Sidney Lust's Leader Theater at 507 Ninth Street NW in Washington, D.C.
Ilargi: I seem to be a bit of a lone voice on the issue, but that doesn’t really make me less worried. Last week I wrote that the financial crisis, which is rapidly spreading towards a full-blown economic crisis, a seismic storm of category 12, could well give birth to a political crisis in the US. My question then and now: what is the legitimacy of a government that has lost control of its economy?
Sure, the Shrub Cabal has transferred enormous swaths of power and authority away from Congress and Senate, the bodies allotted these powers by the US Constitution. But one could presume that it might still be possible for the people and its elected representatives to take back at least part of them. What happens now makes me think that we may have passed all points of any return.
In a functioning democracy, the people’s representatives must be called to task for their mistakes, intentional or not, and if found lacking in judgment, step down. If that doesn’t happen, the system is hollowed out from within, and it will lose its legitimacy.
Lost among the hundreds of billion in rescue funds for financial institutions, supplied by the taxpayer, are the "reform"measures that are being considered. The core of the proposals is yet another transfer of power, this time over the financial world, in all its aspects, and on an international scale. Once again, the powers are to be taken away from the people’s representatives. This time the powers in question will be handed over to the Federal Reserve.
And that means that the status of America as a functioning democracy becomes ever more questionable. Yesterdays anouncement by the government, and the gigantic new rescue plan -the next in a by now long list- that will be unveiled within the next 72 hours, made some European leaders cast doubt on US claims of propagating a free market.
The way in which this process is undertaken can perhaps best be illustrated by the founding of the Federal Reserve in 1913. The Constitution explicitly and expressly reserves the control over the nation’s money supply to Congress. 95 years ago, an interpretation of this was accepted that stated that this meant Congress could hand over the control to whomever it pleased. And it decided, in a weird session, to cede its Constitutional power to the Federal Reserve, which was and is made up of a select group of private bankers.
But let’s seek an analogy here. Say that I have, with the consent of both teams, been named the referee in a football match. Does that imply that I have the right to, at any point during the game, hand over the whistle to the local drunk, to the coach of one of the teams, or to the town bookmaker who has vested interest in a favorable outcome? It may be a hard question to answer, but I would venture to say no such right is implied.
Ben Bernanke was not elected by the people. Yet, he will be handed (even more of) the power of the nation’s money. And power over the economy is power over the nation itself. No matter what grand plans Congress comes up with, if you refuse to fund them, they ain’t happening.
Hank Paulson was not elected by the people. If you think there’s no connection between Paulson being Goldman’s CEO for 8 years, and the fact the Goldman will now be able to bury an insane amount of toilet paper in the contaminated RTC composter that is being set up in the capital's backrooms, at the same time that shorting Goldman is banned, then I want some of the drugs you’re taking.
The members of Congress are elected. But they have no idea what is going on. The New York Times quotes even the "finance experts" among them as saying they were stunned when Ben and Hank told them about the shape of things to come. The same two dudes who until now, in every single Congressional hearing, have insisted that the economy was strong, a propaganda piece incessantly repeated by everyone involved, including Shrub.
So who do the members of Congress turn to when they have to vote on issues they don’t understand? They listen to their staff, made up to a large extent of lobbyists, who are on the payroll of the same financial institutions that Congress, see the Constitution, is mandated to regulate. And of course those lobbyists have not been elected by the people.
Shrub has asked Congress for $700 billion in additional funds to buy up worthless paper from the banks. That means that every single American hands over another $2333 dollars, and can then call themselves the proud owner of what has no value whatsoever. The idea is that, as in the original RTC set-up during the Savings and Loan debacle, the paper will eventually regain some of that value. But see, now we’re back in that faith-based casino. And call it what you will, but by now the entire world will laugh in your face if you use the term democracy to address the United States of America.
As the misery among the American people increases, you may think back of when and why I talked about a potential political crisis. It is easy to fool and manipulate a prosperous people. And as the past decade has shown, it's even easy to fool and manipulate people into thinking they're -still- prosperous. But it is an entirely different matter to convince cold and hungry people that they are warm and well-fed.
One last thought: $700 billion doesn't even begin to to buy a dent into to the "wealth" of stinking mob Kleenex that is out there. What are these guys thinking? I don't know, perhaps it's just another giving it to you piecemeal event. I sure as hell am not going to volunteer to be downwind of the smell of this operation. And I humbly suggest you don't either.
Congressional Leaders Stunned by Warnings
It was a room full of people who rarely hold their tongues. But as the Fed chairman, Ben S. Bernanke, laid out the potentially devastating ramifications of the financial crisis before congressional leaders on Thursday night, there was a stunned silence at first.
Mr. Bernanke and Treasury Secretary Henry M. Paulson Jr. had made an urgent and unusual evening visit to Capitol Hill, and they were gathered around a conference table in the offices of House Speaker Nancy Pelosi. “When you listened to him describe it you gulped," said Senator Charles E. Schumer, Democrat of New York.
As Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Banking, Housing and Urban Affairs Committee, put it Friday morning on the ABC program “Good Morning America,” the congressional leaders were told “that we’re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.”
Mr. Schumer added, “History was sort of hanging over it, like this was a moment.” When Mr. Schumer described the meeting as “somber,” Mr. Dodd cut in. “Somber doesn’t begin to justify the words,” he said. “We have never heard language like this.” “What you heard last evening,” he added, “is one of those rare moments, certainly rare in my experience here, is Democrats and Republicans deciding we need to work together quickly.”
Although Mr. Schumer, Mr. Dodd and other participants declined to repeat precisely what they were told by Mr. Bernanke and Mr. Paulson, they said the two men described the financial system as effectively bound in a knot that was being pulled tighter and tighter by the day.
“You have the credit lines in America, which are the lifeblood of the economy, frozen.” Mr. Schumer said. “That hasn’t happened before. It’s a brave new world. You are in uncharted territory, but the one thing you do know is you can’t leave them frozen or the economy will just head south at a rapid rate.” As he spoke, Mr. Schumer swooped his hand, to make the gesture of a plummeting bird. “You know we’d be lucky ...” he said as his voice trailed off. “Well, I’ll leave it at that.”
As officials at the Treasury Department raced on Friday to draft legislative language for an ambitious plan for the government to buy billions of dollars of illiquid debt from ailing American financial institutions, legislators on Capitol Hill said they planned to work through the weekend reviewing the proposal and making efforts to bring a package of measures to the floor of the House and Senate by the end of next week.
Lawmakers in both parties described the meeting in Ms. Pelosi’s office on Thursday night with Mr. Paulson and Mr. Bernanke as collaborative, and that they were prepared to put politics aside to address the needs of the American people. While Democrats initially said after the meeting that they planned to use the administration’s proposal of a huge rescue effort to win support for an economic stimulus package, they pulled back slightly on Friday morning, saying that their top priority was to help put together the bailout package and stabilize the economy.
But it was clear they continued to examine ways to make clear that the government was stepping up not just to help the major financial firms but also to protect the interests of American taxpayers and families by safeguarding their pensions and college savings, and by preventing any further drying up of consumer credit.
In addition to potential stimulus measures, which could include an extension of unemployment benefits and spending on public infrastructure projects, Democrats said they intended to consider measures to help stem home foreclosures and stabilize real estate values.
Among the potential steps Congress can take include approving legislation to allow bankruptcy judges to modify the terms of primary mortgages — authority that the bankruptcy laws do not currently allow and that the banking industry has strenuously opposed. But the Democrats said it was too soon to discuss such details, and that they were awaiting a draft of the proposal from the Treasury Department.
“We have got to deal with the foreclosure issue,” Mr. Dodd said. “You have got to stop that hemorrhaging..If you don’t, the problem doesn’t go away. Ben Bernanke has said it over and over again. Hank Paulson recognizes it. This problem began with bad lending practices. Those are his words, not mine, and so this plan must address that or I’ll be back here in front of a bank of microphones at some point explaining the next failure.”
Even before the drafting of the plan was complete, the Bush administration and the Fed began efforts to sell the idea of a huge rescue to potentially skeptical rank-and-file members of Congress. Mr. Paulson and Mr. Bernanke held a conference call with House Republicans to explain their thinking.
Senator Richard C. Shelby of Alabama, the senior Republican on the Senate banking committee, said in a television interview that cost to the government of purchasing bad debt could run to $1 trillion — a potential warning sign since Mr. Shelby is a longtime skeptic of government intervention in the private market.
Until Mr. Shelby was interviewed on Friday morning, officials on Capitol Hill had been careful not to discuss specific figures, though the rescue envisioned by the Treasury Department clearly entails a government appropriation of hundreds of billions of dollars.
Resolution Trust: the mother of all scams
In what is both the single most socialist move ever made by the US government, and the biggest robbery of US taxpayer since the creation of the union, the Fed and the Treasury have quickly realized who pays the government and acted quickly to ensure the survival of all the crooks on Wall Street. If anyone was at all confused about the puppet and master relationship between big business and DC, this shocking slight of hand should leave no doubt whatsoever who’s in control.
As my good friends at the Housing Timebomb pointed out, the last time this amazing scam was pulled off was during the savings and loans crisis, and the RTC cost the taxpayer $124.6 billion, or roughly $400 for every person living in the US of A. But this meltdown makes the S&L blip look like the boom era, since we’re already $6 trillion in the hole, and that’s just the tip of the iceberg ($20,000 per person already).
What in holy hell is an RTC? Good question. Here to explain exactly how this awesomely-constructed scam works is sparrowshead with his mad clip art skillz:
- So all the banks and big companies that lost money can take all their CDOs, CDSs, subprime stuff and every other shitty investment that backfired, and stuff them into a big trash can euphemistally called a Resolution Trust Corporation. This has two huge advantages - it legally protects them from debt repayment problems and other subtle bankruptcy problems, and it shores up their balance sheets and immediately enables their share price to skyrocket now the debt has gone bye-bye.
- Immediately, previously-insolvent investment banks can now go and borrow money and act like this whole business was just a meaningless, forgetful night of snorting coke from a hooker’s ass.
- Now the RTC has to be supported by Uncle Sam, who basically has to put the infrastructure budget for - well - pretty much everything on hold and start printing money 24/7.
- The great American taxpayer gets left by massive T-bill repayments together with a multi-trillion debt that will take generations to pay off, and the people in investment banks can start buying Ferraris, golf courses and private jets.
Now if I could use an RTC, I’d be happy. Just to emphasize how glorious this scheme really is, think about it as if an RTC existed for your family. Here’s how it would work for mine:
- I dump all my credit card debt, mortgages, car loans, college loans and every other damned rope around my neck and stick it in the RTC.
- I go and get new credit cards and start all over again.
- My neighbors figure out how to pay off the RTC while I can’t decide on the trim for my new Mercedes.
You’ll hear the following phrase repeatedly over the next few weeks from politicians, the Fed, the Treasury and every other scumbag out there: “We had no choice“. Bailout Bernanke has hit the motherload with this one, creating the largest taxpayer liability in the history of the planet.
A few years ago, when we worried about our tiny national debt and how it affected the future economic health of the US, nobody would have even conceived of such an unethical, impracticable, socialist, dumb and downright criminal idea, that made that national debt look like an average-sized bar tab.
The frauds involved with the biggest economic con in history have gotten away with it. They have escaped the bankruptcy they created by pumping trillions onto subprime borrowers who were too stupid to realize what they doing, and who trusted lenders whose only motivation was to get them more in debt. The government has simply written a check to these guys to cover their losses so they can start all over again.
Did you vote for this? Were you asked your opinion? Who the fuck hired Bernanke? Who knows, but you were just given the biggest bill you’re ever likely to see in your lifetime. And did I mention that a substantial amount of that money is going to foreign investors who lost money on the subprime scam? Economically, the USA will never recover from this.
The Unitary Federal Reserve - Crisis Choreography
Along with much of the world, I have watched with increasing disquiet as the United States of America morphed under President Bush into a lawless soft dictatorship more like the USSR than the USA. Under his theory of the "unitary executive" the laws that Congress enacted were disapplied by signing statements and secret legal opinions.
The protections of the Constitution were eroded and marginalized by police powers and warrantless surveillance. International treaties governing the protection of sovereignty, rules of war and the universal rights of man were distorted by unilateral interpretation and willfully hidden misconduct. Court rulings and judicial review were avoided, and where forced, were ignored or overridden or negated by executive pardon.
Transparency and audit became a joke with refusals to cooperate with tribunals or to comply with supeonas or produce evidence. This lawlessness has not made the world or the United States or its allies safer in the age of terrorism as it has degraded and confused what we might have hoped to defend.
Just as we here in the rest of the world hoped we might breathe easy with the end of the Bush administration in sight, and several creditable candidates for president coming forward, the lawless unitary executive has expanded to embrace the Treasury and the Federal Reserve, debasing and contaminating the financial markets globally with its spread to our own central banks and market authorities and destabilizing our banks and investment markets.
Once again in the name of crisis and expediency the laws are ignored, decisions are taken in secret, extra-judicial reapportionment of property and contract is mandated by executive fiat, and legislative review and judicial intervention are impossible. Over the past year every financial crisis has been met with lawless and Enron-esque innovation by the Federal Reserve and Treasury, and this week was arguably more extreme.
After this week's secret and unaccountable and extra-legal moves by the US financial authorities, I will not be holding any assets in the United States. I do not understand the rules. I doubt any rules will be applied fairly to all the players. I cannot be sure who the umpire works for, or what principles the umpire thinks they should uphold. I will not play the game.*
Let's look at a timeline of some of the decisions I would class as extra-legal or Enron-esque:
- The (Selectively Leaked) Discount Rate Cut (August 2008)
- Super SIV (October 2007)
- Term Auction Facility (December 2007)
- Bear Stearns/JP Morgan bailout and subsidy (March 2008)
- Primary Dealer Credit Facility (March 2008)
- Reverse MBS Swaps (April 2008)
- Equity investment and collateral (September 2008)
- Administrative Repeal of 23A (September 2008)
- AIG nationalisation (September 2008)
- Expansion of the Fed Balance Sheet through unprecedented Treasury refinance without appropriation by Congress (September 2008)
- Central bank dollar liquidity draws (September 2008)
- Resolution Trust Company/Super SIV Redux (next)
And that's just the list of actions we know about. Much may have been orchestrated and influenced behind the scenes in credit markets and traded equities and commodities.
At no stage have any of these significant enhancements to the prerogatives of the Federal Reserve, these derogations of explicit statutory limits, these stark departures from past authority and conduct, been the subject of democratic legislative proposal or review, or even public consultation and comment. In the name of exigency, they have all been sprung as fait accompli on a shocked financial community, and since been treated as unquestionable and unreviewable. Every initiative introduced as a temporary measure has become a permanent fixture.
The unitary executive of the Bush presidency eroded and disregarded the civil rights of Americans and others. The unitary Federal Reserve disregards the property and contract rights of Americans and others. Arguably the actions of the Federal Reserve over the past year represent the largest state confiscation of wealth in the history of man, dispossessing currency investors, equity investors, bond investors and taxpayers of literally trillions of dollars of current and future wealth by executive fiat.
The hypocrisy of the Bush administration criticizing Chavez while defending Paulson and Bernanke should be the stuff of late night stand up comedy. And the answer to the crisis so created, according to those in authority in Washington and Wall Street, is to give more concentrated power with less review and less oversight to the Federal Reserve.
The reforms now being discussed in Washington are aimed at:
- gutting the SEC so that it can no longer challenge the Fed's primacy in investment bank and financial conglomerate prudential supervision, oversight of clearing and settlement systems, market integrity and stability and introducing “principles based” regulation so that no one well connected need ever worry about prosecution or conviction ever again;
- gutting the FDIC so that it can no longer challenge the Fed's determination of capital adequacy or prudential supervision at insured banks or restrain cross-affiliate financing or excessively risky activity within bank holding company groups;
- gutting the CFTC so that the Fed has primacy to oversee risk management in all OTC and exchange-traded derivatives clearing and margin; and
- providing explicit powers to the Federal Reserve to promote "market stability" by means which shall be secret, unreviewable, and above challenge in the courts; and
- making the Federal Reserve the prime global regulator for review of the regulatory and prudential supervision arrangements everywhere else in the world through mandated “harmonization” of global standards as a quid pro quo for foreign market recognition and access.
Stalin couldn’t have drafted a better plan for central control of the global economy after wreaking such havoc and devastation.
Up until this week I thought the gold bugs a bit mad. I couldn't see the sense of holding something that couldn't be spent but could be seized (as gold was seized in the 1940s). I still think they are a bit mad, but I am actively looking for any alternative to currency and market investments as a medium of exchange and store of value. Given the very public concerns now being expressed in China and Russia, I am keeping company I would have once thought very surprising indeed.
For now the ECB, Bank of England and others are content to cooperate with the Fed, but as the chaos deepens and it becomes clear that the losses are to be allocated principally outside the US borders to those foolish enough to hold assets the Fed’s policies degrade and debase, they will begin to question and to look to each other for common interest and alignment.
The loss of 1200 lives on the Lusitania was deliberately allowed to justify US entry into World War I. The attacks on Pearl Harbour were known in the White House three days before the bombs fell, but were ignored to justify entry into World War II. Tonkin Gulf was a fraud. WTC hijackers were financed by US allies and WTC 7 was . . . whatever. Saddam’s weapons of mass destruction were fabricated in the forgery shop of Ahmad Chalabi’s Iraqi National Congress. You get the idea.
Not all catastrophic events were willful or anticipated, but all were used to force through an agenda that was pre-agreed by a powerful elite that stood to profit from a preferred course of policies that could only be pursued in the undemocratic atmosphere of crisis. Crisis prevents objective determination of the public interest. Crisis undermines both markets and democracy.
I no longer believe that every financial collapse is unanticipated or without behind the scenes orchestration of effects. I no longer trust the authorities to act fairly, honestly, in the public interest.
In the past year and just this past week, trillions of dollars of wealth have been allocated or misallocated, preserved, appropriated or destroyed by central bank fiat. If we really have nations of laws and not men, capitalist markets and not command economies, then it’s essential we peek behind the curtain to ask by whom and why and hold them accountable.
Lawlessness has not enhanced our security as citizens, and lawlessness will not enhance our security as investors or depositors either. Banks and markets require regulation in the public interest, and determination of the public interest requires transparency, accountability and the rule of law.
Ilargi: The SEC decision to ban short selling of financials is largely based on complaints from Morgan Stanley and Goldman Sachs about "bear raids", in which -false- rumors are spread in order to bring a company’s stock down. This is illegal. But if you look closer, you will find that there is no proof whatsoever of such raids occurring. The only conclusion you can draw from that is that Morgan and Goldman are spreading false rumors in order to save their stocks. Needless to say that, too, is illegal.
Morgan Stanley, Goldman love shorts...and hate them
Morgan Stanley and Goldman Sachs blamed short sellers for their problems this week, an interesting twist for two investment banks known for making money from short sellers and even betting on weakening shares themselves.
Shares of Morgan Stanley and Goldman took a real beating in the middle of this week. The market activity seemed to threaten Morgan Stanley's survival, forcing the investment bank to consider selling itself. If Goldman's shares had fallen long enough, it could have looked at similar measures.
But while pursuing capital, Morgan Stanley Chief Executive John Mack also lobbied the government for relief, which arrived on Friday, when the Securities and Exchange Commission took the highly unusual step of banning short-selling in 799 financial stocks, including Morgan Stanley and Goldman. The overall market cheered the move, but some investors were not pleased.
"I did not hear the big Wall Street banks complaining until short sellers began shorting the financial stocks," said Harry Strunk, partner at Treflie Capital Management, which invests in hedge funds that short, among others. Morgan Stanley and Goldman Sachs believe there is a difference between the shorting of their shares, and the shorting they facilitate for clients.
Both banks believe they are the victims of "bear raids," where short sellers gang up on a stock to try to push its shares lower, rather than having a considered investment thesis. Short sellers bet a company's shares will drop.
"What's happening out there? It's very clear to me -- we're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down," wrote Morgan Stanley CEO John Mack in a memo obtained by Reuters on Wednesday.
Conspiring with other investors to manipulate a share price is illegal, as is knowingly spreading false rumors to move a stock price. But so far no evidence has emerged publicly that any such thing has happened. Some hedge funds believe that Morgan Stanley and Goldman were not victims, but were instead legitimately reevaluated by a world where investors are increasingly skeptical.
"We get very little disclosure from investment banks about their positions, and when savvy banks looked inside Bear's and Lehman's kimonos, they didn't like what they saw," said James Ellman, president at hedge fund Seacliff Capital. "It's rational to lose faith."
A spokesman for Morgan Stanley said the bank has been fully transparent about its mortgage-related exposures and has broken out the write-downs it has taken on each asset category within its mortgage business.
Skepticism about investment banks has run high for some time, reaching a fever pitch this year as Bear Stearns faced a run on the bank, Lehman Brothers filed for bankruptcy, and Merrill Lynch & Co agreed to sell itself to Bank of America Corp.
Short sellers are key clients for Goldman and Morgan Stanley, but quantifying their importance is difficult.
There are some clues as to the importance of short sellers to both firms. Morgan Stanley and Goldman are top firms in prime brokerage, which entails trading and financing securities for hedge funds, including helping them short.
Advisory firm TABB Group estimated earlier this year that prime brokerage in the United States alone would generate $11.5 billion of revenue for banks. The group surveyed 61 hedge funds with an average of $4.3 billion under management, and more than half had a prime brokerage relationship with either Goldman or Morgan Stanley or both.
Faith is in short supply after Lehman Brothers Holdings Inc filed for bankruptcy on Monday. That investment bank had sparred for months with short-sellers who accused the firm of understating its bad assets, even as Lehman said it was strong.
The short sellers turned out to be right -- last weekend, prospective buyers that scrutinized Lehman's books refused to buy the firm because there were too many toxic assets, according to people familiar with the matter.
Morgan Stanley and Goldman have successfully fended off short sellers for now. Their shares surged 20 percent on Friday. And ticking off some of the short-selling clients may be a small price to pay, said Brad Alford, president at investment advisor Alpha Capital. "Hedge funds are getting nailed today, which will hurt Morgan Stanley and Goldman Sachs, but at least their shares won't go to zero now," Alford said.
Ban on Short-Selling Will Hurt Rather Than Help Broker-Dealers
New measures to shore up the markets are coming so fast and furious that it is becoming hard to keep track of them. What most people do not realize is that they produced some not-very-pretty unintended consequences. As we discussed at the time:
- Congress raises conforming limits on Fannie/Freddie to help unfreeze the mortgage market. Result: agency spreads skyrocket, bringing down Bear and a host of hedge funds. Mortgage markets still remain frozen.
- Fed opens TSLF to unfreeze mortgage market. Result: Carlyle goes bankrupt as people rapidly arbitrage the difference between holding MBS in firms that can and can't access the new credit facility. Mortgage markets remain frozen.
Note the spike in agency spreads and bankruptcy of Carlyle helped precipitate the run on Bear. In fact, as Richard Bookstaber discussed at length in his book, Demon of Our Own Design, this sort of unintended consequence is precisely what you'd expect to see in a tightly coupled system, such are our financial system.
Tight coupling occurs when processes move from step to step so rapidly that intervention is well-nigh impossible. Bear Stearns and Lehman are classic examples. A downgrade of their debt beyond a certain level meant that their counterparties could no longer trade with them, because that exposure would get them downgraded too. Thus a move (or threatened move) beyond a trigger point kicked off a sequence of unstoppable events.
One possible consequence is that hedge funds forced to exit positions by the SEC ban on short-selling might take losses big enough to lead to a run of the fund, forcing liquidation of positions. That rapid selling could produce distressed prices, and in a worst-case scenario, brokers could take losses if collateralized positions fell in value and hedge funds were unable to meet margin calls. Note Morgan Stanley and Goldman are far and away the biggest prime brokers.
John Hempton sets forth another unintended consequence which is more certain to happen and broader in its impact and puts none to fine a point on it in his post title, "SEC Tries to Bankrupt Wall Street":Last I looked when I was short a stock the broker borrowed the stock (yes, Virgina you do get a borrow) and sold it. They then had cash. That cash was not available to me - it was pledged to whoever provided the stock to remove or reduce the risk that the stock won't be returned.
That means it is generally available to the broker (who will generally lend me the stock from their inventory or margin or prime broker clients). Now there are a few hundred billion of short-sales out there. Probably more than normal - but a lot in almost all markets.
And those short sales produce cash balances of a few hundred billion, most of which are available to Wall Street brokers. If you ban short-selling those balances will taken away from Wall Street brokers. That would be rather unpleasant. Last I looked the debt market was skittish and was hardly going to replace that money.
So I conclude that the SEC in their "infinite wisdom" are going to stick the knife into Wall Street and bankrupt the lot of them. For political optics. So they can be seen to be doing something about short-selling.
The only reason the damage might not be as broad-scale as Hempton fears is that the "temporary" ban is on shorting financial stock. Oh wait, financial represented (until they started hitting the rocks) 40% of S&P earnings.
And there is something far simpler that the SEC could do. Just re-implement the uptick rule (it means you can short only when the last sale price was above the immediately prior sale). That rule comported itself well for over 50 years but for some unfathomable reason (no doubt at the behest of Wall Street) was eliminated b the SEC.
Hedge funds seen switching short exposure to retail
Hedge funds are likely to increase short exposure to retail stocks following a ban on short selling financial shares imposed by UK and U.S. regulators, industry insiders said on Friday.
Equity long/short and market neutral hedge funds will be among those most affected by the ban as short selling -- betting the price of a share will fall -- is a key component of their investment strategies. Shorting financial stocks has been a popular trade among hedge funds this year, but now they will be forced to switch their attention to other sectors.
John Godden, of hedge fund consultant IGS Group, said: "Commodity and infrastructure providers are continuing to be strong and showing signs of growth going forward. Some service industries are likely to be pretty heavily hit by a slowdown so from a market neutral perspective, there's your long and short sectors."
"You're going to see shorting occurring where there's pressure on volumes and margins in the service industries such as retail," Godden said. Mehraj Mattoo, global head of alternative investments at Commerzbank, added, "If the Wall Street problem begins to translate into the Main Street problem, then clearly some of the retailers and the builders will be affected so there are plenty of other sectors where hedge funds could be taking short positions."
On Thursday, the UK Financial Services Authority banned short selling of financial stocks until January. It said it could extend the ban to other sectors. Short selling has been blamed by many for exacerbating recent market volatility and in some corners for the slump in the share price of HBOS which led to Lloyds TSB stepping in with a deal to rescue the lender.
The retail sector is already the most shorted sector. Research firm dataexplorers.com data shows that at Tuesday's close retail stocks had an average of 8.2 percent of their shares in issue on loan, a reliable indicator of the amount of short selling on a company.
Banks were only the fifth most shorted sector, with 5.9 percent of their shares on loan on average.
Among retail stocks, the most shorted company was HMV, which had almost 37 percent of its stock on loan at close of business on Tuesday.
The banning of short positions on banks, aimed at supporting share prices amid market turmoil, could dent the profits of some of the firms it aims to help -- those with prime brokerage units who provide services to the hedge funds.
Andrew Shrimpton, a partner with hedge fund consultants Kinetic Partners and a former head of the hedge fund unit at the Financial Services Authority, said, "It is going impact the profitability of prime brokers ... There is no question of that." "The ban on short selling (financial stocks) will mean some hedge funds will not be able to execute strategies they want to do," Shrimpton said. "For prime brokers this will reduce revenues. It will have a negative impact."
In recent years, prime brokerage has been one of the fastest growing profit centres for investment banks. The gains are a result of hedge fund industry assets under management expanding to over $2 trillion -- double the level of four years ago.
The exact financial impact on prime brokerage is hard to estimate since banks do not break out data on the business. Morgan Stanley and Goldman Sachs, which have a combined market share of around 60 percent in prime brokerage according to industry estimates, are expected to be the worst hit.
How SEC Regulatory Exemptions Helped Lead to Collapse
The losses incurred by Bear Stearns and other large broker-dealers were not caused by "rumors" or a "crisis of confidence," but rather by inadequate net capital and the lack of constraints on the incurring of debt.
--Lee Pickard, former director, SEC trading and markets division.
Is Financial Innovation just another word for excessive and reckless leverage? Apparently so. As we learn this morning via Julie Satow of the NY Sun, special exemptions from the SEC are in large part responsible for the huge build up in financial sector leverage over the past 4 years -- as well as the massive current unwind.
Satow interviews the above quoted former SEC director, and he spits out the blunt truth: The current excess leverage now unwinding was the result of a purposeful SEC exemption given to five firms.
You read that right -- the events of the past year are not a mere accident, but are the results of a conscious and willful SEC decision to allow these firms to legally violate existing net capital rules that, in the past 30 years, had limited broker dealers debt-to-net capital ratio to 12-to-1.
Instead, the 2004 exemption -- given only to 5 firms -- allowed them to lever up 30 and even 40 to 1. Who were the five that received this special exemption? You won't be surprised to learn that they were Goldman, Merrill, Lehman, Bear Stearns, and Morgan Stanley.
As Mr. Pickard points out that "The proof is in the pudding — three of the five broker-dealers have blown up."
So while the SEC runs around reinstating short selling rules, and clueless pension fund managers mindlessly point to the wrong issue, we learn that it was the SEC who was in large part responsible for the reckless leverage that led to the current crisis. You couldn't make this stuff up if you tried.
Here's an excerpt from The Sun:"The Securities and Exchange Commission can blame itself for the current crisis. That is the allegation being made by a former SEC official, Lee Pickard, who says a rule change in 2004 led to the failure of Lehman Brothers, Bear Stearns, and Merrill Lynch.
The SEC allowed five firms — the three that have collapsed plus Goldman Sachs and Morgan Stanley — to more than double the leverage they were allowed to keep on their balance sheets and remove discounts that had been applied to the assets they had been required to keep to protect them from defaults.
Making matters worse, according to Mr. Pickard, who helped write the original rule in 1975 as director of the SEC's trading and markets division, is a move by the SEC this month to further erode the restraints on surviving broker-dealers by withdrawing requirements that they maintain a certain level of rating from the ratings agencies.
"They constructed a mechanism that simply didn't work," Mr. Pickard said. "The proof is in the pudding — three of the five broker-dealers have blown up."
The so-called net capital rule was created in 1975 to allow the SEC to oversee broker-dealers, or companies that trade securities for customers as well as their own accounts. It requires that firms value all of their tradable assets at market prices, and then it applies a haircut, or a discount, to account for the assets' market risk. So equities, for example, have a haircut of 15%, while a 30-year Treasury bill, because it is less risky, has a 6% haircut.
The net capital rule also requires that broker dealers limit their debt-to-net capital ratio to 12-to-1, although they must issue an early warning if they begin approaching this limit, and are forced to stop trading if they exceed it, so broker dealers often keep their debt-to-net capital ratios much lower.
Washington declares war on debt crisis!
In the last few hours, in a desperate attempt to ward off a catastrophic Wall Street meltdown, the government has announced three unprecedented actions:
First, President Bush, Fed Chairman Bernanke and Treasury Secretary Paulson have called on leaders of both parties in Congress to work through the weekend to develop a plan to let the government buy up bad debts from banks.
Such a plan may buy some large banks some time. But like the bailouts of Freddie Mac, Fannie Mae and AIG, it does very little to change the reality on the ground.
Millions of Americans can still not pay their mortgages. The value of millions of homes is still falling. The nation's $47 trillion debt market is still in deep trouble, and so are the countless companies, consumers and governments that depend on it.
Second, The Securities and Exchange Commission has announced a temporary ban on short selling of 799 financial stocks — an attempt to reduce the massive downward pressure on their share values.
But short selling is a major vehicle that's widely used by prudent investors to reduce their risk and hedge their investments against the very dangers that we see all around us today.
By making it more difficult for investors to hedge in those stocks, the authorities are merely compounding the problem: If investors cannot sell short financial stocks, they will sell short something else as a proxy for financial stocks, including companies in other sectors that remain vulnerable to a credit crisis and a recession.
Alternatively, if investors feel those proxy hedges are not adequate, they will simply resort to outright liquidation of their securities, making the next stock market decline that much worse. Clearly, the SEC cannot repeal the law of gravity. And no matter what they do, the government cannot stop investors from selling.
Third, early this morning, Washington moved to guarantee money market funds that invest in high risk instruments like commercial paper. This supposedly protects money fund investors from the kind of "Breaking the Buck" crisis that arose this week at Reserve Primary Fund, buying some time for a $2 trillion industry in turmoil. But alas, this, too, is a disastrous and futile gesture.
The reason: To fund the Fannie Mae, Freddie Mac, AIG and new banking bailouts, it's estimated that the U.S. Treasury will need to borrow at least $1 trillion in new money from investors in the United States and abroad.
But by guaranteeing money funds that invest in high-risk, higher-yielding instruments, the authorities are actually encouraging investors not to invest in the lower-yielding U.S. Treasuries.
Result: With this step, the U.S. government is shooting its funding operation in the foot. It's merely making it that much more difficult for the U.S. Treasury itself to raise the money it will need for each and every one of its bailout efforts.
And sure enough ...This morning, U.S. bond prices are collapsing, as the interest rate the U.S. Treasury has to pay on its 10-year bonds has surged by an unprecedented 39 basis points (.39 percentage points).
Bottom line: These three government bombshells do not end the credit crisis. They merely threaten to spread the plague to the one borrower who heretofore stood above the crowd of sinking debtors: The United States Government itself.
Urgent Answers to
Your Urgent Questions
With each of these dramatic Wall Street disasters, unprecedented government counter-actions, and violent market reactions ... my inbox has quickly filled up with urgent questions. Here are the main ones with my response.
Q. Will these new government actions end the crisis?
A. No. It may buy a bit of time for some banks. But now that the nation's $47-trillion debt balloon and $180-trillion derivative bubble have burst, no amount of legislation can restore them. Nor can the government legislate a bull market in stocks or an end to the recession.
Q. The SEC is forbidding short sales. What impact will this have on the stock market?
A. The immediate impact is the rally you've seen so far. However, this action merely destabilizes the market further by making it more difficult for investors to hedge their risk.
Q. I own put options. How does the SEC's action affect me?
A. Put options are not short sales and are not part of the SEC's prohibition. Moreover, the SEC's action is strictly regarding a finite list of 799 financial stocks. All other stocks are not covered.
Q. Won't financial stocks rally sharply in this environment?
A. They already have rallied. But that rally is likely to be short-lived, just like every other government-inspired rally to date. Remember: The government cannot save the entire banking system, let alone the entire $47 trillion U.S. debt market.
Q. Is this the signal to jump back into stocks?
A. For stocks that are vulnerable to a credit crisis and an economic decline, this is a signal to SELL. And for those who are looking for a hedge or profit opportunity for the next big decline, this is an ideal opportunity to get started.
Q. I have put options based on your recommendations. What should I do?
A. We see this rally as an opportunity to add more. If you subscribe to our services that recommend put options, stand by. We will send you new alerts early next week.
Q. What about inverse ETFs? How does this affect them?
A. Our strategy is unchanged: If you own them, hold. If you don't own any, you could soon have a good opportunity to buy to prepare for the next decline. The best time to start hedging strategies is precisely at a time like this — when the government stimulates temporary, artificial rallies in the market, prior to the next major decline.
However, due to the SEC's new rules against short selling, issuers of inverse ETFs may have to make adjustments to their investment strategies. We will provide more information on this aspect as soon as it is available, probably early next week.
Q. Based on your recommendations, I was planning to move out of a bank that you said is unsafe. Should I forget about doing that now?
A. No. Do not assume your institution will benefit from the new government rescues. If anything, when the government starts borrowing the money it needs to fund its bailouts, it will only serve to drive all interest rates higher, making the mortgage and banking crisis that much worse. In the final analysis, uninsured bank depositors will still lose money; insured depositors will still suffer serious inconveniences; and shareholder value could still be wiped out.
Q. You are saying the U.S. Treasury is taking on too much risk. So why should I buy Treasury bills?
A. The additional risk the Treasury is taking will be reflected in Treasury bonds, which are likely to fall in price and rise in yield. It will not have more than a tiny affect on short-term Treasury bills, which barely fluctuate in price and mature in less than one year. Plus, if you stick primarily with 3-month Treasury bills or equivalent, you should be able to roll over those bills at higher yields as interest rates rise.
Q. Gold surged $130 in just 24 hours. Is it too late to buy?
A: Larry has been recommending gold for many months. And on the day BEFORE gold's $130 surge, he sent out a new flash alert to his Real Wealth subscribers to add substantially to their gold holdings. He continues to recommend buying on any temporary dips.
Q. I follow some of the services put out by your other editors, and they don't always agree with you on each market. What gives?
A. I don't tell our analysts what to write or what to think. Each follows an independent strategy based on his or her research and analysis. However, I am pleased to note that all have recommended prudent steps to take out partial profits on a timely basis as well as hedges to help protect you from downside risk.
Q. Can the government continue bailing out everyone forever? Where is the limit? And how can I know when that limit is being reached?
A. Contrary to popular belief, the government's resources are NOT unlimited. Brace yourself for the day in the not-too-distant future when the government finds it increasingly difficult to borrow the money it needs to fund its bailouts. This occurred at least once before, in February of 1980, when the U.S. Treasury could not find buyers for its Treasury bonds. And it was forced to dramatically reverse its monetary and fiscal policy in order to restore its borrowing power.
When that happens again, it will signal that the government has reached the limit in its ability to save the financial system and stimulate the economy.
Q. It sounds like you're saying we should abandon everything and run for the hills. Is that an accurate reading of your views?
A. No. For every weak bank, there are several strong banks; and for every company that's likely to fail, there are many that have the wherewithal to survive. These companies cannot prevent a very painful and traumatic decline. But once the economy and markets hit rock bottom, they can play a constructive role in the subsequent recovery.
Q. Everyone seems to be in favor of the government's rescues. They say that, no matter how rash they may be, the alternative is worse. But you don't seem to agree with that view. Why not?
A. Because the rescues are vastly premature. Before the government can play a constructive role in a recovery, the bad debts and weakest links in our economy need to be liquidated. By intervening now, the government is merely preventing that natural process from progressing. It is spreading the pain to more sectors, prolonging the crisis and weakening our nation's future recovery powers. The sooner it abandons or limits its rescues, the sooner we can put this crisis behind us and move on to a true recovery in the American economy.
WaMu on the auction block
Five banks have come forward to evaluate Washington Mutual’s financial records as part of an auction process run by WaMu’s adviser, people familiar with the matter said on Thursday.
WaMu shares rose 14 per cent on Thursday after news it had put itself up for sale. The five banks that have looked through the WaMu materials include JPMorgan Chase, Wells Fargo, Citigroup, HSBC and Banco Santander, the people familiar said. It was unclear whether any of them intended to make an offer for WaMu.
Goldman Sachs is conducting the auction for Seattle-based WaMu, which is the sixth largest US bank, with $310bn in assets. JPMorgan made an offer for WaMu this spring but was rebuffed. JPMorgan may be waiting to see whether the auction heats up before determining whether to bid for WaMu’s assets now or try to buy pieces of the bank more cheaply later, sources close to the matter said.
Fred Cannon, analyst at Keefe, Bruyette & Woods, said WaMu’s franchise and retail branch network on the west coast of the US made it an attractive prospect for banks such as JPMorgan, but added that a buyer would have to take up to a $37bn accounting hit from the deteriorating mortgage portfolio.
TPG, the private equity firm that led an investor group that put $7bn into WaMU in April, on Wednesday tried to facilitate a sale of the ailing bank, waiving its right to be compensated for dilution from any future capital-raising. In its memo to its investors back in April, TPG estimated that cumulative losses from the residential mortgages at WaMU would likely be in the ”mid $20 billions” but other firms looking at WaMu at the time thought losses could be far higher.
WaMu’s troubles have accelerated over the past week after downgrades to junk status from Standard & Poor’s and Moody’s rocked investor confidence. If the auction does not draw interest, Goldman may have to evaluate other options for the bank. These could include raising capital by selling off the attractive assets, which would still leave WaMu holding the mortgage portfolio, or raising fresh capital to allow the bank to stand alone – a challenge in the current climate.
TPG litself put $2bn into WaMu. Since then, TPG has sold down its exposure and now has about $1.3bn spread across three of its funds. TPG’s right to a so-called “reset” – originally meant to safeguard the value of its minority investment in WaMu – made it difficult to attract new capital and effectively functioned as a poison pill.
Ameribank 12th bank failure this year
Regulators closed on Friday Ameribank Inc, which became the 12th bank failure this year as the struggling economy and falling home prices take their toll on financial institutions.
The Federal Deposit Insurance Corp said the Northfork, West Virginia-based bank had $115 million in assets and $102 million in deposits as of June 30. The failure is expected to cost the U.S. bank deposit insurance fund about $42 million.
Pioneer Community Bank Inc in Iaeger, West Virginia, and The Citizens Savings Bank in Martins Ferry, Ohio, entered into agreements to assume all the deposits and certain assets of Ameribank, which was closed by the Office of Thrift Supervision. Customers can access their money over the weekend by check, teller machine or debit card, the FDIC said.
Federal Reserve needs to rediscover power to shock and awe to ease crisis
The world's central banks no longer seem able to shock and awe the markets with a blast of liquidity.
Yesterday's move by the US Federal Reserve, the European banks and the Bank of Japan to douse the global banking system with $184bn (£101bn) may get us through the week without another catastrophic failure, but it does nothing to halt the downward spiral into debt deflation.
"The central bank action treats a symptom of the disease, not the disease itself," said Stephen Lewis, chief economist at Insinger de Beaufort. "It is a palliative. At root, there is no way of imbuing worthless financial claims with value."
The yield on three-month Treasury notes remains near zero - a level last seen after Pearl Harbour - reflecting a near total loss of confidence in all financial instruments. The five-year CDS credit default swaps on a great clutch of America's biggest companies are flashing imminent bankruptcy signals: Washington Mutual (2638), General Motors (2284), MBIA Insurance (2187), Advanced Micro (1773), Ford Motor (1718).
We are dangerously close to a $3.5 trillion collapse of America's money market fund industry. "It's an incredibly serious issue. A tipping point in this crisis would be when you have a run on money markets, and we are right on the cusp of that," said Paul McCulley, PIMCO's portfolio chief.
The Fed, the US Treasury and Congress are still scrambling to catch up with this crisis, responding to events with piecemeal measures made up on the hoof. Obviously it is not enough. Former Fed chief Paul Volcker is now calling for a vast sink - underwritten by the US taxpayer, and modelled on the Resolution Trust Corporation (RTC) - to soak up trillions of dollars of toxic debt and asset-backed securities once and for all.
"Until there is a new mechanism in place to remove this decaying tissue from the system, the infection will spread, confidence will deteriorate further, and we will have to live through the mother of all credit contractions. This contraction will undercut the financial system, and with it, the broader economy," he wrote in a joint article with other elder statesmen.
"It will in the short run require serious money. But a failure to act boldly would cost the taxpayer and the country far more. The pathology of this crisis is that unless you get ahead of it and deal with it from strength, it devours the weakest link in the chain and then moves on to the next link. Crisis times require stern measures."
The RTC was created in 1989 to absorb the bad debts from the Savings and Loans crisis. The assets of the bankrupt lenders were taken over by the state, preventing fire-sales that can drive prices even lower in a self-feeding spiral. It worked well enough. The RTC sat on the devalued assets until the bloodbath was over. In the end it made a nice profit.
Such a Super-Sewer would put a floor under the collapsing value of CDOs, CLOs, HELOCs and all the myriad instruments of leveraged excess that lie at the root of this crisis. By doing so it would at last allow banks to lick their wounds and compute losses. Above all, it would mitigate the US housing crash, changing the whole profile of projected defaults now haunting the banking system.
How much would it cost? Prof Kenneth Rogoff, former chief economist at the IMF, says the bill would run to at least $1 trillion. This would increase the US government debt from 48pc to 55pc of GDP (under IMF measures) - still lower than that of Germany, France, Italy or Japan.
Barney Frank, chair of the House Banking Committee, said he is ready to embrace the idea. "There have been a series of ad hoc interventions that have not worked. Has the private market made so many mistakes there needs to be some public intervention? We have to consider whether to create another entity," he said.
Yet days goes by, banks topple, and still nothing concrete emerges from Washington. Capitol Hill is shutting down for a month. The politicians are in election mode. Congressional leaders say the issue may have to wait until the new session in January. The drift is eerily reminiscent of early 1931, in the months before the global system snapped with the failure of Austria's Credit Anstalt.
The Fed and the US Treasury seem out of their depth. It is shocking to learn that New York Fed chief Tim Geithner was not aware until this weekend that AIG plays a key role at the epicentre of the world's derivative system, underpinning the massive nexus of CDO credit contracts. Specifically, it has a CDS portfolio of $447bn, mostly writing credit protection for European clients.
RBC Capital Markets says the world banking system would face fresh losses of $180bn if AIG collapsed. Fed officials seemed to think an insurer could safely be allowed to fail. After hair-raising briefings over recent days, they learned better. Hence the about-turn bail-out on Tuesday night for $85bn.
No doubt Treasury Secretary Hank Paulson has an impossible task, but it is a moot point whether his decision to seize the mortgage giants Fannie Mae and Freddie Mac was itself the trigger of the Lehmans/Merrill/AIG/ debacle.
He bailed out bondholders - mostly Chinese, Japanese and Russian state entities - in order to ensure they would continue to fund the US housing market, and to underpin the dollar. But to defend himself against accusations of moral hazard, he offered up the shareholders for ritual sacrifice. He did so even though the Treasury itself had encouraged investors to inject billions of fresh capital, and had repeatedly insisted that the twins were in good health.
The result was to jam shut the window for the long list of struggling lenders, brokers and insurers seeking fresh capital. Who will invest anything if Washington can so capriciously change the rules and expropriate their shares at a stroke? History will judge whether he lost sight of his mission.
As for the world's central banks, they have to ask themselves whether they risk losing the plot altogether by harping on about inflation when the imminent danger is debt deflation. The Fed's Tuesday statement suggesting that the risks of inflation and slowing growth are roughly matched is so tone-deaf, and so implausible after the $50 collapse in oil prices, that it should be framed for posterity. The central banks were too loose during the credit bubble. They are too tight now.
This crisis will not begin to abate until monetary gods at the Fed and the ECB make it clear at long last that they grasp the full extent of the crisis by slashing interest rates in a single concerted action. That will shock and awe.
Greenspan’s sins return to haunt us
Back in 2002, when his reputation as “The Man Who Saved the World” was at its peak, Alan Greenspan, former chairman of the Federal Reserve, came to Britain to pick up his knighthood. His biggest fan, Gordon Brown, now the UK prime minister, had ensured that the citation said it was being awarded for promoting “economic stability”.
During his trip, Mr Greenspan visited the Bank of England’s monetary policy committee. He told them the US financial system had been resilient amid the bursting of the internet bubble. Share prices had halved and there had been massive bond defaults, but no big bank collapses. Mr Greenspan lauded the fact that risk had been spread, using complex derivative instruments.
One of the MPC members asked: how could this be? Someone must have lost all that money; who was it? A look of quiet satisfaction came across Mr Greenspan’s face as he answered: “European insurance companies.”
Six years later, AIG, the largest US insurance company, has in effect been nationalised to stop it blowing up the financial world. The US has nationalised the core of its mortgage industry and the government has become the arbiter of which financial companies should survive or die.
Financial markets have an enormous capacity for flexibility, but market participants need to be sure that there are rules, and a referee willing to impose them. Permanent damage has been done to the financial system, despite the extraordinary measures of Messrs Henry Paulson, the US Treasury secretary, and Ben Bernanke, the Fed chairman, to address the problems that stem from the actions of their predecessors. As Mr Paulson has suggested, he is playing a hand dealt by others.
Many blame the Greenspan Fed for this mess. They are right, but not for the reason often cited. It is unfair to say low interest rates are to blame. In the past decade, there is no evidence the US suffered from excessive growth leading to inflation. The economy needed low interest rates and a fiscal stimulus to avoid a severe recession. The Fed was right to do its bit.
Where Mr Greenspan bears responsibility is his role in ensuring that the era of cheap interest rates created a speculative bubble. He cannot claim he was not warned of the risks. Take two incidents from the 1990s. The first came before he made his 1996 speech referring to “irrational exuberance”. In a Federal Open Market Committee meeting, he conceded there was an equity bubble but declined to do anything about it.
He admitted that proposals for tightening the margin requirement, which people need to hold against equity positions, would be effective: “I guarantee that if you want to get rid of the bubble, whatever it is, that will do it.” It seems odd that since then, in defending the Fed’s inaction, he has claimed in three speeches that tightening margins would not have worked.
The second incident stems from spring 1998 when the head of the Commodity Futures Trading Commission expressed concern about the massive increase in over-the-counter derivatives. These have been at the heart of the counter-party risk in the crisis. Mr Greenspan suggested new regulation risked disrupting the capital markets.
At the turn of the millennium, with no move to tighten margin requirements, a feedback loop sent share prices into orbit. As prices rose, more brokers were willing to lend to buy more shares. As share prices went up the buying continued, until the bubble burst. To create one bubble may be seen as a misfortune; to create two looks like carelessness. Yet that is exactly what the Greenspan Fed did.
Bruised by stock market losses, Americans bought houses. The mortgage industry used securitised bonds to ensure that the people who initiated the mortgage did not worry about getting paid back; risk was packaged and sold to others. This time Mr Greenspan did not just stand aside. He said repeatedly that housing was a safe investment because prices do not fall. Home owners could wait out any downturn. Is it any surprise that so many people thought if the world’s financial genius held this view it must be all right?
Even as things went completely wild, Mr Greenspan dismissed those who warned that a new bubble was emerging. It was just a case of a little “froth” in a few areas. Later, after waiting until 2007, two years after he left office, he conceded that “froth” had been his euphemism for “bubble”. “All the froth bubbles add up to an aggregate bubble,” he told the Financial Times.
This time, as with the equity bubble, the mistake was not to set interest rates too low; it was to stand back as wildly imprudent policies were pursued by mortgage lenders. Indeed, any lender would have been encouraged by his words in April 2005: “Where once more-marginal applicants would simply have been denied credit, lenders are now able to quite efficiently judge the risk posed by individual applicants and to price that risk appropriately. These improvements have led to rapid growth in subprime mortgage lending.” Well, he was right about the rapid growth in subprime lending.
Mr Greenspan was in charge of supervising and regulating much of the banking industry for two decades. The Fed says it is responsible for ensuring “safe and sound banking practices”. It is right that other regulators should have stepped in, too – the US regulatory structure has not kept pace with market changes .
But given the Fed’s institutional importance and Mr Greenspan’s personal stature, does anyone doubt that the Fed could have used its limited powers to ensure a closer examination of what was going on? Mr Greenspan realises that something big has happened and describes it as a “once in a hundred years” event. But then, you do not get Alan Greenspans coming along every day.
Decades of greed and hubris. A week of shock and panic. But what comes next?
On Tuesday, in the middle of the worst financial panic since the Great Depression, the kings of Wall Street held their last jamboree.
Bankers and investors in London, Zurich, Tokyo, Dubai and Shanghai dialled a freephone number in New York, and waited as Classic FM-style music played. At 4pm London time, a disembodied voice announced: “Good morning. My name is Gerald, and I’ll be your conference facilitator today.” Then, a minute or so later, the man from the investment bank Goldman Sachs came on the phone.
David Viniar, 51, is Goldman’s chief financial officer, an old-fashioned Master of the Universe with a salary to match. Last year, according to Business Week magazine, he earned $23 million. Over the past five years, his style when discussing the firm’s quarterly results has been insouciant, cool, matter-of-factly triumphant – think of John Wayne playing a Second World War flying ace. But his performance that day rang hollow. He knew, as did those listening, that he was in the midst of the end of the world as bankers knew it.
Wall Street and the City of London have been teetering on the brink of semi-liquidation all week. Imagine a high street lined by banks, one after another turning out the lights or selling themselves to the neighbours. In addition to the evisceration of two great American financial names – Merrill Lynch and Lehman Brothers – American authorities had to bail out AIG, formerly the largest insurance company in the world.
In Britain, HBOS, which has more than 22 million customers and holds more than £250 billion of our savings, had to be rescued from collapse by a rival, Lloyds TSB. As a result, shares around the world plummeted. The FTSE100 plunged by more than 500 points between Monday and Thursday, falling four per cent on Monday alone.
It rebounded, however, at the end of the week, after the Bank of England, the Federal Reserve and other central banks pumped nearly a quarter of a trillion dollars into the money markets to keep them from seizing up. During these few days, the global financial market has been fundamentally reordered. If the new system fails, some fear we could face another Great Depression.
For proof of the turmoil, look at the fate of Goldman Sachs, and of its rival Morgan Stanley. At the start of the week, as Lehman Brothers failed, they were presumed to be safe – but the stock of both plunged as shareholders lost confidence in their ability to survive in a world of commercial-bank behemoths such as HSBC and Bank of America, both of which enjoy the cushion of money from depositors.
With Morgan Stanley in merger talks, Goldman may become the last survivor of the titans of Wall Street – even if standing on its own against larger rivals could prove extremely uncomfortable. If there was an institution that should be able to weather any storm, it would be Goldman. As Wall Street’s – and the world’s – number one investment bank, Goldman is king of the hill in global finance, perhaps the world’s most respected enterprise.
Its staff go through as many as 20 interviews to get an entry-level job, and its alumni fill positions of power around the globe. At that conference call, Viniar pointed out that although Goldman’s profits were down, they were better than any other investment bank’s, and the company was in sound shape. “It is performance that counts,” he said, “not the business model.”
But the analysts monitoring Goldman knew that this Master of the Universe had had the stuffing knocked out of him. Feeling his pain, they lobbed easy, half-hearted questions. Then came a moment of pure embarrassment. An analyst from Lehman Brothers, the giant securities firm that had gone bust days before, identified himself and joined the conversation.
The ghostly echo of the institution he was representing from the protection of a New York bankruptcy court was an acute reminder of Goldman’s own hazardous position. It will come as scant consolation for Viniar that the man who had put him in that position was his former boss at Goldman: Hank Paulson, the US Treasury Secretary, who has orchestrated the events of the week.
Paulson’s plan was simple: take the gamble, pull the safety net out from under the financial system, and see if, with selective help from the authorities, it could avoid meltdown. Let Lehman fail. Force Merrill into the arms of Bank of America, but save AIG. In other words, act on the advice of Walter Bagehot, the great 19th-century English financial journalist, and stuff short-term funds down the bankers’ throats to bolster their crushed confidence.
UK shorting ban could help rival hedge fund centres
Britain's temporary ban on short-selling financial stocks is irksome for London's hedge funds and is another factor which could help undermine the city's pre-eminent position in Europe as a hedge fund base.
Short-selling is a key trading strategy for hedge funds as they aim to profit regardless of whether a stock is rising or falling, but London's curbs come as rival centres seek to attract hedge funds to bolster their financial sectors. Switzerland, France, Luxembourg and Scandinavia have all begun to emerge as alternative options for hedge funds looking for lower tax and a higher quality of life.
The European industry could follow the U.S. model and develop in a number of regional centres, although London's upmarket St James's and Mayfair districts are likely to remain the heart of the industry in Europe for at least the time being.
"It's like in the U.S.," said Thames River fund-of-hedge-funds manager Ken Kinsey-Quick. "New York dominated, then in the 90s managers started to spread to Connecticut then all over the U.S. "London will be like New York today. I don't think it'll give up its pole position but it won't get 100 percent of the business."
Hedge funds managers in London are already facing a tax introduced earlier this year on so-called non-domiciled individuals, under which they must pay a 30,000 pounds-a-year levy after seven years of living in Britain.
Now their freedom to short-sell stocks has come into the firing line after being blamed by regulators, politicians and some market participants for accelerating the collapses in share price of banks such as Lehman Brothers and HBOS.
The controls, echoed in New York, helped inspire a sharp rally of banking stocks in Europe and the United States but were not universally welcomed. "The move may not prove popular for (hedge fund) managers in London and may also limit their ability to compete with managers based in other jurisdictions," said Jerome de Lavenere Lussan, Managing Partner at Laven Partners.
However, he noted hedge funds would not necessarily be able to escape the regulations by moving abroad, since any rules would apply to the London-based investment banks they trade through. It was London's relative lack of rules, such as the Sarbanes-Oxley provisions in the United States -- which imposed extra reporting requirements on companies -- which made London so popular in the first place.
"One of the reasons London became so popular ... was the difficulty and expense of doing business in the U.S.", said Odi Lahav, head of Moody's European Alternative Investment Group. While some other regulators followed the UK's example, Switzerland for instance allows "covered" shorting, where a hedge fund borrows shares before selling them, as opposed to "naked" shorting, when investors sell stock without owning or borrowing it.
Switzerland has been the most prominent in marketing itself, outlining plans to simplify the tax and regulatory regime to attract hedge funds and private equity. Some funds are already making the move -- commodity hedge fund Krom River is moving to Zug in Switzerland from London to take advantage of lower tax and better lifestyle, the Financial Times has reported, although the firm declined to comment.
"It (the European hedge fund industry) most certainly is expanding. There are great managers in Oslo, Stockholm, we're seeing now some starting out in Amsterdam and Copenhagen," said Thames River's Kinsey-Quick. According to news and data group HedgeFund Intelligence, the number of hedge funds based in continental Europe and the amount of money they run is showing signs of growth.
At the start of 2007, Stockholm had three with $7.1 billion and Moscow had two running $4.3 billion -- numbers which had grown by the start of 2008 when Stockholm had four funds with $12.5 billion in assets and Moscow had three with $4.6 billion. London was still way ahead with 75 such funds with $348.6 billion in assets.
Cyril Julliard, co-founder of Paris-based fund-of-hedge-fund firm ERAAM, said the industry was growing in the French capital. "I think that the AMF French market regulator has established a regime that is more or less favourable to hedge funds setting up business in Paris," he said.
Some say the move to European locations outside London is set to accelerate as investors accept that the best fund managers do not need to be based close by -- particularly in the current environment, where the average hedge fund is down 3.55 percent year-to-date, according to Credit Suisse/Tremont.
"One of the impacts of performance depression is that investors and funds of hedge funds will go further afield and look at managers they have not looked at before," said analyst Ferenc Sanderson at Lipper, a Thomson Reuters company. "In the old days it was expected that managers said 'I want to be near those guys (investors)'. Now managers say 'If I'm good enough they'll find me'".
How Wall Street Lied to Its Computers
So where were the quants? That’s what has been running through my head as I watch some of the oldest and seemingly best-run firms on Wall Street implode because of what turned out to be really bad bets on mortgage securities.
Before I started covering the Internet in 1997, I spent 13 years covering trading and finance. I covered my share of trading disasters from junk bonds, mortgage securities and the financial blank canvas known as derivatives. And I got to know bunch of quantitative analysts (”quants”): mathematicians, computer scientists and economists who were working on Wall Street to develop the art and science of risk management.
They were developing systems that would comb through all of a firm’s positions, analyze everything that might go wrong and estimate how much it might lose on a really bad day. We’ve had some bad days lately, and it turns out Bear Stearns, Lehman Brothers and maybe some others bet far too much. Their quants didn’t save them.
I called some old timers in the risk-management world to see what went wrong. I fully expected them to tell me that the problem was that the alarms were blaring and red lights were flashing on the risk machines and greedy Wall Street bosses ignored the warnings to keep the profits flowing. Ultimately, the people who ran the firms must take responsibility, but it wasn’t quite that simple.
In fact, most Wall Street computer models radically underestimated the risk of the complex mortgage securities, they said. That is partly because the level of financial distress is “the equivalent of the 100-year flood,” in the words of Leslie Rahl, the president of Capital Market Risk Advisors, a consulting firm.
But she and others say there is more to it: The people who ran the financial firms chose to program their risk-management systems with overly optimistic assumptions and to feed them oversimplified data. This kept them from sounding the alarm early enough.
Top bankers couldn’t simply ignore the computer models, because after the last round of big financial losses, regulators now require them to monitor their risk positions. Indeed, if the models say a firm’s risk has increased, the firm must either reduce its bets or set aside more capital as a cushion in case things go wrong.
In other words, the computer is supposed to monitor the temperature of the party and drain the punch bowl as things get hot. And just as drunken revelers may want to put the thermostat in the freezer, Wall Street executives had lots of incentives to make sure their risk systems didn’t see much risk.
“There was a willful designing of the systems to measure the risks in a certain way that would not necessarily pick up all the right risks,” said Gregg Berman, the co-head of the risk-management group at RiskMetrics, a software company spun out of JPMorgan. “They wanted to keep their capital base as stable as possible so that the limits they imposed on their trading desks and portfolio managers would be stable.”
One way they did this, Mr. Berman said, was to make sure the computer models looked at several years of trading history instead of just the last few months. The most important models calculate a measure known as Value at Risk — the amount of money you might lose in the worst plausible situation. They try to figure out what that worst case is by looking at how volatile markets have been in the past.
But since the markets were placid for several years (as mortgage bankers busily lent money to anyone with a pulse), the computers were slow to say that risk had increased as defaults started to rise. It was like a weather forecaster in Houston last weekend talking about the onset of Hurricane Ike by giving the average wind speed for the previous month.
But many on Wall Street did even worse, as Mr. Berman describes it. They continued to trade very complex securities concocted by their most creative bankers even though their risk management systems weren’t able to understand the details of what they owned.
A lot of deals were nonstandard in many ways, “so you really had to go through the entire prospectus and read every single line to pick up all the nuances,” Mr. Berman said. “And that slows down the process when mortgage yields looked very attractive.”
So some trading desks took the most arcane security, made of slices of mortgages, and entered it into the computer if it were a simple bond with a set interest rate and duration. This seemed only like a tiny bit of corner-cutting because the credit-rating agencies declared that some of these securities were triple-A. (20/20 hindsight: not!) But once the mortgage market started to deteriorate, the computers were not able to identify all the parts of the portfolio that might be hurt.
Lying to your risk-management computer is like lying to your doctor. You just aren’t going to get the help you really need. All this is not to say that the models would have gotten things right if only they were fed the most accurate information. Ms. Rahl said that it was now clear that the computers needed to assume extra risk in owning a newfangled security that had never been seen before.
“New products, by definition, carry more risk,” she said. The models should penalize investments that are complex, hard to understand and infrequently traded, she said. They didn’t. “One of the things that has caused great pain is complex products,” Ms. Rahl said.
That made me think back to some of the great trading debacles of the last century, such as the collapse of Askin Capital Management, a hedge fund that fell apart because of complex mortgage security investments gone bad. Wasn’t the moral of those stories that you shouldn’t put your money (or your client’s money) in something you didn’t understand? Furthermore, even if you are convinced you do understand it, you’re not going to be able to sell it when you need the money if no one else does.
“In some ways there is nothing new,” said Ms. Rahl, who helped investigate what went wrong at Askin. “The big deals are front-page news, then they go into the recesses of people’s memories.” And, ultimately, the most important risk-management systems are the ones that have gray hair. “It’s not just the Ph.D.’s who must run risk management,” Ms. Rahl said. “It is the people who know the markets and have lifelong perspective.” And at too many firms it is those people who failed to make sure the quants really did their jobs.
Why Have the Government Bailouts Involved Only a 79.9% Equity Position?
A small but unexplained detail in the federal government's nationalization of Fannie, Freddie, and AIG has been that the deals have been structured so that the Fed or Treasury ends up owning no more than 79.9% of the nationalized entities' stock (or having warrants that, if exercised, would produce the same result). So what is the source of the 79.9% threshold? Why didn't the government do a 99.99% dilution of shareholders (and thereby a full de facto taking)?
It turns out that the explanation is not related to 80% being the threshold before the Fed/USG would have to carry the entities on their own books. Federal Accounting Standards are silent on the issue, but the Congressional Budget Office is already treating Fannie/Freddie like USG assets/liabilities (consistent with GAAP).
Instead, the explanation is tax. Section 163 of the Internal Revenue Code generally provides that interest paid on debt is tax-deductible for federal income tax. But there's an exception. If the interest is paid on a loan from an entity that controls 80% or more of the voting power and value of a corporations' total shares, then the interest is not tax-deductible. Fannie and Freddie are generally tax-exempt. They are, however, subject to federal income tax. AIG, of course, has no tax-exempt status, whatsoever.
Because the bailout deals were structured so that the Fed or Treasury will make sizable loans to the nationalized entities, they had to be careful not to reach the 80% threshold, lest the nationalized entities (which still pay taxes) lose their tax deduction for the interest paid on the Fed/Treasury loans (LIBOR +850 on $85BN for AIG--that's a lot of interest).
Of course, one might well ask why the Treasury would want to ensure Fannie and Freddie have a deduction--that just means less revenue for the government, right? I'm not sure of the answer to this--I think there are several possible explanations, but none is overwhelming. Nonetheless, the tax explanation seems to fit better than any other.
The Fiscal Meltdown Reveals the Democratic Deficit
I participated last Monday night in the BBC "Economist Debates" on the economic meltdown broadcast from the heart of the City, London's financial district. Nearly all of the CEOs, financial consultants and bankers on our over sized debate panel echoed the media coverage, treating the crisis as a technical problem, a puzzle economists had to solve. The market paradigm within which the crisis unfolded is taken for granted and solutions are sought within the paradigm.
But the problem is the paradigm of four decades of a Reagan/Thatcher privatization ideology that has insisted government can do no right and markets can do no wrong. We now have had forty years of old Republicans and New Democrats, Bill Clinton included, old Tories and new Labor, Tony Blair included, all conspiring to deregulate media, deregulate banks, deregulate the financial industry and get government out of the way of the market's invisible hand.
In their foolish assault on 'big government' and 'welfare bureaucracy' and in their political campaigns against Washington, these representatives of the democratic process have in fact undermined democracy and made war on the very spirit of the commonweal.
Government is us: the political arrangements we forge in order to be able to do together the many public things we cannot do one by one; the deliberative processes we establish so that public policy will reflect public goods rather than private preferences.
The Washington against which we rail is also us, the political home of those we choose to represent us, like Senator McCain, and yes, Senator Obama. But a seductive market ideology has talked us out of our citizenship, talked us into believing that all that is demanded from us as citizens can be achieved by us as consumers. Hence, voting has become a form of shopping, elections a version of American Idol.
Yes, there is to be sure a technical issue in the crisis: it's called leveraging and it is a the very foundation of the banking system. Leveraging is what allows banks to put your deposits to work by reinvesting most of them and keeping only a small percent on hand for depositors wanting their money back. But for a system of leveraging to work there must be transparency, full disclosure and a reasonable limit on just how much leveraging is permitted. Normally, governments establish and enforce transparency and limits.
But not in the age of free market dogmatism, not under conditions of exuberant deregulation. At the heart of the market ideology is a demand that democratic oversight be withdrawn. The buying and selling of paper is to be left to the whims of private actors who often are as economically ignorant as those ordinary mortgage holders who get stiffed when the original variable rate mortgages get sold and then screwed again when the banks that sell this dubious paper go under and are bailed out by mortgage holders as taxpayers.
The media reports banks are being bailed out by government, but that is just another word for the taxpayers. We are consumers when it comes to buying bad credit, but citizens when it comes to paying for the costs. This is the new market form of socialism, where risk are socialized (we pay for them) but profits remain private (market pirates keep them).
What does this all mean for the crisis? It means that the way out lies not just through technical fixes or pumping public money into failing banks and insurance companies. It means reasserting our rights as citizens to regulate the market. It means insisting we will not support the new 'socialism of risk' unless we also share in the profits (that's another way to reduce taxes!).
In short, it means consumers must become citizens again, reclaiming their democratic right to fiscal transparency, political oversight and market regulation. It means the public sector must come back not just in the default mode when the private sector fails, but actively and constructively so that the public weal takes precedence over private interests in good times as well.
Such an arrangement has a name: democracy. The crisis will have been worth it if we finally learn this lesson.
Credit default swaps killed AIG, and there’s more to come...
When you hear that the collapse of AIG or Lehman Bros. or Bear Stearns might lead to a systemic collapse of the global financial system, the feared culprit is, largely, that once-obscure (OK, still obscure) instrument known as a credit default swap. So, what is a CDS, and why is it so dangerous?
At first glance, a credit default swap seems like a perfectly sensible financial tool. It is, basically, insurance on bonds. Imagine a large bank buys some bonds issued by General Electric. The bank expects to receive a steady stream of payments from GE over the years.
That's how bonds work: The issuer pays the bondholder some money every six months. But the bank figures there's a chance that GE might go bankrupt. It's a small chance, but not zero, and if it happens, the bank doesn't get any more of those payments.
The bank might decide to buy a CDS, a sort of insurance policy. If GE never goes bankrupt, the bank is out whatever premium it paid for the CDS. If GE goes bankrupt and stops paying its bondholders, the bank gets money from whoever sold the CDS.
Who sells these CDSs? Banks, hedge funds, and AIG. It's easy to see the attraction. Historically, bond issuers almost never go bankrupt. So, many banks and hedge funds figured they could make a fortune by selling CDSs, keeping the premium, and almost never having to pay out anything.
In fact, beginning in the late '90s, CDSs became a great way to make a lot more money than was possible through traditional investment methods. Let's say you think GE is rock solid, that it will never default on a bond, since it hasn't in recent memory. You could buy a GE bond and make, say, a meager 6 percent interest.
Or you could just sell GE credit default swaps. You get money from other banks, and all you have to give is the promise to pay if something bad happens. That's zero money down and a profit limited only by how many you can sell.
Over the past few years, CDSs helped transform bond trading into a highly leveraged, high-velocity business. Banks and hedge funds found that it was much easier and quicker to just buy and sell CDS contracts rather than buy and sell actual bonds. As of the end of 2007, they had grown to roughly $60 trillion in global business.
So, what went wrong? Many CDSs were sold as insurance to cover those exotic financial instruments that created and spread the subprime housing crisis. As those mortgage-backed securities and collateralized debt obligations became nearly worthless, suddenly that seemingly low-risk event-an actual bond default-was happening daily.
The banks and hedge funds selling CDSs were no longer taking in free cash; they were having to pay out big money. Most banks, though, were not all that bad off, because they were simultaneously on both sides of the CDS trade. Most banks and hedge funds would buy CDS protection on the one hand and then sell CDS protection to someone else at the same time. When a bond defaulted, the banks might have to pay some money out, but they'd also be getting money back in. They netted out.
Everyone, that is, except for AIG. AIG was on one side of these trades only: They sold CDS. They never bought. Once bonds started defaulting, they had to pay out and nobody was paying them. AIG seems to have thought CDS were just an extension of the insurance business. But they're not. When you insure homes or cars or lives, you can expect steady, actuarially predictable trends.
If you sell enough and price things right, you know that you'll always have more premiums coming in than payments going out. That's because there is low correlation between insurance triggering events. My death doesn't, generally, hasten your death. My house burning down doesn't increase the likelihood of your house burning down.
Not so with bonds. Once some bonds start defaulting, other bonds are more likely to default. The risk increases exponentially. Credit default swaps written by AIG cover more than $440 billion in bonds. We learned this week that AIG has nowhere near enough money to cover all of those. Their customers-those banks and hedge funds buying CDSs-started getting nervous. So did government regulators. They started to wonder if AIG has enough money to pay out all the CDS claims it will likely owe.
This week, Moody's Investors Service, the credit-rating agency, announced that it was less confident in AIG's ability to pay all its debts and would lower its credit rating. That has formal implications: It means AIG has to put up more collateral to guarantee its ability to pay.
Just when AIG is in trouble for being on the hook for all those CDS debts, along comes this credit-rating problem that will force it to pay even more money. AIG didn't have more money. The company started selling things it owned-like its aircraft-leasing division 3. All of this has pushed AIG's stock price down dramatically. That makes it even harder for AIG to convince companies to give it money to pitch in. So, it's asking the government to help out.
AIG might be in trouble. But what do I care? Because the global economy could, possibly, come to a halt.
Banks all over the world bought CDS protection from AIG. If AIG is not able to make good on that promise of payment, then every one of those banks has lost that protection. Overnight, the banks have to buy replacement coverage at much higher rates, because the risks now are much worse than they were when AIG sold most of these CDS contracts.
In short, banks all over the world are instantly worth less money. The numbers seem to be quite huge-possibly in the hundreds of billions. To cover that instantaneous loss, banks will lend out less money. That means other banks can't borrow to pay this new cost, and weaker banks might not have enough; they'll collapse. That will further shrink the global pool of money.
This will likely spur a whole new round of CDS payouts-all those collapsed banks issue bonds that someone, somewhere sold CDS protection for. That new round of CDS payouts could cause another round of bank failures.
Generally, with enough time, financial markets can adjust to just about anything. This, though, would be an instantaneous transformation of the global financial system. Surely, the worst part will be the confusion. CDS are largely over-the-counter instruments. That means they're not traded on an exchange. One bank just agrees with another bank to do a CDS deal. There's no reliable central repository of information.
There's no way to know how exposed a bank is. Banks would have no way of knowing how badly other banks have been affected. Without any clarity, banks will likely simply stop lending to each other. Since we're only just now getting a handle on how widespread and intertwined they have become, it seems possible that AIG, alone, could bring the global economy to something of a standstill. It's also possible that it wouldn't.