The Smartest Guys in the Room.....are crooks

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Re: The Smartest Guys in the Room

Postby admin » Mon Feb 22, 2010 6:13 pm

from Huffington Post ... 71902.html

Wall Street saw this coming -- indeed, they sold trash assets and placed bets that they would crater. The crisis was not a mistake -- it was the foregone conclusion. The FBI warned of an epidemic of fraud back in 2004 -- with 80% of the fraud on the part of lenders. As Bill Black has been warning since the days of the Saving and Loan crisis, the most devastating kind of fraud is the "control fraud," perpetrated by the financial institution's management. Wall Street is, and was, run by control frauds. Not only were they busy defrauding the borrowers, like Greece, but they were simultaneously defrauding the owners of the firms they ran. Now add to that list the taxpayers that bailed out the firms. And Goldman is front and center when it comes to bad apples.

First sell toxic investment assets, then use credit default swaps to "bet" on the failure of those assets.......

From 2001 through November 2009 (note the date -- a full year after Lehman) Goldman created financial instruments to hide European government debt, for example through currency trades or by pushing debt into the future. But not only did Goldman and other financial firms help and encourage Greece to take on more debt, they also brokered credit default swaps on Greece's debt-making income on bets that Greece would default. No doubt they also took positions as the financial conditions deteriorated-betting on default and driving up CDS spreads.

But it gets even worse: An article by the German newspaper, Handelsblatt, ("Die Fieberkurve der griechischen Schuldenkrise", Feb. 20, 2010) strongly indicates that AIG, everybody's favorite poster boy for financial deviancy, may have been the party which sold the credit default swaps on Greece (English translation here).

Generally, speaking, these CDSs lead to credit downgrades by ratings agencies, which drive spreads higher. In other words, Wall Street, led here by Goldman and AIG, helped to create the debt, then helped to create the hysteria about possible defaults. As CDS prices rise and Greece's credit rating collapses, the interest rate it must pay on bonds rises-fueling a death spiral because it cannot cut spending or raise taxes sufficiently to reduce its deficit.
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Re: The Smartest Guys in the Room

Postby admin » Sun Feb 14, 2010 10:27 pm

Wall St. Helped to Mask Debt Fueling Europe’s Crisis
Published: February 13, 2010

Short summary:
As in the American subprime crisis and the implosion of the American International Group, financial derivatives played a role in the run-up of Greek debt. Instruments developed by Goldman Sachs, JPMorgan Chase and a wide range of other banks enabled politicians to mask additional borrowing in Greece, Italy and possibly elsewhere.

In dozens of deals across the Continent, banks provided cash upfront in return for government payments in the future, with those liabilities then left off the books. Greece, for example, traded away the rights to airport fees and lottery proceeds in years to come.

Critics say that such deals, because they are not recorded as loans, mislead investors and regulators about the depth of a country’s liabilities.

Some of the Greek deals were named after figures in Greek mythology. One of them, for instance, was called Aeolos, after the god of the winds.
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Re: The Smartest Guys in the Room

Postby admin » Wed Oct 21, 2009 8:45 am

Zooming In on the Year’s Biggest Hoax ... gest_hoax/

Posted on Oct 20, 2009

By Robert Scheer

Who are these people? I am not referring to the pathetic parents of “Balloon Boy,” whose fake drama I have been unable to escape while on the treadmill this week, thanks to my gym’s insistence on tuning its flat-screen TVs to Wolf Blitzer’s nonstop self-parody.

The Colorado incident was significant only in the tawdriness of those who perpetrated the made-for-TV scam and their allies in the mindless media who covered this sham “reality” so relentlessly. But even so it was enough to push aside most consideration of the true hoax reported last week with far less fervor: the obscene rewards that Wall Street bankers bestowed upon themselves for ripping off our economy.

The people I want to know more about are the superrich who expect to be rewarded for their failures, like the folks at Goldman Sachs who will receive $16.71 billion in bonuses—an average of $530,000 per employee—this year after their company did as much as any to bring the world economy to the brink of disaster.

“The Guys from Goldman Sachs” is what The New York Times once called them in recognition of their chokehold on the federal government. Their power is marked by the two treasury secretaries who led the fight to legally enable and then reward Wall Street for its obscene excesses. Why wasn’t there a CNN stakeout at the homes of former Goldman-execs-turned-treasury-chiefs Robert Rubin and Henry Paulson aimed at finding out how they feel about the almost $7 billion profit that Goldman Sachs made in the last two quarters in the wake of the government’s bailout of the firm?

They were both deeply involved last fall, along with Rubin protégé and current Treasury Secretary Timothy Geithner, then head of the New York Fed, in saving Goldman as archrival Lehman Brothers was forced to go belly up. As opposed to Lehman, Goldman was allowed to change its status and become a commercial bank qualifying for Federal Reserve and TARP funding. Goldman received $10 billion in immediate bailout funds, and we are supposed to be grateful that the company has paid it back in return for an end to any pretense of government control over its executive compensation. The additional cool $12.9 billion that Goldman received from the government as a pass-through from the bailout of AIG to cover Goldman’s toxic paper is money the investment bank has no intention of ever paying back.

The rationale for saving Goldman and the other too-big-to-fail usurers was that the rescue would increase lending to businesses and consumers and thus revive the economy. But Goldman made money last quarter by shunning such loans and instead putting the government-guaranteed low-interest money it now can borrow toward acquisitions and bond and stock trading. As The New York Times reported: “Titans like Goldman Sachs and JPMorgan Chase are making fortunes in hot areas like trading stocks and bonds, rather than the ho-hum business of lending people money.”

Under the headline “Bailout Helps Fuel a New Era of Wall Street Wealth,” Times reporter Graham Bowley detailed many of the enabling favors that the government, under two presidents, extended to Goldman, like clearing the way for the company to issue bonds guaranteed by the FDIC. “It may come as a surprise that one of the most powerful forces driving the resurgence on Wall Street,” the Times reported, “is not the banks but Washington. Many of the steps that policy makers took last year to stabilize the financial system—reducing interest rates to near zero, bolstering big banks with taxpayer money, guaranteeing billions of dollars of financial institution debts—helped set the stage for this new era of Wall Street wealth.”

It should not come as a surprise to Timothy Geithner, who, as The Wall Street Journal reported last week, talks to the honchos of Goldman more often than to members of Congress ostensibly in charge of banking legislation. Nor will it shock the lobbyists for Wall Street—augmented, as The Nation reported last week, by the pro-Goldman efforts of former Democratic congressman and faux populist Dick Gephardt—that the rich will emerge richer from this deep recession in which so many Americans have lost everything. The die is cast: People working in finance grabbed two-thirds of the growth in GDP over the last decade, with the rest of us scrambling for the other third.

Nor will the situation change anytime soon. The House Financial Services Committee is in charge of writing new rules to protect consumers, but as the respected Sunlight Foundation reports, 27 of the 71 members of that committee receive at least one-fourth of their campaign funds from the financial industry, with the rest of the committee members not far behind.

Now if we could get one of the banking lobbyists to float a duct-taped flying saucer balloon, Wolf Blitzer might cover the real hoax.

AP Photo/Gerald Herbert

“Balloon Boy” he ain’t: Treasury Secretary Timothy Geithner, shown here during a joint hearing of the House Financial Services and the Agriculture Committees on Capitol Hill in Washington on July 10, 2009, was a key player in the 2008-9 economic meltdown.

A Progressive Journal of News and Opinion. Editor, Robert Scheer. Publisher, Zuade Kaufman.
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Re: The Smartest Guys in the Room

Postby admin » Mon Apr 06, 2009 4:20 pm

Moyers Journal: Maddoff Was A Piker – America’s Big Banks Are a Far Larger Fraudulent Ponzi Scheme

By Bill Moyers,

Bill Moyers Journal

April 6, 2009.

One of America's top bank fraud experts explains the financial industry's "liar's loans" and wholesale greed that got us in this mess.

Bill Moyers: For months now, revelations of the wholesale greed and blatant transgressions of Wall Street have reminded us that "The Best Way to Rob a Bank Is to Own One." In fact, the man you're about to meet wrote a book with just that title. It was based on his experience as a tough regulator during one of the darkest chapters in our financial history: the savings and loan scandal in the late 1980s.
Bill Black was in New York for a conference at the John Jay College of Criminal Justice where scholars and journalists gathered to ask the question, "How do they get away with it?" Well, no one has asked that question more often than Bill Black. The former Director of the Institute for Fraud Prevention now teaches Economics and Law at the University of Missouri, Kansas City.

During the savings and loan crisis, it was Black who accused then-house speaker Jim Wright and five US Senators, including John Glenn and John McCain, of doing favors for the S&L's in exchange for contributions and other perks. The senators got off with a slap on the wrist, but so enraged was one of those bankers, Charles Keating -- after whom the senate's so-called "Keating Five" were named -- he sent a memo that read, in part, "get Black -- kill him dead." Metaphorically, of course. Of course.

Now Black is focused on an even greater scandal (than S & L), and he spares no one -- not even the President he worked hard to elect, Barack Obama. But his main targets are the Wall Street barons, heirs of an earlier generation whose scandalous rip-offs of wealth back in the 1930s earned them comparison to Al Capone and the mob, and the nickname "banksters."

Bill Black, welcome to the Journal.

William K. Black: Thank you.

Bill Moyers: I was taken with your candor at the conference here in New York to hear you say that this crisis we're going through, this economic and financial meltdown is driven by fraud. What's your definition of fraud?

Black: Fraud is deceit. And the essence of fraud is, "I create trust in you, and then I betray that trust, and get you to give me something of value." And as a result, there's no more effective acid against trust than fraud, especially fraud by elites; that's what we have.

Moyers: In your book, you make it clear that calculated dishonesty by people in charge is at the heart of most large corporate failures and scandals, including, of course, the S&L, but is that true? Is that what you're saying here, that it was in the boardrooms and the CEO offices where this fraud began?

Black: Absolutely.

Moyers: How did they do it? What do you mean?

Black: Well, the way that you do it is to make really bad loans, because they pay better. Then you grow extremely rapidly, in other words, you're a Ponzi-like scheme. And the third thing you do is we call it leverage. That just means borrowing a lot of money, and the combination creates a situation where you have guaranteed record profits in the early years. That makes you rich, through the bonuses that modern executive compensation has produced. It also makes it inevitable that there's going to be a disaster down the road.

Moyers: So you're suggesting, saying that CEOs of some of these banks and mortgage firms in order to increase their own personal income, deliberately set out to make bad loans?

Black: Yes.

Moyers: How do they get away with it? I mean, what about their own checks and balances in the company? What about their accounting divisions?

Black: All of those checks and balances report to the CEO, so if the CEO goes bad, all of the checks and balances are easily overcome. And the art form is not simply to defeat those internal controls, but to suborn them, to turn them into your greatest allies. And the bonus programs are exactly how you do that.

Moyers: If I wanted to go looking for the parties to this, with a good bird dog, where would you send me?

Black: Well, that's exactly what hasn't happened. We haven't looked, all right? The Bush Administration essentially got rid of regulation, so if nobody was looking, you were able to do this with impunity and that's exactly what happened. Where would you look? You'd look at the specialty lenders. The lenders that did almost all of their work in the sub-prime and what's called Alt-A, liars' loans.

Moyers: Yeah. Liars' loans--

Black: Liars' loans.

Moyers: Why did they call them liars' loans?

Black: Because they were liars' loans.

Moyers: And they knew it?

Black: They knew it. They knew that they were frauds.

[ Why did they seek immunity from fraud charges in Canada - civil and criminal
- in ABCP - worse, why did the Supreme Court approve it? ]

Black: Liars' loans mean that we don't check. You tell us what your income is. You tell us what your job is. You tell us what your assets are, and we agree to believe you. We won't check on any of those things. And by the way, you get a better deal if you inflate your income and your job history and your assets.

Moyers: You think they really said that to borrowers?

Black: We know that they said that to borrowers. In fact, they were also called, in the trade, ninja loans.

Moyers: Ninja?

Black: Yeah, because no income verification, no job verification, no asset verification.

Moyers: You're talking about significant American companies.

Black: Huge! One company produced as many losses as the entire Savings and Loan debacle.

Moyers: Which company?

Black: IndyMac specialized in making liars' loans. In 2006 alone, it sold $80 billion dollars of liars' loans to other companies. $80 billion.

Moyers: And was this happening exclusively in this sub-prime mortgage business?

Black: No, and that's a big part of the story as well. Even prime loans began to have non-verification. Even Ronald Reagan, you know, said, "Trust, but verify." They just gutted the verification process. We know that will produce enormous fraud, under economic theory, criminology theory, and two thousand years of life experience.

Moyers: Is it possible that these complex instruments were deliberately created so swindlers could exploit them?

Black: Oh, absolutely. This stuff, the exotic stuff that you're talking about was created out of things like liars' loans, that were known to be extraordinarily bad. And now it was getting triple-A ratings. Now a triple-A rating is supposed to mean there is zero credit risk. So you take something that not only has significant, it has crushing risk. That's why it's toxic. And you create this fiction that it has zero risk. That itself, of course, is a fraudulent exercise. And again, there was nobody looking, during the Bush years.

So finally, only a year ago, we started to have a Congressional investigation of some of these rating agencies, and it's scandalous what came out. [Yup IMMUNITY!!! - in Canada!] What we know now is that the rating agencies never looked at a single loan file. When they finally did look, after the markets had completely collapsed, they found, and I'm quoting Fitch, the smallest of the rating agencies, "the results were disconcerting, in that there was the appearance of fraud in nearly every file we examined."

Moyers: So if your assumption is correct, your evidence is sound, the bank, the lending company, created a fraud. And the ratings agency that is supposed to test the value of these assets knowingly entered into the fraud. Both parties are committing fraud by intention.

Black: Right, and the investment banker that -- we call it pooling -- puts together these bad mortgages, these liars' loans, and creates the toxic waste of these derivatives. All of them do that. And then they sell it to the world and the world just thinks because it has a triple-A rating it must actually be safe. Well, instead, there are 60 and 80 percent losses on these things, because of course they, in reality, are toxic waste.

Moyers: You're describing what Bernie Madoff did to a limited number of people. But you're saying it's systemic, a systemic Ponzi scheme.

Black: Oh, Bernie was a piker. He doesn't even get into the front ranks of a Ponzi scheme…

Moyers: But you're saying our system became a Ponzi scheme.

Black: Our system…

Moyers: Our financial system…

Black: Became a Ponzi scheme. Everybody was buying a pig in the poke. But they were buying a pig in the poke with a pretty pink ribbon, and the pink ribbon said, "Triple-A."

Moyers: Is there a law against liars' loans?

Black: Not directly, but there, of course, many laws against fraud, and liars' loans - fraudulent.

Moyers: Because…

Black: Because they're not going to be repaid and because they had false representations. They involve deceit, which is the essence of fraud.

Moyers: Why is it so hard to prosecute? Why hasn't anyone been brought to justice over this?

Black: Because they didn't even begin to investigate the major lenders until the market had actually collapsed, which is completely contrary to what we did successfully in the Savings and Loan crisis, right? Even while the institutions were reporting they were the most profitable savings and loan in America, we knew they were frauds. And we were moving to close them down. Here, the Justice Department, even though it very appropriately warned, in 2004, that there was an epidemic…

Moyers: Who did?

Black: The FBI publicly warned, in September 2004 that there was an epidemic of mortgage fraud, that if it was allowed to continue it would produce a crisis at least as large as the Savings and Loan debacle. And that they were going to make sure that they didn't let that happen. So what goes wrong? After 9/11, the attacks, the Justice Department transfers 500 white-collar specialists in the FBI to national terrorism. Well, we can all understand that. But then, the Bush administration refused to replace the missing 500 agents. So even today, again, as you say, this crisis is 1000 times worse, perhaps, certainly 100 times worse, than the Savings and Loan crisis. There are one-fifth as many FBI agents as worked the Savings and Loan crisis.

Moyers: You talk about the Bush administration. Of course, there's that famous photograph of some of the regulators in 2003, who come to a press conference with a chainsaw suggesting that they're going to slash, cut business loose from regulation, right?

Black: Well, they succeeded. And in that picture, by the way, the other -- three of the other guys with pruning shears are there…

Moyers: That's right.

Black: They're the trade representatives. They're the lobbyists for the bankers. And everybody's grinning. The government's working together with the industry to destroy regulation. Well, we now know what happens when you destroy regulation. You get the biggest financial calamity of anybody under the age of 80.

Moyers: But I can point you to statements by Larry Summers, who was then Bill Clinton's Secretary of the Treasury, or the other Clinton Secretary of the Treasury, Rubin. I can point you to suspects in both parties, right?

Black: There were two really big things, under the Clinton administration. One, they got rid of the law that came out of the real-world disasters of the Great Depression. We learned a lot of things in the Great Depression. And one is we had to separate what's called commercial banking from investment banking. That's the Glass-Steagall law. But we thought we were much smarter, supposedly. So we got rid of that law, and that was bipartisan. And the other thing is we passed a law, because there was a very good regulator, Brooksley Born, that everybody should know about and probably doesn't. She tried to do the right thing to regulate one of these exotic derivatives that you're talking about. We call them C.D.F.S. And Summers, Rubin, and Phil Gramm came together to say not only will we block this particular regulation. We will pass a law that says you can't regulate. And it's this type of derivative that is most involved in the AIG scandal. AIG all by itself, cost the same as the entire Savings and Loan debacle.

Moyers: What did AIG contribute? What did they do wrong?

Black: They made bad loans. Their type of loan was to sell a guarantee, right? And they charged a lot of fees up front. So, they booked a lot of income. Paid enormous bonuses. The bonuses we're thinking about now, they're much smaller than these bonuses that were also the product of accounting fraud. And they got very, very rich. But, of course, then they had guaranteed this toxic waste. These liars' loans. Well, we've just gone through why those toxic waste, those liars' loans, are going to have enormous losses. And so, you have to pay the guarantee on those enormous losses. And you go bankrupt. Except that you don't in the modern world, because you've come to the United States, and the taxpayers play the fool.

Under Secretary Geithner and under Secretary Paulson before him… we took $5 billion dollars, for example, in U.S. taxpayer money. And sent it to a huge Swiss Bank called UBS. At the same time that that bank was defrauding the taxpayers of America. And we were bringing a criminal case against them. We eventually get them to pay a $780 million fine, but wait, we gave them $5 billion. So, the taxpayers of America paid the fine of a Swiss Bank. And why are we bailing out somebody who that is defrauding us?

Moyers: And why…

Black: How mad is this?

Moyers: What is your explanation for why the bankers who created this mess are still calling the shots?

Black: Well, that, especially after what's just happened at G.M., that's… it's scandalous.

Moyers: Why are they firing the president of G.M. and not firing the head of all these banks that are involved?

Black: There are two reasons. One, they're much closer to the bankers. These are people from the banking industry. And they have a lot more sympathy. In fact, they're outright hostile to autoworkers, as you can see. They want to bash all of their contracts. But when they get to banking, they say, contracts, sacred.'

But the other element of your question is we don't want to change the bankers, because if we do, if we put honest people in, who didn't cause the problem, their first job would be to find the scope of the problem. And that would destroy the cover up.

Moyers: The cover up?

Black: Sure. The cover up.

Moyers: That's a serious charge.

Black: Of course.

Moyers: Who's covering up?

Black: Geithner is charging, is covering up. Just like Paulson did before him. Geithner is publicly saying that it's going to take $2 trillion -- a trillion is a thousand billion -- $2 trillion taxpayer dollars to deal with this problem. But they're allowing all the banks to report that they're not only solvent, but fully capitalized. Both statements can't be true.

It can't be that they need $2 trillion, because they have masses losses, and that they're fine. These are all people who have failed. Paulson failed, Geithner failed. They were all promoted because they failed, not because…

Moyers: What do you mean?

Black: Well, Geithner has, was one of our nation's top regulators, during the entire subprime scandal, that I just described. He took absolutely no effective action. He gave no warning. He did nothing in response to the FBI warning that there was an epidemic of fraud. All this pig in the poke stuff happened under him. So, in his phrase about legacy assets. Well he's a failed legacy regulator.

Moyers: But he denies that he was a regulator. Let me show you some of his testimony before Congress. Take a look at this. TIMOTHY GEITHNER:I've never been a regulator, for better or worse. And I think you're right to say that we have to be very skeptical that regulation can solve all of these problems. We have parts of our system that are overwhelmed by regulation. Overwhelmed by regulation! It wasn't the absence of regulation that was the problem, it was despite the presence of regulation you've got huge risks that build up.

Black: Well, he may be right that he never regulated, but his job was to regulate. That was his mission statement.

Moyers: As?

Black: As president of the Federal Reserve Bank of New York, which is responsible for regulating most of the largest bank holding companies in America. And he's completely wrong that we had too much regulation in some of these areas. I mean, he gives no details, obviously. But that's just plain wrong.

Moyers: How is this happening? I mean why is it happening?

Black: Until you get the facts, it's harder to blow all this up. And, of course, the entire strategy is to keep people from getting the facts.

Moyers: What facts?

Black: The facts about how bad the condition of the banks is. So, as long as I keep the old CEO who caused the problems, is he going to go vigorously around finding the problems? Finding the frauds?

Moyers: You--

Black: Taking away people's bonuses?

Moyers: To hear you say this is unusual because you supported Barack Obama, during the campaign. But you're seeming disillusioned now.

Black: Well, certainly in the financial sphere, I am. I think, first, the policies are substantively bad. Second, I think they completely lack integrity. Third, they violate the rule of law. This is being done just like Secretary Paulson did it. In violation of the law. We adopted a law after the Savings and Loan crisis, called the Prompt Corrective Action Law. And it requires them to close these institutions. And they're refusing to obey the law.

Moyers: In other words, they could have closed these banks without nationalizing them?

Black: Well, you do a receivership. No one -- Ronald Reagan did receiverships. Nobody called it nationalization.

Moyers: And that's a law?

Black: That's the law.

Moyers: So, Paulson could have done this? Geithner could do this?

Black: Not could. Was mandated--

Moyers: By the law.

Black: By the law.

Moyers: This law, you're talking about.

Black: Yes.

Moyers: What the reason they give for not doing it?

Black: They ignore it. And nobody calls them on it.

Moyers: Well, where's Congress? Where's the press? Where--

Black: Well, where's the Pecora investigation?

Moyers: The what?

Black: The Pecora investigation. The Great Depression, we said, "Hey, we have to learn the facts. What caused this disaster, so that we can take steps, like pass the Glass-Steagall law, that will prevent future disasters?" Where's our investigation? What would happen if after a plane crashes, we said, "Oh, we don't want to look in the past. We want to be forward looking. Many people might have been, you know, we don't want to pass blame. No. We have a nonpartisan, skilled inquiry. We spend lots of money on, get really bright people. And we find out, to the best of our ability, what caused every single major plane crash in America. And because of that, aviation has an extraordinarily good safety record. We ought to follow the same policies in the financial sphere. We have to find out what caused the disasters, or we will keep reliving them. And here, we've got a double tragedy. It isn't just that we are failing to learn from the mistakes of the past. We're failing to learn from the successes of the past.

Moyers: What do you mean?

Black: In the Savings and Loan debacle, we developed excellent ways for dealing with the frauds, and for dealing with the failed institutions. And for 15 years after the Savings and Loan crisis, didn't matter which party was in power, the U.S. Treasury Secretary would fly over to Tokyo and tell the Japanese, "You ought to do things the way we did in the Savings and Loan crisis, because it worked really well. Instead you're covering up the bank losses, because you know, you say you need confidence. And so, we have to lie to the people to create confidence. And it doesn't work. You will cause your recession to continue and continue." And the Japanese call it the lost decade. That was the result. So, now we get in trouble, and what do we do? We adopt the Japanese approach of lying about the assets. And you know what? It's working just as well as it did in Japan.

Moyers: Yeah. Are you saying that Timothy Geithner, the Secretary of the Treasury, and others in the administration, with the banks, are engaged in a cover up to keep us from knowing what went wrong?

Black: Absolutely.

Moyers: You are.

Black: Absolutely, because they are scared to death. All right? They're scared to death of a collapse. They're afraid that if they admit the truth, that many of the large banks are insolvent. They think Americans are a bunch of cowards, and that we'll run screaming to the exits.

And we won't rely on deposit insurance. And, by the way, you can rely on deposit insurance. And it's foolishness. All right? Now, it may be worse than that. You can impute more cynical motives. But I think they are sincerely just panicked about, "We just can't let the big banks fail." That's wrong.

Moyers: But what might happen, at this point, if in fact they keep from us the true health of the banks?

Black: Well, then the banks will, as they did in Japan, either stay enormously weak, or Treasury will be forced to increasingly absurd giveaways of taxpayer money. We've seen how horrific AIG -- and remember, they kept secrets from everyone.

Moyers: A.I.G. did?

Black: What we're doing with -- no, Treasury and both administrations. The Bush administration and now the Obama administration kept secret from us what was being done with AIG. AIG was being used secretly to bail out favored banks like UBS and like Goldman Sachs. Secretary Paulson's firm, that he had come from being CEO. It got the largest amount of money. $12.9 billion. And they didn't want us to know that.

And it was only Congressional pressure, and not Congressional pressure, by the way, on Geithner, but Congressional pressure on AIG. Where Congress said, "We will not give you a single penny more unless we know who received the money." And, you know, when he was Treasury Secretary, Paulson created a recommendation group to tell Treasury what they ought to do with AIG. And he put Goldman Sachs on it.

Moyers: Even though Goldman Sachs had a big vested stake.

Black: Massive stake. And even though he had just been CEO of Goldman Sachs before becoming Treasury Secretary. Now, in most stages in American history, that would be a scandal of such proportions that he wouldn't be allowed in civilized society.

Moyers: Yeah, like a conflict of interest, it seems.

Black: Massive conflict of interests.

Moyers: So, how did he get away with it?

Black: I don't know whether we've lost our capability of outrage. Or whether the cover up has been so successful that people just don't have the facts to react to it.

Moyers: Who's going to get the facts?

Black: We need some chairmen or chairwomen--

Moyers: In Congress.

Black: --in Congress, to hold the necessary hearings. And we can blast this out. But if you leave the failed CEOs in place, it isn't just that they're terrible business people, though they are. It isn't just that they lack integrity, though they do. Because they were engaged in these frauds. But they're not going to disclose the truth about the assets.

Moyers: And we have to know that, in order to know what?

Black: To know everything. To know who committed the frauds. Whose bonuses we should recover. How much the assets are worth. How much they should be sold for. Is the bank insolvent, such that we should resolve it in this way? It's the predicate, right? You need to know the facts to make intelligent decisions.

And they're deliberately leaving in place the people that caused the problem, because they don't want the facts. And this is not new. The Reagan Administration's central priority, at all times, during the Savings and Loan crisis, was covering up the losses.

Moyers: So, you're saying that people in power, political power, and financial power, act in concert when their own behinds are in the ringer, right?

Black: That's right. And it's particularly a crisis that brings this out, because then the class of the banker says, "You've got to keep the information away from the public or everything will collapse. If they understand how bad it is, they'll run for the exits."

Moyers: Yeah, and this week in New York, at this conference, you described this as more than a financial crisis. You called it a moral crisis.

Black: Yes.

Moyers: Why?

Black: Because it is a fundamental lack of integrity. But also because, if you look back at crises, an economist who is also a presidential appointee, as a regulator in the Savings and Loan industry, right here in New York, Larry White, wrote a book about the Savings and Loan crisis. And he said, you know, one of the most interesting questions is why so few people engaged in fraud? Because objectively, you could have gotten away with it.

But only about ten percent of the CEOs, engaged in fraud. So, 90 percent of them were restrained by ethics and integrity. So, far more than law or by F.B.I. agents, it's our integrity that often prevents the greatest abuses. And what we had in this crisis, is the most elite institutions in America engaging or facilitating fraud.

Moyers: This wound that you say has been inflicted on American life. The loss of worker's income. And security and pensions and future happened, because of the misconduct of a relatively few, very well-heeled people, in very well-decorated corporate suites, right?

Black: Right.

Moyers: It was relatively a handful of people.

Black: And their ideologies, which swept away regulation. So, in the example, regulation means that cheaters don't prosper. So, instead of being bad for capitalism, it's what saves capitalism. "Honest purveyors prosper" is what we want. And you need regulation and law enforcement to be able to do this. The tragedy of this crisis is it didn't need to happen at all.

Moyers: When you wake in the middle of the night, thinking about your work, what do you make of that? What do you tell yourself?

Black: There's a saying that we took great comfort in. It's actually by the Dutch, who were fighting this impossible war for independence against what was then the most powerful nation in the world, Spain. And their motto was, "It is not necessary to hope in order to persevere."

Now, going forward, get rid of the people that have caused the problems. That's a pretty straightforward thing, as well. Why would we keep CEOs and CFOs and other senior officers, that caused the problems? That's facially nuts. That's our current system. So stop that current system. We're hiding the losses, instead of trying to find out the real losses. Stop that, because you need good information to make good decisions, right? Follow what works instead of what's failed.

Start appointing people who have records of success, instead of records of failure. That would be another nice place to start. There are lots of things we can do. Even today, as late as it is. Even though they've had a terrible start to the administration. They could change, and they could change within weeks. And by the way, the folks who are the better regulators, they paid their taxes. So, you can get them through the vetting process a lot quicker.

Bill Moyers is president of the Schumann Center for Media and Democracy.
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Re: The Smartest Guys in the Room

Postby admin » Thu Feb 19, 2009 7:58 am

here is what I have learned about the smartest guys in the room:

They find themselves in a position as CEO or similar in a large organization. They learn that profits and instant results are what the board and or shareholders desire most. They discover that by promising amazing instant results, they can tie amazing pay packages (millions in extra pay, based on billions of extra profits promised) to these results.
They then cheat their way to amazing instant result in whatever way possible to obtain the millions in extra pay.

They then depart with the extra pay, while the company suffers, or fails entirely due to the now failed profits.

Enron, Nortel, Worldcom, too many stock option deals to list, CIBC, and major bank. As Liz Pulliam Weston of
MSN Money says in her good writing recently:
"In the system we have now, cheaters prosper.............................This isn't just bad for the consumer. It's bad for capitalism. Instead of the most efficient companies winning, the biggest liars are."

see below for further writing, article on CIBC compensation in Post:

CIBC gets flak over pension increase
Could Be Millions

Barbara Shecter, Financial Post

Thursday, February 19, 2009

In an era in which bank executives are handing back bonuses and directors are under pressure to show prudence in granting compensation, Canadian Imperial Bank of Commerce has angered some institutional investors by increasing chief executive Gerry McCaughey's pension payout by what could amount to several million dollars.

The change is contained in the bank's recently released proxy circular document in a series of notes that describe a bump-up in the maximum allowable compensation on which Mr. McCaughey's pension will be based to $2.3-million from $1.9-million.

"That's in the millions of dollars over many years [of retirement]," said Doug Pearce, CEO and chief investment officer of B. C. Investment Management Corp., which manages nearly $80-billion in assets, including bank stocks, on behalf of pensioners in British Columbia. "The boards have told us they want to pay for performance but that doesn't appear to be the case ... because that goes on for the rest of your life."

The proxy document says the change was made to bring Mr. McCaughey's allowable compensation for the pension calculation in line with the standards set by other Canadian banks and large insurance companies. Based on the formula, he could qualify for $1.6-million a year, up nearly $300,000.

Although CIBC continued its policy of withholding consideration of a bonus for the CEO so the board could have the benefit of another year's performance under its belt, and Mr. McCaughey gave up his cash bonus in 2007, Mr. Pearce said the B. C. pension group will be communicating with CIBC to express displeasure about the prospective top-up.

He also expressed displeasure that investors had to "dig so deep" to find the information in the notes of the proxy document.

Canadian banks have fared better than their counterparts in the United States and the United Kingdom in the fallout of the global credit crisis, and have not faltered or been nationalized. But investors have nonetheless been hammered by the impact of bad loans and writedowns and the companies deserve to come under fire for compensation practices that prompt excessive risk-taking, said Stephen Jarislowsky, founder of Montreal-based Jarislowsky Fraser, which manages $52-billion in assets.

CIBC's share price slumped 27% last year, despite a relatively good performance among its peers.

"It's outrageous," Mr. Jarislowsky said of the annual top-up to Mr. McGaughey's pension. "To do it at this moment in time, it shows a complete lack of judgment on the part of the board of directors."

The crisis in the financial sector has unfolded alongside eye-popping bonuses for bankers of troubled companies, prompting shareholders, politicians and regulators around the world to push for changes in incentives that are blamed for the risky behaviour that caused the meltdown.

This month, the chief executives of Royal Bank of Canada and Bank of Montreal handed back bonuses of $5-million and $4.1-million, respectively.

Still, despite such moves and the relatively good performance of Canadian banks, which won praise this week from Barack Obama, the U. S. President, Ottawa nonetheless seems poised to be involved with creating new international guidelines on pay for bankers before the next summit of the G20 nations.

The Canadian Coalition for Good Governance, which represents 43 pensions and other money managers that manage approximately $1.4-trillion of assets on behalf of Canadian investors, has made executive compensation a priority and will be closely scrutinizing the incentive portions of proxy documents.
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Postby admin » Fri Nov 07, 2008 10:39 am

Wall Street Fat Cats Are Trying to Pocket Billions in Bailout Cash

By Nomi Prins,


November 7, 2008.

They got us into this mess, and now they want to cash out -- will President Obama stop them?

The election results pretty much confirmed the extent to which Main Street is rightly livid about the Wall Street mentality that led to our financial crisis.

During his historic victory speech, President-elect Obama told supporters, and the rest of the world, "If this financial crisis taught us anything, it's that we cannot have a thriving Wall Street while Main Street suffers." [Never saw that in any of the clips]
But, it seems that Wall Street didn't get that memo. It turns out that the nine banks about to be getting a total equity capital injection of $125 billion, courtesy of Phase I of The Bailout Plan, had reserved $108 billion during the first nine months of 2008 in order to pay for compensation and bonuses (PDF).

Paying Wall Street bonuses was not supposed to be part of the plan. At least that's how Federal Reserve Chairman Ben Bernanke and Treasury Secretary Hank Paulson explained it to Congress and the American people. So, on Oct. 1, when the Senate, including Obama, approved the $700 billion bailout package, the illusion was that this would magically loosen the credit markets, and with taxpayer-funded relief, banks would first start lending to each other again, and then, to citizens and small businesses. And all would be well.

That didn't happen. Which is why it's particularly offensive that the no-strings-attached money is going to line the pockets of Wall Street execs. The country's top investment bank (which since Sept. 21 calls itself a bank holding company), Goldman Sachs, set aside $11.4 billion during the first nine months of this year -- slightly more than the firm's $10 billion U.S. government gift -- to cover bonus payments for its 443 senior partners, who are set to make about $5 million each, and other employees.

Whereas Wall Street may not believe in higher taxes for the richest citizens, it does believe in higher bonuses for the head honchos. No matter what the market conditions are on the outside, steadfast feelings of entitlement tend to prevail.

Last year, when the financial crisis was just brewing, the top five investment banks paid themselves $39 billion in compensation and bonuses, up 6 percent over 2006. Goldman's CEO, Lloyd C. Blankfein, bagged a record bonus of $60.7 million, including $26.8 million in cash. That amount was nearly double the $38 million that Paulson made at the firm in 2005, the year before he became the Treasury secretary, a post for which he received unanimous approval from the Senate on June 28, 2006.

Two of those firms, Bear Stearns and Lehman Brothers, went bankrupt this year. Bank of America is acquiring a third, Merrill Lynch. Shares in the remaining two, Morgan Stanley and Goldman Sachs, took a 60 percent nosedive this year.

Yet, that didn't stop their campaign contribution money from spewing out. Goldman was Obama's largest corporate campaign contributor, with $874,207. Also in his top 20 were three other recipients of bailout capital: JP Morgan/Chase, Citigroup and Morgan Stanley.

Last week, House Oversight Committee Chairman Henry Waxman, D-Calif., gave the bailout capital recipient firms until Nov 10 to come up with some darn good reasons to be paying themselves so much (PDF). Specifically, he requested detailed information on the total and average compensation per year from 2006 to 2008, the number of employees expected to be paid more than $500,000 in total compensation, and the total compensation projected for the top 10 executives.

Similarly, New York state Attorney General Andrew Cuomo demanded information about this year's bonuses, including a detailed accounting of expected payments to top management and the size of the firms' expected bonus pool before and after knowing that they would be recipients of taxpayer funds.

The deadline Cuomo set for receiving bonus records was Nov. 5. Predictably, the firms in question requested more time as the date approached -- it takes a while to massage numbers, after all.

Meanwhile, they have been subtly releasing data to the media regarding how much lower bonuses will be this year, in order to combat inspection and criticism. This is Wall Street in its best defense mode, projecting an aura of accommodation and self-pity (because it's shedding jobs, too), in order to maintain a status quo state of self-regulation.

House Financial Service Committee Chairman Barney Frank is holding his own oversight hearing on the matter next week, having announced that "any use of the these funds for any purpose other than lending -- for bonuses, for severance pay, for dividends, for acquisitions of other institutions, etc. -- is a violation of the terms" of the bailout plan.

Banks are going to tell Congress that of course they won't use that $125 billion for bonuses -- it will go to shoring up balance sheets and for acquisitions just like they promised. And bonus money will come from earnings, as it always does.

If it sounds like accounting mumbo-jumbo, that's because it is. It doesn't matter where in the balance sheet capital comes from or goes, the point is there's more of it because of taxpayer redistribution in the wrong direction than there would have been otherwise, and that's not just. This begs the larger question: Why pay bonuses in a year of massive financial destruction, anyway?

"Exactly," says Gar Alperovitz, co-author, with Lew Daly, of the new book Unjust Deserts. "We're making homeowners take a big hit, and if there's any justification for any of these bonuses -- which is dubious -- sharing that burden is important."

But that's not quite the sharing that Wall Street wanted from the bailout package. Yet, if "change has come to America," as per Obama's promise, then it's high time for Wall Street to shoulder its part -- starting with this bonus season. A decisive move by Obama on this topic would go a long way toward solidifying the central promise of his campaign
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Postby admin » Thu Jul 31, 2008 9:55 pm

The New York Times

Scenes From a Merrill Meltdown
July 31, 2008, 4:47 pm

From Michael M. Grynbaum, a DealBook colleague:

When the history of the Great Market Crash of 2008 is written, perhaps the following will make for a fitting epigraph:

“Market is collapsing. No more $2k dinners at CRU!! The Financials are being invicerated! [sic]”

That cri-de-coeur, penned by a Merrill Lynch executive in an e-mail message last November, showed up in an 80-page lawsuit (PDF) filed on Thursday by the state of Massachusetts, which is suing Merrill for misleading investors about toxic auction-rate securities. (Cru is the West Village hot spot whose $78 prix-fixe includes braised Berkshire pork belly and foie gras terrine.)

It was the latest entry in a peculiar genre of poem: the Wall Street confessional. The missives, which first gained notoriety in the Eliot Spitzer era, are making a comeback as a new wave of financial fraud cases pop up in the courts.

Add a few Merrill messages to the canon. Referring to the firm’s auction trading desk, a managing director wrote, “Come on down and visit us in the vomitorium!!” (This came as clients were allegedly advised to snap up the suspect securities.)

Later, after an unfriendly questioner emerged on a sales call, the managing director urged a research analyst: “Shut this guy down. Suggest he call outside this call. He is focusing attention away from your positive message.”

Finally, the same banker used an incriminating metaphor to motivate her sales team.

“The gloves are off and we are not concerned with issuer perception of our abilities and the competition,” she wrote. “Gotta move these microwave ovens!!”

Go to Massachusetts Secretary of the Commonwealth’s Complaint and Exhibits »
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Postby admin » Wed Jul 30, 2008 7:44 am

I think it was Einstein who said that you needed three things if you were looking for a business partner:

1. smarts
2. hard working
3. honesty

if you have any two without the third you are in trouble. This forum looks at the growing number of people who are smart and hard working, but who too often tend to "take the money from the company and run".

Billion-dollar bankruptcies highest since 2003
Tue Jul 29, 2008 6:21pm

NEW YORK (Reuters) - Billion-dollar bankruptcies are at their highest in five years only half way through 2008, according to bankruptcy filing tracker

A total of seven U.S. companies with more than a billion dollars in assets have filed for bankruptcy protection so far this year, it said.

Fremont General Corp, which was one of the largest U.S. providers of subprime mortgages before regulators ordered it to stop making the loans, was the largest filing of the year with $13 billion in pre-petition assets, said. Fremont filed for Chapter 11 bankruptcy protection in May, after arranging to sell bank branches and deposits to CapitalSource Inc.

SemGroup LP, the energy trader which filed for bankruptcy protection from creditors last week, was the second-largest bankruptcy filing of the year with $6 billion in pre-petition assets.

"We seem to be in the midst of a 'perfect storm' leading to more bankruptcies: high levels of debt, high energy and raw materials costs and weakness in the U.S. economy," George Putnam, III of New Generation Research, which publishes said in a statement.

He forecast bankruptcies could peak as early as the middle of 2009 or continue rising well into 2010.

The recent spike in billion-dollar bankruptcies, comes only about half way through 2008 and is well above the previous levels. In 2007 only one company listed more than $1 billion in pre-petition assets, New Century Financial Corp. In 2006, auto parts maker Dana Corp had the largest filing, listing $9 billion in pre-petition assets.

The last year in the previous bankruptcy wave was 2003, when there were 15 billion-dollar bankruptcies filed. The number of billion-dollar bankruptcies peaked in 2001 when there were 25, according to

But the bankruptcies are not yet as large as the filings in the last wave of corporate bankruptcies. The Enron Corp and Conseco Inc bankruptcy filings in 2001 and 2002 each topped $60 billion. WorldCom still holds the record with its $103.9 billion bankruptcy filing in 2002, according to

(Editing by Andre Grenon)
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Postby admin » Tue Jul 29, 2008 8:18 am


July 29, 2008
Write-Down Is Planned at Merrill
Only 10 days after stunning Wall Street with a huge quarterly loss, Merrill Lynch unexpectedly disclosed another multibillion-dollar write-down on Monday and sought to bolster its finances once again by selling new stock to the public and to an investment company controlled by Singapore.

Moving to purge itself of the tricky mortgage-linked investments that have brought the once-proud firm to its knees, Merrill said that it had sold almost all of the troublesome investments, once valued at nearly $31 billion, at a fire-sale price of 22 cents on the dollar.

As a result, Merrill expects to record a write-down of $5.7 billion for the third quarter. Such an outcome could push Merrill into the red for a fifth consecutive quarter if revenue remains weak and would bring its charges since the credit crisis erupted last summer to more than $45 billion.

The problems at Merrill, the nation’s largest brokerage, underscore how bankers and policy makers are struggling to contain the damage to the financial system and the broader economy caused by the collapse of housing-related debt. The latest news came on a day when the International Monetary Fund said there was no end in sight to the housing slump, a forecast that depressed financial shares as well as the broader market.

To shore up its finances, Merrill said it would raise $8.5 billion in new capital from common shareholders, including $3.4 billion from the investment arm of the Singapore government, Temasek Holdings, which, with an 8.85 percent stake as of June 30, is already Merrill’s largest shareholder. Those shares and a conversion of preferred securities into common stock will dilute the value of stock held by current shareholders by about 40 percent.

John A. Thain, who has struggled to turn Merrill around since becoming chief executive in December, said the sale of the worrisome investments, known as collateralized debt obligations, or C.D.O.’s, was “a significant milestone in our risk reduction efforts.”

The C.D.O.’s have plunged in value over the last year, forcing Merrill to take one write-down after another and sapping investors’ confidence. Merrill’s share price fell 11.6 percent on Monday, before the news of the write-down and stock sale were announced after the close of trading. Merrill is trading near its lowest level in a decade.

But the sale of the C.D.O.’s, to an investment fund based in Dallas, may enable Merrill to move on, investors said.

“What they sold, from a headline standpoint, is certainly constructive because they have reduced risk in a very sensitive area,” said Thomas C. Priore, chief executive of Institutional Credit Partners, a $12 billion hedge fund and C.D.O. manager in New York.

Merrill had been working on the C.D.O. sale and the effort to raise capital before its earnings call but did not finalize the actions until recent days.

Merrill’s sales could cause further write-downs at other Wall Street firms with C.D.O. exposure. If those companies — the likes of Citigroup and Lehman Brothers — have similar C.D.O.’s valued at prices higher than those at which Merrill sold, the firms may be forced to take additional charges to reflect the difference.

Merrill recently moved to raise money by selling its 20 percent stake in Bloomberg L.P., the financial news and data company, for $4.425 billion. Mr. Thain hinted at the C.D.O. sale in the quarterly earnings call, in response to a question from Meredith Whitney, an analyst with Oppenheimer & Company.

“Why not, at this point, be the first to purge assets and get it over with? And, if that means raising capital, raise capital,” Ms. Whitney said.

Mr. Thain responded that Merrill had been selling assets but had not yet sold any C.D.O.’s.

“Your question is a very leading one, and that would certainly be something that we would hope that we could do,” Mr. Thain said.

Merrill sold the investments at a steep loss. The United States super senior asset backed-security C.D.O.’s that Merrill sold were once valued at $30.6 billion. As of the end of second-quarter, Merrill valued them at $11.1 billion — or 36 cents on the dollar. And Merrill sold them for $6.7 billion to an affiliate of Lone Star Funds, the Dallas private equity firm.

Merrill provided 75 percent financing to Lone Star Funds, which means Merrill lent the private equity fund about $5 billion to complete the sale.

The discounted sales will cause the majority of Merrill’s write-down in the third quarter.

Merrill also said it had settled a battle with the reinsurance company XL Capital Assurance, which had insured some of the firm’s C.D.O.’s.
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Postby admin » Sun Jul 27, 2008 9:48 pm

Money can't fix Fannie and Freddie

Globe and Mail

July 26, 2008 at 6:00 AM EDT

Zimbabwe, wracked by hyperinflation, introduced a 100-billion Zimbabwean dollar bank note a week ago. As one of the most worthless bits of paper on the planet, the bill can't buy much – just one or two loaves of bread. But there's always a chance, if you stacked a few of them together, that you could pay for a grungy bungalow in Stockton, Calif., where one in every 25 households got a foreclosure notice between April and June, or in Flint, Mich., where homes once worth six figures receive no bids at all.

As with currency in Zimbabwe, everything about the U.S. housing crisis is marked by large numbers. That's especially true when the topic is Fannie Mae and Freddie Mac, those monuments to American capitalism, or is it socialism? Hard to tell these days.

The twins of U.S. home finance own or guarantee $5.2-trillion (U.S.) in mortgages, slightly less than the gross domestic product of China, India and Russia combined. There's about $1.5-trillion of outstanding debt on the balance sheets of the two companies, as of the end of March, which is a bit more than the economic output of Canada, Spain or Brazil. The notional value of the derivative contracts they've got is about $2.5-trillion – France's GDP – according to Montreal's BCA Research. Too big to fail? Definitely.

As for how much dough they might need to survive as private enterprises – and I use that phrase loosely – that, too, is enormous. Citigroup, UBS and other big banks have been raising money in $5-billion and $10-billion chunks. But in the most pessimistic scenarios, where the housing virus lingers into 2010, Fannie and Freddie could be forced to find $52-billion in new capital by the end of next year, BCA says. They probably couldn't do it. Nationalization would be inevitable.

Numbers, numbers everywhere, but how did it come to this? Maybe the best way to explain it is to begin with another number: $115-million. That's the amount in bonuses that U.S. regulators once tried to retrieve from three former senior Fannie executives, including former CEO Franklin Raines.

Oh, how the Fannie Mae folks had gorged themselves during the glory days. In 2003, Mr. Raines, in addition to his $5.2-million in salary and bonus, got the company to foot the bill for $200,000 in personal travel, $37,000 for personal tax and financial advice, $11.6-million in “incentive plan” payouts, life insurance, pension, stock options – you could run out of breath listing it all. Daniel Mudd, his chief operating officer, got a slightly less lucrative package, still totalling some $7-million, including $80,000 to buy him club memberships.

But hey, weren't these guys worth it? Hadn't they engineered a remarkable growth story? No longer just guaranteeing or packaging mortgages – how boring – Messrs. Raines and Mudd had plunged headlong into investing in them, and without the capital constraints of a normal commercial bank, Fannie nearly doubled its profits between 2000 and 2003.

That turned out to be a sham, and by the end of 2004, Mr. Raines was forced into early retirement in a $10-billion accounting scandal. An investigation was hatched and a U.S. government agency found that Mr. Raines had earned more than $90-million in total compensation from '98 through 2003, and the majority of it, $52-million, was paid for achieving profit targets – with phony profits.

But here's the punchline: When regulators tried to recover the money, Mr. Raines dug in. He and the two other former executives settled the case a few months ago, paying $3-million in fines (which was covered by a company insurance policy). Mr. Raines also donated $1.8-million from the sale of Fannie stock to programs aimed at boosting home ownership and averting foreclosures, and forfeited some stock options that were far out-of-the-money anyway.

And Daniel Mudd? He's now Fannie Mae's CEO.

The message to senior bankers could hardly be clearer. Their's is a sweet one-way deal. When aggressive lending and preposterous accounting bring terrific profits, they can earn enough to live like kings. And when those same lending and accounting practices blow up, others will take the hit and the execs can still live like kings. Hell, they might even get promoted.

If you fix this moral hazard, you can start to fix the U.S. financial system. But even then, it should never again be allowed to spawn two companies like Fannie and Freddie. They grew powerful by wrapping themselves in the flag. Their mission was to promote the American dream of home ownership. And will you look at what a success that was? At the start of 2001, when the U.S. Federal Reserve began a cheap-money policy that sowed the seeds of the housing bubble, the home ownership rate was 67.5 per cent. Today, it's 67.8 per cent and falling as foreclosures grip the country. Meanwhile, U.S. taxpayers and investors suck up billions in losses. What a waste.
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Postby admin » Sun Jul 27, 2008 8:59 pm

How High Leverage Has Brought Down the Whole Banking Industry

-- Posted Tuesday, 22 July 2008

On Tuesday, as the S&P 500 briefly touched 1,200, the banking sector represented by KBW Bank Index [$BKX] (or other similar indices) went down to 47 (which had been range bound and traded around 75-90 early this year), and VIX reached 30, it seemed that the stock market was under capitulation similar to the March plummet. The dropping of $BKX was so severe that it broke my technical target of 55 by 8 points.

Now we may see a bear market rally lasting for a few months, similar to post-March capitulation. I still feel Jeremy Grantham's target of 1,100 will be reached sooner than 2010, probably later this year or early next year. I also doubt that funds which have withdrawn money from the market this year, especially in last several weeks, will re-enter the market anytime soon. The worst case scenario is that they may never re-enter the market at all, if these are funds for the baby boomers.

There is an interesting book "Bringing Down the House", which was turned into a movie called "21". It is about a group of MIT students who were trained as card counters to play blackjack at casinos. They acted as a group, and played small when the odds were not clear or not in their favor. But after receiving a signal from his group member, one of them acting as a super-rich guy entered into the table and played huge stakes when the odds were in their favor. This is a typical example of using leverage against casinos.

It turns out to be that this highly leveraged technique is also used by banks, especially investment banks. No one is trying to bring them down as in the case of "Bringing Down the House". All the current troubles for this industry are of their own making. They are the ones who choose to gamble with their own capital, unlike the casinos. They can't blame anyone else but themselves. However, now with the help of their friends in the government, they are arguing that they need unlimited funding protection and bailout from the government, or more accurately, U.S. taxpayers.

To understand leverage, just look at one of the WSJ articles from last Wednesday (7/16). Lehman's (LEH) market cap of $9B is only 40% of their book value of $23B, and it sounds very cheap. But then look at their assets: They have $160B hard-to-value Level 2 assets and $41B impossible-to-value Level 3 assets. The WSJ article applies a 5% haircut on Level 2 and 25% on Level 3 to come up with $19B future write-offs. However, based on analysis from many other public sources, most of the Level 3 assets are MBS CDOs, even if they are AAA rated, the recovery rate is only about 50%. And anything under AAA rating is pretty much wiped out. For Level 2 assets, it would be very lucky if only 10% haircut is true. The combination of both more realistic haircuts will result in $36B additional losses, which would more than wipe out their book value of $23B plus their market cap of $9B. This is leverage in the working, unfortunately at the downside.

Let us also look at Fannie Mae (FNM) and see what the level of leverage they are using. FNM has long-term liabilities of about $580B, according to Yahoo Finance. It has a negative duration mismatch of 14 months between its assets and its liabilities. Due to this mis-match, a 1% drop in interest rate will cause roughly 14/12 or 1.17% loss in value, or $7B (1.17% x $580B). And their market cap is only $10B. We are only talking about pure interest rate risk, not even losses from credit risk due to lending practice, delinquency, foreclosure, etc., which will be much larger than the interest rate risk.

People have drawn parallels between the current failure of IndyMac and the failure of Continental Illinois Bank in 1984, with the expectation that IndyMac will cost FDIC about $4B to $8B, while FDIC has only $52B in its insurance funds. But this comparison has missed the whole S&L crisis, in which losses were much larger than one commercial bank, and FDIC was actually not quite involved. For S&L crisis, the Federal Savings & Loan Insurance Corporation (FSLIC) was the main show, and it had $5.6B in 1984 to pay claims; by 1989 its balance had turned into an $87B deficit. The total number of failed S&L institutions is estimated to be around 1,000, and GAO (US General Accounting Office) has estimated the total losses for S&L to be at $166B for taxpayers.

Today people are trying to estimate how many banks will fail this time. The number probably won't get to the 1,000 mark as in the S&L’s case, and the figure of a few hundred banks has often been mentioned. At the end of this crisis, FDIC will be most likely in the red, similar to FSLIC.

A week ago, Bridgewater Associates issued a report saying that the banking system losses will likely hit $1.6 trillion, but didn't give any breakdowns. This is more than the $1 trillion estimate in my previous article “Will CDS Replace Subprime To Cause $1 Trillion Total Loss For This Credit Crisis?” in January this year. I actually tried to give a breakdown at that time as follows: $500B for OTC (over the counter) credit default swaps (CDS), $250B for subprime, and $250B for everything else such as commercial real estate, leveraged loans, credit card losses, auto loans, etc. Due to the further deterioration of the real estate market and continued losses, I think I underestimated the subprime by about $150B, also I should have included some losses from the next tiers of Alt-A and prime mortgages since the losses have already cut into them, especially Alt-A products. In addition, CDS has become a larger, deeper and wilder threat to the whole banking system day by day, maybe $1 trillion is a better estimate now. Overall, $2 trillion losses for this credit crisis are really not stretching at all.

So far this year, some financial institutions have touched the single-digit territory, such as Fannie Mae, Freddie Mac (FRE), Wachovia (WB) and Bear Stearns. After the current bear market rally for the banking sector, who will be the next round of candidates to join the single-digit club? Investment banks are still the usual suspects, such as Lehman (LEH), UBS (UBS), and possibly even Merrill Lynch (MER) and Citigroup (C) too.

In order to avoid the domino effect of the current credit crisis rippling through the whole banking industry, the Fed is currently holding the bag by bailing out everyone in trouble. And so far we are only talking about residential mortgages and their CDO derivatives. If the next wave of the credit default swap crisis hits, it will be much more complicated than LTCM, much worse than S&L, and much deeper than subprime. With raising capital becoming more difficult these days, banks have to rely more and more on the Fed with balance sheet of only $800B to deal with a $2 trillion problem.

Can the Fed handle the worst monetary crisis in 60 years? Should taxpayers save and bail out the financial institutions in trouble? Did we ask them to use high leverage initially? Have they ever shared the profit with the public at the time when they were making tons of money by using leverage? Why should the whole society have to pay for the bad decision of a few banks at the downside, but never be allowed to participate at the upside?

Thomas Tan, CFA, MBA

Those interested in discovering more about me, my trading strategy and reading many of my other blogs can visit web site at
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Postby admin » Tue May 13, 2008 9:58 pm

doom and gloom or realistic thinking? Time will tell. I personally like his reasoning, but then again, my mind may be permanently bent from a few to many years inside a bank...........cheers, advocate

The Great Depression of the 2010s

By Darryl Robert Schoon
May 5 2008 12:22PM

Economics is not rocket science. Neither is power.

Depressions are monetary phenomena caused by central bank issuance of excessive credit. In 1913, the newly created US central bank, the Federal Reserve, began issuing credit-based money in the US. Within ten years, the central bank flow of credit ignited the 1920s US stock market bubble; and shortly thereafter, following the collapse of the bubble in 1929, the world entered its first Great Depression in 1933.

Investment banks are the undoing of central banking. While all banks, central, commercial and investment, view credit as the opportunity to exploit society’s growth and productivity, investment bank exploitation of growth and productivity exposes society to extreme risks - for investment banks use society’s savings to make their volatile and speculative bets.

The speculative risks undertaken by investment banks is done by leveraging the savings of society; and, when investment bank bets are sufficiently large enough and the bets go bad - as they inevitably do as the luck of investment bankers is due more to their proximity to credit than to their ability to foresee the future - it is society that will bear the brunt of the pain in the loss of its savings.

Inevitably, investment bankers cannot resist the temptations of excessive credit and, like the buyers of teaser-rate home mortgages, they will always overreach themselves - an overreaching that will have disastrous consequences for the society whose savings they bet.

The leveraged overreaching by investment banks in the 1920s caused the Great Depression of the 1930s and their more recent overreaching in this decade, the 2000s, is about to cause another Great Depression in the next, the 2010s.

It is the proximity of investment banks to the pools of savings that allows investment banks to profit. By their access to society’s savings, investment banks use society’s wealth as the foundation of their highly leveraged bets in financial markets; and in so doing, they have now placed all of us in harms way.


The collapse of financial markets in the first Great Depression led to the US Congress to enact laws that would hopefully insure that such a collapse would never again happen. To that end, in 1933 the Glass-Steagall Act was passed by Congress and signed into law.

Acknowledging the role that investment banks had played in the Great Depression, the passage of the Glass-Steagall Act in 1933 separated investment banking and commercial banking to insure that investment bank speculation would not again destabilize commercial banks as it did during the Great Depression leading to the loss of America’s savings.

What bankers hath joined together let no man put asunder

However, in 1999, the US Congress repealed the Glass-Steagall Act and America was once again vulnerable to the highly leveraged shenanigans of Wall Street. This time, however, it was not only the US but the entire world whose futures were to be bet and lost by Wall Street gamblers.

The globalization of financial markets had spread the dangers of US investment banking to banks, insurance companies, and pension funds around the world. Now, the savings of Europe and Asia as well as the US were to be impacted by the wagers of Wall Street who in the 2000s literally bet the house on the possibility that subprime CDOs were actually worth their AAA ratings.

Glass-Steagall, the law enacted in 1933 to prevent another Great Depression was repealed at the behest of bankers. While it is true that at certain times the US government will act in the best interest of society, usually (and usually in the guise of so doing) the US government is the pawn of the special interests that benefit from the trough of government largesse and regulation. The repealing of the Glass-Steagall Act in 1999 was therefore a reversion to the mean.

We are today in the initial stages of another collapse that will lead to another Great Depression. The safeguards put in place to prevent such from happening were not only disassembled in 1999; but, now in 2008, the US government has moved even closer to exposing its citizenry and indeed the world to the speculative carnage and folly of investment banking excess.


As credit markets seized up, the Fed gave the 20 primary dealers in U.S. government bonds the same access to discount- window loans that had previously been reserved for banks. The central bank now auctions as much as $100 billion to lenders a month, and has cut the cost on direct loans to just a quarter- point above the overnight rate on loans between banks.

The US Federal Reserve is now underwriting, i.e. subsidizing, the commercial activities of global private investment banks. The 20 primary dealers in US government bonds include the world’s largest investment banks - BNP Paribas Securities Corp. (French), Barclays Capital Inc (British), Banc of America Securities LLC (USA), UBS Securities LLC (Swiss), Dresdner Kleinwort Wasserstein Securities LLC (German), Daiwa Securities US Inc. (Japan) etc.

In truth, these investment banks are global entities and have no actual nationality no matter what jurisdiction in which they are legally domiciled. As such, they also have no allegiance except to their own self-interests.


Why is the US government allocating public resources for the benefit of private international investment banks?


US resources are subsidizing international investment banks through the Federal Reserve Bank, a quasi private entity which was given governmental powers in 1913 (some allege in violation of the US Constitution). That a quasi private bank is bailing out private banks with public monies does make sense. What doesn’t make sense is why the public allows it.

There is much discussion as to the justification and reasons for US, UK, European, and Japanese central banks bailing out private banks with public money. Issues such as moral hazard are now being raised in questioning the right and consequence of so doing.

In truth, such issues are irrelevant. Not that they are in themselves not important, but issues such as moral hazard will have no effect whatsoever on what is going to happen.

Intent is the underlying motive that explains what is about to occur. The intent of private bankers is not public stability, nor growth, nor productivity - it is the pursuit of private profit via the use of public credit and debt.

Today, most governments, especially the US and UK, are controlled by private bankers - which is why government policy continues and will continue to favor the interests of private bankers over the public good.


I am sure that in some quarters of the Catholic Church objections were raised (perhaps even on theological grounds) about the torture used by the Church during the Spanish Inquisition; just as today, there have been objections raised by some in the US in regards to the use of torture in its "war on terror".

Objections are always tolerated by those in power as long as the objections do not rise to the level of action. The objection to central bank credit and influence in our monetary affairs is therefore rhetorical. The influence of private bankers and central banking in our monetary affairs will not change until their influence has run its course - which is now about to happen.

The present epoch of central banking will perhaps be known as the period when bankers roamed the earth. Just as during the Jurassic Age, when dinosaurs roamed freely eating whatever and whomever they encountered, bankers did much the same in the present epoch that is now about to end - profiting by the productivity of society and the public and private debts incurred as a result of bankers’ induced credit-based spending.

Bankers achieved their immense power during this era by exploiting flaws in human nature and systemic flaws in the economic system they constructed for their own benefit. But as with all flaws, human or economic, the consequences of so doing are exposed over time. That time has now arrived.

Money is not credit, nor is money created de jure by circulating paper coupons imprinted with a government stamp stating the coupons are now legal tender to be used in the settlement of debts.

The idea that central bank coupons/paper money, sic debt, can be used to settle another debt is astounding. That we have been led to accept it is so is even more astounding. Throughout history, every experiment with paper "money" as a settlement of debt has failed. Our experiment with paper money towards that end will be no different.

The recent correction in the price of gold and silver is just that, a correction in an otherwise direct repudiation of the on-going attempt by governments and bankers to substitute paper coupons for real money.

A paper yen, a paper euro, a paper dollar, when no longer backed and convertible to gold or silver is but a paper coupon masquerading as money - a coupon with an expiration date in invisible ink.

In truth, the bankers’ real gambit is not their bet that paper money can be substituted for gold and silver or that subprime mortgages can be passed off as AAA securities. Their real gambit is that central bank issuance of debt as money and their control of governments will never be discovered by the public.


The world of credit and debt and all it has created has been made possible by bankers and their debt based system of money and central banking. Its cost, however, will be born by future generations who were not present when the debts were incurred.

Those who utter in pious simplicity those wonderful words, "our children are our future", have no idea what they have done to those very children and their future by spending today what future generations will have to earn tomorrow.

Here, in the US, an entire generation has grown up on the suspect promises of easy credit and paper money. That generation is now beginning to suspect that something is wrong, that the price of their gas, food and healthcare is rapidly rising and their dream of home ownership is a trap from which bankruptcy is increasingly their only escape.

Still, this generation has no idea of how terribly wrong it actually is and why it has happened; and their ignorance of such will give them little comfort during the Great Depression that lies directly ahead.

The chickens are coming home to roost; and they closer they come, the more they are looking like vultures.
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How they become "bought"

Postby admin » Sat Apr 26, 2008 11:34 pm

The New York Times

April 27, 2008
Triple-A Failure

Illustrations by Christoph Niemann
The Ratings Game

In 1996, Thomas Friedman, the New York Times columnist, remarked on “The NewsHour With Jim Lehrer” that there were two superpowers in the world — the United States and Moody’s bond-rating service — and it was sometimes unclear which was more powerful. Moody’s was then a private company that rated corporate bonds, but it was, already, spreading its wings into the exotic business of rating securities backed by pools of residential mortgages.

Obscure and dry-seeming as it was, this business offered a certain magic. The magic consisted of turning risky mortgages into investments that would be suitable for investors who would know nothing about the underlying loans. To get why this is impressive, you have to think about all that determines whether a mortgage is safe. Who owns the property? What is his or her income? Bundle hundreds of mortgages into a single security and the questions multiply; no investor could begin to answer them. But suppose the security had a rating. If it were rated triple-A by a firm like Moody’s, then the investor could forget about the underlying mortgages. He wouldn’t need to know what properties were in the pool, only that the pool was triple-A — it was just as safe, in theory, as other triple-A securities.

Over the last decade, Moody’s and its two principal competitors, Standard & Poor’s and Fitch, played this game to perfection — putting what amounted to gold seals on mortgage securities that investors swept up with increasing élan. For the rating agencies, this business was extremely lucrative. Their profits surged, Moody’s in particular: it went public, saw its stock increase sixfold and its earnings grow by 900 percent.

By providing the mortgage industry with an entree to Wall Street, the agencies also transformed what had been among the sleepiest corners of finance. No longer did mortgage banks have to wait 10 or 20 or 30 years to get their money back from homeowners. Now they sold their loans into securitized pools and — their capital thus replenished — wrote new loans at a much quicker pace.

Mortgage volume surged; in 2006, it topped $2.5 trillion. Also, many more mortgages were issued to risky subprime borrowers. Almost all of those subprime loans ended up in securitized pools; indeed, the reason banks were willing to issue so many risky loans is that they could fob them off on Wall Street.

But who was evaluating these securities? Who was passing judgment on the quality of the mortgages, on the equity behind them and on myriad other investment considerations? Certainly not the investors. They relied on a credit rating.

Thus the agencies became the de facto watchdog over the mortgage industry. In a practical sense, it was Moody’s and Standard & Poor’s that set the credit standards that determined which loans Wall Street could repackage and, ultimately, which borrowers would qualify. Effectively, they did the job that was expected of banks and government regulators. And today, they are a central culprit in the mortgage bust, in which the total loss has been projected at $250 billion and possibly much more.

In the wake of the housing collapse, Congress is exploring why the industry failed and whether it should be revamped (hearings in the Senate Banking Committee were expected to begin April 22). Two key questions are whether the credit agencies — which benefit from a unique series of government charters — enjoy too much official protection and whether their judgment was tainted. Presumably to forestall criticism and possible legislation, Moody’s and S.&P. have announced reforms. But they reject the notion that they should have been more vigilant. Instead, they lay the blame on the mortgage holders who turned out to be deadbeats, many of whom lied to obtain their loans.

Arthur Levitt, the former chairman of the Securities and Exchange Commission, charges that “the credit-rating agencies suffer from a conflict of interest — perceived and apparent — that may have distorted their judgment, especially when it came to complex structured financial products.” Frank Partnoy, a professor at the University of San Diego School of Law who has written extensively about the credit-rating industry, says that the conflict is a serious problem. Thanks to the industry’s close relationship with the banks whose securities it rates, Partnoy says, the agencies have behaved less like gatekeepers than gate openers. Last year, Moody’s had to downgrade more than 5,000 mortgage securities — a tacit acknowledgment that the mortgage bubble was abetted by its overly generous ratings. Mortgage securities rated by Standard & Poor’s and Fitch have suffered a similar wave of downgrades.

Presto! How 2,393 Subprime Loans Become a High-Grade Investment

The business of assigning a rating to a mortgage security is a complicated affair, and Moody’s recently was willing to walk me through an actual mortgage-backed security step by step. I was led down a carpeted hallway to a well-appointed conference room to meet with three specialists in mortgage-backed paper. Moody’s was fair-minded in choosing an example; the case they showed me, which they masked with the name “Subprime XYZ,” was a pool of 2,393 mortgages with a total face value of $430 million.

Subprime XYZ typified the exuberance of the age. All the mortgages in the pool were subprime — that is, they had been extended to borrowers with checkered credit histories. In an earlier era, such people would have been restricted from borrowing more than 75 percent or so of the value of their homes, but during the great bubble, no such limits applied.

Moody’s did not have access to the individual loan files, much less did it communicate with the borrowers or try to verify the information they provided in their loan applications. “We aren’t loan officers,” Claire Robinson, a 20-year veteran who is in charge of asset-backed finance for Moody’s, told me. “Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance, what percent will pay their loans?”

The loans in Subprime XYZ were issued in early spring 2006 — what would turn out to be the peak of the boom. They were originated by a West Coast company that Moody’s identified as a “nonbank lender.” Traditionally, people have gotten their mortgages from banks, but in recent years, new types of lenders peddling sexier products grabbed an increasing share of the market. This particular lender took the loans it made to a New York investment bank; the bank designed an investment vehicle and brought the package to Moody’s.

Moody’s assigned an analyst to evaluate the package, subject to review by a committee. The investment bank provided an enormous spreadsheet chock with data on the borrowers’ credit histories and much else that might, at very least, have given Moody’s pause. Three-quarters of the borrowers had adjustable-rate mortgages, or ARMs — “teaser” loans on which the interest rate could be raised in short order. Since subprime borrowers cannot afford higher rates, they would need to refinance soon. This is a classic sign of a bubble — lending on the belief, or the hope, that new money will bail out the old.

Moody’s learned that almost half of these borrowers — 43 percent — did not provide written verification of their incomes. The data also showed that 12 percent of the mortgages were for properties in Southern California, including a half-percent in a single ZIP code, in Riverside. That suggested a risky degree of concentration.

On the plus side, Moody’s noted, 94 percent of those borrowers with adjustable-rate loans said their mortgages were for primary residences. “That was a comfort feeling,” Robinson said. Historically, people have been slow to abandon their primary homes. When you get into a crunch, she added, “You’ll give up your ski chalet first.”

Another factor giving Moody’s comfort was that all of the ARM loans in the pool were first mortgages (as distinct from, say, home-equity loans). Nearly half of the borrowers, however, took out a simultaneous second loan. Most often, their two loans added up to all of their property’s presumed resale value, which meant the borrowers had not a cent of equity.

In the frenetic, deal-happy climate of 2006, the Moody’s analyst had only a single day to process the credit data from the bank. The analyst wasn’t evaluating the mortgages but, rather, the bonds issued by the investment vehicle created to house them. A so-called special-purpose vehicle — a ghost corporation with no people or furniture and no assets either until the deal was struck — would purchase the mortgages. Thereafter, monthly payments from the homeowners would go to the S.P.V. The S.P.V. would finance itself by selling bonds. The question for Moody’s was whether the inflow of mortgage checks would cover the outgoing payments to bondholders. From the investment bank’s point of view, the key to the deal was obtaining a triple-A rating — without which the deal wouldn’t be profitable. That a vehicle backed by subprime mortgages could borrow at triple-A rates seems like a trick of finance. “People say, ‘How can you create triple-A out of B-rated paper?’ ” notes Arturo Cifuentes, a former Moody’s credit analyst who now designs credit instruments. It may seem like a scam, but it’s not.

The secret sauce is that the S.P.V. would float 12 classes of bonds, from triple-A to a lowly Ba1. The highest-rated bonds would have first priority on the cash received from mortgage holders until they were fully paid, then the next tier of bonds, then the next and so on. The bonds at the bottom of the pile got the highest interest rate, but if homeowners defaulted, they would absorb the first losses.

It was this segregation of payments that protected the bonds at the top of the structure and enabled Moody’s to classify them as triple-A. Imagine a seaside condo beset by flooding: just as the penthouse will not get wet until the lower floors are thoroughly soaked, so the triple-A bonds would not lose a dime unless the lower credits were wiped out.

Structured finance, of which this deal is typical, is both clever and useful; in the housing industry it has greatly expanded the pool of credit. But in extreme conditions, it can fail. The old-fashioned corner banker used his instincts, as well as his pencil, to apportion credit; modern finance is formulaic. However elegant its models, forecasting the behavior of 2,393 mortgage holders is an uncertain business. “Everyone assumed the credit agencies knew what they were doing,” says Joseph Mason, a credit expert at Drexel University. “A structural engineer can predict what load a steel support will bear; in financial engineering we can’t predict as well.”

Mortgage-backed securities like those in Subprime XYZ were not the terminus of the great mortgage machine. They were, in fact, building blocks for even more esoteric vehicles known as collateralized debt obligations, or C.D.O.’s. C.D.O.’s were financed with similar ladders of bonds, from triple-A on down, and the credit-rating agencies’ role was just as central. The difference is that XYZ was a first-order derivative — its assets included real mortgages owned by actual homeowners. C.D.O.’s were a step removed — instead of buying mortgages, they bought bonds that were backed by mortgages, like the bonds issued by Subprime XYZ. (It is painful to consider, but there were also third-order instruments, known as C.D.O.’s squared, which bought bonds issued by other C.D.O.’s.)

Miscalculations that were damaging at the level of Subprime XYZ were devastating at the C.D.O. level. Just as bad weather will cause more serious delays to travelers with multiple flights, so, if the underlying mortgage bonds were misrated, the trouble was compounded in the case of the C.D.O.’s that purchased them.

Moody’s used statistical models to assess C.D.O.’s; it relied on historical patterns of default. This assumed that the past would remain relevant in an era in which the mortgage industry was morphing into a wildly speculative business. The complexity of C.D.O.’s undermined the process as well. Jamie Dimon, the chief executive of JPMorgan Chase, which recently scooped up the mortally wounded Bear Stearns, says, “There was a large failure of common sense” by rating agencies and also by banks like his. “Very complex securities shouldn’t have been rated as if they were easy-to-value bonds.”

The Accidental Watchdog

John Moody, a Wall Street analyst and former errand runner, hit on the idea of synthesizing all kinds of credit information into a single rating in 1909, when he published the manual “Moody’s Analyses of Railroad Investments.” The idea caught on with investors, who subscribed to his service, and by the mid-’20s, Moody’s faced three competitors: Standard Statistics and Poor’s Publishing (which later merged) and Fitch.

Then as now, Moody’s graded bonds on a scale with 21 steps, from Aaa to C. (There are small differences in the agencies’ nomenclatures, just as a grande latte at Starbucks becomes a “medium” at Peet’s. At Moody’s, ratings that start with the letter “A” carry minimal to low credit risk; those starting with “B” carry moderate to high risk; and “C” ratings denote bonds in poor standing or actual default.) The ratings are meant to be an estimate of probabilities, not a buy or sell recommendation. For instance, Ba bonds default far more often than triple-As. But Moody’s, as it is wont to remind people, is not in the business of advising investors whether to buy Ba’s; it merely publishes a rating.

Until the 1970s, its business grew slowly. But several trends coalesced to speed it up. The first was the collapse of Penn Central in 1970 — a shattering event that the credit agencies failed to foresee. It so unnerved investors that they began to pay more attention to credit risk.

Government responded. The Securities and Exchange Commission, faced with the question of how to measure the capital of broker-dealers, decided to penalize brokers for holding bonds that were less than investment-grade (the term applies to Moody’s 10 top grades). This prompted a question: investment grade according to whom? The S.E.C. opted to create a new category of officially designated rating agencies, and grandfathered the big three — S.&P., Moody’s and Fitch. In effect, the government outsourced its regulatory function to three for-profit companies.

Bank regulators issued similar rules for banks. Pension funds, mutual funds, insurance regulators followed. Over the ’80s and ’90s, a latticework of such rules redefined credit markets. Many classes of investors were now forbidden to buy noninvestment-grade bonds at all.

Issuers thus were forced to seek credit ratings (or else their bonds would not be marketable). The agencies — realizing they had a hot product and, what’s more, a captive market — started charging the very organizations whose bonds they were rating. This was an efficient way to do business, but it put the agencies in a conflicted position. As Partnoy says, rather than selling opinions to investors, the rating agencies were now selling “licenses” to borrowers. Indeed, whether their opinions were accurate no longer mattered so much. Just as a police officer stopping a motorist will want to see his license but not inquire how well he did on his road test, it was the rating — not its accuracy — that mattered to Wall Street.

The case of Enron is illustrative. Throughout the summer and fall of 2001, even though its credit was rapidly deteriorating, the rating agencies kept it at investment grade. This was not unusual; the agencies typically lag behind the news. On Nov. 28, 2001, S.&P. finally dropped Enron’s bonds to subinvestment grade. Although its action merely validated the market consensus, it caused the stock to collapse. To investors, S.&P.’s action was a signal that Enron was locked out of credit markets; it had lost its “license” to borrow. Four days later it filed for bankruptcy.

Another trend that spurred the agencies’ growth was that more companies began borrowing in bond markets instead of from banks. According to Chris Mahoney, a just-retired Moody’s veteran of 22 years, “The agencies went from being obscure and unimportant players to central ones.”

A Conflict of Interest?

Nothing sent the agencies into high gear as much as the development of structured finance. As Wall Street bankers designed ever more securitized products — using mortgages, credit-card debt, car loans, corporate debt, every type of paper imaginable — the agencies became truly powerful.

In structured-credit vehicles like Subprime XYZ, the agencies played a much more pivotal role than they had with (conventional) bonds. According to Lewis Ranieri, the Salomon Brothers banker who was a pioneer in mortgage bonds, “The whole creation of mortgage securities was involved with a rating.”

What the bankers in these deals are really doing is buying a bunch of I.O.U.’s and repackaging them in a different form. Something has to make the package worth — or seem to be worth — more that the sum of its parts, otherwise there would be no point in packaging such securities, nor would there be any profits from which to pay the bankers’ fees.

That something is the rating. Credit markets are not continuous; a bond that qualifies, though only by a hair, as investment grade is worth a lot more than one that just fails. As with a would-be immigrant traveling from Mexico, there is a huge incentive to get over the line.

The challenge to investment banks is to design securities that just meet the rating agencies’ tests. Risky mortgages serve their purpose; since the interest rate on them is higher, more money comes into the pool and is available for paying bond interest. But if the mortgages are too risky, Moody’s will object. Banks are adroit at working the system, and pools like Subprime XYZ are intentionally designed to include a layer of Baa bonds, or those just over the border. “Every agency has a model available to bankers that allows them to run the numbers until they get something they like and send it in for a rating,” a former Moody’s expert in securitization says. In other words, banks were gaming the system; according to Chris Flanagan, the subprime analyst at JPMorgan, “Gaming is the whole thing.”

When a bank proposes a rating structure on a pool of debt, the rating agency will insist on a cushion of extra capital, known as an “enhancement.” The bank inevitably lobbies for a thin cushion (the thinner the capitalization, the fatter the bank’s profits). It’s up to the agency to make sure that the cushion is big enough to safeguard the bonds. The process involves extended consultations between the agency and its client. In short, obtaining a rating is a collaborative process.

The evidence on whether rating agencies bend to the bankers’ will is mixed. The agencies do not deny that a conflict exists, but they assert that they are keen to the dangers and minimize them. For instance, they do not reward analysts on the basis of whether they approve deals. No smoking gun, no conspiratorial e-mail message, has surfaced to suggest that they are lying. But in structured finance, the agencies face pressures that did not exist when John Moody was rating railroads. On the traditional side of the business, Moody’s has thousands of clients (virtually every corporation and municipality that sells bonds). No one of them has much clout. But in structured finance, a handful of banks return again and again, paying much bigger fees. A deal the size of XYZ can bring Moody’s $200,000 and more for complicated deals. And the banks pay only if Moody’s delivers the desired rating. Tom McGuire, the Jesuit theologian who ran Moody’s through the mid-’90s, says this arrangement is unhealthy. If Moody’s and a client bank don’t see eye to eye, the bank can either tweak the numbers or try its luck with a competitor like S.&P., a process known as “ratings shopping.”

And it seems to have helped the banks get better ratings. Mason, of Drexel University, compared default rates for corporate bonds rated Baa with those of similarly rated collateralized debt obligations until 2005 (before the bubble burst). Mason found that the C.D.O.’s defaulted eight times as often. One interpretation of the data is that Moody’s was far less discerning when the client was a Wall Street securitizer.

After Enron blew up, Congress ordered the S.E.C. to look at the rating industry and possibly reform it. The S.E.C. ducked. Congress looked again in 2006 and enacted a law making it easier for competing agencies to gain official recognition, but didn’t change the industry’s business model. By then, the mortgage boom was in high gear. From 2002 to 2006, Moody’s profits nearly tripled, mostly thanks to the high margins the agencies charged in structured finance. In 2006, Moody’s reported net income of $750 million. Raymond W. McDaniel Jr., its chief executive, gloated in the annual report for that year, “I firmly believe that Moody’s business stands on the ‘right side of history’ in terms of the alignment of our role and function with advancements in global capital markets.”

Using Weather in Antarctica To Forecast Conditions in Hawaii

Even as McDaniel was crowing, it was clear in some corners of Wall Street that the mortgage market was headed for trouble. The housing industry was cooling off fast. James Kragenbring, a money manager with Advantus Capital Management, complained to the agencies as early as 2005 that their ratings were too generous. A report from the hedge fund of John Paulson proclaimed astonishment at “the mispricing of these securities.” He started betting that mortgage debt would crash.

Even Mark Zandi, the very visible economist at Moody’s forecasting division (which is separate from the ratings side), was worried about the chilling crosswinds blowing in credit markets. In a report published in May 2006, he noted that consumer borrowing had soared, household debt was at a record and a fifth of such debt was classified as subprime. At the same time, loan officers were loosening underwriting standards and easing rates to offer still more loans. Zandi fretted about the “razor-thin” level of homeowners’ equity, the avalanche of teaser mortgages and the $750 billion of mortgages he judged to be at risk. Zandi concluded, “The environment feels increasingly ripe for some type of financial event.”

A month after Zandi’s report, Moody’s rated Subprime XYZ. The analyst on the deal also had concerns. Moody’s was aware that mortgage standards had been deteriorating, and it had been demanding more of a cushion in such pools. Nonetheless, its credit-rating model continued to envision rising home values. Largely for that reason, the analyst forecast losses for XYZ at only 4.9 percent of the underlying mortgage pool. Since even the lowest-rated bonds in XYZ would be covered up to a loss level of 7.25 percent, the bonds seemed safe.

XYZ now became the responsibility of a Moody’s team that monitors securities and changes the ratings if need be (the analyst moved on to rate a new deal). Almost immediately, the team noticed a problem. Usually, people who finance a home stay current on their payments for at least a while. But a sliver of folks in XYZ fell behind within 90 days of signing their papers. After six months, an alarming 6 percent of the mortgages were seriously delinquent. (Historically, it is rare for more than 1 percent of mortgages at that stage to be delinquent.)

Moody’s monitors began to make inquiries with the lender and were shocked by what they heard. Some properties lacked sod or landscaping, and keys remained in the mailbox; the buyers had never moved in. The implication was that people had bought homes on spec: as the housing market turned, the buyers walked.

By the spring of 2007, 13 percent of Subprime XYZ was delinquent — and it was worsening by the month. XYZ was hardly atypical; the entire class of 2006 was performing terribly. (The class of 2007 would turn out to be even worse.)

In April 2007, Moody’s announced it was revising the model it used to evaluate subprime mortgages. It noted that the model “was first introduced in 2002. Since then, the mortgage market has evolved considerably.” This was a rather stunning admission; its model had been based on a world that no longer existed.

Poring over the data, Moody’s discovered that the size of people’s first mortgages was no longer a good predictor of whether they would default; rather, it was the size of their first and second loans — that is, their total debt — combined. This was rather intuitive; Moody’s simply hadn’t reckoned on it. Similarly, credit scores, long a mainstay of its analyses, had not proved to be a “strong predictor” of defaults this time. Translation: even people with good credit scores were defaulting. Amy Tobey, leader of the team that monitored XYZ, told me, “It seems there was a shift in mentality; people are treating homes as investment assets.” Indeed. And homeowners without equity were making what economists call a rational choice; they were abandoning properties rather than make payments on them. Homeowners’ equity had never been as high as believed because appraisals had been inflated.

Over the summer and fall of 2007, Moody’s and the other agencies repeatedly tightened their methodology for rating mortgage securities, but it was too late. They had to downgrade tens of billions of dollars of securities. By early this year, when I met with Moody’s, an astonishing 27 percent of the mortgage holders in Subprime XYZ were delinquent. Losses on the pool were now estimated at 14 percent to 16 percent — three times the original estimate. Seemingly high-quality bonds rated A3 by Moody’s had been downgraded five notches to Ba2, as had the other bonds in the pool aside from its triple-A’s.

The pain didn’t stop there. Many of the lower-rated bonds issued by XYZ, and by mortgage pools like it, were purchased by C.D.O.’s, the second-order mortgage vehicles, which were eager to buy lower-rated mortgage paper because it paid a higher yield. As the agencies endowed C.D.O. securities with triple-A ratings, demand for them was red hot. Much of it was from global investors who knew nothing about the U.S. mortgage market. In 2006 and 2007, the banks created more than $200 billion of C.D.O.’s backed by lower-rated mortgage paper. Moody’s assigned a different team to rate C.D.O.’s. This team knew far less about the underlying mortgages than did the committee that evaluated Subprime XYZ. In fact, Moody’s rated C.D.O.’s without knowing which bonds the pool would buy.

A C.D.O. operates like a mutual fund; it can buy or sell mortgage bonds and frequently does so. Thus, the agencies rate pools with assets that are perpetually shifting. They base their ratings on an extensive set of guidelines or covenants that limit the C.D.O. manager’s discretion.

Late in 2006, Moody’s rated a C.D.O. with $750 million worth of securities. The covenants, which act as a template, restricted the C.D.O. to, at most, an 80 percent exposure to subprime assets, and many other such conditions. “We’re structure experts,” Yuri Yoshizawa, the head of Moody’s’ derivative group, explained. “We’re not underlying-asset experts.” They were checking the math, not the mortgages. But no C.D.O. can be better than its collateral.

Moody’s rated three-quarters of this C.D.O.’s bonds triple-A. The ratings were derived using a mathematical construct known as a Monte Carlo simulation — as if each of the underlying bonds would perform like cards drawn at random from a deck of mortgage bonds in the past. There were two problems with this approach. First, the bonds weren’t like those in the past; the mortgage market had changed. As Mark Adelson, a former managing director in Moody’s structured-finance division, remarks, it was “like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.” And second, the bonds weren’t random. Moody’s had underestimated the extent to which underwriting standards had weakened everywhere. When one mortgage bond failed, the odds were that others would, too.

Moody’s estimated that this C.D.O. could potentially incur losses of 2 percent. It has since revised its estimate to 27 percent. The bonds it rated have been decimated, their market value having plunged by half or more. A triple-A layer of bonds has been downgraded 16 notches, all the way to B. Hundreds of C.D.O.’s have suffered similar fates (most of Wall Street’s losses have been on C.D.O.’s). For Moody’s and the other rating agencies, it has been an extraordinary rout.

Whom Can We Rely On?

The agencies have blamed the large incidence of fraud, but then they could have demanded verification of the mortgage data or refused to rate securities where the data were not provided. That was, after all, their mandate. This is what they pledge for the future. Moody’s, S.&P. and Fitch say that they are tightening procedures — they will demand more data and more verification and will subject their analysts to more outside checks. None of this, however, will remove the conflict of interest in the issuer-pays model. Though some have proposed requiring that agencies with official recognition charge investors, rather than issuers, a more practical reform may be for the government to stop certifying agencies altogether.

Then, if the Fed or other regulators wanted to restrict what sorts of bonds could be owned by banks, or by pension funds or by anyone else in need of protection, they would have to do it themselves — not farm the job out to Moody’s. The ratings agencies would still exist, but stripped of their official imprimatur, their ratings would lose a little of their aura, and investors might trust in them a bit less. Moody’s itself favors doing away with the official designation, and it, like S.&P., embraces the idea that investors should not “rely” on ratings for buy-and-sell decisions.

This leaves an awkward question, with respect to insanely complex structured securities: What can they rely on? The agencies seem utterly too involved to serve as a neutral arbiter, and the banks are sure to invent new and equally hard-to-assess vehicles in the future. Vickie Tillman, the executive vice president of S.&P., told Congress last fall that in addition to the housing slump, “ahistorical behavorial modes” by homeowners were to blame for the wave of downgrades. She cited S.&P.’s data going back to the 1970s, as if consumers were at fault for not living up to the past. The real problem is that the agencies’ mathematical formulas look backward while life is lived forward. That is unlikely to change.

Roger Lowenstein, a contributing writer, last wrote for the magazine about the Federal Reserve chief, Ben Bernanke. His new book, “While America Aged,” will be published next month.
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Postby admin » Sat Mar 22, 2008 11:01 pm

Dear New York Times,

I write to you from the plains of Western Canada with my own answer to the question your good writers posed, namely, "WHAT CREATED THIS MONSTER".

I understand your writers also look at the answers, and I do not wish to take away from their answers, however just to lend my perspective. I come from twenty years inside the brokerage industry.

In short, I feel that the system has been completely taken over by persons bent on short term thinking and a near psychopathic addiction to money and power. They (Martha Stout, THE SOCIOPATH NEXT DOOR) say that nearly on in twenty or twenty five people we meet each day carries with them the invisible secret weapon in that they can do anything, hurt anyone, without fear, anxiety, or conscience to slow them down or stop them.

My experience is that a larger proportion of those individuals gravitate to industries where power and money collect, and finance is one of those industries. I feel from my perspective that nearly one in ten persons in the higher positions in these industries could be carrying this secret weapon with them. They are using this weapon (the ability to harm without conscience) against clients, shareholders, the public, employees. That is problem number one.

Problem number two is part fear, part apathy that allows this 5% or 10% of our population to get away with sociopathic or psychopathic behavior. Recall Stanely Milgram's famous "shock" experiments at Yale University in 1961 or 1962, where subjects were told to administer electric shocks to other "test subjects" who got wrong answers in a memory test. Those who gave the shocks thought they were testing the effects of shocks on memory (if memory serves me) when in fact, it was the people giving the shocks who were the subjects under study, to see how far they would go to hurt their fellow humans when told to do so. In total surprise to all involved, it was found that 62% of the population will nearly blindly follow orders up to and including orders to damage their fellows, when they are under the impression that they are "following orders" or acting on authority from above. This is problem number two. Imagine having 5% to 10% of the workplace with sociopathic tendencies, and those persons scrape, climb and claw their way to the upper echelons of the corporation. Below them we have another 62% of the population who will blindly follow orders from these people. That puts us at very near 70%+ of a large company that may be "the corrupt, leading the blind". Add in another 10% or more, who are too new to know what is even going on around them, another 10% who are too old and jaded to care, and maybe 10% who are simply afraid to say a word because they know what the repercussions are to those who "are not team players". The sociopaths in the company will destroy them, assited blindly by the other 60%, 70%, 80%, or more of the firm. The numbers add up to a nearly negative chance that sociopaths at work will be stopped. We are still only on problem number two.

Problem number three (in my country to your north at least) is that we allow these people to self regulate. To police themselves. To act on the honor system. Big mistake, but they have lobbied hard, worked hard and paid hard to earn this right. So we have the richest, smartest, most morally deficient and perhaps those with a pthalogical addication to money and power, we let those people govern themselves on the honor system. Big problem in my country. We now face the largest bankruptcy in our history due to this, and your country may be in a similar boat. If we should happen to experience another depression like the 1930's, it can be attributed, in my opinion in large part to these problems which are so very easy to fix.

The fourth problem is that due to a combination of the previous, (and a few more), we find ourselves on a slippery slope. We are now on that slippery slope, where, without rules to follow, or without enforcement of those rules (in Canada), and with the richest, smartest, most pathalogically money addicted people running our financial system, there are no limits to the size or the types of frauds and crimes that can be played out with the savings of your country or mine. The imagination of those in charge is the only limitation on what can be dreamt up. The sky is the limit. Remember Key Lay. Remember Bernie Ebbers. He was a milkman up in my province before he found the financial services industry had the "sky is the limit", no rules atmosphere he liked so much.

So these "smartest guys in the room" types, move ahead with dreams, and schemes, inventing whatever comes into their minds and then peddling it along to the public. It strikes me that the newer investments, or the newer schemes they have used in the last decade or two, have come closer and closer to financial alchemy. In a manner similar to the gangs out there who cook up newer, more dangerous synthetic drug combinations to sell to the unsuspecting public, the financial industry has taken a similar bizarre turn into left field, where nearly no one can understand the products, or the concepts, but the con continues.

I refer to them as "Banksters". They are organized, they work in cartel, in syndicate on major deals, and they have a code of silence among each other. In my country the definition of organized crime is "three or more individuals acting in concert to......". The banksters up here (we have five major banks in Canada who control 90% of the market) are very organized. Unfortunately our commerical police force in Canada had only made two convictions (verses 1236 in the US) up to the end of 2007. Those fortunate few who retire from our famous "county mounties", the RCMP, speak in our Canadian Business Magazine that "Canada is a good country for crooks". We may in fact be no different in our problems than your country.

Here is where we are with finance. We are, in exactly the same spot that the tobacco industry was in the 1950's. Making dangerous products that hurt the public. Doing this knowingly because the industry was/is run by pathlogically addicted people whose addiction is to more and more money.

They purchased industry support, systemically corrupted doctors, lawyers, media, and whomever was needed to corrupt to continue with the creation of their knowingly tainted product. Finance is there today. Look back fifty years. See the movie "Tobacco Conspiracy" and recall what history has taught us. (Pharmaceuticals may be in there just between tobacco and finance, but I digress)
Millions are no longer enough. Billions are no longer enough. A lifetime earning living is no longer satisfactory when it can be done in months or years......if you are sick enough, oops, quick enough. If you have gotten this far, I want to thank you a great deal for putting up with a guy from the Prairies. I am proud to be your neighbor and I hope I can borrow a cup of something I need if we get to that next depression. (mac site) will point you towards my thoughts, comments and work towards improving this problem in my own country, which is at least ten years behind yours, and will give you a web flogg that holds many topics in this area. Finally, to see how truly far behind the world that Canadian investment regulations have fallen, see for the top research site in the Canada on financial abuse of citizens by the financial industry. Many of these abuses may occur in your country.
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the smartest guys..........police themselves. Who knew?

Postby admin » Sat Mar 22, 2008 10:56 pm


March 23, 2008
What Created This Monster?
LIKE Noah building his ark as thunderheads gathered, Bill Gross has spent the last two years anticipating the flood that swamped Bear Stearns about 10 days ago. As manager of the world’s biggest bond fund and custodian of nearly a trillion dollars in assets, Mr. Gross amassed a cash hoard of $50 billion in case trading partners suddenly demanded payment from his firm, Pimco.

And every day for the last three weeks he has convened meetings in a war room in Pimco’s headquarters in Newport Beach, Calif., “to make sure the ark doesn’t have any leaks,” Mr. Gross said. “We come in every day at 3:30 a.m. and leave at 6 p.m. I’m not used to setting my alarm for 2:45 a.m., but these are extraordinary times.”

Even though Mr. Gross, 63, is a market veteran who has lived through the collapse of other banks and brokerage firms, the 1987 stock market crash, and the near meltdown of the Long-Term Capital Management hedge fund a decade ago, he says the current crisis feels different — in both size and significance.

The Federal Reserve not only taken has action unprecedented since the Great Depression — by lending money directly to major investment banks — but also has put taxpayers on the hook for billions of dollars in questionable trades these same bankers made when the good times were rolling.

“Bear Stearns has made it obvious that things have gone too far,” says Mr. Gross, who plans to use some of his cash to bargain-shop. “The investment community has morphed into something beyond banks and something beyond regulation. We call it the shadow banking system.”

It is the private trading of complex instruments that lurk in the financial shadows that worries regulators and Wall Street and that have created stresses in the broader economy. Economic downturns and panics have occurred before, of course. Few, however, have posed such a serious threat to the entire financial system that regulators have responded as if they were confronting a potential epidemic.

As Congress and Republican and Democratic presidential administrations pushed for financial deregulation over the last decade, the biggest banks and brokerage firms created a dizzying array of innovative products that experts now acknowledge are hard to understand and even harder to value.

On Wall Street, of course, what you don’t see can hurt you. In the past decade, there has been an explosion in complex derivative instruments, such as collateralized debt obligations and credit default swaps, which were intended primarily to transfer risk.

Bizuayehu Tesfaye/Associated Press

Alan Greenspan, the former chairman of the Federal Reserve. He played a pivotal role in the
regulation of derivatives products and oversight of the increasingly complex mortgage market.
These products are virtually hidden from investors, analysts and regulators, even though they have emerged as one of Wall Street’s most outsized profit engines. They don’t trade openly on public exchanges, and financial services firms disclose few details about them.

Used judiciously, derivatives can limit the damage from financial miscues and uncertainty, greasing the wheels of commerce. Used unwisely — when greed and the urge to gamble with borrowed money overtake sensible risk-taking — derivatives can become Wall Street’s version of nitroglycerin.

Bear Stearns’s vast portfolio of these instruments was among the main reasons for the bank’s collapse, but derivatives are buried in the accounts of just about every Wall Street firm, as well as major commercial banks like Citigroup and JPMorgan Chase. What’s more, these exotic investments have been exported all over the globe, causing losses in places as distant from Wall Street as a small Norwegian town north of the Arctic Circle.

With Bear Stearns forced into a sale and the entire financial system still under the threat of further losses, Wall Street executives, regulators and politicians are scrambling to figure out just what went wrong and how it can be fixed.

But because the forces that have collided in recent weeks were set in motion long before the subprime mortgage mess first made news last year, solutions won’t come easily or quickly, analysts say.

In fact, while home loans to risky borrowers were among the first to go bad, analysts say that the crisis didn’t stem from the housing market alone and that it certainly won’t end there.

“The problem has been spreading its wings and taking in markets very far afield from mortgages,” says Alan S. Blinder, former vice chairman of the Federal Reserve and now an economics professor at Princeton. “It’s a failure at a lot of levels. It’s hard to find a piece of the system that actually worked well in the lead-up to the bust.”

Stung by the new focus on their complex products, advocates of the derivatives trade say they are unfairly being made a scapegoat for the recent panic on Wall Street.

“Some people want to blame our industry because they have a vested interest in doing so, either by making a name for themselves or by hampering the adaptability and usefulness of our products for competitive purposes,” said Robert G. Pickel, chief executive of the International Swaps and Derivatives Association, a trade group. “We believe that there are good investment decisions and bad investment decisions. We don’t decry motor vehicles because some have been involved in accidents.”

Already, legislators in Washington are offering detailed plans for new regulations, including ones to treat Wall Street banks like their more heavily regulated commercial brethren. At the same time, normally wary corporate leaders like James Dimon, the chief executive of JPMorgan Chase, are beginning to acknowledge that maybe, just maybe, new regulations are necessary.

“We have a terribly global world and, over all, financial regulation has not kept up with that,” Mr. Dimon said in an interview on Monday, the day after his bank agreed to take over Bear Stearns at a fire-sale price. “I can’t even describe the seriousness of that. I always talk about how bad things can happen that you can’t expect. I didn’t fathom this event.”

TWO months before he resigned as chief executive of Citigroup last year amid nearly $20 billion in write-downs, Charles O. Prince III sat down in Washington with Representative Barney Frank, the chairman of the House Financial Services Committee. Among the topics they discussed were investment vehicles that allowed Citigroup and other banks to keep billions of dollars in potential liabilities off of their balance sheets — and away from the scrutiny of investors and analysts.

“Why aren’t they on your balance sheet?” asked Mr. Frank, Democrat of Massachusetts. The congressman recalled that Mr. Prince said doing so would have put Citigroup at a disadvantage with Wall Street investment banks that were more loosely regulated and were allowed to take far greater risks. (A spokeswoman for Mr. Prince confirmed the conversation.)

It was at that moment, Mr. Frank says, that he first realized just how much freedom Wall Street firms had, and how lightly regulated they were in comparison with commercial banks, which have to answer to an alphabet soup of government agencies like the Federal Reserve and the comptroller of the currency.

“Not only did Wall Street have so much freedom, but it gave commercial banks an incentive to try and evade their regulations,” Mr. Frank says. When it came to Wall Street, he says, “we thought we didn’t need regulation.”

In fact, Washington has long followed the financial industry’s lead in supporting deregulation, even as newly minted but little-understood products like derivatives proliferated.

During the late 1990s, Wall Street fought bitterly against any attempt to regulate the emerging derivatives market, recalls Michael Greenberger, a former senior regulator at the Commodity Futures Trading Commission. Although the Long-Term Capital debacle in 1998 alerted regulators and bankers alike to the dangers of big bets with borrowed money, a rescue effort engineered by the Federal Reserve Bank of New York prevented the damage from spreading.

“After that, all was forgotten,” says Mr. Greenberger, now a professor at the University of Maryland. At the same time, derivatives were being praised as a boon that would make the economy more stable.

Speaking in Boca Raton, Fla., in March 1999, Alan Greenspan, then the Fed chairman, told the Futures Industry Association, a Wall Street trade group, that “these instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it.”

Although Mr. Greenspan acknowledged that the “possibility of increased systemic risk does appear to be an issue that requires fuller understanding,” he argued that new regulations “would be a major mistake.”

“Regulatory risk measurement schemes,” he added, “are simpler and much less accurate than banks’ risk measurement models.”

Mr. Greenberger, still concerned about regulatory battles he lost a decade ago, says that Mr. Greenspan “felt derivatives would spread the risk in the economy.”

“In reality,” Mr. Greenberger added, “it spread a virus through the economy because these products are so opaque and hard to value.” A representative for Mr. Greenspan said he was preparing to travel and could not comment.

A milestone in the deregulation effort came in the fall of 2000, when a lame-duck session of Congress passed a little-noticed piece of legislation called the Commodity Futures Modernization Act. The bill effectively kept much of the market for derivatives and other exotic instruments off-limits to agencies that regulate more conventional assets like stocks, bonds and futures contracts.

Supported by Phil Gramm, then a Republican senator from Texas and chairman of the Senate Banking Committee, the legislation was a 262-page amendment to a far larger appropriations bill. It was signed into law by President Bill Clinton that December.

Mr. Gramm, now the vice chairman of UBS, the Swiss investment banking giant, was unavailable for comment. (UBS has recently seen its fortunes hammered by ill-considered derivative investments.)

“I don’t believe anybody understood the significance of this,” says Mr. Greenberger, describing the bill’s impact.

By the beginning of this decade, according to Mr. Frank and Mr. Blinder, Mr. Greenspan resisted suggestions that the Fed use its powers to regulate the mortgage market or to crack down on practices like providing loans to borrowers with little, if any, documentation.

“Greenspan specifically refused to act,” Mr. Frank says. “He had the authority, but he didn’t use it.”

Others on Capitol Hill, like Representative Scott Garrett, Republican of New Jersey and a member of the Financial Services banking subcommittee, reject the idea that loosening financial rules helped to create the current crisis.

“I don’t think deregulation was the cause,” he says. “And had we had additional regulation in place, I’m not sure what we’re experiencing now would have been averted.”

Regardless, with profit margins shrinking in traditional businesses like underwriting and trading, Wall Street firms rushed into the new frontier of lucrative financial products like derivatives. Students with doctorates in physics and other mathematical disciplines were hired directly out of graduate school to design them, and Wall Street firms increasingly made big bets on derivatives linked to mortgages and other products.

THREE years ago, many of Wall Street’s best and brightest gathered to assess the landscape of financial risk. Top executives from firms like Goldman Sachs, Lehman Brothers and Citigroup — calling themselves the Counterparty Risk Management Policy Group II — debated the likelihood of an event that could send a seismic wave across financial markets.

The group’s conclusion, detailed in a 153-page report, was that the chances of a systemic upheaval had declined sharply after the Long-Term Capital bailout. Members recommended some nips and tucks around the market’s edges, to ensure that trades were cleared and settled more efficiently. They also recommended that secretive hedge funds volunteer more information about their activities. Yet, over all, they concluded that financial markets were more stable than they had been just a few years earlier.

Few could argue. Wall Street banks were fat and happy. They were posting record profits and had healthy capital cushions. Money flowed easily as corporate default rates were practically nil and the few bumps and bruises that occurred in the market were readily absorbed.

More important, innovative products designed to mitigate risk were seen as having reduced the likelihood that a financial cataclysm could put the entire system at risk.

“With the 2005 report, my hope at the time was that that work would help in dealing with future financial shocks, and I confess to being quite frustrated that it didn’t do as much as I had hoped,” says E. Gerald Corrigan, a managing director at Goldman Sachs and a former New York Fed president, who was chairman of the policy group. “Still, I shudder to think what today would look like if not for the fact that some of the changes were, in fact, implemented.”

ONE of the fastest-growing and most lucrative businesses on Wall Street in the past decade has been in derivatives — a sector that boomed after the near collapse of Long-Term Capital.

It is a stealth market that relies on trades conducted by phone between Wall Street dealer desks, away from open securities exchanges. How much changes hands or who holds what is ultimately unknown to analysts, investors and regulators.

Credit rating agencies, which banks paid to grade some of the new products, slapped high ratings on many of them, despite having only a loose familiarity with the quality of the assets behind these instruments.

Even the people running Wall Street firms didn’t really understand what they were buying and selling, says Byron Wien, a 40-year veteran of the stock market who is now the chief investment strategist of Pequot Capital, a hedge fund.

“These are ordinary folks who know a spreadsheet, but they are not steeped in the sophistication of these kind of models,” Mr. Wien says. “You put a lot of equations in front of them with little Greek letters on their sides, and they won’t know what they’re looking at.”

Mr. Blinder, the former Fed vice chairman, holds a doctorate in economics from M.I.T. but says he has only a “modest understanding” of complex derivatives. “I know the basic understanding of how they work,” he said, “but if you presented me with one and asked me to put a market value on it, I’d be guessing.”

Such uncertainty led some to single out derivatives for greater scrutiny and caution. Most famous, perhaps, was Warren E. Buffett, the legendary investor and chairman of Berkshire Hathaway, who in 2003 said derivatives were potential “weapons of mass destruction.”

Behind the scenes, however, there was another player who was scrambling to assess the growing power, use and dangers of derivatives.

Timothy F. Geithner, a career civil servant who took over as president of the New York Fed in 2003, was trying to solve a variety of global crises while at the Treasury Department. As a Fed president, he tried to get a handle on hedge fund activities and the use of leverage on Wall Street, and he zeroed in on the credit derivatives market.

Mr. Geithner brought together leaders of Wall Street firms in a series of meetings in 2005 and 2006 to discuss credit derivatives, and he pushed many of them to clear and settle derivatives trading electronically, hoping to eliminate a large paper backlog that had clogged the system.

Even so, Mr. Geithner had one hand tied behind his back. While the Fed regulated large commercial banks like Citigroup and JPMorgan, it had no oversight on activities of the investment banks, hedge funds and other participants in the burgeoning derivatives market. And the industry and sympathetic politicians in Washington fought attempts to regulate the products, arguing that it would force the lucrative business overseas.

“Tim has been learning on the job, and he has my sympathy,” said Christopher Whalen, a managing partner of Institutional Risk Analytics, a risk management firm in Torrance, Calif. “But I don’t think he’s enough of a real practitioner to go mano-a-mano with these bankers.”

Mr. Geithner declined an interview request for this article.

In a May 2006 speech about credit derivatives, Mr. Geithner praised the benefits of the products: improved risk management and distribution, as well as enhanced market efficiency and resiliency. As he had on earlier occasions, he also warned that the “formidable complexity of measuring the scale of potential exposure” to derivatives made it hard to monitor the products and to gauge the financial vulnerability of individual banks, brokerage firms and other institutions.

“Perhaps the more difficult challenge is to capture the broader risks the institution might confront in conditions of a general deterioration in confidence in credit and an erosion in liquidity,” Mr. Geithner said in the speech. “Most crises come from the unanticipated.”

WHEN increased defaults in subprime mortgages began crushing mortgage-linked securities last summer, several credit markets and many firms that play substantial roles in those markets were sideswiped because of a rapid loss of faith in the value of the products.

Two large Bear Stearns hedge funds collapsed because of bad subprime mortgage bets. The losses were amplified by a hefty dollop of borrowed money that was used to try to juice returns in one of the funds.

All around the Street, dealers were having trouble moving exotic securities linked to subprime mortgages, particularly collateralized debt obligations, which were backed by pools of bonds. Within days, the once-booming and actively traded C.D.O. market — which in three short years had seen issues triple in size, to $486 billion — ground to a halt.

Jeremy Grantham, chairman and chief investment strategist at GMO, a Boston investment firm, said: “When we had the shot across the bow and people realized something was going wrong with subprime, I said: ‘Treat this as a dress rehearsal. Stress-test your portfolios because the next time or the time after, the shot won’t be across the bow.’ ”

In the fall, the Treasury Department and several Wall Street banks scrambled to try to put together a bailout plan to save up to $80 billion in troubled securities. The bailout fell apart, quickly replaced by another aimed at major bond guarantors. That crisis was averted after the guarantors raised fresh capital.

Yet each near miss brought with it growing fears that the stakes were growing bigger and the risks more dangerous. Wall Street banks, as well as banks abroad, took billions of dollars in write-downs, and the chiefs of UBS, Merrill Lynch and Citigroup were all ousted because of huge losses.

“It was like watching a slow-motion train wreck,” Mr. Grantham says. “After all of the write-downs at the banks in June, July and August, we were in a full-fledged credit crisis with C.E.O.’s of top banks running around like headless chickens. And the U.S. equity market’s peak in October? What sort of denial were they in?”

Finally, last week, with Wall Street about to take a direct hit, the Fed stepped in and bailed out Bear Stearns.

It remains unclear, exactly, what doomsday scenario Federal Reserve officials consider themselves to have averted. Some on Wall Street say the fear was that a collapse of Bear could take other banks, including possibly Lehman Brothers or Merrill Lynch, with it. Others say the concern was that Bear, which held $30 billion in mortgage-related assets, would cause further deterioration in that beleaguered market.

Still others say the primary reason the Fed moved so quickly was to divert an even bigger crisis: a meltdown in an arcane yet huge market known as credit default swaps. Like C.D.O.’s, which few outside of Wall Street had ever heard about before last summer, the credit default swaps market is conducted entirely behind the scenes and is not regulated.

Nonetheless, the market’s growth has exploded exponentially since Long-Term Capital almost went under. Today, the outstanding value of the swaps stands at more than $45.5 trillion, up from $900 billion in 2001. The contracts act like insurance policies designed to cover losses to banks and bondholders when companies fail to pay their debts. It’s a market that also remains largely untested.

While there have been a handful of relatively minor defaults that, in some cases, ended in litigation as participants struggled over contract language and other issues, the market has not had to absorb a bankruptcy of one of its biggest players. Bear Stearns held credit default swap contracts carrying an outstanding value of $2.5 trillion, analysts say.

“The rescue was absolutely all about counterparty risk. If Bear went under, everyone’s solvency was going to be thrown into question. There could have been a systematic run on counterparties in general,” said Meredith Whitney, a bank analyst at Oppenheimer. “It was 100 percent related to credit default swaps.”

Amid the regulatory swirl surrounding Bear Stearns, analysts have questioned why the Securities and Exchange Commission did not send up any flares about looming problems at that firm or others on Wall Street. After all, they say, it was the S.E.C., not the Federal Reserve, that was Bear’s primary regulator.

Although S.E.C. officials were unavailable for comment, its chairman, Christopher Cox, has maintained that the agency has effectively carried out its regulatory duties. In a letter last week to the nongovernmental Basel Committee of Banking Supervision, Mr. Cox attributed the collapse of Bear to “a lack of confidence, not a lack of capital.”

IT’S still too early to assess whether the Federal Reserve’s actions have succeeded in protecting the broader economic system. And experts are debating whether the government’s intervention in the Bear Stearns debacle will ultimately encourage riskier behavior on the Street.

“It showed that anything important is going to be bailed out one way or the other,” says Kevin Phillips, a former Republican strategist whose new book, “Bad Money,” analyzes what he describes as the intersection of reckless finance and poor public policy.

Mr. Phillips says that it’s likely that the Fed’s actions have ushered in a new era in financial regulation.

“What we may be looking at is a rethinking of the whole role of the Federal Reserve and what they represent,” he says. “If they didn’t solve it in this round, I’m not sure they can stretch it out and do it again without creating a new law.”

On Capitol Hill, leading Democrats like Senator Christopher J. Dodd of Connecticut, chairman of the Senate Banking Committee, and Mr. Frank of the House Financial Services Committee are pushing for just that.

Last Thursday, Mr. Frank offered up a raft of suggestions, including requiring investment banks to disclose off-balance-sheet risks while also making the firms subject to audits — much like commercial banks are now. He also wants investment banks to set aside reserves for potential losses to provide a greater cushion during financial panics.

Earlier in the week, Mr. Dodd said the Fed should be given some supervisory powers over the investment banks.

But broad new rules aimed at systemic risk are likely to face strong opposition from both the industry and others traditionally wary of regulation. Analysts expect new, smaller-bore laws aimed at the mortgage industry in particular, which was the first sector hit in the squeeze and which affected Wall Street millionaires as well as millions of ordinary American homeowners.

THERE is an emerging consensus that the ability of mortgage lenders to package their loans as securities that were then sold off to other parties played a key role in allowing borrowing standards to plummet.

Mr. Blinder suggests that mortgage originators be required to hold onto a portion of the loans they make, with the investment banks who securitize them also retaining a chunk. “That way, they don’t simply play hot potato,” he says.

Mr. Grantham agrees. “There is just a terrible risk created when you can underwrite a piece of junk and simply pass it along to someone else,” he says.

Ratings agencies have similarly been under fire ever since the credit crisis began to unfold, and new regulations may force them to distance themselves from the investment banks whose products they were paid to rate.

In the meantime, analysts say, a broader reconsideration of derivatives and the shadow banking system is also in order. “Not all innovation is good,” says Mr. Whalen of Institutional Risk Analytics. “If it is too complicated for most of us to understand in 10 to 15 minutes, then we probably shouldn’t be doing it.”
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