The Agonist - The Markets

What Really Happened with the AIG Swaps? It's Not What You Think

Thu, 19 Nov 2009 08:01:11 -0800

By now most people who follow Goldman Sachs in the news know that it received $13 billion from the Federal Reserve to liquidate its portfolio of derivatives with AIG. Because the Fed was willing to pay Goldman par value on these derivatives, even though the market valued them at about 48 cents on the dollar, Goldman walked away with no loss whatever from the AIG collapse. This has been described as a great gift for Goldman and all the other banks who dealt with AIG and who were treated the same way. Many others have described this as a colossal rip-off of the taxpayers.

How did this come about? We know a lot more this week about these transactions because of a report that has been issued by Neil Barofsky, the Special Inspector General for the bank bailout programs. The press has described this report as particularly damning of the NY Federal Reserve which negotiated these deals with the banks, and which was led at the time by Timothy Geithner, the current Treasury Secretary. These press reports, however, have mischaracterized what happened and what went wrong. The NY Fed acted properly and entirely as one would expect under the circumstances when they negotiated these contract abrogations. To see what really went wrong, follow along on the details below.

The AIG Transactions

First, a little bit of background on what got AIG into trouble. The insurance giant had a subsidiary in London called AIG Financial Products (AIGFP). This company developed a business that offered customers financial protection on a derivatives contract known as a Collateralized Debt Obligation (CDO). These derivatives packaged together various debt instruments, such as loans, bonds, mortgage-backed securities, even other CDOs, into a single security. When you bought the security, you received a regularly scheduled set of cash flows generated by these debt instruments as interest payments were made. You paid an up-front premium for these cash flows, which usually took place over a three to five year period during the life of the security.

It is interesting to note that the buyer of the security, and for that matter the seller/creator of the security, had no legal interest in the debt instruments. The bonds or loans could be any debt of this nature where public information was known about the interest rate, and whether or not a default had occurred by the debtor. There could be dozens, or even hundreds of different debt instruments bundled into one security.

These CDOs carried a public rating from Moody’s or S&P or Fitch, any of the three big ratings agencies. Also, you could get a daily price on the CDOs from a third party pricing agent located in London. If the price was 100, the security traded at its par value, meaning all payments were highly likely to take place over the life of the security as required by the contract. If the price was 48, on the other hand, it meant the market believed the security was seriously impaired due to defaults occurring on some of the debt instruments in the security.

Big banks loved to create CDOs up until the market crashed in 2007. CDOs were very lucrative. Banks had loan books that gave them a natural portfolio of debt as a start in creating a CDO, but there also was the booming housing market bubble that allowed for the creation of mortgage-backed securities. A huge amount of CDOs were created based on these mortgage instruments. Banks also realized that when they created and sold these securities to earn the profitable premiums involved, they were still on the hook in case any of the debt instruments in a security experienced a default. They wanted to get rid of this risk as much as possible, and pay away a little bit of their lucrative premiums for the privilege.

Here is where AIGFP comes in. AIGFP invented a derivative that acted like an insurance contract. Banks would pay AIGFP a premium, and AIGFP would promise to indemnify the banks in the event they experienced any losses on a specified CDO. The company used a derivative called a Credit Default Swap (CDS, unfortunately easy to confuse with a CDO) to structure this insurance product.

AIGFP was not regulated by any financial oversight agency. It didn’t even have to keep reserves on potential payouts on these CDSs, and even if it did, it has stated that the reserve amount would have been very small because it did not anticipate significant losses on the underlying debt instruments it was insuring. What AIGFP had going for it, and what the banks liked, was that it was a wholly-owned subsidiary of AIG, which carried a Aaa rating in its own name for everything it did. By virtue of this rating, AIG was viewed as one of the highest quality companies in the financial world – almost as safe and sound as a government.

The most common type of CDOs brought to AIGFP were called multi-sector: they had a little bit of everything mixed into them – loans, bonds, mortgage-backed securities on sub-prime mortgages as well as higher-quality instruments like prime mortgages. As long as none of these different types of instruments experienced unusual rates of default, the entire CDO would be traded on the market at a price close to par, and the ratings agencies would have no cause to downgrade the security.

What began to cause AIGFP trouble with its portfolio of credit default swaps backing up about $72 billion of multi-sector CDOs, was not that there were so many defaults on the CDOS that AIGFP had to make large payments under the swaps. The real problem was a series of collateral obligations AIGFP undertook every time it entered into a CDS, and the collateral conditions varied from one swap to the next.

There were three possible triggers for a collateral payment from AIGFP to the banks that bought insurance in the form of CDSs. The first occurred if the underlying CDOs being insured in the swap experienced a drop in price on the market – say from par value to 48 cents. The second occurred if the ratings given by Moody’s or some other agency on the CDOs were downgraded. The third occurred if AIG’s Aaa rating itself was downgraded.

You can now begin to see the sequence of liquidity disasters that befell AIGFP, and soon engulfed its parent AIG, starting in the summer of 2007 and extending until September 16, 2008 when AIG was near death. First, as the market realized that the US sub-prime mortgage business was experiencing very high and unexpected defaults, everyone looked at multi-sector CDOs that carried a significant percentage of these debt instruments in the security. These CDOs began to trade at lower and lower levels in the market as no one was sure just how impaired they would become.

Second, the ratings agencies began to downgrade dozens of CDOs because of the heightened default risk, and the lower prices in the market.

Third, the ratings agencies realized by 2008 that AIG stood behind the CDO market as insurer for the tune of $72 billion. At first, the long term rating of AIG was lowered, and this began a series of collateral calls from AIGFP’s swap customers. Then, by the summer of 2008, the ratings agencies were looking at downgrading AIG’s short term ratings, and doing so by several notches, which brought into question whether AIG could meet all of its obligations under these swaps. This accelerated the demands for collateral on AIG, which was experiencing a very unexpected triple whammy of collateral calls. By September, 2008, AIG had already coughed up an astounding $30 billion in collateral, and was really only half way through what ultimately it would need to satisfy contractual demands for collateral from the market. It simply ran out of resources to raise any more liquidity, and it faced inevitable default under its swap contracts, which would have led to bankruptcy.

This was the situation facing the Fed by the second week of September, 2008.

The Fed Steps In

The Fed already had its hands full in the summer and fall of 2008. First, Bear Stearns collapsed and was thrown into the arms of JP Morgan Chase, but only after the Fed agreed to take over the Bear Stearns real estate portfolio worth $30 billion in dodgy real estate assets. The quasi-government giants Fannie Mae and Freddie Mac had to be taken over by the government, then Countrywide Financial collapsed and also was pushed into a forced sale to a bank.

There was so much criticism directed at the government for the way in which these rescues were being done, and the amount of taxpayer money spent in the process, that when it came time to deal with the collapse of Lehman Brothers, the Treasury and the Fed threw this firm to the wolves on September 15, 2008. It received no help from the government and was thrown into the bankruptcy courts. This precipitated a global market meltdown.

The trigger for this meltdown occurred at the oldest mutual fund in the US, American Reserve Fund, which took a writedown of $785 million on Lehman Bros. bonds it held in its money market fund. This was announced on the afternoon of September 15, and by the close of business that day massive amounts of withdrawals were taking place at American Reserve since no money market fund had ever experienced such a loss (money market funds were supposed to be as safe as checking accounts).

When the market opened the next morning, mutual funds everywhere couldn’t cope with the withdrawals. The commercial paper market ground to a halt, as did the Eurodollar market for short term loans in London. Stock markets around the globe tanked. The global financial system was nearly paralyzed.

The US government stepped in and guaranteed the safety of all money market funds. It allowed Goldman Sachs and Morgan Stanley, the last two surviving old-line investment banks, to become commercial banks and enjoy the benefits of Fed liquidity. The Fed had been working since the previous week on the dire liquidity situation at AIG, and it had asked JP Morgan Chase and Goldman Sachs to form a bank syndicate to provide AIG with a massive $75 billion loan to solve its liquidity problem.

JP Morgan Chase came up with a package that charged AIG an onerous 11.3% on the $75 billion loan – a full $9 billion a year in interest alone. The banks would take an 80% ownership interest in AIG’s assets. This loan package was also intended to stop the ratings agencies from yet again lowering AIG’s ratings, which would have cost the company yet another round of collateral calls from the market.

There was one big problem, though. When the banks looked at AIGFP’s portfolio of swaps, and the potential collateral demands that could still occur, they realized that AIG, if it could sell all of its assets at decent market prices, still wouldn’t be able to meet the liquidity demands. In other words, the way the market was developing, AIG was headed straight towards default and the bankruptcy courts. Making this situation even worse was the global market collapse occurring at the same time as the result of the Lehman bankruptcy. The banks told the Fed that the loan package had collapsed. The banks effectively threw the AIG problem on to the laps of the regulators, none of whom by the way had any legal responsibility, regulatory oversight, or historical familiarity with AIG. It was an insurance company that had somehow become bigger and more important than even the biggest banks.

In deciding what to do, the Fed had about 24 hours from September 15 to 16 to analyze with the Treasury the AIG situation. They discovered that AIG would default on $103 billion in loans from state and local governments, $50 billion in bank loans and derivatives, $20 billion in commercial paper, and $40 billion in insurance covering 401k retirement packages across the US. The problems ranged from the horrendous to the horrific. The municipal bond market stood to be devastated by state and municipal loan losses. The Lehman bankruptcy involved $8 billion in commercial paper losses, which led to the Reserve Primary Fund disaster, but AIG’s commercial paper losses were much bigger at $20 billion. The 401k losses would affect tens of millions of Americans. AIG’s loan losses spread to banks all around the world.

The Fed and Treasury, standing in the middle of a global financial collapse the day after the Lehman Brothers bankruptcy, felt they had no choice but to save AIG, a much bigger player with far greater reach and implications for economic and financial disaster. The Treasury authorized an $85 billion line of credit at the Federal Reserve NY for the purpose of lending to AIG the amounts needed to post collateral behind its swaps at AIGFP. The Fed had no plan in place on how to do this, so it simply lifted the term sheet conditions from the JP Morgan failed loan package, and used those terms to lend to AIG.

From September 16 through October, the Fed lent $61 billion to AIG, over half of which found its way into the market as collateral to support its swaps. At the same time, AIG was instructed to begin reducing its swap book. This required AIG to turn to all the big banks with which it had a swap portfolio, and ask to close out, or abrogate the swap contracts. The banks would consider doing this, but would not want to be then left with the CDO risk that caused it to enter into the swaps in the first place. There was some talk of AIG therefore taking over the CDOs as well, which had sunk substantially in value because of the default risk, but it was very difficult to agree with each bank on what these CDOs were worth. In fact, the banks weren’t willing to sell these CDOs at any discount whatsoever, despite what the market said they were worth, so AIG turned to the Fed for help, and authorized the Fed to negotiate on their behalf.

Here is where we come to the gist of the Barofsky report and the criticisms of the Fed. But let us recap two critical facts up to this point. As of September 15, AIG was certainly heading for bankruptcy, within a manner of days. The banks stood to lose billions on their swaps with AIG, because they would be under-collateralized if the CDOs fell further in value, and because they could not easily all at once get replacement CDS coverage for their CDOs.

Second, shortly after September 16, the banks began receiving collateral from AIG, courtesy of the Fed via the $85 billion loan authorization. For the next two months, the banks were made whole as necessary whenever their CDOs fell in value. The banks could look at their portfolio with AIGFP and consider it safe and secure because of the collateral, and as important, because of the guaranty of more collateral to come as necessary, courtesy of the federal government.

The Fed Tries Its Hand at Negotiating

In early November the Fed assigned a team of managers to begin negotiating for the abrogation of the CDSs. They chose the eight largest bank counterparties to talk to, including Goldman Sachs, BOA, JP Morgan Chase, Deutsche Bank, UBS, and top of the list was Societe Generale in Paris. The plan was to ask the banks to tear up the CDS contracts through a legal abrogation agreement. It was common for banks to do this in the derivatives market from time to time, though never before on a large scale. The banks always required the customer to pay them for any potential real market losses they may incur in abrogating the contract, plus interest and a bit of a fee for all the trouble. Abrogations have never been cheap, especially if the customer was desperate to get out of a deal.

What would the banks want? Collectively, they held CDOs worth a face value of $62.1 billion, and these were the underlying CDOs behind the swaps bought from AIGFP. The banks wanted to give these over to the Fed and get $62.1 billion back, because otherwise the banks would be stuck with CDOs that were unhedged for further default problems.

The market price for this collective group of CDOs was in early November $29.6 billion, which tells you just how badly the market had trashed these instruments. But the banks held cash collateral of $35.0 billion to protect against just this contingency, and if you add the two numbers up, you come to a bit over the $62.1 billion in face value. In other words, the banks were sitting pretty. They were 100% covered for the existing market losses on these CDOs, and the market pricing was beginning to stabilize.

Remember that all this collateral came from the Fed on behalf of the now moribund AIG. The banks wanted to do a simple deal. They would give the Fed all the CDOs in exchange for $29.6 billion in cash – their current market value. They would keep all the existing cash collateral, so they would be perfectly whole. They would then abrogate the CDSs and have no further claim on AIGFP, as if the whole mess never occurred. The Fed, meaning the taxpayers, would be out $62.1 billion in cash to clean this mess up.

In preparing talking points for the negotiations, the Fed reminded each bank that it would be appropriate to give back some of the collateral to the Fed rather than keep it all. The Fed, by stepping in a month earlier, had saved the banks from billions of losses had AIG gone into bankruptcy, and these losses might have included a systemic crisis in which a few other banks went under and couldn’t pay their obligations as well. “”Be nice to us, given all that we have done for you,” was the Fed motto.

The Fed then tied the hands of their negotiators in several ways. First, the Fed would not threaten to throw AIG into bankruptcy if they didn’t get a “haircut” on the $35 billion in collateral. This would be unethical because the Fed had no plan to put AIG into bankruptcy and everybody knew it. Second, the Fed negotiators would have to do the same haircut deal with everybody. If Goldman Sachs agreed to return 30% of the collateral, JP Morgan Chase would have to agree to the same thing. Third, the banks were told up front that their participation in the negotiations was entirely “voluntary”; nobody was going to be forced to do anything or accept any haircut.

You should not be surprised that seven of the eight banks refused to take any haircut on the collateral and would therefore return none of it. They argued the cash was theirs, not the Fed’s, and they owned it by the sanctity of a legal contract that the Fed was proposing to violate. Second, AIGFP was not in default and there was no bankruptcy, and there wouldn’t be any, so giving back collateral when there was no legal requirement would constitute a breach of fiduciary duty that the banks had to their shareholders. Unstated in all this was the fact that the Fed wasn’t threatening any consequences if the banks refused to give back any of the collateral.

The kicker that destroyed any possibility of the Fed getting some of the collateral back occurred with the French bank. They told the Fed that it was not simply a fiduciary responsibility they had to follow in keeping cash that was rightfully theirs – it was decidedly against French law to give back the collateral because there was no bankruptcy. The French regulators confirmed this in no uncertain terms to the Fed, with the implication that if the Fed pushed on this point relationships with the French government would be damaged. Remember that all the banks had to agree to the same deal, so each bank had a veto power over any deal, and the French bank had the ultimate veto – it was illegal for them to give back the collateral.

The negotiating team reported all this back to Timothy Geithner, and recommended that the Fed settle all the swap abrogations by allowing the banks to keep all the collateral and thereby effectively receive par value on contracts that in the market were worth less than half that. Geithner agreed and the deal was done. The Fed then promptly kept all these details secret, including the names of the banks involved, and even went to court to maintain this secrecy under the financial equivalent of a “state secret” argument. They recently lost this argument on appeal to a higher court, and the Barofsky report severely berated the Fed for this because no terrible consequences have occurred now that the details are known.

What Went Wrong Here?

The Barofsky report lays a pretty heavy blanket of criticism on the Fed for not just the secrecy of their actions, but the actions themselves. The Fed didn’t have to treat everyone all the same. It could have accepted different levels of haircuts. It didn’t have to put so much faith in the sanctity of contracts when AIG was in virtual suspended animation – bankruptcy in all but name.

These criticisms do not show an understanding of how the Fed works. Like any large American organization, it pays considerable attention to the law. Timothy Geithner had a high powered, high-priced General Counsel sitting as his right side all the way. Geithner was told clearly that as long as AIG was not in bankruptcy, the Fed might damage its reputation by violating the terms of perfectly sound legal contracts and insisting on repayment of collateral when it was not legally required. He was also told the Fed had no ethical right to threaten bankruptcy when the threat could not be backed up later in court with proof it was real. He was probably told – though there is no proof of this in the report – that giving any bank preferential treatment on haircuts exposed the Fed later to lawsuits of unfair treatment.

Timothy Geithner is like most American executives – he is a technocrat. He respects technical advice, especially of the legal kind, and he abides by it. Past presidents of the NY Fed might be different – Gerald Corrigan comes to mind during the Drexel Burnham bankruptcy. He would bang some heads together to get an outcome that satisfied the political pressure on the Fed, even if it meant overriding legal advice. Gerald Corrigan, by the way, now works for Goldman Sachs. He might have in this situation taken Goldman Sachs and JP Morgan Chase aside and said, “I want you guys to get your consortium of banks to agree on a haircut – something like 30% would be nice – and I want all of you to come back and voluntarily request that the CDS collateral provisions be waived in favor of paying back to the Fed some amount of the collateral. I don’t care how you do this, and it is not going to be the Fed asking for it – it is going to be voluntarily offered to us.” The banks would not need to be told that there was a steel hand underneath the Fed’s velvet glove.

Maybe Timothy Geithner would have done this, technocrat though he is, if there were enough political pressure on him to save the taxpayers billions of dollars, but there wasn’t. No one in the Bush administration – certainly not Henry Paulson at Treasury – was demanding fairness for the taxpayers. There was public disgust over the whole bailout process, but this disgust got bottled up in a Congress paid for by the financial industry. Barofsky might have mentioned that lack of political pressure, and the consequent insensitivity to taxpayer needs that the Fed and the Treasury displayed, but he didn’t, maybe because his current paymaster, the Obama administration, isn’t showing any such sensitivity either.

Which brings us to the crux of the problem, only hinted at in the Barofsky report. The real problem for the taxpayers didn’t occur when the NY Fed failed to negotiate the return of some of the collateral in November, 2008. The problem occurred on September 16, when the Fed and the Treasury were suddenly faced with a collapsing AIG. Had there been any forethought and planning for such an event, the reaction could have been very different and far less panicky.

The first response should have been: ”Financial markets worldwide are frozen, and they are going to stay frozen for a long time no matter what we do with AIG." In hindsight, this is exactly what happened. The commercial paper market has taken nearly a year to recover a fraction of its previous activity, and this was only after the Fed had to guarantee transactions. Credit spreads took nine months to begin coming down to normal levels. Banks are lending to each other only because governments around the world now guarantee their bank activity, but banks are still not lending to corporations, small businesses, or individuals. The housing market in the US exists entirely on the generosity of Federally-managed firms like Fannie Mae, Freddie Mac, and FHA. In other words, the disaster that the Fed faced on September 16 rolled on despite the rescue of AIG.

If AIG had been allowed to fail, the market would have learned a serious lesson about dealing with companies that act like banks but really have no controls or regulatory oversight like banks. The pain would have been greatest at the banks themselves. Some banks like Citigroup and Bank of America would have been even more crippled than they are now, but their current status as zombie banks would not be any different. The damage done to 401ks could have been mitigated by additional federal government guaranties, but even here the cost while enormous would have been less than what was spent paying off AIGFP’s credit default swaps at par.

Suppose you say that it is impossible to expect government bureaucrats to react on September 16 in any different manner. You can argue that any normal person would have panicked too, and that tough-nosed regulators like Gerald Corrigan don’t come around all that often – in fact these days they are all working for Goldman Sachs. Fine. Where, then, was the prudential planning for this catastrophe. All it would have taken is someone in advance of the crisis – a clever lawyer for example – inserting one clause in the agreements with banks before any collateral was posted with them. It would have said “The Federal Reserve Bank of New York reserves the right at any time to demand immediate repayment of any or all amounts of collateral posted with Bank X, with no compensation required to be paid to Bank X in any form by the Federal Reserve Bank of New York, and Bank X hereby waives all rights to petition for a legal stay of said repayment.” If the banks didn’t like this clause, they wouldn’t get their collateral. They could go ahead and sue the government for breach of contract, but in the meantime they would be experiencing real pain with their CDO portfolio and the pressure would be on them to settle. Once the collateral was out the door, the Fed lost all leverage with the banks, and this is why the November negotiations were a foregone conclusion and a waste of time.

Finally, what is fundamentally missing at the Fed and the Treasury, and certainly now with two successive administrations and almost all 535 public servants in Congress, is the sense that the big financial institutions which have created this monstrous mess are dispensible. The problems that have arisen due to their avarice and misjudgments are only going to be solved over time, and are best solved in bankruptcy courts or through FDIC closure processes, not by making these institutions wards of the state until 10 or so years later they are nursed back to health. The public can and has been protected through deposit insurance, but the collapse of lending and credit in general has not been mitigated one whit by anything done so far to rescue these institutions. Let them die a merciful, quick death if death is their fate anyway. We will all of us individually benefit from such mercy as well.

When You Know Things Are Frothy

Mon, 16 Nov 2009 08:18:18 -0800

I'm not a contrarian, although I suppose on the face of it I probably come across as one. I'd label myself a skeptic more than anything else when it comes to markets. A skeptic in the sense that I rarely buy the official narrative. More of a realist I suppose. But that may just be a personal and intellectual conceit.

One of the official narratives I've been hearing a lot of lately--maybe not so much a narrative as a lot of cheerleading--is about gold. Now, there is a secular case to be made for gold. That case rests mostly on a falling dollar and the inverse correlation between our domestic markets and the rise in gold. The case has merit.

But when I see a story like this, one that says gold has a lot longer to climb, the red-flags of my bullshit detector go off. (Metaphor mixed on purpose.)

My question: where have we heard this before? And who's next? James Glassman of Dow 36,000 infamy?

US dollar et Euro

Sat, 14 Nov 2009 20:38:50 -0800

One € bought 1.49$ recently. Have you noticed that there is suspiciously little whining in the press about the falling exchange rate of US dollar?

Last time the exchange rate peaked in 1.59 or something like that.

In real terms, a liter of milk costs here now 91 €cents (down from 1.05) and a liter of juice costs 67 €cents. Hint: we buy milk in euros and juice in dollars, because it is imported.

80%-90% of time juice is more expensive than milk, thus you can see that dollar is at least 36% undervalued.

Boy Does Wall Street Have a Deal For You!

Thu, 12 Nov 2009 07:56:40 -0800

American cowboy capitalism at its finest is on display today as Kohlberg, Kravis & Roberts (KKR), one of the country’s largest leveraged buy-out firms, is proposing to bring the Dollar General company back on to the public market. You – yes you, oh innocent investor – can buy a piece of this company for just $22 a share! Any why not? Dollar General is one of those stores where everything is on sale for $1, and cash-poor, recession plagued Americans have been flocking to stores just like these.

This is the only part of the retail sector that has been doing well. Wal-Mart, Dollar General and similar low cost vendors have been holding their heads above water while everyone else has been sinking. But before you plunk down your $22/share, come along with me on a ride through the fine print of the prospectus, to learn just what is going on here. You’ll understand better that the role the Wall Street boys want you to play is that of the sucker – the person who gets them out of a tight jam for a mistake they made.

That’s what everybody said about KKR 2-1/2 years ago when they bought all the shares of Dollar General and took them private. KKR, along with Citigroup and Goldman Sachs and a few other Wall Street firms, bought Dollar General for $7.3 billion, of which $2.8 billion was cash, and the rest - $4.5 billion - was borrowed from banks using Dollar General’s own assets as collateral.

If KKR can get $22/share for their Initial Public Offering this week (IPO), Dollar General will be valued at $7.8 billion, so that looks at first like a modest profit for KKR and its fellow buy-out partners. But this is a leveraged buy-out deal, so the real question is, what happened to all the debt taken on to buy this firm?

The answer is, it’s still there. The Dollar General company the public is being asked to buy this week has $4.1 billion in debt, down just slightly from the $4.5 billion that KKR dumped on it when it took the company private. Every quarter the company has to service this debt by paying interest to the banks, and that interest amount consumes 39% of the company’s operating earnings. This is ten times the debt burden of the average retail company.

The first thing you have to know, therefore, is that you are buying a company that may have kept its head above water in this recession when it comes to sales revenue, but it is drowning nonetheless in debt.

The second thing you should look at in an IPO like this is the price/earnings ratio, or P/E ratio. The price per share divided by the earnings per share tells the multiple of annual earnings investors are willing to pay for a company. For example, Wal-Mart trades at a P/E of 15, meaning at its current stock price investors are willing to value the company at 15 times its annual income. This is a company much larger than Dollar General, but in somewhat the same business, so investors treat the two companies as comparable.

You would think, therefore, that the P/E implied for Dollar General at an initial public price of $22/share would be about 15 times earnings, but it is not. By setting the price at $22/share, KKR is asking investors to buy the company at a P/E of 29. KKR is claiming that the Dollar General franchise is twice as valuable as Wal-Mart’s franchise, not so much in terms of size, but in terms of growth potential.

You have every right to believe this if you wish, and buy Dollar General at $22/share if you wish, but check out first some more fine print. In May of this year, Dollar General granted 732,000 shares as stock options to management, and it used two models to figure out what the company was worth and what price to set for these options. One model estimated the present value of all future cash flows for the company, and the other looked at market prices for comparable companies. The average of the two models valued the company at $12.95/share.

To defend its new price for the IPO, KKR says that the stock market has rallied over 60% from its lows this year, so naturally Dollar General must be worth much more too. Certainly the stock market has put on an impressive rally, but using the other model – the cash flow model – it cannot possibly be the case that Dollar General’s future cash flows will now have doubled in such a short period of time.

Something is wrong here, unless you are a Dollar General executive, because you are going to make a quick $9/share profit if investors snap up the company stock at $22/share. And if you are KKR, the company is worth about $13/share when it comes time to valuing the executive stock options, but $22/share when it comes time to asking the public to buy into the company.

Are you still tempted? How about this delicious morsel in the fine print of the prospectus. Last month, knowing they were going to take Dollar General public, KKR, Goldman Sachs, Citigroup and the other owners paid themselves a dividend out of Dollar General’s earnings. The amount - $239 million – exceeded the quarterly operating earnings of the company, so some of it had to come from the company’s remaining equity. How convenient that the owners enriched themselves royally just before the IPO, and thereby reduced the equity cushion of a company already loaded up with too much debt.

As a final straw, guess which Wall Street brokers are going to bring the IPO to market and earn all the fees from underwriting this offering? How about KKR, Goldman Sachs, and Citigroup? As if they haven’t already earned enough money off this company.

There are dozens and dozens of companies like Dollar General that were taken private by leveraged buy-out firms during the market frenzy that peaked in 2007. They were all bought with little cash and enormous amounts of debts, and they are sitting like time bombs on the balance sheets of the leveraged buy-out firms that misjudged the market. As the months go by and the buy-out firms watch their fees from their investors get eaten up by high interest costs, they are getting more and more desperate to dump these companies back on to the public markets and naïve individual investors.

How wonderful, then, that we’ve had a 60% rally in the stock market since March. Do you think, maybe, Wall Street has a vested interest in keeping this rally going and exciting you and me about green shoots?

(Many of the facts on this IPO can be confirmed in this article on Bloomberg:

http://www.bloomberg.com/apps/news?pid=20601087&sid=awIsi0HV9G34&pos=6)

Why This Economic Recovery is Destined for Disaster

Mon, 09 Nov 2009 17:48:15 -0800

A most revealing comment was made today by The Maestro, Alan Greenspan, speaking at a conference in Alberta on energy and the global economy:

We have been very fortunate that the stock markets moved back and are re-liquifying the whole process.

He pointed to the “wealth effect” created by a rising stock market, especially when investors cash in their capital gains.

In olden times, before Alan Greenspan spent over a decade as Federal Reserve Chairman, Fed officials worried about the growth in money supply, the level of prices in the economy, unemployment, and the strength of the dollar overseas. In fact, if you read the enabling legislation for the Fed, these are the things the Board of Governors should be concentrating on.

Greenspan of course is no longer the Chairman of the Federal Reserve – his protégé Ben Bernanke is. For the most part, when he was Chairman he never spoke about the stock market for fear of influencing its direction. Now that he is a private citizen, he can blurt out whatever he wants to say, and how illuminating it is to hear him talk about the stock market “re-liquifying” the economy.

Not for nothing was he given the sobriquet “Bubbles Greenspan” when he was in office. Economists, Fed watchers, traders, investors – all sorts of people suspected Greenspan never met a financial bubble he didn’t like. He cheered on the 1990s tech bubble as an example of a paradigm shift in the economy. He sat back idly while the housing bubble in this decade blew out of all proportions. The best he could say was that central bankers were helpless in the face of growing financial market distortions, and all they could do was clean up the mess afterwards.

The reality was that he encouraged these bubbles through deliberate inaction. After the end of the tech bubble he was terrified of deflation, pushed interest rates to 1%, and kept them there long enough for a housing bubble to ignite. He gave speeches encouraging home buyers to take out adjustable rate mortgages – the type that have blown up disastrously in the face of thousands of homeowners. He wanted the explosion in consumer spending that resulted from the housing bubble. He didn’t care if he caused asset inflation, as long as it didn’t seep into the general price levels of the economy.

Were he still at the Fed, he’d obviously be very pleased with the stock market recovery this year, because it makes people more confident, it gives them the illusion of being wealthier, and in some cases if they cash in their gains, it gives them real money to spend. Maybe he’d be happy with the weak dollar, and the fact that the infamous “carry trade” has moved from Japan to the U.S. Now the speculators of the world borrow dollars at 0%, driving the exchange rate down for the dollar, and they invest in the hottest commodities, like gold, Chinese real estate, oil, equity markets everywhere, high yield bonds, and even mortgage backed securities.

Does Ben Bernanke believe in the re-liquifying dreams of The Maestro? In the infamous words of Sarah Palin, “You Betcha!” Just look at his actions. He has pushed interest rates to zero and said they will stay there for a long, long time. He is knowingly encouraging the carry trade and devaluing the dollar. Neither the Fed nor the Treasury has lifted a finger to support the dollar on the exchange markets. He has thrown trillions of dollars at the banks and encouraged them to revive their speculative practices from a few years ago before the crash. He is trying desperately to get the securitization business up and running again, and he would love the hedge fund and leveraged buyout boys to get back into the equity extraction game.

Of course, he would also love to see more controls on leverage this time, smaller bonuses being paid to bankers, and less swagger emanating from Wall Street, but he’s not pressing too hard on these points. The important thing is to get the economy back to where it was before 2007. Nor is he alone in this desire; the G-20 countries this weekend said the same thing – it is way too early to remove the excessive liquidity that has been pumped into the global economy.

This stock market rally is therefore both welcome and engineered by our financial masters. So is the bubble in gold, the collapse of the dollar, and in Asia, the construction of even more high rises and industrial parks that are destined to remain empty.

Not a single lesson has been learned from the market collapse last year. Every effort is being made to avoid letting anyone suffer any pain for their mistakes. The great global reflation that is underway is nothing but a repeat of the bubble-inducing liquidity push that occurred at the start of this decade. The whole effort is a tremendous gamble – a hope that real and substantive economic activity will be ignited by all this speculative activity.

But remember what Greenspan said is the end result of the stock market rally – a “wealth effect” – spending on vacations, McMansions, luxury automobiles, and other goodies for the wealthy who happen to own an equity portfolio. You yourself won’t be getting a decent raise in your salary; it certainly didn’t happen during the last two bubbles. The cost of education or medical care isn’t going down. In short, the real economy is not going to rebound based on the most recent bubbles.

Inevitably these bubbles too must burst. Where will we be then? For one thing, there will be a lot of embarrassed economists, almost all of whom now are predicting a slow but steady recovery, because that’s what the Leading Economic Indicators say, along with the stock market, credit spreads, and all the usual auguries. Few people are willing to say “this time is different”, but it really is different. The old tools of the past don’t work anymore. We are not suffering through a typical recession caused by overinvestment, excess inventories, and so on. This is much rarer – a recession caused by the collapse of credit, by too much outstanding debt that must now be paid or defaulted on, by deflation, and by a government that won’t be there this time to lift us up.

Perhaps then our central bankers will learn that asset bubbles are just another form of inflation, one that benefits a few of the wealthiest in the world, and hardly anyone else. Unfortunately, when an asset bubble bursts, we all share the pain.

Time for a Windfall Tax On Goldman?

Tue, 20 Oct 2009 09:20:46 -0700

I can think of no better way of keeping Goldman in line and teaching it a lesson at the same time than a windfall tax. Indeed, folks at the Wall Street Journal are warming to the idea too:

“A windfall tax is blunt, arbitrary and something supporters of free markets usually instinctively avoid. Even so, following news that Goldman Sachs Group has already set aside a $16.7 billion bonus pool for 2009, the case for windfall taxes on banks that pay giant bonuses is becoming unanswerable.

This year’s bank profits are windfalls in the purest sense. They aren’t the due rewards for exceptional skill but gifts from taxpayers. Many banks are earning huge, risk-free profits borrowing from central banks at ultralow interest rates and lending back to governments at much-higher rates. If this giant, hidden subsidy was being used to support new lending, fair enough. Instead, it looks destined for bankers’ pockets.

Yes, you read that correctly, the Wall Street Journal published that piece. We might not need those pitchforks just yet.

Goldman Sachs: 'Trading With Advantages'

Thu, 15 Oct 2009 12:04:09 -0700

A comment from Numerian worth a full post on its own:

At first glance, the top line number for Goldman Sachs’ third quarter performance looks spectacular: Net Revenue of $12.37 billion, and $3.19 billion of Net Income. These numbers were multiples larger than the results for the third quarter last year, at the peak of the credit crisis, when Goldman converted itself into a commercial bank. It’s when you look into the details you realize that Goldman didn’t make its numbers this quarter as a commercial bank, nor even as an investment bank (which is what it used to be), but as a hedge fund.

The spectacular part of the performance came from Trading ($5.99 billion in net revenue – mostly from trading credit products and mortgages); Equities ($2.78 billion in net revenue, mostly from equity derivatives), and Principal Investments net revenue of $1.28 billion. The image one gets from the word “trading” is that Goldman Sachs has hundreds of very bright and aggressive young men sitting in front of screens and making brilliant decisions on what to buy and sell, and when. Traders are supposed to live by their wits, making judicious bets on the market. Good traders who don’t have inside information tend to win about 55% of the time and lose money 45% of the time, the difference being their profit resulting from their trading acumen.

Goldman Sachs doesn’t work this way. They have bright people no doubt, and somewhere on the trading floor these people on occasion make good and bad judgment calls. From what it looks like, however, their traders are benefiting from two things: information not available to the market, and muscle. These two things give the firm an edge that almost guarantees substantial “trading profits” quarter after quarter.

The information part comes from a variety of sources. We’ve seen this year the scandal over High Frequency Trading, where Goldman and other firms have computers positioned at the New York Stock Exchange getting information on trades a millisecond before they are posted publicly. Goldman sees where the market is going second by second, positions itself for very short term profits, and in effect extracts a tax on trading by individual investors and mutual funds. Goldman Sachs is the biggest player in this business, and no wonder they are lobbying in Congress to prevent the government from shutting this down, and/or imposing its own transactional tax on trading.

For credit products, mortgage securities, and equity derivatives, Goldman Sachs extracts similar information from its clients interested in buying or selling these products. Goldman can tell when a particularly large deal is going to move market prices, and the firm can piggy back along with the client by doing its own trading. In these businesses, dealers also hold a trading position for liquidity purposes, and given Goldman’s enormous size in the market, they can use this position to muscle prices in the direction they want. This bullying tactic works short term, usually intraday or over one or two days, but that is sufficient to generate hundreds of millions in trading revenue.

None of these information sources or uses are illegal at this point, unless Goldman were positioning itself before the client’s order was placed in the market. Also, Goldman is smart enough not to allow its traders to know if Goldman is bringing an equity or bond issue to market, because this would breach “Chinese Wall” restrictions.

How do we know all this revenue is based on information and muscle? Because Goldman Sachs does not show any of the performance measures typical of a trading firm. Its Value at Risk measure, which calculates how much it could lose on a given day under very adverse market circumstances, went down from $245 million to $208 million. VAR should be sharply higher reflecting the increased risk necessary to generate so much more trading revenue. Similarly, Goldman had a record number of “$100 million revenue days” and very few days in the quarter when they lost money trading. This is hardly the profile of your typical day trader pitting his wits against the fickleness of the market; this is the profile of a hedge fund with critical information and size advantages, using them to maximize profit.

Notice that the firm made $1.26 billion from Principal Investments. The firm holds a pool of $21.08 billion in its own investments that are not related to client activity, and that can be held for short or long periods of time. This is speculation pure and simple – the sort of thing a hedge fund would do with its investors’ assets.

Now let’s look at how well Goldman Sachs performed in its traditional investment banking business. All these results are for the quarter, compared to the dreadful third quarter of last year.

· Investment banking: $899 million in revenue, down 31%
· Financial advisory: $325 million in revenue, down 14%, mostly due to a decline in merger activity
· Underwriting: $574 million in revenue, down 15%
· Asset management: $1.45 billion in revenue, down 29%
· Securities services: $472 million in revenue, down 48%

As an investment bank, Goldman Sachs is doing very poorly, or the economy and market for investment banking services is doing very poorly. After all, Goldman and Morgan Stanley are the only two traditional investment banks in business; all the rest collapsed last year or were merged into commercial banks.

Don’t bother looking for Goldman’s results from commercial banking. They don’t exist. Goldman has resolutely stated that it has no intention of changing its “banking model”, which means no intention of getting into the traditional banking business of making loans to companies and individuals. This despite the fact that it probably owes its very survival to an agreement from the government in September last year to allow it to convert into a commercial bank.

This begs the critical question: Why is the government allowing Goldman Sachs to function this way? It now has access to the Fed discount window and lender of last resort facilities, it gets funding from the Fed at close to zero percent, it is no longer subject to market runs on its stock because the FDIC backs up its deposits, and supposedly it is now visited routinely by Fed examiners who can see exactly what is going on. Yet there is not a peep of objection from the Fed, the Treasury, the White House, or even Congress about a soi-disant investment bank now converted into a commercial bank, which openly disdains any suggestion it should act like a commercial bank, which is struggling in its traditional investment banking businesses, and which is still allowed to make money hand over fist through outright speculation and what we might call “trading with advantages.”

It is also allowed to keep its own peculiar VAR model, very different from the ones used by commercial banks, and which is probably understating in comparison the true risks it is taking. It is allowed to peg its compensation pool not to net income, like a commercial bank does, but to the much larger number of net revenue. This explains in part why of its $7.58 billion in total expenses for the quarter, $5.35 billion was spent in salaries and bonuses. This is not necessarily against accounting standards, but it is much more on the scale of compensation found at a hedge fund, not at a commercial bank.

Maybe the Fed has difficulty deciding what to do about Goldman Sachs because other large commercial banks, like JP Morgan Chase and Citigroup, have investment portfolios and proprietary trading just like Goldman, only on a smaller scale. Still, Goldman Sachs even before the credit crisis was an anomaly in the investment banking world, since it was acting increasingly like a hedge fund. It is now a much bigger anomaly in its new home of commercial banking.

Most of the talk about Goldman Sachs is about its outsized bonus pool and insensitivity to the role taxpayers played in saving the firm from destruction. This misses the bigger point, which is the fact that the outsized bonus pool comes from the firm’s conversion into a hedge fund, when its legal status as a commercial bank should forbid this activity.

It is time for somebody, somewhere in government with authority to give Goldman Sachs’ shareholders an ultimatum: you have 90 days to decide what you want to be: a commercial bank, or a hedge fund. If you choose to be a commercial bank with access to all the taxpayer-funded benefits, you will present to the government a plan for divesting all of your “trading” and proprietary investment activity, and you will show how and when you will begin building up a credit culture and start making loans to American businesses and consumers.

If you choose to be a hedge fund, adios and good luck, and don’t come running to the government ever again if you get into trouble. Oh, and by the way, as a hedge fund, divest yourself of the investment banking, advisory, underwriting, asset management, and securities services businesses. We hear Wells Fargo is looking to get into these businesses, and there are no doubt other banks that would take a serious look as well.

Until such time as someone in government delivers this ultimatum to Goldman Sachs, it will continue to thumb its nose at each and every taxpayer in this country who saved its hide.

I'm not holding my breath.

The Morality of Deliberate Defaults

Sun, 04 Oct 2009 04:41:01 -0700

Over a quarter of American homeowners owe more on their mortgage than their home is worth. In some bubbly markets like California, three out of four homeowners are underwater. Should these homeowners deliberately default, rather than continue to pay on a mortgage when it may take 20 years or longer for market values to equal mortgage values?

Eighty-one percent of Americans think no, according to a survey done this summer by the University of Chicago and Northwestern University business schools. Most American homeowners think it is “immoral” to deliberately default on a mortgage when it is possible to make continuing payments. Yet the numbers of American homeowners doing just that is growing. It is estimated that four percent of all defaults on mortgages are “strategic defaults” according to a phrase used by the financial industry: the homeowner can pay the mortgage but makes a strategic decision to suffer foreclosure rather than continue to make payments on a wasting asset.

Four percent may seem like a small number but it is enormous in banking terms. Two years ago at the start of the collapse of the housing market, Ken Lewis, CEO of Bank America and recently “retired” this week, said that it was astonishing that any homeowner would deliberately default on a mortgage when they continued to make payments on their credit cards and were obviously able to meet their mortgage obligations. This was a world that had gone upside down in banking terms, because the last thing a consumer wanted to lose was their shelter.

Ken Lewis implied that something had gone wrong with Americans, as if there had been a moral collapse where people no longer felt obligated to fulfill their legal commitments when they easily could do so. Such a collapse if it spread could devastate the banking industry, because it added an entirely new dynamic to the foreclosure risks banks face – a dynamic that was certainly not contemplated in all the modeling banks did to project their credit losses. If foreclosure losses were to become much larger than banks ever anticipated, some banks might not survive.

What is this “morality” people assume when they borrow money? It is not quite in the realm of sinful prohibitions such as those of the Ten Commandments, adjuring us not to kill or commit adultery. Borrowers pay back debt in a timely way in order to protect their personal honor, primarily in the business world. A borrower wants to be known as a woman of her word: trustworthy, honest, scrupulous about meeting her legal obligations, and careful in her use of debt. Such a reputation has traditionally been considered as good as material wealth, because it allows the borrower to function successfully in the financial and business world.

The morality of paying back what you owe is therefore a matter of self-interest, and not something motivated by a sense of personal ethical behavior or contributing in some way to the common good. If there has been a breakdown in the willingness of some borrowers to pay back what they owe, and if this trend is growing, then something must be happening that makes it in the self-interest of borrowers to deliberately default. If eighty-one percent of Americans still think it is wrong to “stiff the bank”, then we must look elsewhere to see why strategic defaults are growing, and where we should look is to the banks, not the homeowner. Consider how the role of the banks has drastically changed in the lending market over the past 25 years.

1. Banks make mortgages for the sole purpose of earning fees, not making money off the interest that is paid on the mortgage. Banks do this by charging one fee after another, many of them hidden, at the time of closure, and during any circumstance where the homeowner is late on their payment. Banks also sell the mortgage on to some other financial institution, and often to the federal government, so that the bank can remove itself from any of the credit risk of the mortgage yet keep all the fees it has earned up to that point.

2. Consumers have no ongoing relationship with the lender. Most homeowners get a notice out of the blue that their mortgage has been sold to some other party, and often this happens several times over the life of the mortgage.

3. Banks can often sell the mortgage as part of a package of securities marketed to investors. The investor has absolutely no interest in dealing with the borrower, and leaves this task to a third party mortgage servicer that has even less interest in dealing fairly with the borrower because it doesn’t own any part of the mortgage and doesn’t have a financial incentive to make accommodations to the borrower if there is payment trouble.

4. Banks have failed to protect the most basic interest of the borrower – the mortgage note they signed evidencing the loan. The amount of sloppiness and laxity by banks in keeping records of the loan has shocked courts around the country, to the point that many judges are refusing to allow banks to foreclose on a property if they cannot produce the original note. It used to be that homeowners looked forward to paying off their mortgage and obtaining their mortgage note back from the bank (people used to have mortgage burning parties to celebrate), but in the chaos of the existing mortgage securitization market, the mortgage note is often missing.

5. The practice of banks earning their living off fees rather than interest income has extended to many other products. There has been significant abuse among the big banks with a product that “allows” consumers to overdraw their checking account when using a debit card. The banks charge fees of $35 or more for each overdraft, even if the amount overdrawn is $1.00. The implicit interest rate for this use of money exceeds thousands of a per centum, beyond any definition of usury. Moreover, the banks do not allow the customer to sign up for this service – it is forced on anyone who obtains a debit card – and debits are rank ordered by size in order to create the largest overdraft possible. Worse still, credits are deferred for days even when the check being credited is drawn on the bank itself. In any other industry such practices would be considered racketeering and criminal.

6. Banks taught consumers to look at their home as an investment first, and a shelter second. They did this by emphasizing, along with the real estate industry, that home values never went down. Banks began lending money against the equity built up in a home, as if the home were a piggy bank to be used by the homeowner for luxuries as well as necessities. Homeowners were only told the total amount of debt they owed if they asked; otherwise marketing was focused solely on the monthly payment due and the amount of “cash” one could take out of the home. After 2004, banks abandoned all sensible credit precautions in a rush for fee income, and made mortgages without any verification of the borrower’s income, job, assets, or cash flow. People were given mortgages who were obviously unable to pay out of their own cash flow, which meant the only form of repayment was through a refinancing when the home value increased. Now that home values have declined as much as 50% in some markets, banks are “shocked” that defaults are so high and some homeowners are simply walking away from their home.

To put this all together, banks have severed their relationship with the homeowners to whom they have initially extended a mortgage. If you have a mortgage, you do not have a traditional borrower-lender relationship, and in most cases you don’t have a relationship at all. The homeowner is at the mercy of whatever mortgage servicer may be responsible for ensuring the homeowner makes their payment. The servicer works for the bank currently owning the mortgage, or for the investors, each of whom owns a small portion of the mortgage. When it comes to other products like credit cards or debit cards, banks have become so avaricious in imposing fees and penalties that the relationship has become that of predator to prey.

Banks also marketed homes as investments first and foremost, to be bought and sold as the homeowner constantly traded up, even to the McMansion level. Extra equity that had built up due to the miracle of market forces could easily be extracted as cash and used as a source of even more lucrative fees for banks in the process.

In these circumstances, there is no morality imposed on the borrower to deal with the bank as a proper lender, or to treat the mortgage obligation as some sacred moral responsibility to be paid no matter what the circumstance. For one thing, since the borrower has no lender to talk to, the borrower’s personal circumstances if they are late in making payments are of no interest to whatever third party may have responsibility for the loan, and any remaining relationship the borrower has with the bank is one in which absurd interest rates are being charged for the use of money the consumer didn’t intend to borrow in the first place.

Those homeowners who have strategically defaulted on their mortgage have therefore made a conscious decision that they have no ethical obligation to pay the bank back on an asset worth far less than the mortgage, and they have determined that the consequences of a bad credit record are not that severe. In many states a home foreclosure does not allow the bank to take away other assets of the borrower, and within a few years of a foreclosure a homeowner can begin to obtain loans from banks quite willing to look past the foreclosure event. There are many known cases where a borrower can move across the street to a similar home that is being rented out for half of the amount that was being paid on the mortgage.

It is interesting that during all this time, banks and other corporations are arguing in courts that they deserve to have the same constitutional protections accorded to individuals. The Supreme Court is due to decide soon on whether to consider corporations as individuals. How ironic that would be. With such protections, we should expect corporations to assume all the benefits of being a person, but none of the obligations of individuals, especially the perceived moral obligations. Eighty-one percent of corporations are not suddenly going to say they have a moral obligation to pay down their debts. The practice of debt cramdowns, where the bondholders of a corporate note are forced to accept a lower interest rate or a deferred interest and principal repayment, is extremely common in the corporate world. America’s premier public figure in real estate, Donald Trump, is notorious for defaulting on his debts and forcing the bondholders to accept no or little payment. His companies are not going to change their behavior and start paying their debts on time like individuals would.

The remarkable thing about the morality question is that so many Americans still feel some moral obligation to live up to their word. It puts these Americans at a terrible disadvantage to the banks, which have no such obligations. The only logical response Americans can make is, unfortunately, to become like the banks, and in certain circumstances walk away from their mortgages after weighing the consequences in a rational, business-like manner.

September And The Markets

Tue, 01 Sep 2009 13:29:22 -0700

Just a reminder, September's are usually pretty miserable months for equity markets. I wonder what this one will look like?

Judge Surprises Madoff Deputy by Denying Bail

Thu, 13 Aug 2009 19:20:47 -0700

Tomoeh Murakami Tse | New York | August 13

WaPo - Experts Question Effect in Other Cases

When Frank DiPascali Jr. walked into a federal courthouse Tuesday afternoon, he expected to be able to stroll right back out. Instead, DiPascali, a key witness in the Bernard Madoff Ponzi scheme, was led away in handcuffs after a federal judge took the unusual step of rejecting the prosecution's recommendation that he remain free on $2.5 million in bail pending sentencing.

On Wednesday, while DiPascali, a former Madoff deputy, sat in a Manhattan jailhouse, legal experts questioned the effect the judge's decision would have on potential witnesses as the federal government continues its investigation of the Madoff scheme and other high-profile cases arising from the financial crisis.

While the decision does not set a binding precedent, some prominent former federal prosecutors and criminal defense attorneys said it would have a chilling effect on potential witnesses' willingness to work with authorities. Cooperating witnesses who plead guilty to white-collar crimes often are allowed to remain free on bail until sentencing. This can help prosecutors logistically, as they do not have to arrange for meetings in jail to go over voluminous documents.

Some legal experts said the consequences would be limited in part because any ruling in the Madoff case is not easily applicable to other crimes. But almost universally they expressed surprise at the decision by U.S. District Judge Richard Sullivan, who found that DiPascali may be a flight risk.

[...]

DiPascali is only the second insider to acknowledge his role in the Madoff scheme, the largest and longest-running financial fraud in history. While Madoff insisted during his own guilty plea that he acted alone, DiPascali has indicated others were involved, and he will likely be a key witness in future cases against potential accomplices. Madoff is serving 150 years in a North Carolina prison, the maximum allowed under federal guidelines.

WSJ: Details in DiPascali Deal, August 14

NYT: Madoff Aide Holds Key to Intrigue, August 12

The documents show that Mr. DiPascali had an intimate knowledge of the diverse universe of Madoff investors — from close relatives with minor holdings to foreign hedge funds investing billions.

[...]

Mr. DiPascali’s intimate knowledge of the relationship between Mr. Madoff and his investors clearly would be very helpful to investigators trying to navigate their way through a fraud in which even some of the victims may not be what they seem, several former prosecutors said.

Indeed, one defense lawyer predicted that the government’s investigation could move in a new direction based simply on Mr. DiPascali’s insider knowledge.

“It could well be pivoting toward an examination of the people with whom DiPascali dealt,” said the lawyer, Eric R. Breslin of Newark, on Tuesday.

Marc L. Mukasey, a lawyer for Mr. DiPascali, hinted in court that no commonplace help was involved. “You can imagine the hill that the government faced in offering him a cooperation agreement,” he said. “He won them over.”

Mr. DiPascali, he said, would be a cooperator “of a historic nature, somebody who can pull the curtain back on a fraud and answer a lot of questions” — questions that “the whole world wants to be answered.”

NYT: Madoff Aide Reveals Details of Ponzi Scheme, August 11

Frank DiPascali was a “kid from Queens” fresh out of high school when he landed a job in 1975 with a rising star on Wall Street named Bernard L. Madoff.

On Tuesday, Mr. DiPascali stood in a federal courtroom in Lower Manhattan and admitted that, for at least the last 20 years, he had helped Mr. Madoff carry out one of the biggest frauds in Wall Street history.

Indeed, he detailed for the first time how he and unidentified others helped Mr. Madoff perpetuate the crime — using historical stock data from the Internet to create fake trade blotters, sending out fraudulent account statements to clients and arranging wire transfers between Mr. Madoff’s London and New York offices to create the impression that the firm was earning commissions from stock trades.

“I knew it was criminal, and I did it anyway,” Mr. DiPascali told Judge Richard J. Sullivan, of Federal District Court, just before pleading guilty to 10 felony counts, including conspiracy and tax evasion.

[...]

Mr. DiPascali, who had been one of Mr. Madoff’s closest aides for decades, also said he would “dedicate all my energy to trying to explain to others how this happened” as a cooperating witness for federal prosecutors who are still investigating Mr. Madoff’s vast crime, which left his clients bereft of almost $65 billion they thought was in their accounts.

[...]

A few hints of how helpful his cooperation would be emerged on Tuesday, when he offered one of the most detailed accounts yet from inside the Midtown Manhattan office tower where Mr. Madoff ran his decades-long Ponzi scheme.

Mr. DiPascali described how he, Mr. Madoff and unidentified “other people” created fake account statements, shuffled money between bank accounts and perpetuated a years-long fairy tale that they were making money for clients of Bernard L. Madoff Investment Securities.

“No purchases or sales of securities were actually taking place in their accounts,” Mr. DiPascali said. “It was all fake. It was all fictitious. It was wrong, and I knew it was wrong at the time.”

[...]

Mr. DiPascali told the court on Tuesday that he wanted to apologize to every victim, adding: “I am very, very, very sorry.”

At Least They're Not on Life Support

Sun, 19 Jul 2009 13:43:59 -0700

With many bank earnings now available for the second quarter, I thought I would summarize them all in one post. But there is so much useful data in the earnings results of JP Morgan Chase alone, that it seems more illuminating to start with just this bank. Prepare yourself for some serious financial porn below (lots of numbers), but don’t be afraid. You’re entitled to look. After all, if you are a US taxpayer, you own part of Chase, so these are your results as well.

The press is full of admiration for the new Big Boys on the block – JP Morgan Chase and Goldman Sachs. These are the two banks which have managed to keep their heads above water, steal market share from all their weakened competitors, and return their unwanted TARP money to the Treasury. CEOs Jamie Dimon of Chase and Lloyd Blankfein of Goldman Sachs are attributed with a special kind of financial genius that not only foresaw what was coming, but profited from the disaster. The problem with this laudation is that it is simply undeserved once you dig into their financial reports.

We’ll start with Chase because this bank divulges reams of information and normally gets credit from investors for its transparency. This quarter, we certainly have reams of information, but transparency is somewhat lacking. The reason is that the comparisons to last year’s second quarter are very confusing, since Chase had not yet merged with Washington Mutual, and Chase does not give us tables of the before and after differences. Instead, we get numbers like enormous revenue growth and record earnings that are probably only the result of the merger. We just don’t know, but it is prudent to be very skeptical of the press release exclamations over record this and record that.

Here is something else that is not only confusing, but simply bizarre. By now, one year after the merger, Chase would normally be trumpeting the success of its merger with Bear Stearns, how it has helped revenue and net income, and how the bank is ahead of its plan for obtaining synergies (that’s corporate code for how many people have been fired or quit). I’ve gone through the press release and the investor presentation and have found only one small reference to Bear Stearns. It’s as if the merger never took place and that company doesn’t exist anymore. This is also puzzling because Chase made so much of its money this quarter from investment banking and trading. Wasn’t Bear Stearns a contributor to this success?

The success looks fantastic - $1.47 billion of revenue from the Investment Banking division, compared to $304 million a year earlier – until you realize Chase earned even more from investment banking, $1.61 billion, in the first quarter of this year. The press release of course doesn’t trumpet this fact, so the press (who rarely do their own analysis of corporate earnings), doesn’t know about it and can’t therefore talk about it. It is really remarkable how what gets reported in the press is dictated almost to the letter by what a company says in its press release.

For example, the press is thrilled with the second quarter net income for Chase of $2.72 billion. This was up from $2.14 billion in the same period last year, and much more important, was well beyond what Wall Street analysts were expecting. Wall Street always concentrates on how a company performed compared to expectations, and Chase outstripped what the analysts thought it could produce. But to put this performance in context, we should look at a two year comparison.

In the second quarter of 2007 – just about the peak of the housing bubble – Chase had $19.82 billion of revenue and $4.23 billion of net income. This quarter, the new Chase had $27.71 billion of revenue, as the result of merging with Washington Mutual and Bear Stearns, but revenue has collapsed to $2.72 billion. This is a devastatingly poor performance, and that is the real story here that you are not going to read about in the press.

In fact, the situation at Chase is deteriorating, as represented by poor performance throughout the company except in Investment Banking. This too is ignored by the press, but the fact is that all the other businesses at Chase are sinking into losses or, at best, treading water. Look at some of these divisional results:

Retail Financial Services

There are two parts to this division: retail banking, which manages checking and savings accounts at over 5,200 branches nationwide, and consumer lending for mortgages, home equity lines of credit (HELOCs), auto loans, and student loans. The first part of the business did well, producing $970 million of net income, through wider deposit spreads (we’ll talk about this in a minute), and “higher deposit-related fees.” Banks are ratcheting up fees in retail banking to obscene levels, and engaging in predatory practices like pushing consumers into overdrafts and charging them a small fortune in usury interest. They are doing this because they can, and because they have to.

To see why, look at the results of the second part of this division: Consumer Lending. This business lost $955 million, wiping out total income for the Retail Financial Services business. The reason was the bank set aside $3.8 billion for additional losses on consumer loans, and this expense eats directly into the bottom line. Where did these losses come from? You would think much of this would arise from the well-publicized problems with subprime mortgages, and Chase did increase its charge-offs for these mortgages from $192 million last year, to $410 million this quarter. This was an implied charge-off rate of 11.5%, so nearly one out of every eight subprime mortgages at Chase has resulted in a loss.

But an even greater amount of loss was incurred in prime mortgages: ( $481 million) this quarter, four times greater than last year at this time. The charge-off rate for prime mortgages was 3.07% this quarter, up from 1.08% last year, and 0.44% in second quarter 2007. The problem for Chase is that its prime mortgage portfolio is so much larger than its subprime portfolio, that it can ill afford even a 3% charge-off rate.

The granddaddy of consumer losses this quarter results not from first mortgages, but second mortgages, known as home equity lines of credit. Chase took a $1.3 billion loss in charge-offs for these products, up from $511 million last year. The charge-off rate doubled to 4.61% in one year. Chase has $138.1 billion of HELOCs on the books, and it is doing what it can to control this portfolio. Originations of new HELOCs were down 89% from last year, meaning it is very hard to get one of these lines of credit from Chase anymore. This should not be surprising; HELOCs have a registered lien on the property subordinate to the first mortgage holder, but with a 50% or more decline in housing values in key markets, the collateral value has diminished for the first mortgage holder, and virtually disappeared for the second mortgage holder. Chase is sitting on a $138.1 billion book of these second mortgages, a sizeable portion of which is now unsecured and subject to very large ongoing losses. When banks were busy booking these home equity loans early in the decade, no one anticipated the collateral would be worthless, so this product has turned out to be a disaster for the banks. Don’t expect home equity lines of credit to be easy to get anytime in the future unless you have an enormous amount of equity built up in your home.

The only good news in the HELOC business is that charge-off rates at Chase appear to be stabilizing, but for all other products, including auto and student loans, such events as delinquencies, foreclosures, provisions, and ultimately charge-offs are all increasing. Chase can’t predict when its basic consumer lending business will stabilize, because that depends “on unemployment”, which unfortunately is already at levels worse than expected even by the Fed in its stress test scenarios. The best Chase can say is that charge-offs will continue at the current pace for the rest of the year, with happier days perhaps in 2010. One thing you can bet on, the big banks are going to continue assessing absurd fees on retail banking products in order to make up for these losses. This can easily cost you hundreds of dollars more a year if you don’t monitor your checking and savings account usage like a hawk, and avoid overdrafts by all means possible.

Card Services

The credit card business has been the crown jewel of banking in the US for 25 years, earning a legitimate 20% return on equity because the interest rate on credit cards can easily exceed 30% p.a. Banks have justified this interest rate on the grounds that credit cards are unsecured, which tells you by the way what the interest rate should have been on home equity lines of credit considering that they turned out pretty much to be unsecured lending as well. Nonetheless, even with extreme and usurious interest rates, the credit card business has collapsed in a tsunami of consumer defaults.

In 2007, the charge-off rates for credit cards at Chase was 3.52%. It jumped up to 4.86% last year at this time, and this quarter reached an incredible 10.04%. Double-digit charge-off rates in any line of banking used to be found only in stress test scenarios, under the heading of the unthinkable – a global depression. Now they are found in all major credit card portfolios, suggesting that this is certainly no ordinary recession we are in. For the record, Chase earned $759 million in quarter two of 2007 from its credit card business; this quarter it lost $672 million, a swing of $1.4 billion in earnings, and the losses are worsening even from last quarter.

There is no good news here for Chase. One of their most important businesses and consistent money earners is now staggering under incredible charge-off rates, with no relief in sight. The weakened consumer has begun to drag down bank performance in a very serious way. This, too, is one of the real stories at Chase that somehow missed the headlines.

Other Businesses

Most of the other businesses at Chase saw reduced profitability. Commercial banking – lending to corporations – generated a $368 million profit, up slightly from last year. This was the only improving business in the group. Treasury Services, which sells cash management products to corporations and governments, earned $379 million, down from $425 million last year. Simply put, there was less demand for the product, according to the bank. Asset Management, which represents Chase’s mutual funds, earned $352 million, down from $395 million, because customers were continuing to liquidate holdings.

Then there is something called Corporate and Private Equity. This is basically the CFOs office, which remains one of the most remarkable aspects of modern banking. Banks like Chase have over a trillion dollars in assets, offset by a nearly equal amount of liabilities such as deposits and long term debt. Because these assets and liabilities are not balanced either in size or maturity, someone has to watch the imbalances, which can generate huge amounts of earnings swings. The art and science of Asset & Liability management is expected to manage these swings and keep them positive where possible, which is often equivalent to predicting where interest rates are going. In today’s environment, that is relatively easy for short term rates: they are at zero percent and not going up anytime soon (it’s a very different story for long term rates). The Chief Financial Officer is responsible for Asset & Liability management, often using a staff of less than 20 people, even at a bank like Chase.

This quarter, the CFO earned $820 million in “trading gains” attempting to manage the balance sheet risks. This represented a huge swing from a loss last year of $319 million, and also represented a significant portion of the $2.72 billion Chase earned overall during the quarter. The remarkable thing is not simply the size of this contribution, but the fact that merely a handful of people are responsible for this work. It is one of the reasons the CFO in banking is often considered just slightly less important than the CEO.

It was not specified how these trading gains arose, though it was made clear that the risks are not incorporated in the bank’s Value at Risk model, which measures the potential daily loss from trading given an extreme adverse event that might occur only 1% of the time. The VAR model is restricted to Investment Banking activity only, which was the one stellar part of Chase’s performance this quarter.

Investment Banking

Net income for Investment Banking was $1.47 billion for the quarter, which along with the CFO’s trading gains represented most of the income of the bank. The division earned $393 million just from advisory fees on mergers and acquisitions, plus a record $1.1 billion in fees from equity underwriting. The fees from underwriting debt came to $743 million. Now it is pretty clear looking at the IPO market and records of new equity issuance that corporations and venture capital start ups were not issuing large amounts of stock. This market pretty much remains dead – with one exception – the banking industry itself, forced to raise new capital at the direction of the Federal Reserve. So you had a captive audience of customers forced to raise stock, and forced to go to just a handful of surviving equity underwriters like Chase.

As to the debt side, there was certainly a resurgence of new debt issued in the high yield market, better known as junk bonds. But another big, big issuer of new debt was the US government itself, and Chase was right there reaping in extraordinary fees from underwriting this debt.

Another part of Investment Banking, called Fixed Income Markets, is where the speculative trading takes place. This business generated $4.9 billion in revenue, up from $2.6 billion. At least judging by the Value at Risk number of $250 million for the quarter, Chase has certainly ramped up its speculative juices (VAR was $150 million the previous year). Most of this risk taking took place in bond trading, with equity and FX risk distant second and third players. But some interesting facts are to be found in the footnotes, especially this statement: “(There were) no markdowns related to leveraged lending commitment and mortgage related expenses.” In the previous year, such markdowns came to $1.1 billion, so here is another billion dollar swing in Chase’s favor. What this seems to mean is that Chase didn’t have to take any mark to market losses on its trading assets, unlike last year when it was forced to under much stricter accounting standards. So, perhaps, the FASB ruling liberalizing the mark to market accounting rules might have been worth a billion dollars of revenue this quarter for Chase.

Offsetting this was a $733 million loss from “tightening of credit spreads.” Presumably this refers to the funny business that goes on with accounting for a bank’s own debt. Since debt that has been issued publicly is bought and sold at public prices, it is possible to calculate what it would cost the bank to buy back its debt. If in doing so it would make a gain, it can take that gain into net income, which banks have been doing for the past two quarters as the value of their debt has sunk lower and lower on the markets. Now that this debt is recovering in price, Chase and other banks are forced to reverse these gains and declare a loss.

There was an additional $575 million loss resulting from the credit portfolio hedges Chase maintains. Have you noticed how many different half-billion and billion dollar revenue swings occur at a bank like Chase? While the overall net income was $2.72 billion, the variability of this net income is quite great, because a number of different activities can push the number into a different direction. As a consequence, earnings at Chase are quite unpredictable, which is actually unhealthy because the bank is so complex. Investors don’t like unpredictable earnings, with good reason, and this is probably why Chase’s stock this week didn’t really rise much despite all the “unexpected good news.”

Bailout Heaven

How dependent is Chase on the federal government and its many bailout programs? The answer is very dependent, but quantifying this dependency is difficult because so much of the bailout programs are kept secret.

One example of this is with a portfolio called Held for Sale Loans. This is described by Chase as its leveraged loan portfolio, so it probably consists of the so-called pipeline loans that got caught in the 2008 credit freeze and could not be sold at the anticipated time for anywhere near the anticipated price. One answer to this problem portfolio is for Chase to write down these leveraged loans, but as we have seen this quarter, it felt no need to do so now. A second option is to sell the loans, but to whom? Probably the only buyers are what are known as vulture hedge funds, willing to put in low-ball bids that Chase would never accept in a million years. Still, Chase reduced this portfolio by $12.5 billion, bringing it down to $6.8 billion. The only logical other buyer would be the Federal Reserve under one of its many programs to relieve banks of toxic assets, but the Fed refuses to identify what it holds on behalf of which banks, and the Congress just killed an effort to audit the Fed to find out. Lacking specific facts, we can only make a reasonable speculation that this is just one of the many ways Chase is benefiting from government largesse.

We’ve already discussed some of the indirect ways as well, such as the forced equity underwriting and debt issuance that redounded to Chase’s benefit in the form of hundreds of millions of dollars in fees. There is also the fact that Chase was able to issue debt in its own name with a Aaa rating plastered on it, courtesy of the federal government. This is what one analyst at S&P calls an “unlimited subsidy”, because it is one of the most potent bailout benefits available to the banks.

What you can see here is a picture of ongoing bailout benefits, which are unappreciated by the general public because the press talks about the bailout programs as if they all occurred back in March or September last year when Bear Stearns, Merrill Lynch, WaMu and other firms were sold to surviving banks.

To put some numbers on the ongoing bailout benefits, it helps to look at Chase’s interest rate spread – the difference between what it pays for money and what it earns. In this past quarter, Chase earned 1.45% on its deposits with other banks, a paltry 0.41% on Fed Funds sold, but then 4.91% on trading assets, 3.64% on securities held, and 5.65% on loans. Averaging all this out, Chase earned 4.00% on its assets.

Compare that to its cost of funds. Chase paid only 0.70% on interest bearing deposits of any sort. It paid 0.23% on Fed Funds purchased. It paid 0.24% on commercial paper, 1.59% on “beneficial interest”, and 2.60% on long term debt. Its weighted average cost of funds was 1.04%.

On a net basis, Chase earned a whopping 2.96% spread between interest earned and interest paid. That’s of course pure money in the bank, and that comes courtesy almost entirely from the federal government, especially the almost non-existent cost for short term money. By the way, if you are a Chase retail customer, you didn’t earn anywhere near 1.04% on your deposits, or even 0.70%. On the retail side, Chase is paying around 0.10% on consumer deposits, simply because it can (consumers have shifted significant amounts to Chase on the theory it will be a surviving bank – no one wants the risk of having money in a defaulting bank).

As wonderful as this is for Chase, there are some macro-economic issues at stake here. The federal government, by keeping money as cheap as it is, is taking money away from savers and shipping it off to the banking industry to recapitalize it because of their substantial losses. At some point, and maybe we’ve reached that point, this becomes counter-productive. The average person in the US can no longer earn any decent money on their deposits, and certainly not enough for most people to live on. This is probably slowly pushing more and more consumers into financial distress and ultimately into default. Chase may be a net loser in a big way, but seems happy at the moment to accept cost-free funds without any complaint.

The other purpose of this cheap money policy is to get banks lending again. How is that going? Judging by Chase’s balance sheet, not too well. From the second quarter of last year, wholesale loans at Chase are down from $242.3 billion to $231.6 billion. Consumer loans are down from $466.0 billion to $449.0 billion. Chase seems to be actively closing down any new home equity lines of credit. It is squeezing its credit card holders ferociously by increasing the minimum monthly payment from 2% of balances to 5% of balances, as of next month. Auto loans and student loans are down, as are loans to the security industry. Chase is clearly not in the business of lending more money to America, despite whatever it may say about new accounts signed up or new mortgages originated.

At Least They Are Not on Life Support

This is probably the best thing that can be said about JPM Chase: it is not on life support, nor is it a crippled giant like many of its competitors. It has more capital at its disposal than most big banks. But if it isn’t crippled, it certainly is wounded, and it has not been able to stanch the bleeding. Chase is first and foremost invested in the American consumer, and it is being savaged by an unprecedented level of defaults in its core businesses. The fact that it can make profits in investment banking and trading is of little comfort. A lot of this profit is forced business generated by government policy, and is not going to be repeated. The rest of this profit is fickle, depending on market circumstances.

The basic banking business of Chase is hurting badly, as seen in this quarter’s meager return on equity of 3% (or 6% if you ignore the $1.16 billion non-cash cost to Chase of paying back its TARP money this quarter). These are the sorts of returns banks made in the 1970s, before they discovered ways to lure Americans into debt servitude. One of the reasons Chase has such a low return on equity is that it has built up what it calls a “fortress balance sheet”, with common equity of $146.6 billion this quarter. Such a high level of equity drives down the return on equity ratio, but think how much higher the capital would be if Chase hadn’t received so much government support. Without the government bailout, banking would require so much capital as to offer hardly any return to its shareholders.

In fact, it sounds more and more like commercial banking, in a world where risks are priced and capitalized properly, is a world of modest profit and modest returns for shareholders. Doesn’t that sound like a utility to you? That’s what banks were for most of the past century, until free market theory was used to push banking into a world of aggressive risk taking, outsized profits, and Midas-like bonuses. It worked only because banking has a “put” to the federal government to come to its rescue in times of trouble.

This put has never been applied so vigorously as today, now that Chase and its big competitors have become the ultimate conduit financial vehicle for the federal government. The Treasury and the Fed are propping up so many different markets that it is estimated some 30% of all finance comes from Washington now. Chase is one of the selected vehicles for channeling all this money, and it is allowed to take a generous transaction fee on every dollar. This is no longer banking, but rentier finance for a few institutions granted monopoly rights – again, the classic definition of a public utility.

Despite all this, Chase, as one of the biggest and best of its breed, is unable to generate anything but a 6% return on equity, and that is a variable 6% at that, prone to disappear in any quarter. What must life be like at Bank of America or Citigroup, where the troubles are worse? Or at Goldman Sachs, which is operating in an alternate universe that allows it to receive bank benefits without any of the discipline?

We’ll talk about these institutions in the next post.

Where's My Dividend?

Tue, 14 Jul 2009 07:38:31 -0700

I'm very happy to know that my tax dollars helped make Goldman Sachs $3.4 billion last quarter. Now, where's my dividend?

As a matter of fact, I think we need to see some serious and sustained calls for a windfall profits tax on Goldman's most recent quarter. They profited off of our money. Where's my pitchfork?

Goldman Sachs Punked? The Case of the Stolen Proprietary Algorithm

Tue, 07 Jul 2009 14:49:50 -0700

A case of financial espionage raises questions about Wall Street’s proprietary trading practices and exactly what role they play in the market. The perpetrator of the espionage, Sergei Aleynikov, is a former computer programmer and equity specialist at Goldman Sachs. He is alleged to have downloaded secret software at Goldman that is used to direct large volume, rapid-fire trades to exchanges and commodity markets, often just before the close of regular trading.

At a bail hearing for Aleynikov, now in custody in New York, U.S. Assistant District Attorney Joseph Facciponti said Goldman Sachs stands to lose millions of dollars from its proprietary trading based on the stolen software. Moreover, if others in the market obtain access to these trading secrets, “there is a danger that somebody who knew how to use this program could use it to manipulate markets in unfair ways,” according to Facciponti.

This naturally raises several questions about the software and the trading algorithms incorporated in the program. What do these algorithms do, and how do we know that Goldman Sachs isn’t already using the software “to manipulate markets in unfair ways”?

The algorithms fall under the category of “quantitative trading”, created by “quants” who are often Ph.D’s in the hard sciences or mathematics. Many of them are like Aleynikov, a Russian émigré and former student of applied mathematics in Moscow, who was earning $400,000 a year and left Goldman Sachs to take a job in Chicago that he described paid three times as much. Quantitative trading is only possible in the modern marketplace because so much trading is now electronically based, sent to the exchange by computers, and often without any human intervention beforehand. In the first quarter of this year, it is estimated that over 25% of all New York Stock Exchange trades were computer generated, dwarfing the volume of trades sent in by individual investors.

Quantitative trading algorithms can perform many functions, but one of the principal things they do is research many thousands of stock, bond, foreign exchange and commodity prices in search of anomalies that can be exploited for profit. The algorithm carries an historical data base that reveals typical relationships between or among financial assets. The relationship between, for example, crude oil for three months vs. six months delivery falls into a certain statistical distribution, or to use another case, transportation stocks may trade inversely to energy stocks (as the price of oil goes up, energy stocks go up but transportation stocks go down).

If the algorithm finds that a price relationship is currently trading well beyond its typical range, the computer will shoot off trading instructions to buy and sell the respective financial assets in anticipation of a return of this trading relationship to normal conditions. Since these anomalies are expected to be short-lived, the computer algorithm is required to monitor the market real time and send out follow-up instructions, often by the end of the day, to close out the position and take profit (or cut the firm’s loss if the trade did not go as planned).

This sort of quantitative trading seems to be one of the features of the Goldman program, and Mr. Aleynikov is being accused of downloading this program to an outside computer so he could bring it to his new firm and use it for trading there. But there could be many other types of quantitative trading, some of it “directional” in nature, wherein the algorithm is searching for a financial asset or market that is overbought or oversold and likely to reverse direction. These types of algorithms often compare current prices to a five, thirty, and fifty day moving average of prices for that asset or market, and if the current price violates one of these averages, a buy or sell order will be generated. These programs are so prolific that many individual investors follow these moving averages as well, and “pile on” to the computer trades once an average is violated.

The main criticism of these program trades is that they become self-fulfilling in at least two ways. First, the sheer volume submitted by a firm like Goldman Sachs starts moving the market back to the direction desired by the firm. As such, it sends a signal to the market that a directional change is occurring, and this tends to attract others to the trade, adding to the self-fulfilling nature of what Goldman initiated in the first place. Second, when such trades are done publicly, many individual investors join in and create the momentum necessary for Goldman to profit. Goldman need not publicize its intentions (in fact it operates with intense secrecy), but if it uses something like a moving average strategy that is monitored by tends of thousands of firms and investors, the trade can easily become self-fulfilling.

This is a polite way of describing computer algorithm trades, but less politely, it can be said that firms like Goldman Sachs bully their way to profitability. Their volume is so huge that they become the 800 pound gorilla which dominates the market. There is nothing especially proprietary about their computer algorithm under such circumstances, if large volume can more often than not compel the market to move in a particular direction.

The US district attorney suggests that Goldman did in fact own a proprietary model and it will be harmed if this computer algorithm reaches the public. Presumably, other investors could trade before Goldman initiates its trades (front running). It may also be the case that Goldman has indeed found the Holy Grail – the secret behind how the markets work that allows one to create eternal profits as long as the secret is maintained. Thirty years ago a small group of traders noticed the stock market tends to trade in nine day cycles, after which it reverses direction, or based on certain rules these traders discovered, resets and travels in the same direction for another nine days. This secret provided profitable trading until more and more people learned about it; now it is widely known and used, and seems to work more than 50% of the time, but can now lose you money if you are not careful.

Goldman may have latched onto a secret such as this, the efficacy of which becomes diluted over time as others learn about it. This may be what it wants to protect. It may also be doing its own form of front running. It processes so many proprietary trades for investors that it must have a good institutional sense of the buying and selling pressure in the market. By harnessing this information across its customer base, it can take directional trades as the market does, before it becomes evident to the investing public what is happening. Tying its computer algorithms into its customer data base might generate significant profitable trades, especially since its customer base includes so many major hedge funds which dominate the market.

If you are of a conspiratorial bent, you might assume that Goldman Sachs is operating at least on occasion for the fabled Plunge Protection Team, a cadre of top government officials like Treasury Secretary Geithner and Fed Chairman Bernanke, who purportedly use government money to prop up the stock market or other markets. The PPT really does exist – it is mandated by a regulatory act – but whether it secretly operates to prop up the stock market is certainly questionable. If it did, we can at least say that Goldman Sachs would be the most logical candidate for the government to use.

One of the most famous theories on Wall Street is the Random Walk theory propagated by Burton Malkiel, who has asserted that it is impossible to make speculative profits trading equities because Wall Street prices move randomly. No one can predict a truly random market. This theory has achieved great credibility because of the considerable anecdotal support it receives. Anyone who has invested in a mutual fund or listened to a Wall Street broker knows that these “experts” seem to be right 50% of the time. In fact, these experts tell you not to invest short term because the randomness of prices will kill you.

The U.S. government is telling us something different, through Assistant District Attorney Facciponti. Random Walk may well be the situation facing such investors as you and me, but it is not the case for select insiders such as Goldman Sachs. In the first quarter alone, they generated $2 billion in trading profits just from equities trading. They may have access to inside information, or they may have discovered the Holy Grail of markets, or they may have sophisticated proprietary algorithms, or they can simply bully their way to profits. Whatever the answer, they will profit in good markets and bad markets. Life is anything but random for them.

When someone like Mr. Aleynikov interferes with their exclusive and very profitable and very non-random situation, he deserves to go to jail. Nothing should stand in the way of Goldman Sachs profiting from a market that benefits no one else.

Which brings us back to the suspicious statement that if someone other than Goldman Sachs were to have access to this software, they could “manipulate markets in unfair ways.” This is opposed to Goldman Sachs, which is using the program to manipulate markets, but somehow their manipulation is fair. At least so thinks the U.S. government, but it is very unlikely the average investor agrees. The performance of the global equity markets in 2008 was atrocious, but worse still – investors have nothing to show for their investments now going back to 1999.

A decade of waste, or worse if you were among the many millions who borrowed against your home or traded up to a house that you can no longer afford. All during this time, one firm at least has prospered. It now dominates a stock market in which at least a quarter of the trades are unrelated to the buying and selling of stocks as long term investments. It has seen many of its traditional rivals such as Merrill Lynch, Lehman Brothers and Bear Stearns disappear. It routinely shuffles its executives back and forth to high positions in the government. Should anyone trample on its prerogatives, even if it is a foolish individual, it can bring the full weight and majesty of the federal government to bear on the transgressor. While Goldman Sachs thrives, and the rest of us pay the price for their profitability and extraordinary bonuses, is anyone – anyone at all – asking whatever happened to free markets as the linchpin of a capitalist economy?

Trawling the news I found this intriguing headline "The Mysterious Omen that is ‘Divisor Change’"

Sat, 27 Jun 2009 18:04:05 -0700

Richard Daughty has a fun look at the loss of GM and CitiGroup and the insertion of Cisco Systems and Travelers in the DJI index, necessitating a divisor change.

Now on Sunday amongst friends, you too can opine on the divisor change to 0.132319125 from 0.125552709.

Want to know more, read Richard posting as the Mogambo Guru here. The article has a popularity of 1% at the moment, lets give it a push!

What to Do About the Debt Trap

Thu, 11 Jun 2009 06:53:39 -0700

Well hooray! Ten US banks have been given permission to repay their TARP loans from the federal government - $68 billion worth. This governmental Seal of Approval may mean these banks are healthy and safe and ready to do business, but what it certainly means is that the executives running these banks want to escape any government control over how much they pay themselves.

What’s in it for us the taxpayers? Not much. The government still needs to borrow trillions and trillions of dollars, which means interest rates aren’t going down. No fundamental reforms have been imposed on the banking industry – just some tweaking around credit card rules – so you still will have a very hard time getting credit. You’ll also earn about 0% interest on your bank deposits, but pay 30% or more for credit depending on your financial condition. This is certainly not going to get the consumer spending or the economy moving, so what is it going to take to enact real change to our financial system?

Our own Zuma has come across a potent set of proposals for real reform from the author William Greider. You’ll want to check out both Zuma’s report on the Diaries page, as well as Greider’s article on Alternet (printed originally in The Nation). The gist of these reforms is radical in today’s political climate – it is nothing less than a legal cap on interest rates. No bank or finance company would be able to charge you more than this cap – to do otherwise would be considered usury. What would our economy look like if we had laws against usury?

Why Interest Rate Caps Were Abolished
That’s actually not too hard to answer. The US did have usury laws for a long time up until 1980 when they were completely abolished – by Democrats. The problem was the usury caps were becoming outmoded in the face of sky-high interest rates imposed to fight double-digit inflation. It was not just that the banking industry wanted to get rid of the usury laws; when the Fed was setting the base rate at 11%, and mortgage rates were at 18%, a usury cap of 15% made no sense.

Very quickly, though, some financial instruments began to carry unusually high interest rates, like credit cards, which throughout the 1980s had a peak rate of around 22%. The public was “outraged” at a rate that used to be associated with loan sharks, but the banks pointed out that losses on credit cards in the 1980 – 1982 recession were unexpectedly high and justified such high charges for poor credit risks. Once Ronald Reagan came to power, there was no going back. Free market orthodoxy now ruled the day and the market was allowed to charged whatever it wanted.

Not surprisingly, borrowing rates inched up as the years went by. The credit card industry discovered it could get away with charging 30% - 35%, as long as it stratified card users into risk categories so that middle class and wealthy customers would be charged a more tolerable 15%. These lucky customers, however, rarely borrowed on their credit cards. It was the lower middle class credit user who needed to run a monthly balance, so the preponderance of Americans with such balances were poor credit risks paying 30% or higher.

Growth of the Debt Trap
As we entered the 1990s, something else began to happen to the consumer. Their wages were stagnating, eaten up by rising medical and other costs, so consumers had to borrow to maintain the basics of life such as food and shelter. The credit-worthiness of consumers gradually deteriorated under these conditions, and by the time George Bush wrested the presidency out of Al Gore’s hands, people were borrowing more and paying much more for the privilege.

William Greider writes about the implications of borrowing at excessive interest rates.

Usury is the ancient sin of charging inflated interest rates sure to ruin the borrowers. It is considered immoral by Judaism, Christianity and Islam because usury involves the powerful using their wealth to ensnare weak and defenseless borrowers. The classic usurer offers an impossible choice that debtors cannot easily refuse. If they reject the terms of the loan, they will not be able to pay the rent or buy necessities. If they accept the usurious interest rates, their debts will accumulate until they are bankrupted (at which point the creditors claim their property). No civilized society can endure in such conditions.

The impossible choice referred to here occurs when a consumer needs to borrow for necessities, but the interest rate is high enough that interest on the debt keeps mounting, making it impossible to repay the debt in full. This is known as a debt trap. Exactly what that rate of interest might be depends on the economic condition of the consumer (particularly whether they have any savings to use as collateral), the minimum repayment required monthly by the bank on its loans, and the general level of interest rates in the economy. This makes it hard to say what interest rate might constitute usury at any particular time, though we can say even wealthy people would have trouble retiring a debt where the interest rate is in excess of 30%.

Another way to gauge whether interest rates are usurious is to keep track of how many consumers are in a debt trap. Are they borrowing on their credit cards to pay for basic necessities? Are they borrowing from one source to make minimum payments to another creditor? Is their cumulative debt rising rather than being paid down? There is no doubt that millions of Americans were in this situation by 2000. They were already debt slaves, and usurious rates were clearly at work in the market.

The poorest of the poor couldn’t even borrow at 30%. They were forced to rely on payday loans, using their paycheck at a currency exchange to take down a loan that had equivalent annual interest rates of 400% or higher. If the loan couldn’t be paid in full when due in two weeks, the next paycheck was used to roll it over, and suddenly the consumer was snared in a debt trap of ferocious persistence given the interest rates charged.

At Last, a Proposal to Abolish the Debt Trap
Greider mentions several community activists and community groups who are pushing for usury caps. The caps range from as low as 9% to as high as 30%. These caps would make it much more difficult for consumers to fall into debt traps, which means the consumer would have a reasonable chance to pay down their debts over time. This would also set the banking industry back to the profitability levels of the 1970s when such caps last existed. There is simply no way the banking industry is going to readily accept such a drastic reduction in its income, and such a major change in its business practices.

It is this latter point that is critically important to understanding the debt trap. Banks in the past 30 years have abandoned their traditional fear of lending to consumers, in part because they can charge unlimited interest rates to cover whatever they perceive to be the risk involved. Banking behavior has therefore changed from avoiding certain consumer loans, to encouraging almost all types of consumer loans.

Offers for credit cards have flooded consumer mailboxes almost daily, at least until the this credit crisis hit, and even today consumers who make their monthly credit card payments are sent blank checks in the mail, urging them to borrow sometimes tens of thousands of dollars. It used to be that the debt habit, rather like the smoking habit, started in college when students were offered their first free credit card; now grade school children are being enticed into the borrowing habit. The universal FICO score used to assess a consumer’s creditworthiness actually penalizes people who do not borrow at least some amount of money.

These days, a “deadbeat” is someone who pays all of their bills on time, never borrows, and therefore deprives the banking industry of interest income. To get even with these people, and to disguise the usurious interest rates being charged, banks have invented a host of “fees” that penalize consumers for the slightest failure to meet the tiny print rules associated with their credit card, auto, mortgage, or home equity loans. These rules no longer allow a three or four week period to pay your monthly bill; now the bill is due in two weeks or less. Often it is due on a Saturday or Sunday, causing a late payment fee of $30 or higher.

The large banks derive over half of their net income these days from fees, not from interest revenue. The business of generating fees – and it is a business – has gotten nearly diabolical. It used to be that your checking account would record your debits and credits in the order in which they were received, and checks drawn on other banks could take two or three days to be processed through the clearing house. Since most checking accounts now have debit or ATM cards attached, big banks have deliberately changed these rules. Now all of your debits are processed instantly, the largest going first. Your credits – even if you transfer money from an account within the same bank – are delayed at least a day.

The diabolical aspect of these changes is that the process almost assures a consumer will have a negative balance at some point. But rather than reject the next debit at the retail outlet or gas pump, the banks allow it to go through, creating a deliberate overdraft. Conveniently – for the banks – the checking account has had attached to it an overdraft borrowing account that was never asked for by the consumer, and cannot be opted out. It just shows up one day buried in the fine print updates that banks send out frequently and which are impossible to read or understand.

Millions of Americans have discovered that their debit card has gone overdrawn for $5, and a $35 overdraft fee has been applied. They are now $40 in the hole, and this amount starts compounding every day it is not rectified, with additional $35 charges. It is not uncommon for the card holder to rack up hundreds of dollars in fees and overdraft charges each year on an account that rarely has more than $100 processed each month. The inherent interest rate in these fees and charges is beyond usurious – it comes to 1,000% or more, and it has become a serious cash drain on poor people, worse than their payday loans.

It is not enough, therefore, to impose usury caps on interest rates – the whole definition of what constitutes usury needs to change to incorporate the dozens of fees and charges that plague checking and savings accounts. In other words, the reform has to come to the very way banks do business, because the fees and charges for overdrafts and NSF checks are a business. We should make no mistake about that. There are executives responsible for devising these processes, they have revenue targets to meet, and they have to do all this at the balancing point where the average consumer is irritated but not so annoyed that they will complain to Congress.

No More Loan Sales or Securitizations Either
So far, the reform efforts that Greider is describing only concentrate on simple fixes like a cap on interest rates, though community groups are well aware of the gouging and sub tabula usury rates that are being charged in the overdraft business. It is felt, though, that it will be hard enough to get Congress to look even at simple usury caps. The Democratic leadership in Congress has refused to let such bills come before the House or the Senate, though Vermont Senator Bernie Sanders did recently force a vote on a proposed usury cap at 15% that was defeated 60-33.

The Democrats who lined up to vote against this bill tend to sit on the finance committees in Congress, and derive considerable campaign donations from the banking industry. They are much more prone to listen to banking executives than they are to consumer advocates. Nor is there any pressure for change coming from the White House. The Obama administration seems every bit as beholden to and, you might say smitten by, the views of the bankers.

What the bankers are saying is that usury caps won’t work. Too many people with poor credit will be deprived of credit altogether if usury caps are imposed. This argument is correct. If the banks suddenly had to look at the true repaying capacity of the consumers receiving credit, they would cut off millions from the credit spigot. In fact, that is happening throughout this credit crisis, as credit cards are being withdrawn and home equity lines of credit canceled. The banks have discovered that putting consumers into a debt trap might have worked in the past, but in a recessionary environment it just hastens the day when the consumer collapses and defaults altogether.

This does not mean that the banks have given up on the debt trap business. They are merely recalibrating the pressure points of the trap itself, so that in bad times the consumer will still be able to service the debt even if their income declines. What the reform groups want is entirely different; they want banks to get out of this business completely. They want to return to the 1970s, to a time before the Reagan revolution that brought us into mindless worship of the markets as all-wise and all-powerful. They are even proposing that banks be denied the ability to sell a consumer loan or securitize it to investors. Once a bank makes a loan, it will be required to hold on to it until maturity, thereby taking full responsibility for any losses on its own books rather than passing such risks off to other banks or investors.

The reform groups see, correctly, that the sale or securitization of a loan destroys the need for credit checks and analysis, so that no one in the process really cares whether the consumer could pay back their debt. Most observers, even the banks, agree that the securitization process was flawed precisely for this reason, but the only proposal out there to fix this problem comes from the reform groups that want to outlaw loan sales and securitizations entirely. The banks have not come up with any other ideas because, for the moment, the securitization process is dead. Even though the federal government has stepped in to guarantee securitizations, the market has not revived, which tells us that there may be no way to solve the lack of credit analysis when a loan is securitized or sold.

As of now, the amount of credit flowing through the US economy is near the levels last seen in the early 1990s. In some markets and instruments, credit simply doesn’t exist, so we are back to the early 1980s before the Reagan boom began. If Congress did pass usury caps and outlawed loan sales and securitizations, it would ensure that the US would operate on a flow of credit that was much reduced from the peak years of 2005-2007, and that was more suitable for an economy twenty or more years ago. It is no wonder even the Democrats balk at such a decision.

The Social Cost of Eliminating the Debt Trap
There is another factor to consider here as well. Suppose a usury cap is put in place and millions of poor people are now denied payday loans or their equivalent through ATM debit cards. How will they feed their family or pay the rent? This is a very serious question that is now starting to affect middle class consumers as well. Too many people are completely dependent on credit for the basics of life, and the debt trap is the only avenue they have to maintain even a parlous existence.

It used to be such people had government programs like welfare and food stamps to rely on in tough times, along with unemployment insurance and union payments to laid off workers. The social safety net was virtually dismantled in the 1990s under Bill Clinton, and of course union membership is a small fraction of what it was in the 1970s. In eliminating the social safety net, the theory was that the market would take care of such problems. If people were responsible for their own well-being in times of stress, they would take greater care to save money. Unfortunately, it has proven almost impossible for most middle or lower class people to save money. What has been proven true, though, is that the market did deal with the problem, in a perverse way. The banking industry has become the country’s social safety net, by providing credit even to the poorest of the poor.

The policy conundrum we face, therefore, is how to dismantle the debt trap and the egregious practices of the banks, yet provide for the millions of Americans who use debt for survival. Proposals to bring back usury caps and eliminate loan sales and securitizations are well and good, but they will do more harm than expected if the social safety net isn’t restored first. There is little incentive for Congress or President Obama to pursue true banking industry reform, mostly because the banks own the Congress and were the biggest contributors to Obama’s campaign. And there is even less talk about restoring welfare, improving unemployment benefits, or expanding the food stamp program, beyond superficial changes.

In the meantime, the banking industry is holding on to its usurious lending practices. It has to because the amount of income derived from these practices is too large to forego. But these practices are already under stress, as banks have had to narrow the field of prospective customers in this recession. And now they are under attack from outside through the community reform efforts.

You therefore have two forces, one internal and one external, pushing the banking industry towards fundamental reform, ultimately leading to an abandonment of the debt trap business completely. This would be a very, very good thing for the American consumer, if only the government had some way to provide life’s essentials for the millions of Americans who depend on the debt trap for their survival.