'Organized crime?' Next to a bakery in Queens? With guys in T-shirts running it? With a take of tens of thousands of dollars? From betting on football games? ... The real organized crime, the riskless kind that pays off in the hundreds of millions and billions, is across the river, in lower Manhatttan, on Broad Street, on Wall Street. It's across the continent, in a gleaming marble cube on Rodeo Drive. The only truly meaningful kind of taking of other people's property--the kind that adds up to enough to support an army--of lawyers--is being done by the American financial establishment. ... Example: the sale of fraudulent bonds. ... That's modern organization. That's modern crime. The [SEC] won't bother you. ... The old-style organized criminal had at least to deliver gin or prostitution. But the new way, the Wall Street way, means you don't deliver a thing. You run the company into the ground, you take from the stockholders unreasonably. You sell a worthless bond, and nobody lays a hand on you. It is a lesson for you John Gotti. ... Be in finance. Be in management of a public company. They learned from you and now you can learn from them". Imagine, BS wrote that almost 18 years ago. What's changed? Here's a link:

Thursday, December 20, 2007

Monolines-End of the Line?

"The forest issues is simple: a business ... that is fundamentally based on having a AAA rating is a business that does not deserve a AAA rating in the first place. ... Here we have instead an industry that would go bankrupt as soon as its AAA rating is lost: by definition this is not an industry that can deserve a AAA rating. ... There is a fundamental and conceptual flaw in a business model that is conditional on a AAA rating and that is a business that insures assets and firms that do not have a AAA rating. This is analogue to the voodoo finance of taking subprime and BBB mortgage backed securities and turning them into AAA by the black magic of CDO tranching. ... [M]onoliners collectively insure $3,300 bn of principal and interest ... with only a $22 bn capital base. ... But these risks cannot be an excuse for not admitting that the monoliners don't deserve an AAA rating. ... So enough of wasting time on dissecting the assets and liabilities and capital of individual monoliners; their business model is conceptually flawed in the first place; and their actual business practices have been even more flawed as they have now insured for years toxic RMBS, CDOs, CDOS of CDOs and in some cases even holding these assets on their portfolios such an AAA rating does not make any sense. ... But the current charade ... is another example of rating agencies supporting a rotten business model. ... So it is time to stop this charade of rating forebearance and admit that the emporer has no clothes: a business model that cannot survive without an AAA rating is conceptually a business model that cannot deserve under any circumstance an AAA rating; period! Arguing otherwise is believing in voodoo black magic", Nouriel Roubini (NR) at, 20 December.

"My contention is that the entire US financial engineering contraption is being dissolved, a crumbling pile of wreckage, with evidence of fraud throughout the structure. It is an historically unprecendented failure in innovation, a reckless extension to develop the inflation-based system", Jim Willie (JW) at, 20 December.

"It is unclear how much capital it would take to shore up ACA. Another solution the banks are discussing would relieve ACA of having to post collateral against its insurance contracts if the company is downgraded. ... Investment banks, hedge funds and insurance companies often use credit default swaps to bet on or against bonds without trading the underlying securities. ... At the heart of many insurance contracts issued by the company is a popular transaction known as the negative basis trade. For example, a bank holding a bond that paid interest at 0.50 percentage point over [LIBOR] would pay ACA 0.30 percentage point to insure it, pocketing the 0.20 point difference for the life of the contract. Accounting rules allow the banks to book that entire amount as income when the contracts are written ... 'It's a zero-sum game', [Sean Egan at Egan-Jones] said, noting that the gains at the investment banks buying the protection have to eventually result in losses for the firms they hedged with, 'If you put trades on that worked so well that you bankrupt your counterparty, you will not collect on those trades'," Vikas Bajaj and Gretchen Morgenstern at the NYT, 19 December.

Way to go NR! Right on! Welcome back! I have said in the same words, the monolines business model made no sense since late 2002 when I learned of them! The "emporer has no clothes". What don't the rating agencies understand? The monolines should never have existed! I agree, JW, this may be this round of financial innovation's end. Yes, this a zero-sum game.

From 1988 to 2005 I was a member of a Los Angeles financial professionals group which met monthly. We discussed the monolines in one late 2002 meeting and said what NR is saying here, in the same words, concluding their business model made no sense. Our discussion was spurred by a WSJ article in late 2002 about a dispute between MBIA and Gotham Partners (GP). We concluded GP was right: the monolines should not exist. GP shorted MBIA then showed the world its proof, that MBIA should not exist, as Hershliefer suggested, see my 10 December post. That the monolines have survived since 2002 amazes me.

There's more. "The key to MBIA is that the credit-rating agencies--such as [S&P]--give its insurance arm the rare and coveted rating of triple A. ... At MBIA's request, Eliot Spitzer's office launched an investigation of Gotham over possible market manipulation. ... The questions surrounding MBIA are critical ones not just for the millions of investors who own MBIA-guaranteed bonds but also for everyone who wonders whether the watchdogs of our financial system--the analysts, the accountants, and most critically in this case, the credit-rating agencies--can be trusted. ... To believe Ackman is right, you have to believe all these people are wrong. It's almost impossible. Almost. ... Look beneath the surface of this business, though and you find the potential for conflicts of interst. ... On July 17, 2002, he placed a bet against MBIA using credit-default swaps that would pay off in the event of MBIA's bankruptcy. On July 24, he shorted the stock. Then he released his report. ... MBIA's executive are particularly outraged about Ackman's allegations regarding the special-purpose vehicles. ... Ackman and others say it simply defies common sense to say that the SPV debt--which after all is on MBIA's corporate balance sheet ... doesn't belong to it. ... Morgan Stanley analyst Alice Schroeder wrote, ... 'In addition, the rating agencies are an explicit participant in the guarantor's business model and in effect are now in the awkward position of passing judgment on themselves'," my emphasis. Who wrote this? Bethany McLean in Fortune, 2 May 2005, 2.5 years ago! This article is titled, "MBIA-The Mystery of the $890 Billion Insurer", and is at in the May 2005 archive.

Financial Innovation and History

"Many of the financial institutions and instruments caught up in the crisis are part of the centuries old phenonenon of financial innovation. The new instruments--often designed to avoid regulation--are then proved to be successful or not by the test of financial stress such as we have been recently encountering. ... A key dynamic in the crisis is information asymmetry in the spread between risky and safe securities. ... Historically, financial crises originate on the liability side of banks balance sheets as depositors rush to convert deposits into currency in the face of a financial shock. In recent decades, since the advent of deposit insurance, pressure has come from the asset side. ... In many of these cases financial innovation which increased leverage and was often designed to circumvent regulations was an integral part of the story of the boom", Michael Bordo (MB) at, 17 December.

I agree with MB. Much financial engineering is designed to "circumvent regulations". As Bethany McLean wrote in Fortune on 26 November, it's a "black art". See my 2 October and 8 December posts.

A New Financial Product

"R&R Consulting [R&R] has begun work on a database model to predict aggregate first-run U.S. box office revenues for independent movies. This is the first step in the development of an advanced system of financial securitization for independent film production. The project, called Film Score [FS], is part of the [R&R] mission to bring the same high standards of precision and dependability of the engineering disciplines to the capital markets. ... The project seeks to create a predictive model for determining a film's financial risks. ... [FS] predicts revenues for independent films by quantifying value elements in the selection of screenwriters, directors, producers, actors, and the script itself. ... [T]he model and the database will be able to predict revenues from a targeted film's first U.S. release. ... However, the database will not require specific names of actors or directors because only the profile of the different participants will be used as variables. ... The ultimate objective of precision-tool finance in parsing risk and capital more finely is to 'discover' new sources of capital for arts and society",, 30 November 2007.

Quoted without comment.

Incentives Count, Even For the FBI?

"For two decades, the federal government has pursued, prosecuted and sentenced cocaine offenders in a way that borders on insanity--targeting petty criminals over serious drug dealers and, in doing so, undermining its own mission. ... On its face, the debate was about how much deference must be paid to the [sentencing] guidelines. But is was also about whether the guidelines made sense: they subjected a defendent caught with 50 grams of crack to the same penalty as one with 5,000 grams of powder, even though crack is just adulterated powder cocaine. ... The result has been a tragic playing out of the law of unintended consequences. Instead of focusing on drug lords, federal efforts have been mostly directed at pawns. ... The message is simple: it's not just that the 'get tough' policies of the 1980s don't work; they actually do harm by, among other things, undermining faith in the fairmess and efficiency of the justice system itself. The Supreme Court has finally noticed that. Congress should, too", Ellis Close, at Newsweek, 24 December.

The sentencing guidelines gave federal law enforcement officials an incentive to get lots of "easy" prosecutions of nobodys as opposed to fewer drug kingpin prosecutions. This seems to be how federal law enforcement works. I expect to see many loan brokers prosecuted for mortgage fraud; I will be surprised to see any financial institution executives which sold: CDOs, CPDOs or bank executives who thought their SIVs need not even be disclosed when they had "liquidity puts" prosecuted. "Round up the usual suspects" said Captain Renault in "Casablanca", 1942.

Governments seem to work this way. In Stalin's USSR, a screw making factory was given a screw quota. Result: billions of tiny screws as opposed to various size screws the USSR needed. The Gosplan geniuses had a new idea: give the factory a ton screw quota. Result: a small number of gigantic screws as it was easier to make large screws by the ton instead of small ones. Moral of the story: incentives count.

Real Estate Value Problems

"As the housing market slump deepens, disguised discounts are making it harder to tell exactly how much people are paying for homes. ... But incentives offered to buyers ... are making [county sale records] less reliable as a sign of what buyers actually paid, netting out the giveaways. ... But mortgage-fraud experts say the rebates are often designed to fool lenders into making bigger loans than they otherwise would", WSJ, 19 December.

The article cited a townhome that valued at 14% "above the net price paid by the buyer". The real estate slump may be more severe than many people think.

Wednesday, December 19, 2007

Who Needs the Rating Agencies?-3

"Moody's Investors Service ... said ... it is affirming its highest rating, triple-A on bonds insurer MBIA. ... Moody's ... also affirmed the top rating of insurer Ambac. ... Bill Ackman [BA] of New York hedge fund Pershing Square Capital Management LLC, described the moves by Moody's are 'creeping incrementalism'. ... As with MBIA, Moody's also affirmed the ratings of CIFG Guaranty, while changing the rating outlook to 'negative'," WSJ, 17 December.

"Fitch Ratings said it will set a ceiling for credit ratings on certain complex, and difficult-to-trade investments like debt that helps fund ... [SIVs]. Under the new proposed framework, ratings would be capped at single-A for assets that are opaque and not easily traded. ... Fitch also said that constant proportion debt obligations, or CPDOs, aren't likely to garner ratings above triple-B", WSJ, 19 December.

BA has long been a critic of the monolines. I agree with him. Fitch's new ratings limits are more than overdue. I have no problem with Moody's "tripe-A" ratings on MBIA, Ambac and CIFG.

California Real Estate Update

"Home sale prices in six Southland counties tumbled 10% last month compared with November 2006--the sharpest year-to-year decline in the last 20 years, a real estate information service reported Tuesday. Sales volume dropped ... 43% from a year earlier. ... According to DataQuick, the median price for a home in Southern California fell to $435,000, down 14% from a peak of $505,000 earlier this year. ... Christopher Thornberg, a principal of Beacon Economics, in L.A., ... thinks that ... prices will fall through 2011", LA Times, 19 December.

I expect California real estate prices to fall for at least two more years.

Monday, December 17, 2007

Junkyard Dogs at the Table

"First came the bankers who created funky mortgage investments. Now come the lawyers. ... On Nov. 6, Sagittarius triggered 'an event of default.' This prompted MBIA to claim it should get all the remaining payments. That put it into potential conflict with Deutsche, the CDO's trustee, and UBS, an investor with fewer rights in the event of a default. Sorting out how to value the assets, who gets paid and whether to pull the plug on struggling CDOs is complicated business. ... So far, three CDOs have started the process of liquidation. ... MBIA has reason to aggressively protect its interests--its stock has declined more than 60% this year amid concerns about its mortgage exposure. ... 'No one has cracked the code on how these things work out and divy things up,' says Julia Whitehead, a senior adviser at valuation advisory firm Miller Mathis", Aaron Lucchetti at the WSJ, 17 December.

Each day the market presents new opportunities. Here's one for New York's R&R Consulting. It, Miller Mathis and a third financial engineering firm can offer three-person arbitrations to decide who gets what. As Rhett Butler said in Gone With the Wind, 1939, "There's just as much money to be made in the wreck of a civilization as in the upbuilding of one".

Pension Problems

"Paternoster, the privately-owned pensions group, is taking on the defined-benefit pension scheme of Lasmo, the UK oil exporter owned by Italy's ENI, after winning the largest-ever electronic auction for a pensions buy-out. The auction is thought to have been hosted by Mercer, the pensions consultants, during October. Bidders competed to charge Lasmo the lowest fee for assuming its pension scheme liabilities and supporting asset portfolio", Chris Hughes at, 9 December.

The "lowest fee". Interesting. Whose actuarial assumptions went into the fee estimate? Will Paternoster remain solvent to discharge Lasmo's pension liabilties? Or is the transaction a form of long-term "fraudulent transfer" to enable Lasmo to escape the liabilities? If I recollect properly, General Motors (GM) tried something similar when Delphi was created. See my 7 October post about GM's VEBA.

Sunday, December 16, 2007

"I Know Nothing", Sergeant Schultz as Economist

"The financial crisis of 2007 is bringing out the creative side of the world's central bankers. ... Central bankers are extremely conservative people. ... Their first rule is to do no harm. ... After improving for several months, the banks are swooning again. ... Simply stated, the problem is that the banks are unwilling to lend for anything more than a few days. ... Clearly, they were worried about the quality of the assets on the balance sheets of the potential borrowers. My guess is that banks were having enough trouble figuring out the value of the things they owned, so they figure that other banks must be having the same problems. The result has been paralysis in the inter-bank lending markets. ... And, as I will discuss in a moment, non-US banks faced an added problem--they could not get dollars. ... Everyone has described the current environment as a crisis. ... The discount lending rate is supposed to put a cap on the federal funds rate in the interbank market. ... Today we have the new problem that dollars are in short supply outside of the United States. ... Okay, so what exactly is the Fed trying to do here? ... To understand why [the Fed is] doing this, we need to think about the fact that the central bank can use operations to either change the size of its balance sheet or the composition of the assets that [it holds]. ... This new mechanism is aimed at shifting assets from US Treasury securities ... to some of the lower quality stuff that is accepted as collateral for discount loans. ... I simply note here that in a crisis it can become almost impossible to distinguish illiquidity from insolvency", Stephen Cecchetti (SC) at, 16 December.

"On Wednesday, the Fed said it was teaming up with four other central banks, including the European Union's, in a scheme to inject capital into the market more broadly than it can through short-term loans at the discount window. ... You may wonder what Bernanke & Co. will take as collateral from banks for this handsome handout--pretty much anything a bank has in its vault short of the old electric typewriter and the battered desk chair with one brokern wheel. ... The Fed also will accept as collateral triple-A-rated [CDOs] and mortgage securities. In fact, it's willing to lend up to 98 percent of the face value of the notes. ... Will the Fed lose money on this? Probably, but that's how bailouts work. The government assumes the risk, and often the losses , when others can't. ... In fairness, the Fed is merely doing its job. Its mission calls for it to safeguard the integrity of our financial markets. To do that, the Fed is basically letting banks know it will shoulder any toxic debt they're holding on their balance sheets", Loren Steffy (LS) at, 14 December.

Uh, oh. Beware central bankers being "creative". Learn from the Trojans, beware central bankers bearing "new anything". See my 28 November post. "Their first rule is to do no harm"? To whom? What about Hjalmar Schacht, a German Reichsbank director in 1922-23? No, SC, the problem is: the banks believe other banks are insolvent and lack good assets to use as collateral. "Dollars are in short supply outside of the United States", SC writes. Really? Communist China has $1.4 trillion in foreign exchange reserves as does Japan. SC, read the newspapers. It is almost always impossible to "distinguish illiquidity from insolvency". Again, many posts are nonsense. We can learn one thing from SC's piece: the banks are in much worse condition than anyone will publicly admit.

Yves Smith (YS) at, 13 and 16 December was comfortable with the new Fed Term Auction Facility (TAF). To YS's credit, he refers and provides a link to a 16 December post by Steve Waldman (SW) at critical of the TAF and YS's analysis. I think SW's got this knocked as does LS. I finally understand my problem with the rating agencies. It's the product of a typing error. When the rating agencies are supposedly rating something "triple-A", what they mean to say is "tripe-A". Now I get it.

Goldman SACKS, Its Clients?

"The subprime-mortgage crisis has been a financial catastrophe for much of Wall Street. At Goldman Sachs Group Inc., [GS] thanks to a tiny group of traders, it has generated one of the biggest windfalls the securities industry has seen in years. ... [GS's] trading home run was blasted from an obscure corner of the firm's mortgage department--the structured-products trading group, which now numbers about 16 traders. ... [GS's] success at wringing profits out of the subprime fiasco, however, raises questions about how the firm balances its responsibilities to its shareholders and to its clients. ... The question now being raised: Why did [GS] continue to peddle CDOs to customers early this year while its own traders were betting that CDO values would fall? A spokesman for [GS] declined to comment on the issue", WSJ, 14 December.

"Raises questions"? GS's "clients" apparently come last. Did GS warn its "clients" before its own traders that the "subprime market" was composed of junk? Why should the Fed or Treasury hire any "former" GS executive? What kind of "corporate culture" has GS? "A spokesman for [GS] declined to comment on the issue". Calling Charlie Rangel, calling Barney Frank, etc..

Saturday, December 15, 2007

"Kill All the Lenders"

"The business of Wall Street is to introduce people who should not borrow to people who should not lend, collecting fees from both parties. It's a good business as long as everyone keeps a straight face. In the last few years, it got to be too good a business: It came to be the business of Main Street as well. ... All we need is some new courthouses to hold the foreclosure papers and proceedings on a couple of million American houses. The sooner the banks own them, the sooner they can be resold on realistic terms", Thomas Donlan (TD) at Barron's, 10 December.

"Let me argue why monetary policy easing--not just palliatives such as the liquidity injections announced by central banks this week but rather significant cuts in policy rates--are now necessary and warranted. ... First of all, as argued here since August, the current global financial crisis is due to insolvency on top of illiquidity. ... The job of a central bank is not to bail out the financial system and/or investors but that of bailing out the real economy. Having millions of workers lose their jobs ... does not make sense. ... And inflicting severe misery and pain and collateral damage on innocent bystanders ... is not sound economic policy. ... Third issue: would monetary easing cause a much higher inflation rate and undermine the anti-inflation policy of the central banks? After all inflation rates are now rising around the world thanks to high and rising oil, energy, food and other commodities. ... This is the most severe financial crisis that the global economy has experienced in the last few decades. But so far central banks have been deluding themselves that this is a temporary run-of-the-mill liquidity shock", Nouriel Roubini (NR) at, 15 December.

I was in grammar school in the 1950s. Weekly we got My Weekly Reader (MWR), for a nickel! MWR exposed us to the Fed as seven-year olds! MWR taught that many South American countries were corrupt as they had 20-35% inflation rates because of their unwillingness or inability to balance their budgets. MWR did not teach monetarism, but I conclude its' writers knew more economics than Helicopter Ben (HB). MWR's writers thought the Fed's primary job was to mantain the dollar's value in the foreign exchange markets and that we were lucky to have a responsible central bank like the Fed unlike those of South Americans. HB has a choice, destroy the dollar or let the market destroy the banks. It's that simple.

NR is honest to admit his is an advocacy piece. I agree, there are insolvent actors in the market. My questions to NR are: who are they? What does bailing out "the real economy" mean? Who is helped, who is hurt? Whether or not "having millions of workers lose their jobs" makes sense depends on who they are. I believe having say, 100 to 200 thousand Wall Streeters lose their jobs makes sense. Having say, 300,000 mortgage bankers lose jobs makes sense. Is destroying millions of Americans' life savings through inflation to protect the banks "sound economic policy"? What "anti-inflation policy of the central banks" is NR aware of? If Milton Friedman established anything it is: inflation is a monetary phenomenon. NR confuses central bank rhetoric and actions. They are not "deluding themselves" at all. They will print all the money the large banks need. Got gold? Get more.

Addendum: Mike Shedlock (MS) had a post on NR's post at Mish on 18 December agreeing with me. MS notes he checks his opinions against NR's to see if he may be wrong. So do I.

Citigroup Comes Clean

"Citigroup Inc., badly bruised by mounting losses, is bailing out seven affiliated investment entities, bringing $49 billion in assets onto its balance sheet and further denting its capital base. ... The move could be the death knell for an industrywide effort to create a rescue fund for SIVs. ... Still, Citigroup's move is surprising because the bank made it clear in its most recent filing with the [SEC] that it 'had no contractual obligation' to support any of the SIVs it sponsored. Citigroup said in its filing that it wouldn't take any actions to consolidate the vehicles on its books", WSJ, 14 December.

What did Citigroup do? If it put the assets on its balance sheet, it "consolidated" them. That Citigroup denied it would do this a few weeks ago gives the SEC an opportunity to investigate Citigroup's SEC filings. Where are the Wells notices? Is the Southern District of NY's US Attorney loading his guns? Stay tuned. See my 27 November post.

A Business I Never Understood-8

"Ambac Financial Group Inc. became the latest bond insurer to improve its capital position, reaching an agreement under which a unit of Assured Guaranty Ltd will reinsure a $29 billion Ambac portfolio. ... The company said it is waiting for the rating providers to conclude their evaluations of the financial guarantors' triple-A credit ratings before announcing the details of this and any other capital-enhancement plans", WSJ, 14 December.

Why is Ambac waiting? Why does Ambac care what the rating agencies do? This reinsurance agreement appears to be 8-K reportable. It should be an interesting read. Its' terms should be revealing. Mike Shedlock (MS) has an excellent post on this at, 14 December. I have nothing to add to MS's post. Take a look, enjoy.

People Own These?

"The sharp drop in Treasury-bond yields lately suggests inflation isn't a big concern to investors. ... [T]he yield of the 10-year Treasury note has dropped to 4.169% yesterday from 5.297% in June, even as headline inflation has moved higher", Scott Patterson in the WSJ, 14 December.

To get a 2.5% "real rate of return" from a "riskless" asset implies the Treasury market predicts inflation will average 1.669% (4.169% - 2.500%) over the next ten years! Does anyone believe that? What's going on here? I see no reason to own long-dated Treasury paper at these rates.

Thursday, December 13, 2007

A Business I Never Understood-7

"Fitch Ratings says its business is providing the world with 'independent, timely, and prospective credit opinion.' Judging by its AAA rating on MBIA, it looks like Fitch is 0-for-3. ... Somebody here, please just state the obvious: if MBIA is a AAA credit, then Britney Spears is fit to rejoin the Mouseketeers. ... Maybe it should take this long to determine what the right rating is. However, nobody should need this long to figure out that AAA is the wrong rating, anymore than it should take weeks of testing to ascertain that I'm unfit to be quarterback for the New England Patriots. ... Last week, credit-default swaps tied to MBIA Insurance Corp.'s bonds were 193 basis points, according to data compiled by Bloomberg. In other words, it cost about $193,000 to buy a contract protecting $10 million of bonds from default for five years. ... Credit protection on another AAA-rated bond insurer under review, Ambac Assurance Corp., cost 289 basis points. ... By comparison, credit-default swaps for a real AAA company like Johnson & Johnson were 15 basis points. ... [MBIA] guarantees more than $650 billion of state, municipal and structured-finance bonds, compared with only $6.5 billion in shareholder equity. Big problems are hitting the subprime collateralized debt obligations it backs. [Sean Egan of Egan-Jones] estimates that MBIA needs to raise more than $4 billion of capital, it's stock-market value is just $3.8 billion. ... They're agencies only in the sense that they are agents of the companies that pay them for their ratings", Jonathan Weill (JW) at, 10 December.

With a 178 (193 - 15) basis point five-year differential between MBIA and J&J credit, did MBIA insured bonds fall by say 5.34% (1.78% X 3) assuming an average 15-year maturity? Just curious? Or did they not fall at all and the market "saw through" MBIA and its ilk all along? If they fell 5.34%, that's $35 billion ($650 X .0534)! Similarly, did Ambac's insured bonds fall 8.22% (2.89% - .15% = 2.74%; 2.74% X 3 = 8.22%)? There's a reason I never understood this business. I remember once reading an article in BusinessWeek that described insurance companies as Ponzi Schemes, i.e., they take in money up front in return for a promise to pay it back later. See also my 8 December post.

Wednesday, December 12, 2007

Of Quants, Faith and Alcoholics Anonymous

"R&R Consulting, a New York City structured finance [SF] credit metrics firm, celebrates the power of mathematics in [SF] with the relaunch of its website, ... 'You don't have to have a Ph.D. in engineering to understand what we do,' says Sylvain Raynes [SR], one of R&R's partners, who has a doctorate in areospace engineering from Princeton. 'But you do have to be serious about the science of finance'. R&R uses heavy-duty modeling techniques taken from engineering to analyze the credit quality of non-recourse debt obligations backed by pools of receivables, like credit cards, residential mortgages, automobile loans, equipment leases, or even corporate debt, known as structured securities. ... In the words of Ann Rutledge [AR], also an R&R partner, 'There's only one set of tools you can use to predict how these pools will tend to behave over time. And that's mathematics--mathematics and statistics. You can't have an honest understanding of risk and return on structured securities without these tools.' ... '[SF] is not taught at any depth in most universities, even in financial engineering programs,' says Raynes. 'Practitioners come to our classes, or read our book, 'The Analysis of Structured Securities,' ... and literally feel joy that a whole world is opening up to them',", 17 May 2005.

"'No one really knows how to price asset-backed securities and CDOs and that's a real problem in the market place now,' said [AR], principal of R&R consulting, a [SF] consultancy in New York", WSJ, 10 August 2007.

"'Do you believe? Then place your hands over your investment portfolio and declare your faith in the ones who swear to its goodness', [said] Bob Moon. 'The ratings business , as it stands today, is a quasi-religion that does not have any more to offer than that', [said SR]", at, 19 September 2007.

"'Who are we going to trust? Are you going to look to JPMorgan or Goldman Sachs? Are they going to rate structured deals? Can we trust them on valuation? We need to take the high road ... because I might not do any better.' ... 'The problem as I see it, as we at R&R see it, is a fundamental lack of recognition of the different basis that exists in [SF] as opposed to corporate finance. ... Valuation ... is the only problem for finance,' [SR]. Raynes then asked how do we move forward from here: 'The first thing I would try to do is to establish a unique valuation theory for structured securities. Does this exist? Well it could if people are listening. They are not. ... '[SF] is a beautiful thing. The men of Wall Street like to fall in love with beautiful things. ... So we don't have to be in love with [SF], we just have to respect it',", 25 September 2007.

"No one really knows how ... now", saith AR. Was the knowledge lost? Who ever knew? AR admits she doesn't know. Later, I will offer a suggestion using mutual fund accounting which I understand. "If you give me six lines written by the most honest of men, I will find something in them which will hang him", Cardinal Richelieu (1585-1642). Yes!

"The solution for the subprime-infected credit market seizure that wiped out $66 billion of securities industry capital this year may be found in a bunch of hospital bills. ... [Richard] Field and Deloitte & Touche are a part of a fast-growing cottage industry that includes household names such as Moody's Investors Service trying to shine a light on the world's most opaque markets. ... As much as $2 billion a year could be made by someone with a model that accurately valued asset-backed securities, according to [SR], a principal at R&R Consulting in New York. ... Dan Fuss, vice chairman of Boston-based Loomis Sayles & Co., hasn't found an adequate system to help value CDOs so he refused to include them among the $22 billion of securities he manages. ... Raynes of R&R Consulting was hired two years ago by an affiliate of the Bond Market Association that deals in asset-backed debt to assemble teaching materials on valuing such securities for its members. The trade group paid Raynes half of his fee in advance and failed to pay the remainder after receiving the materials because its members found them too complicated. 'All of the managing directors could not understand any of the formulas so they did not pay us,' he said. 'This is basic bond math, duration and convexity. This is not rocket science. ... Firms promoting new pricing models are 'trying to cash in on fear,' Raynes said. ... We as a market must recognize there is a lack of understanding of what value means in [SF]'," Caroline Salas at,com/, 4 December.

I suspect 73 years from now Graham & Dodd's Security Analysis will outsell SR book. I agree with SR, most ratings are worthless. I disagree with SR, we don't need a "different basis" for SF as opposed to corporate finance valuation. SR belief is pure faith. He believes, I do not. Cash flows are cash flows. Discount rates are discount rates. Consider "arbitage pricing theory" (APT). APT came out in the mid-1970s. I still pick up finance or economics books from time-to-time to keep up.

Are Wall Street MDs as dense as SR thinks? Most went to our better MBA schools: Wharton, Stanford, MIT, Northwestern, Harvard, Columbia and my alma mater, Chicago. Their inability to understand basic bond pricing surprises me. At Chicago, many years ago, I took Rueben Kessel's class on the "Term Structure of Interest Rates", which touched on concepts like duration and convexity. So? Don't MBA schools teach that any more?

SR may be wrong; cash flows are cash flows and their "wrapping", in a corporation, an SIV or a tortilla, only changes their tax and legal attributes. As Cassius said to Brutus, "The fault, dear Brutus, is not in our stars, but in ourselves, that we are underlings", Julius Ceaser, I:2. Similarly, the fault dear SR may be: cash flows are cash flows! Further, do not try to be more precise than your data permits. A humbling book decrying excessive precision is: On the Accuracy of Economic Observations by Oskar Morgenstern (OM), 1950. OM's opinion: economics is at most a "two-digit" science. Be warned. By the way, OM was a Princeton economics professor. I wonder if his name is even mentioned on that campus today.

Mutual fund pricing values each position, using current market prices, adding up the value of all positions, then dividing the total by the number of oustanding shares for a unit price. Simple, voila. We get a few "hooks". If we invest in a "load fund", with say, a 5.75% fee, when we invest $10,000, we only see $9,425 ($10,000 - $575) on our statement. Easy enough. What has this to do with CDOs? About 30 years ago, we had "dual funds" (DF). DF had "common" and "preferred" shares. The preferred shares got the underlying investments' dividends and the common shares the rest. DF were interesting since in theory, you could buy an equal number of common and preferred shares to recreate the underlying portfolio on an unlevered basis. Some academic work was done on why common and preferred shares sold at premiums and discounts. That's not germane to my discussion here. What is: the common and preferred shares together, sold at a discount to the underlying portfolio. Why? The costs of running the DF were "impounded" into the shares current market price. Neat, huh? The market rarely is stupid. What has this to do with CDOs? Simple, how many "tranches" you break mortgages into doesn't matter; in total, they are worth the mortgages! Less administrative costs, of course. Just like DFs. The valuation problem is not with CDOs, but with the underlying mortgages! It's on the ledger's asset, not liabilities side! Wasn't that easy? As to valuing the tranches, just use bankruptcy law concepts as to their seniority, bearing in mind, at some point, even a "deep out of the money" tranche, has option value. It may be one dollar on 100,000, but some value. Debits to the window, credits to the door. Class dismissed. For extra credit read, "The Theory of Recapitalizations And The Evidence Of Dual-Purpose Funds", Litzinger & Sosin, The Journal of Finance, Vol. 32, No. 5, (Dec., 1977) 1433-55 which deals with contingent claim valuation. Speculation: what interest rate would Citigroup have charged a person with a $100 million mortgage portfolio to borrow $85 million against it and create his own "toxic waste" dump? Just curious, more or less than the mortgages' interest rate?

"'The first step if you are an alcoholic and you need to stop drinking is to get on the podium and admit to yourself you're an alcoholic.' ... Raynes said",, 4 December. Amen. That's good Bill Wilson advice as millions of AA members can attest. Try this, "My name is Sylvain. I am a structured finance professional. ... " Sylvain, after the meeting we will introduce you to people who have at least a year in the program so you can pick one to be your "sponsor".

$2 billion a year? Is SR looking for a "philosopher's stone" that will turn lead into gold. I have a better idea SR, if you find the "mother of all valuation models": keep it to yourself and use it to select stocks to purchase and short. If the model works, it should enable you to make some real money. Had you known how to value CDOs, etc., a year ago, you could have made a nice profit shorting: Ambac, MBIA, Countrywide, Citigroup, etc.. Tens, maybe hundreds of billions a year could be available to you. See my 23 August, two 27 September and 24 November posts.

The PCAOB at Work

"In its first-ever enforcement case against a Big Four accounting firm, the nation's audit watchdog fined Deloitte & Touche LLP, $1 million and censured the firm over its work checking the books of a San Diego-based pharmaceutical company. ... The PCAOB previously took enforcement actions against 14 individuals and 10 firms, according to a spokeswoman, although they all involved smaller firms", WSJ, 11 December.

Big deal. $1 million to Deloitte. Peanuts. This looks like a PCAOB face saving move to create some credibility with the public and Congress. It appears Deloitte and the PCAOB identified a "fall guy", James Fazio, who "fell on his sword" for the team. Go PCAOB! Go team!

Who Lost Russia?-2

"There is more to Valdimir Putin's popularity than oil-fueled prosperity. In the early to mid-'90's, I found young Russians to be largely pro-American. They looked on the U.S. as a model for their country and were hopeful that the fall of communism would usher in an era of cooperation between the U.S. and Russia. However, cold water was thrown on these hopes by the Clinton adminstration's decision to support expanding NATO to include former Warsaw Pact countries--without any prospect that Russia would ever be invited. ... Clinton also lost much credibility with Russia by pushing to intervene in Kosovo in 1999. The Bush administration, many Russians say, added insult to injury by sponsoring NATO membership for portions of the former Soviet Union itself--the Baltic States. ... Given that our alliances with both Pakistan and Turkey are getting 'frayed around the edges,' perhaps the U.S. should try to make up for missed opportunities to build a strategic relationship with post-Communist Russia", James Klebba (JL) letter in the WSJ, 12 December.

We have provoked Russia for no strategic benefit. See my 22 October post. I agree with JL.

Too Big To Fail?

"How much would you pay to become, with capital-letter authority, Too Big To Fail? ... 'There is a lot of subsidy provided to really large banks,' [Julapa Jagitiani (JJ)] added, noting that the study was the opinion of the authors [JJ and Elijah Brewer III] and not the Federal Reserve. 'It seems like we may be encouraging misallocation of resources. She did caution that 'at the Federal Reserve, we don't have a list of Too Big To Fail banks'," WSJ, 12 December.

JJ can testify she has not have seen the list, but cannot testify it does not exist. I suspect it exists and that Citigroup, Wells Fargo, JPMorgan and the Bank of America are on it. As for misallocating resources, welcome aboard, JJ. You're saying what Ludwig von Mises said in 1930!

Subsidized Oil Consumption

"Long the biggest spigot for crude oil, Saudi Arabia [SA] now has broader ambitions. It wants to become a big exporter of chemicals, aluminum and plastic, and in the process to create jobs. ... Within [SA], there's heated debate over the wisdom of staking development on industries that use so much energy. ... Saudis are now the world's biggest oil consumers per capita, at more than 32 barrels a year per person. ... Thirty years ago, [SA] had eight million people. Now it has over 24 million. ... Saudis consume vast quantities of electricity because the government holds the price unusually low to keep the populace happy. ... Saudis routinely keep their air-conditioners on full blast even when on vacation. ... The government's aim is to convert oil into jobs. 'We want to use our oil to move beyond oil,' says Fahd al-Rasheed, a former Aramco finance officer", WSJ, 12 December.

SA, Iran and Venezeula, among other oil producing countries, subsidize oil consumption. The USSR did this with bread, so it was cheaper to feed cows and pigs bread than grain. The Saudis seem to be following "Atari" economics, i.e., believing the Saudi government can find profitable investments. It should: stop subsidizing oil consumption and let the market make whatever investments it will. As things stand, Saudi policies increase world oil demand.

Tuesday, December 11, 2007

Is Hank Paulson Andrew Fastow?

"Historically--and under accounting rules--banks stepped in to rework loans only if they were in actual default, when it became the bill collector's responsibility to minimize investor loss. ... At the same time, banks continue to keep those loans off their balance sheets via an increasingly flexible interpretation of existing accounting rules, a move which may have the added benefit of helping protect the banks themselves from investor lawsuits. ... Under accounting rule FAS 140, lenders must make a 'true sale' to the trust, so that it, and not the lender, is the actual owner of the loan proceeds. That allows the lender that originally made the loan to remove it from its balance sheet. ... But critics say another important reason banks and policy makers are straining accounting rules to preserve the QSPE structure is that the legal and accounting structure of the 'true sale' is designed to shield banks from investor lawsuits. ... [T]he potential liability for banks that set up these securitization structures could vastly outnumber the tens of billions banks paid out after Enron. ... Indeed, Treasury Secretary Paulson attempted to assuage the banks' litigation fears in his Thursday remarks unveiling the plan, noting that 'with the investor community on board as a clear beneficiary of this approach, the risk of litigation should be manageable.' ... Still, it's clear that as the crisis has grown, so has the flexibility of the financial community's interpretation of QSPE accounting rules", Tim Reason (TR) at, 11 December.

This is a farce. Why is Hank Paulson running interference for the banks? Is Chris Cox (CC), nominally our SEC chairman, protecting investors as opposed to banks' managements from investors' lawsuits? TR notes CC, "cited a June 22 roundtable hosted by the FASB--at their request--as justification" "to sign off in July on the idea that a 'reasonably forseeable' default gave banks the same authority as an actual default" and could change the accounting treatment of loan modifications. We are Alice in Wonderland. The Treasury, SEC and Fed all protect banks from Patrick Buchanan's "peasants with pitchforks". Thomas Jefferson was right, "banking establishments are more dangerous than standing armies". See also my 18 November post.

Monday, December 10, 2007

The Big Four Lack Substance

"Britain's biggest accountants have had a crisis meeting with the Government to ask it how to value billions of pounds of debt stuck on UK banks' balance sheets by the credit crunch. ... In an unprecedented move, PricewaterhouseCoopers, KPMG, Deloitte and Ernst & Young met officials from the Financial Services Authority late on Friday afternoon to plead with the regulator to sanction a common valuation code in an attempt to push some of the responsibility for quantifying banks' liabilities on to the Government. ... However, the auditors, who fear there is a far greater risk they could be sued this year, want the FSA to rubber-stamp a common approach to valuation which would provide uniformity for bank audits and also limit lawsuits", Helen Power at http://www.telegraph,, 9 December.

Why can't the Big Four (BF) exercise "professional judgment" and individually determine how to value the assets in question. Are BF partners just bookkeepers that need an FSA, Great Britain's SEC, "template" to value securities? What did they do last year? What is the BF's job? What are they paid for? How will they obfuscate the fact that in all likelihood, they did not consider the fair value of any of the securities in question and rubber stamped their bank clients' models? The BF's bank "audits", for the last five or so years, will likely prove worthless, just like many S&L audits the Big Eight did in the early 1980s. See my 1 December and 29 September posts mentioning Adam Smith.

We've seen this before. "An important case is that of Arthur Young & Company [AY], now called Ernst & Young, whose top officials are scheduled to appear before the House Banking Committee on Tuesday. ... To be sure, [AY] is not the only big accounting firm to encounter problems. The Office of Thrift Supervision ... has sued two other big firms--Touche Ross for its auditing of the Beverly Hills Savings and Loan Association [S&L] of Mission Viejo, Calif., and Deloitte, Haskins & Sells for its role in auditing the Sunrise [S&L] of Boyton Beach, Fla. ... For [AY], Lincoln was only the latest in a series of giant--and now failed--banking institutions it audited. The list includes two large insolvencies in Dallas--the collapse of Vernon [S&L] which will cost the taxpayers $1.1 billion and the collapse of Western Federal [S&L] , which could also cost as much as $1 billion", NYT, 14 November 1989, 18 years ago! Don't these guys ever learn? According to Fortune, 5 November 1990, 96% of Vernon's loans were delinquent shortly before it failed. What did AY do at Vernon? Ernst & Young paid the US government $400 million to settle lawsuits arising from its S&L audits,, 24 November 1992. Why any regulator should cut the BF any slack is beyond me.

Two Views of the "Plan"

"But unfortunately, the 'freeze' is just another fraud--and like the other bailout proposals, it has nothing to do with U.S. house prices, with 'working families', keeping people in their homes or any of that nonsense. The sole goal of the freeze is to prevent owners of mortgage-backed securities, many of them foreigners, from suing U.S. banks and forcing them to buy back worthless mortgage securities at face value--right now almost 10 times their market worth. ... The real problem is the contractual ability of investors in mortgage bonds to require banks to buy back the loans at face value if there was fraud in the origination process. ... There are lots of people who would like to muzzle subpoena-happy [NY] Attorney General Andrew Cuomo to buy time and make all this go away. Cuomo is just inches away from getting what he needs to start putting a lot of people in prison. ... What would be prudent and logical is for the banks that sold this toxic waste to buy it back and for a lot of people to go to prison. ... The goal of the freeze may be to delay bond investors from suing by putting off the big foreclosure wave for several years. But it may also be to stop bond investors from suing. ... They could say, 'Fraud? What fraud?! You knew the borrower's real income and asset information later when he refinanced!'. ... We are on the cusp of a mammoth financial crisis, and the Federal Reserve and the U.S. Treasury are trying to limit the liability of their banking friends under the guise of trying to help borrowers. At stake is nothing short of the continued existence of the U.S. banking system", Sean Oleander (SO) at, 9 December.

"In the specific, the benchmark of losses against which this Treasury/banks proposal should be judged is what would happen if this proposal is not implemented: and that benchmark is one where in the absence of loan modifications millions of households will default, end up in foreclosures and the losses to holders of mortgages, RMBS and mortgage related CDOs would be massive. So the benchmark for investors is not one of being paid in full and in time but rather one of massive bankruptcies and severe financial losses. ... As I discussed before ... it is altogether impossible to follow a case-by-case approach as neither the bankruptcy court system nor the creditors are able to expeditiously restructure on an individual basis millions of separate debt contracts. ... Systemic banking crises always require systemic across-the-board solution and eventually are resolved with such approaches; there is nothing new here compared to any other past banking crisis. ... [S]uch investors are also better off under this scheme--as under the alternative of massive defaults--the losses and NPV haircuts would have been much larger; debtors are not really bailed out either as many of them would have defaulted on their mortgages and would have thus obtained eventually greater relief by defaulting than by keep on servicing their mortgages at the lower teaser rates. ... Systemic market failures and crises require systemic response where government resolve the collective action problems of individual creditors rushing to the exits and causing a disorderly workout of severe debt problems. This mortgage disaster is a case where sound public intervention is necessary and desirable", Nouriel Roubini (NR) at, 6 December.

I largely agree with SO, a San Mateo, CA attorney. However, I don't think the freeze's "sole goal is to prevent owners of mortgage-backed securities ... from suing U.S. banks", even if a major goal. I don't know how close Cuomo is to imprisoning people, but I wish him good luck. The "freeze" may enable banks to run "statutes of limitations" on lawsuits or shore up other potential legal defenses.

It had to happen, but I finally disagree with NR. NR creates a "false alternative", i.e., "in the absence of loan modifications millions of households will default". How does NR know? No one believes the creditors will be "paid in full and in time" today. Why use this alternative? Further, creditors will modify borrowers' terms if the creditors believe the modifications will increase their ultimate collection. Why do we need the "Plan"? Why is it "impossible" to follow a "case-by-case" approach to loan restructuring? If "transactions costs" are the differnce, does the "Plan" only eliminate some paperwork and attorneys' fees? Why is there a "systemic crisis"? What does "systemic crisis" mean? Is "systemic crisis" emotive rhetoric to conceal NR's judgment, NR being a smart guy, that many of our major banks are insolvent and he does not want the public to realize it too?! NR says creditors "are also better off under this scheme ... [than] under the alternative of massive defaults". How does NR know? If he's correct, show the creditors. I remember in graduate school reading a piece by Jack Hirshliefer, then a UCLA professor about what speculators do. A speculator takes his position, shows the market "his proof", the price adjusts, the speculator closes his position and books his profit. I believe the citation is: "The Private and Social Value of Information and the Reward to Inventive Activity", American Economic Review, Vol. 61, 561-74 (September, 1971). If NR thinks the creditors are ignorant, let NR show them "the proof" and they will agree to the "Plan" with no coercion! All in all a surprising piece of special pleading for the banks from one of our better analysts. There's another "stinker" here. The debtors "would have thus obtained eventually greater relief by defaulting than by keep on servicing their mortgages at the lower frozen teaser rates". If so, the "Plan" is against the debtors' interests as they are better off defaulting now! Part of the "Plan" is: deceive debtors to creditors' benefit and keep the debtors out of bankruptcy court!

I have an alternative "systemic response" to the "systemic banking" crisis: put the big banks in receivership! Now!