Bust-outs and the Paulson Mob

Yves Smith has a 9 November 2008 post at her Naked Capitalism that closely parallels my thinking about AIG'S bailout, i.e., it's a bankruptcy fraud. Here's a link:

http://www.nakedcapitalism.com/2008/11/aig-looting-continues.html.

I describe a bustout at my 30 July 2008 post, http://skepticaltexascpa.blogspot.com/2008/07/london-banker-on-covered-bonds_30.html.

Bankruptcy fraud is a federal crime, 18 USC 152. Sometimes prosecuted, if small and the "perps" are not politically well connected. "The Beaux Art Dresses Inc., was a domestic corporation organized in December, 1920. ... In August, 1922, the corporation entered into an agreement with a discount company by the terms of which it assigned its accounts receivable to that company for advances of money. ... Within seven weeks before the failure, it purchased merchandise amounting to $47,000 a large part of which purchases were made in the three weeks before the failure. ... At bankruptcy it had liabilities of $67,435.25 and assets of $1,064.14", Beaux Art Dresses v. US, 9 F2d 531, 532 (2nd Cir., 1925). "A decrease of value--more than one-half in two months, after the purchase of new merchandise--under the circumstances disclosed in this record are not to be believed", 534. Ah, for "old time bustouts", when the "mob" did them for profit. They were modest, typically involving $2-$10 million in creditor losses in 2008 $ and easily understood as they used companies which dealt in tangible objects which "disappeared" in the middle of the night. The proof: circumstantial, unexplained asset losses. I estimate $67,000 1922$ is about $2.5 million today, peanuts, 3.7% of Lloyd Blankfein's 2007 bonus, not worth looking at.

Bust outs usually require cooked books to induce the "mullets" to extend credit to the company to be bankrupted and can be charged under 18 USC 1341 and 1343, mail and wire fraud. Insurance companies make ideal bust out candidates because they take in premiums today for a promise to pay claims in the future. Were AIG's books cooked? Was AIG insolvent before Uncle Sam extended it $123 ($150?) billion and if so, who knew? Would anyone have the nerve to conclude AIG was insolvent before its CDS counterparties got more collateral to support their CDSs? What would be the effects? How many billions could it cost Goldman Sachs?

"Appellant, individually and trading as Rand Manufacturing Company, was engaged in business in Philadelphia. On August 22, 1928, an involuntary petition in bankruptcy was filed against Rand, and he was adjudicated a bankrupt on September 12, 1928. To sustain the indictment, Joseph Karp was called as a witness, who testified that he was a certified public accountant living in Brooklyn, N.Y., and that he had considerable experience in examining books of account of garment manufacturers: that he had carefully examined the books of appellant for the purpose of ascertaining the amount of purchases of merchandise, its value and the amount and value of sales of merchandise and finished products, in order to determine if the bankrupt had concealed or disposed of any portion of the merchandise so purchased", Rand v US, 45 F2d 947, 947 (3rd Cir., 1930). "Deducting this amount from the total purchases of 70,574 yards leaves a balance of 22,744 yards of material unaccounted for. ... The witness Karp also testified to a state of facts showing the value of purchases, amount expended for labor, and total sales, which indicated that appellant should have had on hand at the time of bankruptcy, in cash and/or materials, a value amounting to $22,832.94, unaccounted for to the receiver", 948. "Large quantities of merchandise of appellant disappeared, He accounts for the disappearance by claiming a robbery, but the circumstances surrounding the alleged robbery are, to say the least, suspicious. It was proper to submit all of these facts to the jury to determine whether his statement as to the robbery was true or false, whether it led to the conclusion of guilt or innocence as to the charge of concealment", 949, my emphasis. To the jury! Got it yet, Mike Garcia, formerly SDNY US Attorney. Apparently Mary Jo White in her nine years as SDNY US Attorney never did.

What's apparently happening at AIG? First, keep AIG alive to try to "end run" the lookback periods. Next, create massive confusion to conceal what's happening. Which is? AIG's insurance subsidiaries were looted of tens of billions to support AIG's CDSs with the connivance of New York's insurance commissioner, the Fed and the Treasury. The relative positions of insurance policy holders and unsecured creditors were changed during insolvency. If AIG went bankrupt, the bankruptcy judge might let the unsecured creditors "retroject", Hassan v Middlesex, 333 F2d 838 (1st Cir., 1964) AIG's financial condition. If properly done, the scheme could collapse. That's how it looks from here. This secured-unsecured creditor issue sometimes arises in LBOs which later go bust. Neat huh? Bring back "old time" bust-out frauds, they were a relative "public service"; I mean what's a few millions between friends? Or even a few tens of millions?

Blog Review

On 3 November 2008, I got an e-mail from Mikal Belicove, http://www.belicove.com/. It read in part, "My name is Mikal Belicove and I an one of the co-authors if the '2009 Internet Directory: Web 2.0 Edition' (ISBN: 0789738163). I thought you would like to know that I reviewed you blog and named it the 'Best' blog in the Accounting category for my new book. With this is mind, I am writing to see if you would be interested in receiving an icon to put on your blog related to this reference. ... The directory is now available on Amazon and through bookstores nationwide, if you're interested".

I bought the book from Amazon; page six says of Skeptical CPA, "This blog, written by an independent CPA, covers many topics relevant to accounting, from banking to taxes. The blogger shares what he has learned through trial and error, so you can learn from his mistakes".

Thank you Mikal. Yes, I'm independent. Very. No one tells me what to think.

Schwartzman on the Crisis

"First, we need to finalize a common set of accounting principles across borders. ... Third, you need full transparency for financial statements. ... Fourth, you need full disclosure of all financial to the regulator. .. Sixth, we need to abolish mark-to-market accounting for hard-to-value assets. There is now emerging a broad realization that mark-to-market accounting has exacerbated the current crisis. ... If we are to sweep a vast array of financial institutions into the net of a single regulator, then that regulator has to be able to regulate not by promulgating a blizzard of ever more complex rules, but by enunciating a set of guiding principles. If these principles are coupled with strong disclosure and oversight, they will give the regulator the flexibility needed to cope with an ever-changing financial landscape, and to provide a clear direction for the regulated institutions. ... We must not create a new system of regulation that throttles innovation through the ever-increasing complexity of its rules", my emphasis, Stephen Schwartzman (SS) at the WSJ, 4 November 2008.

"Blackstone Group Chief Executive [SS] recently put forth a seven-point plan aimed at helping avoid another financial crisis. Among his tonics: abolish mark-to-maket accounting, which requires financial institutions to value hard-to-price assets. ... Blackstone will likely have to write down its $1.25 billion Freescale equity investment by about 50%. And other large Blackstone holdings may soon join Freescale underwater", my emphasis, Peter Lattman (PL) at the WSJ, 6 November 2008.

"Blackstone Group CEO Steve Schwartzman doesn't believe that financial companies should be forced to put market prices on hard-to-value assets during difficult periods like the current depressing stretch. ... In the third quarter, Blackstone took average markdowns of 8% on its private-equity funds and 10% on its realty funds. Those values, however, probably aren't realistic, given a drop in public-equity markets and the depressed prices of bonds issued by several companies in which Blackstone's funds hold big equity stakes. ... Blackstone went public at $31 in June 2007 and Barron's has been bearish on the stock since then. ... Blackstone defends its valuations, saying that most of the companies in which it invests are doing well and that it shouldn't be bound by values of comparable public companies, given the long time horizon of its holdings. ... Schwartzman wrote an op-ed column in the Wall Street Journal last week in which he urged 'full transparency' of financial statements. That's ironic because Blackstone in probably the most opaque of the major asset managers. ... Blackstone's $6 billion equity interest in Hilton probably has little value now. Blackstone is a sizable owner of office buildings because of its 2007 deal to buy Sam Zell's Equity Office Properties. ... It's unkown whether Blackstone's accountants will force it to take a harder look at its investment carrying values when the company prepares its year-end financial report", Andrew Barry (AB) at Barron's, 10 November 2008.

"I hear a lot about substituting international accounting standards, which are perceived as principles-based, for U.S. Generally Accepted Accounting Principles, which is recognized as being rules-based, but I do not hear anything about how GAAP got that way. GAAP was originally principles-based, but shifted to being rules based as a consequence of the principles not being defined tightly enough for courts to determine whether they were being complied with. International standards are in the process of making the same shift, as is evident from rules that are being issued in the form of interpretations", John Ferguson (JF) letter to the WSJ, 14 November 2008.

"Schwartzman proposes some useful principles for reforming the financial system, but in citing lessons learned he omits the most important one. That lesson is that the principals must have some 'skin in the game' until the game is ended. Underwriters must not be allowed to pawn off the risk in the underwriting decisions they make", Frank Nicolai (FN) letter to the WSJ, 14 November 2008.

I've said before, I wish the WSJ would stop printing this junk. I am not part of SS's mark-to-market broad realization. What do I think SS wants? To do whatever he wants and toothless regulators which can be infinitely cowed. We don't need this. We need: more financial institution bankruptcies and uncompromised federal prosecutors who put big league miscreants in prison. SS, you're a lucky guy. You took Blackstone public near the top of the market. You're a billionaire. You lucky guy. Be happy, now take your money off the table and get lost.

PL, be more careful. How do you know what SS's plan is aimed at? I think it's aimed at covering his tush and maximizing his ability to game the system.

AB, I would consider it a favor, if you convinced your fellows at the WSJ, Barron's sister publication, to stop giving SS any more space to peddle his nonsense. According to Blackstone's 2007 Form 10-K, it paid Deloitte & Touche (D&T) $157 million last year for various services, including those to its real estate funds. We'll see how aggressive D&T is in having Blackstone write its assets down.

I agree with JF.

Wall Street is a scam. People there get paid like sucessful entrepreneurs and are just hired help. Imagine, Lloyd Blankfein thinks he did something worth about $70 million in 2007. What, pray tell? What capital have of Wall Streeters at risk? More importantly, whose capital have they put at risk?

I've posted on Schwartzman and Blackstone before:

http://skepticaltexascpa.blogspot.com/2008/01/still-greater-fools.html.

http://skepticaltexascpa.blogspot.com/2008/07/schwartzman-and-mcteer-on-accounting.html.

http://skepticaltexascpa.blogspot.com/2008/07/blackstone-real-estate-genius.html.

Argentina's Impending Bankruptcy

"Argentina's leftist government presented its controversial proposal to nationalize private pension funds to the lower house of Congress, which was expected to approve it late Thursday or early Friday. President Cristina Kirchner said that seizing the private funds--which have nearly $30 billion in assets, as well as future pension contributions amounting to $4 to $5 billion annually--will protect Argentina's savers amid the global market turbulence. ... 'The government says it has its accounts in order, but it is launching a fiscal grab,' opposition Congressman Fernando Iglesias said in remarks during the debate on Thursday. ... In the meantime, the government has been employing strong-arm tactics to bolster the embattled peso and stem a surge in dollar-buying by Argentine investors unnerved by the nationalization bid. ... The government has said it is aiming to halt tax evasion, but exchange traders say the move [on currency-exchange houses] is actually aimed at intimidating those seeking dollars and those selling them", my emphasis, Matt Moffett at the WSJ, 7 November 2008.

When the US dollar reverses its present course it will be interesting to see if the Obama administration follows Argentina.

TIPSing Over?-2

"A big head-scratcher for investors is figuring out the appropriate yield for [10-year Treasury] bonds. They yielded 3.97% Friday, up from an October low of 3.43%. ... Seeing that, investors might be expected to pile into the 10-year, pushing its yield down to 5% or lower, in the belief that deflation is a real threat and interest rates will just keep heading lower. In other words, the 10-year Treasury would start mimicking the 10-year Japanese government bond. ... One interpretation is that government bond investors simply don't think the U.S. is entering a deflationary lost decade. ... Two things could keep yields high. First, the U.S. relies on foreigners to finance its current account deficit. ... Second, bond buyers--seeing how much money the authorities are throwing around--expect the volume of government debt to skyrocket", Peter Eavis at the WSJ, 1 November 2008.

Either way bonds are a sell.

Are Insurers Next?-2

"For years, variable annuities got a bad rap thanks to the high fees charged to buyers. Now stockholders of several life insurers that sell these financial products are worried they are the ones who got a raw deal. Shares of Hartford Financial Services Group Inc. are down 80% so far this year, and shares of Lincoln National Corp. and Prudential Financial are off 61% and 56%, respectively. Among the concerns: Will mounting costs in the market downdraft force some insurers that sell these products--many of which guarantee at least some kind of return to holders regardless of market conditions--to raise more capital to satisfy regulatory requirements? ... Fitch Ratings in a report last month estimated that capital needed to support the variable-annuity business had increased by as much as $15 billion across the U.S. life-insurance industry year-to-date, thanks largely to the dramatic decline in the markets", Leslie Scism at the WSJ, 5 November 2008.

"At the prompting of a major life-insurance trade group, state insurance regulators are considering moves to loosen capital requirements for the battered industry, a development that could buoy companies but also raise concerns about consumer protection. ... 'Let's be honest, were in new territory here,' said Susan Voss, commissioner of insurance in Iowa and secretary-treasurer of the National Association of Insurance Commissioners, in an interview Thursday. 'We want to be as nimble as possible and address these issues.' She added: 'I can tell you, we won't do anything that puts our consumers in a vulnerable position. It's a balancing act.' ... Scott Robinson, a senior credit officer at Moody's Investors Service, estimated that insurers in the U.S. may need 'in excess of $10 billion' in additonal capital if they aim to maintain current risk-based-capital-levels, a key measure of financial stability, though the total depends on market levels and other variables. ... Many items on the ACLI's list of sought-after changes relate to life-insurance accounting, while two focus on variable annuities", my emphasis, Leslie Scism at the WSJ, 14 November 2008.

"U.S. life insurers, weakened by losses on their immense investment portfolios, are maneuvering to get a slice of government bailout funds by buying up tiny banks. On Monday, two insurers, Genworth Financial Inc. and Lincoln National Corp., agreed to but small savings-and-loan institutions in Maple Grove, Minn., and Goodland, Ind. And on Friday, Hartford Financial Services Group Inc. said it had struck a deal to purchase Federal Trust Corp., in Sanford, Fla. ... It isn't yet clear whether insurers have received approval of government financing. But regulators have an interest in shoring up the insurance industry, which is one of the biggest providers of capital to U.S. businesses through its purchases of bonds and other assets. The insurance industry's interest in getting TARP money complicates an already heated competition for limited bailout funds. ... As turmoil from the stock and bond markets has seeped into the insurance industry, insurers have been hoarding cash to calm shareholders. ... They also took tens of billions of dollars of unrealized losses as the prices of corporate bonds dropped while investors dumped them in order to buy safer U.S. Treasurys. At the same time, their variable-annuity bussinesses are suffering as the stock market drops", my emphasis, Leslie Scism, Michael Crittenden, Matthew Karnitsching & Mattias Rieker at the WSJ, 18 November 2008.

This industry is worth watching.

Loosen capital requirements. Are the insurers investment banks looking to the SEC to ratify 40 to 1 leverage ratios? "It's a balancing act". It's an act all right. How many insurers are already insolvent? When all else fails, cook the books, i.e., create new accounting principles! Robinson is correct, the industry could need $50 billion under the right set of assumptions.

Limited bailout funds? We can fix that. Safer Treasurys? As Henny Youngman used to respond when asked, "How's your wife? Compared to who?"

Niall Ferguson on Wall Street

December 2008's Vanity Fair has a lengthy 17-page article by Harvard History professor Niall Ferguson (NF) about Wall Street. Some excerpts: "To understand the downfall of Planet Finance, you need to take several steps back and locate this crisis in the long run of financial history. ... If stock-market movements followed the normal-distribution, or bell, curve, like human heights, an annual drop of 10 percent or more would happen only once every 500 years, whereas in the case of the Dow Jones Industrial Average, it has happened in 20 of the last 100 years. ... Credit and money, in other words, have for decades been growing more rapidly than underlying economic activity. Is it any wonder, then, that money has ceased to hold its value the way it did in the era of the gold standard? ... Those few goldbugs who always doubted the soundness of fiat money--paper currency without a metal anchor--have in large measure been vindicated. But why were the rest of us so blinded by money illusion? ... Do you, however, know about the second-order effects of this crisis in the markets for derivatives? Do you in fact know what a derivative is? Once excoriated by Warren Buffett as 'financial weapons of mass destruction,' derivatives are what make this crisis both unique and unfathomable in its ramifications. ... But the events of the 1990s, as the rise of quantitative finance replaced preppies with quants (quantitative analysts) all along Wall Street, revealed a new truth: those whom the gods want to destroy they first teach math. ... The key point is to appreciate why the quants were so wrong. The problem lay with the assumptions that underlie so much of mathematical finance. The quants' Value at Risk models had implied that the loss the firm suffered in August 1998 was so unlikely that it ought never to have happened in the entire life of the universe. But that was because the models were working with just five years of data. If they had gone back even 11 years, they would have captured the 1987 stock-market crash. If they had gone back 80 years, they would have captured the last great Russian default, after the 1917 revolution. Meriwether himself, born in 1947, ruefully observed, 'If I had lived through the Depression, I would have been in a better position to understand events.' To put it bluntly, the Nobel Prize winners knew plenty of mathematics but not enough history. ... Planet Finance has now returned to Planet Earth with a bang. The key figures of the Age of Leverage--the lax central bankers, the reckless investment bankers, the hubristic quants--are now feeling the full force of this planet's gravity", my emphasis, the link: http://www.vanityfair.com/politics/features/2008/12/banks200812.

I disagree with one thing NF wrote, the "key figures" are far from "feeling the full force of this planet's gravity". The Fed still exists, Lloyd Blankfein has not met his Robespierre yet nor has Henry Paulson followed Albert Fall to federal prison. These characters have a long way to fall. We must be in the last days. I find myself in substantial agreement with a Harvard professor. Worse, he said something nice about gold. Revoke his tenure, immediately.

LBOs and Banks

"In late September the Delaware Chancery Court signaled the end of an era. That's when it ruled that Apollo Investment Management couldn't wriggle out of its $10.6 billion cash offer for Huntsman Chemical--despite pleas by the private equity firm that the resulting company would be insolvent. ... Now, if they buy a business, they may have to stick around and run it in order to make money. 'There will be no exits in the current situation,' says Dominique Senequier, head of AXA Private Equity in Pairs. 'Sponsors will have to live with their portfolios for quite a while.' ... In the absence of bank loans, private equity firms are forced either to extend credit themselves or to buy companies with pure equity. ... Remove leverage from the equation, however, and an annual return of 20% is harder to get. ... 'It changes from financial engineering to operational expertise,' says Luba Nikulina, a senior investment consultant at Watson Wyatt Worldwide who advises insititutional investors on private equity investments. Using leverage, she adds, 'is not a sustainable business model'," my emphasis, Daniel Fisher and Anita Raghavan at Forbes, 17 November 2008.

Much of private equity (PE) firms' returns arise from banks underpricing loans used to buy target companies. No individual would lend to the PE firms on the terms banks do, hence LBO loans are a continuing source of banking problems. Bank loans to effect these purchases would be impossible if banks were not "maturity transformers" to use Mencius Moldbug's term. Bank LBO loans appropriate bank depositors funds to benefit PE firm sponsors. If things get bad enough for PE firms, Apollo's Leon Black may have to get a job. I discussed bank loan pricing here:

http://skepticaltexascpa.blogspot.com/2007/07/private-equity.html

http://skepticaltexascpa.blogspot.com/2007/08/private-equitys-bubble.html.

Mike Garcia at Work

"Federal prosecutors said Thursday that they would not bring criminal charges against Eliot Spitzer for his role in a prostitution scandal. ... U.S. Attorney Michael Garcia [MG] said criminal investigators found no evidence that Spitzer or his office misused public or campaign funds for prostitution. Investigators found that Spitzer solicited high-priced call girls, but federal prosecutors typically do not prosecute clients of prostitution rings. ... Garcia said that Spitzer later revealed to investigators that on multiple occasions he arranged for women to travel for one state to another state to engage in prostitution. Federal law makes it a crime to induce someone to cross state lines for immoral purposes", my emphasis, Tom Hays at the Houston Chronicle, 7 November 2008.

Hooray, MG, I agree with your exercise of prosecutorial discretion. Now tell us why you launched this investigation in the first place? Was it to ingratiate yourself with Wall Street higher ups? Don't be bashful. We're waiting. I last commented on this waste of prosecutorial resources on 24 March 2008, http://skepticaltexascpa.blogspot.com/2008/03/on-eliot-spitzer-and-john-ashcroft.html. "Immoral purposes", does that include the sale of CDSs? Or any "financially engineered" product"?

SEC Alumni(ae)-2

"A senior [SEC] official is leaving the agency, in what is likely to be one of many departures at the SEC. John White, director of the corporation-finance division, which oversees corporate disclosures and shareholder issues, is returning to New York law firm Cravath, Swaine & Moore LLP [CS&M]. He will advise corporate boards on governance issues. ... Mr. White, 60 years old, took the post in 2006, when the agency was grappling with concerns that regulations were driving companies away from the U.S. He spearheaded several efforts to address that, including loosening a Sarbanes-Oxley Act provision that requires companies and outside auditors to review internal controls over financial reporting", Kara Scannell at the WSJ, 7 November 2008.

We out here in the hinterlands thank CS&M for "lending" the SEC one of its partners.