"Farmer's son who helps make sorghum molasses from sugarcane, Racine, West Virginia"
Ilargi: Oh brother, where do I start? You've all heard about the Lehman Repo 105 case, I assume, and possibly read some of the comments on the case. But I think we need to focus our attention elsewhere, none of the commenters I read are trying to figure out who’s behind the curtain, even though they tell themselves they are. And once again, I didn’t have to look far for an example that makes my case for me. This one's about Orange County suing Toyota, and Connecticut pondering similar action (Toyota may well be gone a year from now, they'll have to pony up untold billions of dollars in damages in the American legal system):
Connecticut Attorney General Richard Blumenthal said Friday he is investigating Toyota's response to vehicle-accelerator problems after three Camry crashes in Connecticut this week, one of which was fatal. In a letter to Toyota, Mr. Blumenthal asked whether Toyota plans to send engineers to examine the vehicles in the crashes to assess the cause. "Toyota has a moral, ethical and possibly legal duty to investigate accidents that may involve faulty accelerators [..]"
When I read things like that, there’s a big red alarm going off in my head. An Attorney General who states that Toyota has a moral and ethical obligation to look into people dying from using its products, but who isn't sure it's illegal for Toyota to NOT do so.
That, for me, is the best possible way to summarize the essential problems we keep on being bombarded with left, right and center. An AG who can’t get himself to express outright that being directly responsible for people's deaths is illegal. And you know what? He may well be right. Toyota, for all we know, may be acquitted in a court of law. I wouldn't put it beyond the opaque scope of our legal systems. If I push you off the 40th floor of a building, and there's video of the act, I can be sentenced to death. A large corporation, however, can apparently make the case before a jury that you jumped, or would have jumped, or might have jumped anyway, so I’m not really responsible for you dying. If I can afford Johnnie Cochran, all bets are off. Which reminds me of the statement by a Toyota exec a while back, who said in the US Congress that his company didn't know how people "used its products". Hey, we thought they bought the Camry to sit in the driveway, who knew they'd actually hit the road?
Harry Markopolos describes how no-one involved with Bernie Madoff wanted to know the truth about him, because their very wealth and well-being depended on not knowing it. And if you look at society as a whole, the same is true for 99% of the population, be it in America, Japan or Europe. We wish to believe that we live in democratic systems that apply the rule of law equally to all citizens, because it makes us feel better about our lives. And if we don’t live in such a system, we’d rather not be told. We maintain our faith and allegiance in the face of pretty much anything reality throws at us. We're being robbed blind and refusing to see.
Lehman's CEO Dick Fuld made almost half a billion dollars off the fraud he oversaw, states Dylan Ratigan. Fuld has been walking around free, enjoying his loot, for 18 months, since Lehman collapsed. And that's not because nobody among the US market regulators knew. You know why it is? It's because they DID know. It’s because the SEC and the NY Fed under Geithner and the Treasury under Paulson and the Fed under Greenspan and Bernanke DID know, that Dick Fuld gets to spend his part of the loot. It’s because part of the loot went to all of the above, because they’re all guilty as sin. Oh wait, what does that say about Obama? That he's guilty too, or only that he's not all that savvy? And look in the mirror, what does it say about you?
Yves Smith says Tim Geithner needs to be fired for his involvement in the insane saga of the Lehman demise. Well, that's a nice first reaction, but when you dig a bit, he should maybe also have been fired for his part in the AIG scam. Or Bear Stearns for that matter, which he had the duty to oversee as head of the New York Fed. Tim Geithner will never be brought to justice precisely because Tim Geithner himself should be brought before a jury of his peers, and his peers are as guilty as he is.
Firing Geithner would be letting him off easy. He should be put on temporary leave pending an independent investigation. That's how politics works in other countries, so why not in the US? The investigation should be rapid and thorough, and led by someone who can prove they’re not associated with Wall Street in any given way. Say, Elizabeth Warren or Bill Black. And then there should be a temp replacement as Treasury Secretary, say, let's see, Elizabeth Warren or Bill Black. Or you could give either post to Harry Markopolos. Am I leaving out anyone? There's really only a few good "men", ain't there? It’s much easier to come up with a lost of names of people who should never ever be appointed to these posts than it is to name those who might.
But yeah, I know, I'm only dreaming. This present bag of Al Capones, except for a few carefully selected scapegoats (Dick Fuld: Tar and Feathers!), will never be brought to justice, because Eliott Ness wouldn't stand a chance in today's America, or London, Paris, or Tokyo. We just would like to believe he would, so much so that that very belief is actually aiding and abetting both the crimes and perpetrators. We don’t want real life, we want the hologram. We tell ourselves: "but there's nothing I can do about it", and we use that statement as an excuse to let people like Dick Fuld and Tim Geithner walk all over our children's graves.
There's times when I think that perhaps the best thing that could happen to us is for our lives and dreams to be thrown off a cliff and see what survives the landing, we can't seem to wake up in any other way. You know, the sort of thing that sounds good in theory. But I can clearly see the suffering that would come with it, and I don’t like it. Not one bit. Whatever we do, though, we must make sure of one thing. That we find back our moral fiber, and act on it.
Ilargi: And of course you can still donate to this site, and if you ask me you should. Top left hand corner!
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Swift US financial overhaul is 'unrealistic'
Republicans have warned Chris Dodd, the Democratic chairman of the Senate banking committee, that his aim to get a financial regulation bill to the Senate floor by the end of the month is unrealistic. In a setback for Democrats’ hopes of signing both healthcare reform and an overhaul of financial regulation into law within weeks, the Republican members of the banking committee wrote to Mr Dodd on Friday evening. They expressed "concern that your proposed timetable will not allow members sufficient time to fully understand the details of your new legislative proposals".
Mr Dodd is due to deliver a long-awaited new draft of regulation legislation on Monday before a "mark-up", or public revision, of the text the following week. He announced the timetable on Thursday after breaking off negotiations with Republicans aimed at cutting a private bipartisan deal. The landmark bill will eventually be merged with a version passed last November in the House of Representatives. It would drive more over-the-counter derivatives through central clearing houses, introduce a "resolution authority" allowing regulators to wind down a failing financial institution and introduce new consumer protection regulation to oversee the sale of loans.
Bob Corker, the lead Republican negotiator for much of the last month, charged that the Democrats’ ambition to pass healthcare reform before the spring break at the end of this month lay behind the curtailing of talks on regulation, which is competing for Congress’s attention. The letter was signed by all the Republican members of the banking committee, including Mr Corker, the senator from Tennessee, and Richard Shelby, the senior Republican on the committee, even though the two men have been at odds on whether it was worth negotiating with Mr Dodd.
In a letter whose politeness belies the potential roadblock to Mr Dodd’s hopes of a speedy next stage, the Republican senators wrote: "Given the sheer magnitude and complexity of the financial reform package you intend to introduce, this legislation will inevitably have a substantial impact on our financial system and overall economy. Accordingly, we urge you to allow for sufficient time to review the language." Members of both parties are privately expressing scepticism that any agreement will be reached during the mark-up and the consensus expectation is for a partisan Democratic bill to be moved to the Senate floor before negotiations begin again in earnest to win Republicans around with amendments.
Ratigan And Spitzer Discuss Repo 105, Conclude "Civil Cases Will Be Brought"
by Tyler Durden
Yesterday we predicted that Repo 105 would be the media buzzword for the next days and weeks. We were right. Dylan Ratigan and Eliot Spitzer digest the Lehman examiner report, and simplify it enough so that Joe Sixpack can grasp the nuances. It is, in our opinion, now beyond a reasonable doubt that Lehman's CFO should all stand in a court of law for securities fraud violations, despite Erin Callan's and Dick Fuld's protestations that all they did was in Lehman's best interest. We do not doubt that; however we are currently poring through the Q&A's of the four most recent Lehman conference call Q&As with analysts...
Something tells us quite a few smoking guns will emerge. Lehman has become merely the latest example of all that is broken with today's crony capitalist system. Before that it was Goldman and swap gate; before that it was Goldman and AIG-gate; before that it was Goldman and SLP-gate, and on, and on. The evident conclusion is that the core driver of modern capitalist society is fraud at its very core, and nothing short of a massive revolutionary overhaul of the political system, which is the number one defender of the status quo courtesy of very lucrative bribes and kickbacks originating from the same rotten Wall Street that day after day is uncovered to be nothing but a sham filled with toxic assets, used to collateralize an ever growing wall of liquidity (think you Bernanke). Anyway, back to Dylan, who, in traditional fashion, is painstakingly diplomatic "
This report comes just short of suggesting this is by no means an accident but instead one of the greatest crimes ever perpetrated by a group of people, and enabled by the US government." And Spitzer concludes: "there is no doubt civil cases will be brought. We had a failure of CEO, the CFO, the accountants, and indeed the regulators, the Fed and the Treasury, that were inside these banks, and the question has to be asked: where were they.
Orange County Sues Toyota
Prosecutors in Orange County, Calif., filed a civil lawsuit Friday against Toyota Motor Corp., accusing the auto maker of selling vehicles while allegedly suppressing information about safety defects. The prosecutor's office said it will seek to stop Toyota Motor Sales U.S.A. Inc., the company's U.S. sales and marketing arm, "from continuing to endanger the public through the sale of defective vehicles and deceptive business practices." At a press conference, Orange County District Attorney Tony Rackauckas said his office filed an unfair business practices lawsuit in Orange County Superior Court.
Toyota has recalled more than eight million vehicles world-wide for issues related to unintended acceleration. Company executives have been grilled at congressional hearings in Washington on the issues that have called into question the company's reputation as a safety leader. "Despite knowledge of the defects, Toyota continues to sell and lease its cars and trucks while knowingly concealing and suppressing information about the defects from consumers," the Orange County district attorney's office said in a statement. In a statement on its Web site, Toyota said it hadn't received the complaint and declined to comment on pending litigation.
Separately, Connecticut Attorney General Richard Blumenthal said Friday he is investigating Toyota's response to vehicle-accelerator problems after three Camry crashes in Connecticut this week, one of which was fatal. In a letter to Toyota, Mr. Blumenthal asked whether Toyota plans to send engineers to examine the vehicles in the crashes to assess the cause. "Toyota has a moral, ethical and possibly legal duty to investigate accidentsthat may involve faulty accelerators," Mr. Blumenthal said in the letter to Toyota Motor Sales. "Ascertaining whether vehicle defects played a role in these and future incidents is absolutely vital to public safety." The lawsuits add to pressure on Toyota as it juggles congressional inquiries, investigations by federal safety regulators, class-action lawsuits and the media spotlight.
Lehman file rocks Wall Street
The fallout from the report into the collapse of Lehman Brothers shook Wall Street and London on Friday as US officials grilled banks about off balance-sheet trades and questions were raised over the City’s role in the company’s attempts to cover up its problems. The 2,200-page report by Anton Valukas, appointed by a US court to probe the reasons for Lehman’s failure in September 2008, paints a damning picture of the bank’s top management, including former chief executive Dick Fuld, three of its chief financial officers and auditors Ernst & Young.
Its conclusions – that there is credible evidence against Mr Fuld and others for breach of their fiduciary duties and against E&Y for professional malpractice – are also a further blow to the battered credibility of the entire banking industry. "Give bankers of any ilk an inch and they will take a mile," said Simon Maughan, analyst at MF Global in London. "Lehman might just have taken a couple of miles." Mr Fuld, Ian Lowitt, one of Lehman’s CFOs mentioned in the report, and E&Y have denied wrongdoing. Erin Callan and Christopher O’Meara, the other two CFOs, could not be reached for comment. Senior US financial executives said they had received worried calls from US regulators early on Friday asking about the use of transactions like "Repo 105" – a device that helped Lehman flatter its financial health.
The trades, which were never disclosed to investors, rating agencies or regulators, are described as "window-dressing" and "an accounting gimmick" in the report released on Thursday by Mr Valukas. Goldman Sachs and Morgan Stanley, which competed with Lehman in investment banking and had similar funding needs, said they had never used such transactions. People close to the situation said US regulators wanted to ensure that Repo 105, which enabled Lehman to move some $50bn off its balance sheet at the end of the first and second quarter of 2008, was not a widespread practice. The trades helped Lehman to reduce its leverage and balance sheet at the height of the crisis, avoiding potentially costly rating downgrades but misleading investors as to the true state of its finances, Mr Valukas claims.
Bankers said Repo 105 was an unusual move as it was more costly than traditional repos – where a bank pledges collateral to another in exchange for cash and promises to return the funds with interest. Mr Valukas found that Lehman had to structure these deals through its UK subsidiary because it could not find a US law firm to give a legal opinion on them. Lehman used UK-based Linklaters instead. Linklaters on Friday said it had not been contacted by Mr Valukas, adding it had reviewed its opinions and was "not aware of any facts or circumstances which would justify any criticism". Lehman’s counterparties on the repo trades included Barclays, UBS, Mizuho, Mitsubishi, ABN Amro (now Royal Bank of Scotland) and KBC. They declined to comment or could not be reached.
Findings on Lehman Take Even Experts by Surprise
For the year that it took the court-appointed examiner to complete his report on the demise of Lehman Brothers, officials from Wall Street to Washington were anticipating it as the definitive account of the largest bankruptcy in American history. And the report did just that when it was unveiled on Thursday, riveting readers with the exhaustive detail contained in its nine volumes and 2,200 pages. Yet almost immediately, it raised a host of new questions. Now government regulators have what some lawyers call a road map for further inquiry into former Lehman executives like Richard S. Fuld Jr. and the auditing firm Ernst & Young.
Whether the Justice Department and the Securities and Exchange Commission will actually pursue their own legal actions is unclear. But legal experts said on Friday that the examiner, Anton R. Valukas, had provided plenty of material for civil regulatory action at the least with his findings of "materially misleading" accounting and "actionable balance sheet manipulation." "It’s certainly not helpful to any of them," Michael J. Missal, a partner at the law firm K&L Gates and the examiner in the bankruptcy case of New Century Financial, said of some individuals accused of impropriety in the report. "It certainly assists private litigants and probably increases the pressure on the government to take some kind of action here." Representatives for the S.E.C. and the United States attorneys offices in Manhattan and Brooklyn declined to comment.
While Mr. Fuld and other former top Lehman officials are already defendants in a number of civil lawsuits, the new discoveries by Mr. Valukas have taken even veteran observers by surprise. Chief among these was the revelation of a particularly aggressive accounting practice, known internally as Repo 105, that Mr. Valukas said helped the investment bank mask the true depths of its financial woes. Examiners in bankruptcy cases are appointed by the Justice Department to investigate accusations of wrongdoing or misconduct. Their job is to determine whether creditors can recover more money in these cases, and their findings often serve as guides for more lawsuits and even regulatory action.
What examiners are not asked to do is play judge and jury. Though the report contains strong language — Mr. Valukas deems Mr. Fuld "at least grossly negligent" in his role overseeing Lehman — it stops short of accusing anyone of criminal conduct or of violating securities law. Patricia Hynes, a lawyer for Mr. Fuld, said on Thursday that her client "did not know what those transactions were — he didn’t structure or negotiate them, nor was he aware of their accounting treatment." She did not return an e-mail seeking additional comment on Friday.
Mr. Valukas’s findings have stirred loud discussion among legal and accounting experts over the ways Lehman sought to improve its quarterly results months before it collapsed. Over hundreds of pages, Mr. Valukas details the genesis of and the process behind Repo 105. Based on standard repurchase agreements — short-term loans commonly used by many firms for daily financing needs, in which borrowers temporarily exchange assets in return for cash up front — Lehman took a particularly aggressive accounting approach to these transactions. Here, the investment bank used repos to temporarily park assets off its books to make its end-of-quarter debt levels look better than they did — while calling them sales instead of loans.
The accounting tactic, first used by Lehman in 2001, had one catch, according to Mr. Valukas: no American law firm would sign off on its use. Enter Linklaters, a highly respected British law firm that gave Lehman the answer it wanted. So long as the repos were conducted in London through the bank’s European arm, and so long as the company took other cosmetic steps to make these transactions appear to be sales instead of financings, Linklaters determined that they would pass regulatory muster. A spokeswoman for Linklaters said on Friday that the firm was not contacted by Mr. Valukas and that its legal opinions were not criticized in the examiner’s report as wrong or improper.
Lehman also had the backing of Ernst & Young, which certified the bank’s financial statements despite receiving warnings from a whistle-blower who said there were accounting improprieties. An Ernst & Young spokesman said on Thursday that the firm stood by its work for 2007, the last year it conducted an audit of Lehman’s financial results. But Lynn E. Turner, a former chief accountant for the S.E.C., accused Ernst & Young of abdicating its responsibility to the audit committee of Lehman’s board by not presenting the concerns.
"This is pretty aggressive and pretty abusive. I don’t know how under GAAP this follows the rules whatsoever," he said, referring to Generally Accepted Accounting Principles. "That reeks of an auditor who, rather than being really truly independent, is beholden to management," he said, adding that the S.E.C. and the Justice Department should follow up on Mr. Valukas’s findings. Executives at other Wall Street banks professed surprise at Lehman’s accounting maneuvers. Goldman Sachs, Barclays Capital and other banks said on Friday they did not use repos to hide liabilities on their balance sheets.
Repos Played a Key Role in Lehman's Demise
Six weeks before it went bankrupt, Lehman Brothers Holdings Inc. was effectively out of securities that could be used as collateral to back the short-term loans it needed to survive. The bank's subsequent scramble to stay alive exposed the murky but crucial role that short-term lending, done in a corner of Wall Street known as the repo market, plays in the financial world. The report by Lehman's court-appointed bankruptcy examiner, which runs thousands of pages, recounts efforts by the bank to use slight-of-hand accounting transactions to spiff up its financial picture and sometimes use low-quality collateral to get loans. It also details the sometimes angry and confusing tussles between Lehman and its lenders over who got to hold the assets.
Lehman's battles show that the repo market, the lifeblood of Wall Street, often isn't as routine as some investors believe. The basic mechanics involve firms raising cash to fund operations by posting high-quality assets, with an obligation to repurchase them within days. But the examiner's report exposes the market's lack of information and the confusing, sometimes contradictory agreements between Lehman and its lenders that help explain why the market seized up in the financial crisis.
In one such tussle, Lehman had posted as collateral with J.P. Morgan Chase & Co. over the summer of 2008 a security called Fenway, which Lehman claimed had a value of $3 billion. J.P. Morgan concluded the security "was worth practically nothing" just days before Lehman went under, prompting the big bank to demand more collateral from Lehman. Those factors, combined with collapsing market conditions, put repo agreements into a tailspin. "The basic problem is that the investment banks have become highly dependent on the repo markets for their funding ... but they were using a whole bunch of nontraditional securities for those repo agreements," said Stephen Lubben, a professor at Seton Hall University's law school who specializes in bankruptcy and corporate debt.
"The market is extremely opaque and had become very dependent on the value of mortgage-backed securities. As we got into the second half of 2008, it became very unclear what the value was on a lot of those things," Mr. Lubben said. The result was the market froze up as lenders refused to do business with one another, potentially sending other major Wall Street firms into bankruptcy. The market only began functioning again after governments stepped in to backstop banks.
The report also cited a July discussion where a top Lehman finance executive told a Citigroup executive that all of Lehman's liquid securities had already been used as collateral in repo transactions and that to get the type of collateral Citigroup wanted, it would have to take it from another repo agreement. At another point, Lehman offered Citigroup a package of structured securities, which Citi rejected as "bottom of the barrel" and "junk," adding that they hardly ever traded.
Yet at the same time, the report says, Lehman was able to double-count some liquid securities by using them in repo transactions and counting them in its internal liquidity pool, which would be "monetized at short notice in all market environments." Lehman said it had $42 billion in that pool at the end of the third quarter of 2008, but according to the report, at least $10 billion of that pool had been pledged as collateral in repo agreements.
According to the report, released on Thursday, Lehman was able to use the repo market in other ways to artificially lower its leverage at the end of the quarter, keeping as much as $50 billion in assets off its balance sheet using what it dubbed "Repo 105" transactions. And the bank was able to post over $10 billion in assets as collateral for repo loans, but still count the money as "formally unencumbered collateral in its liquidity pool." The rare look into the repo market embedded in the report comes 18 months after Lehman Brothers collapsed in the U.S.'s largest bankruptcy filing. While top Lehman executives were quick to blame the real-estate market for their woes, the exhaustive report singles out senior executives and auditor Ernst & Young for serious lapses.
The report exposed for the first time what appears to be an accounting slight of hand known as a Repo 105 transaction, where Lehman was able to book what looked like an ordinary asset for cash as an out-and-out sale, drastically reducing its leverage and making its financial picture look better than it really was. The transactions often were done in flurries in a financial quarter's waning days, before Lehman reported earnings. Four days prior to the close of the 2007 fiscal year, Jerry Rizzieri, a member of Lehman's fixed-income division, was searching for a way to meet his balance-sheet target, according to the report. He wrote in an email: "Can you imagine what this would be like without 105?"
A day before the close of Lehman's first quarter in 2008, other employees scrambled to make balance-sheet reductions, the report said. Kaushik Amin, then-head of Liquid Markets, wrote to a colleague: "We have a desperate situation, and I need another 2 billion from you, either through Repo 105 or outright sales. Cost is irrelevant, we need to do it." Marie Stewart, the former global head of Lehman's accounting policy group, told the examiner the transactions were "a lazy way of managing the balance sheet as opposed to legitimately meeting balance-sheet targets at quarter end."
Lehman's use of this accounting technique goes back to the start of the decade when Lehman business units from New York and London met to discuss how the firm could manage its balance sheet using accounting rules that had taken effect in September 2000. Lehman soon created the "Repo 105" maneuver: Because assets the firm moved amounted to 105% or more of the cash it received in return, Lehman could treat the transactions as sales and remove securities inventory that otherwise would have to be kept on its balance sheet.
Because no U.S. law firm would bless the transaction, Lehman got an opinion letter from London-based law firm Linklaters. That letter essentially blessed using the maneuver for Lehman's European broker-dealer under English law. If one of Lehman's U.S. entities needed to engage in a Repo 105 transaction, the firm moved the securities to its European arm to conduct the deal on the U.S. entity's behalf, the report found. That is likely why the counterparties on the repo transactions were largely a group of seven non-U.S. banks. These included Germany's Deutsche Bank AG, Barclays PLC of the U.K. and Japan's Mitsubishi UFJ Financial Group. In a statement, a Linklaters spokeswoman said the report "does not criticize" the legal opinions it gave Lehman "or suggest or say they were wrong or improper." The law firm said it was never contacted during the investigation.
British law firm cleared way for Lehman cover-up
Linklaters, one of Britain’s leading law firms, approved controversial accounting practices that allowed Lehman Brothers to shift billions of dollars of debt off its balance sheet and mask the perilous state of the bank’s finances before its catastrophic collapse in 2008. A 2,200-page report into the collapse of the 158-year old institution has uncovered evidence that Lehman used "balance sheet manipulation" in the form of an accounting practice known as "Repo 105" without telling investors or regulators that made the business appear healthier.
Lehman had initially sought legal clearance from an American law firm to permit Repo 105 transactions but was denied. It then sought advice from Linklaters in London, which said the deals were possible under English law. The Repo 105 practice had been in use by Lehmans since 2001 but it was in the bank’s final two years that it was regularly used to alter public perceptions of the bank’s balance sheet. In the run-up to a reporting period, Lehman would enter an arrangement to sell and then repurchase financial assets. Normally, such deals are accounted as "transactions" but by adding a cash element Lehman was able to call them "sales".
The bank’s balance sheet could therefore be pumped up with cash from the sale and would also reduce its borrowings. At the beginning of a new quarter, Lehman would borrow more money and repurchase the assets to put them back on its balance sheet. The assets were transferred through Lehman’s London operations so the Repo 105 deals could be conducted under English law.
Anton Valukas, of Jenner & Block, who was appointed as examiner by the judge handling Lehman’s bankruptcy, said: "Unable to find a United States law firm that would provide it with an opinion letter permitting the true sale accounting treatment under United States law, Lehman conducted its Repo105 programme under the aegis of an opinion letter the Linklaters law firm in London." In 2008, just before Lehman filed for bankruptcy, it transferred $50.38 billion in a Repo 105 arrangement, reducing its leverage from 13.9 per cent to 12.1 per cent. "Lehman’s failure to disclose the use of an accounting device to significantly and temporarily lower leverage, at the same time that it affirmatively represented those 'low' leverage numbers to investors as positive news, created a misleading portrayal of Lehman’s true financial health," Mr Valukas said.
Linklaters is part of Britain’s "magic circle" of leading law firms, which includes Clifford Chance, Allen & Overy, Slaughter and May and Freshfields Bruckhaus Deringer, and is one of the biggest practices in the world. Linklaters said it had not been contacted by the examiner during his investigation and stood by its advice to Lehman Brothers. In a statement, the firm said that Mr Valukas had not criticised the opinions provided to Lehman Brothers or found that they were improper. "We have reviewed those opinions and are not aware of any facts or circumstances which would justify any criticism," Linklaters added.
Mr Valukas’s report also accuses Ernst & Young of professional negligence over a number of years before the catastrophic downfall Lehman and warns the British accountancy firm it could face legal action for signing off the Repo 105 arrangements. Mr Valukas criticises Ernst & Young "for among other things its failure to question and challenge improper or inadequate disclosure in those financial statements." He said the accountancy firm "was professionally negligent in allowing those [Repo 105] reports to go unchallenged." He added that there could be a colourable claim for professional malpractice against the accountancy giant.
Dick Fuld, the former chairman and chief executive of Lehman, and some of his closest lieutenants, are also facing legal claims for breach of fiduciary duty after using the "lazy accounting gimmick" to hide the fact that the bank was insolvent. The Valukas report paints a damning picture of the bank’s final two years, branding it as a hothouse institution so obsessed with growth that senior executives said openly they did not want to hear "too much detail" about the risks they might face in case it held them back.
The examiner concluded that although Lehman’s top management chose to disregard or overrule the firm’s risk controls on a regular basis and while certain of their risk decisions were "unwise" and represented poor "judgment", this did not amount to a breach of fiduciary duty. He noted that the sole function of the Repo 105 transactions was "balance sheet manipulation", adding that even Lehman’s own accounting personnel described them as an "accounting gimmick" and a "lazy way of managing the balance sheet".
Mr Valukas concluded that there were "colourable claims" against Mr Fuld, Christopher O’Meara, Lehman’s head of risk, Erin Callan, the chief financial officer and Ian Lowitt, who replaced Ms Callan as chief financial officer. He described a "colourable claim" as one for which "there is sufficient credible evidence" to support a finding in a court. Mr Fuld’s lawyer said last night that the former Lehman boss did not know what the Repo 105 transactions were or their accounting treatment. Ernst & Young said: "Our opinion indicated that Lehman’s financial statements for that year were fairly presented in accordance with Generally Accepted Accounting Principles [GAAP], and we remain of that view."
When Lehman filed for bankruptcy on September 15, 2008, with about $600 billion in debt, its collapse contributed to the freezing of credit markets worldwide and to increasing the depth of the global recession. Judge James Peck, who is handling the Lehman bankruptcy in the Bankruptcy Court of the Southern District of New York, appointed Mr Valukas a year ago to investigate the events that led to Lehman’s collapse, including any possible "fraud, dishonesty, incompetence, misconduct, mismanagement, or irregularity".
On Thursday, Judge Peck unsealed Mr Vulakas’s report, which had been presented to him last month. The meticulously researched document describes Lehman’s aggressive growth strategy, which, Mr Vulakas said, was intended to take advantage of the sub-prime mortgage crisis that broke in 2006 by increasing its exposure to real estate at a time when others were cutting back. While Mr Vulakas concluded that Mr Fuld and other senior executives may have a case to answer in the use of Repo 105 arrangements, their management of Lehman’s aggressive expansion and attitude to risk were not so "reckless and irrational" as to give rise to a breach of fiduciary duty.
Mr Valukas also concluded that after Lehman’s collapse Barclays may have received "a limited amount of assets" improperly when it took control of Lehman’s core US brokerage. He added that Lehman could have potential claims against JPMorgan Chase and Citibank in connection with demands for collateral and certain changes made to guarantee agreements in Lehman’s final days. The long-awaited report, which cost $38 million to produce, is likely to give ammunition to shareholders suing Lehman as well as to government prosecutors.
Compiled with the help of a team of 70 attorneys, it is based on more than 250 interviews, five million documents and 26 million pages of company e-mails. Hector Sants, chief executive of Britain’s Financial Services Authority (FSA), was the only person to decline to be interviewed. However, the FSA did provide detailed, written answers to specific questions regarding the FSA’s involvement in the weekend before Lehman’s collapse and in the Barclays transaction that would have been posed to Mr Sants.
Lehman Brothers ‘Shenanigans’ on Hidden Leverage May Haunt Fuld
Lehman Brothers Holdings Inc.’s Richard Fuld exuded confidence as he briefed analysts on June 16, 2008, four days after demoting his firm’s finance chief in the wake of a $2.8 billion quarterly loss. "I am the one who ultimately signs off and I’m comfortable with our valuations at the end of our second quarter," then- Chief Executive Officer Fuld said on the conference call. "We have always had a rigorous internal process."
The rigor was based on a shaky foundation, according to a 2,200-page report about the firm’s demise by Anton Valukas, the examiner for the bankrupt firm. Lehman Brothers "reverse- engineered" a key measure of stability, masking the firm’s true financial condition, Valukas said. Some asset valuations were also "unreasonable," he said. Keen to show that it had reduced leverage, a gauge of a company’s ability to withstand losses, Chief Financial Officer Ian Lowitt said on the June 16 call that the firm had shrunk its net leverage ratio to 12 times from 15.4 in the second quarter.
It accomplished the feat by reducing net assets by $70 billion, said Lowitt, who had just replaced Erin Callan in his post. "We’re going to operate conservatively," he said. Unbeknownst to shareholders, the firm was hiding $50 billion in assets through off-balance sheet transactions known as Repo 105s that temporarily removed holdings until days after the quarter closed, according to Valukas. In the first quarter, the firm had used the same strategy to hide $49 billion in assets, he said in the report.
Lehman Brothers actions amounted to no more than "shenanigans," said Sanford C. Bernstein & Co. analyst Brad Hintz, a former Lehman chief financial officer. "If all you’re doing is hiding something behind the curtain, the financial strength isn’t there." The repos helped prop up Lehman’s credit rating, Valukas said. The off-balance dealings required more collateral than if Lehman had opted for ordinary transactions visible to shareholders, he said.
"Repos were just one of many ways to hide losses," said Janet Tavakoli, president of Chicago-based financial consulting firm Tavakoli Structured Finance Inc. "All of the former investment banks used those techniques. All of them borrowed too much money and were overleveraged." Lehman Brothers bolstered capital by raising about $12 billion from investors during the first half of 2008, a time when Valukas said the New York-based firm’s financial statements were misleading.
Investors included Blackrock Inc., the largest publicly traded fund manager in the U.S., a venture run by former American International Group Inc. CEO Maurice "Hank" Greenberg, and New Jersey government retirees. Fuld, 63, was "at least grossly negligent in causing Lehman Brothers to file misleading periodic reports," Valukas said. Fuld’s lawyer, Patricia Hynes, disputed the examiner’s conclusions.
"Mr. Fuld did not know what those transactions were -- he didn’t structure or negotiate them, nor was he aware of their accounting treatment," Hynes said in a statement. She also said none of Lehman’s senior financial officers, lawyers or outside auditors raised concern about the transactions with Fuld. Robert Cleary, a lawyer for Callan at Proskauer Rose, didn’t return a call seeking comment. Callan, 44, took a personal leave of absence last month from Swiss bank Credit Suisse Group AG, where she had worked since 2008.
Lewis Liman, a lawyer for Lowitt, 46, said in an e-mail that his client did nothing wrong. Lowitt is now chief operating officer at Barclays Wealth Americas, whose parent, Barclays Plc, bought Lehman’s North American brokerage for $1.54 billion. In its final year, Lehman overvalued real-estate holdings, including a stake in U.S. apartment developer Archstone-Smith Trust, Valukas said. Lehman and Tishman Speyer Properties LP completed a joint acquisition of Archstone for $22 billion, including debt, in October 2007.
Lehman presented "unreasonable" valuations of its Archstone stake in the first three quarters of 2008, overvaluing the holding by as much as $450 million in the second quarter, the examiner wrote. The bankruptcy case is In re Lehman Brothers Holdings Inc., 08-13555, U.S. Bankruptcy Court, Southern District of New York (Manhattan).
Fed Helped Lehman Raise Cash Quickly
They were considered the dregs of Lehman Brothers — "bottom of the barrel," as one banker put it. But as Lehman executives tried to keep the floundering bank afloat in 2008, they used these troubled investments to raise quick cash that helped mask the extent of the firm’s troubles. And they did it with the help of the Federal Reserve Bank of New York.
The newly released report on the collapse of Lehman Brothers — which lays out what it characterizes as "materially misleading" accounting at the bank — also sheds surprising new light on Lehman’s dealings with the New York Fed. Lehman engaged in a series of transactions with the New York Fed that were similar to the ones that drew criticism from the bankruptcy court examiner who investigated its collapse. The examiner, Anton R. Valukas, drew no conclusions about the transactions with the Fed, and focused instead on deals that were known inside Lehman as "Repo 105."
But the report by Mr. Valukas nonetheless raises fresh questions about the role of the New York Fed in supporting Lehman during the frantic months leading up to its collapse. It suggests that Lehman executives believed the Fed would be able to help the bank avert disaster and provide it with a business opportunity. "Bernanke and Co. may have ‘saved the day’ " a Lehman executive, Geoffrey Feldkamp, wrote in an e-mail message to a colleague in March 2008, according to the report. Neither Ben S. Bernanke, the chairman of the Federal Reserve, nor Treasury officials saved Lehman, of course.
But it was that month that the Fed started a special lending program open to Wall Street banks like Lehman that could not borrow directly from it. The Fed also lowered its standards for the kinds of collateral that it would accept against such short-term loans. Lehman, desperate for financing, seized its chance. It packaged billions of dollars of troubled corporate loans into an investment called Freedom CLO. Then, in a series of transactions, it shifted Freedom back and forth to the New York Fed, in exchange for cash. Those moves helped make Lehman look healthier.
Essentially, Lehman was able to temporarily warehouse illiquid investments that were worrying its investors at the New York Fed in return for cash. The Fed created this facility immediately after the near collapse of Bear Stearns. Some suspect that other banks engaged in similar maneuvers. "There were a number of tricks designed to make their balance sheet look stronger than it was," said Janet Tavakoli, a structured finance analyst. "And they weren’t alone."
A spokesman for the New York Fed said the loan facility was created to help the entire financial system and prevent the problems at one bank from cascading. The collateral accepted from Lehman met the Fed’s standards, he added. A third party valued it, the Fed accepted it and then reduced prices to limit the risk. In March 2008, Lehman packaged 66 corporate loans to create the $2.8 billion Freedom CLO, which it planned to use exclusively for transactions with the Fed, the examiner’s report found.
The idea, according to a former Lehman trader familiar with Freedom, was to temporarily reduce the size of Lehman’s balance sheet. The Repo 105 transactions, according to the examiner, were created with a similar goal in mind. The deals with the New York Fed let Lehman pledge Freedom — a mix of low-quality assets, plus some cash — in return for all cash from the Fed.
According to the examiner’s report, New York Fed officials were aware that Lehman viewed the lending facility as an opportunity to finance a bundle of loans that it could not offload easily to a rival bank. In August 2008, Lehman tried to pledge Freedom CLO and similar investments as collateral for its trading positions with Citigroup. A Citigroup executive rejected the offer as "junk" that was impossible to value, the report said.
NY Fed Under Geithner Implicated in Lehman Accounting Fraud Allegation
by Yves Smith
te a few observers, including this blogger, have been stunned and frustrated at the refusal to investigate what was almost certain accounting fraud at Lehman. Despite the bankruptcy administrator’s effort to blame the gaping hole in Lehman’s balance sheet on its disorderly collapse, the idea that the firm, which was by its own accounts solvent, would suddenly spring a roughly $130+ billion hole in its $660 balance sheet, is simply implausible on its face. Indeed, it was such common knowledge in the Lehman flailing about period that Lehman’s accounts were sus that Hank Paulson’s recent book mentions repeatedly that Lehman’s valuations were phony as if it were no big deal.
Well, it is folks, as a newly-released examiner’s report by Anton Valukas in connection with the Lehman bankruptcy makes clear. The unraveling isn’t merely implicating Fuld and his recent succession of CFOs, or its accounting firm, Ernst & Young, as might be expected. It also emerges that the NY Fed, and thus Timothy Geithner, were at a minimum massively derelict in the performance of their duties, and may well be culpable in aiding and abetting Lehman in accounting fraud and Sarbox violations.
We need to demand an immediate release of the e-mails, phone records, and meeting notes from the NY Fed and key Lehman principals regarding the NY Fed’s review of Lehman’s solvency. If, as things appear now, Lehman was allowed by the Fed’s inaction to remain in business, when the Fed should have insisted on a wind-down (and the failed Barclay’s said this was not infeasible: even an orderly bankruptcy would have been preferrable, as Harvey Miller, who handled the Lehman BK filing has made clear; a good bank/bad bank structure, with a Fed backstop of the bad bank, would have been an option if the Fed’s justification for inaction was systemic risk), the NY Fed at a minimum helped perpetuate a fraud on investors and counterparties.
This pattern further suggests the Fed, which by its charter is tasked to promote the safety and soundness of the banking system, instead, via its collusion with Lehman management, operated to protect particular actors to the detriment of the public at large.
And most important, it says that the NY Fed, and likely Geithner himself, undermined, perhaps even violated, laws designed to protect investors and markets. If so, he is not fit to be Treasury secretary or hold any office related to financial supervision and should resign immediately.
I am reading the report, and will provide an update later, but here are the key bits (hat tip reader John M). As much as Karl Denninger has done some terrific initial reporting, he does not go far enough as far as the wider implications are concerned.
The key revelation is that Lehman as of late 2007 was routinely using repo transactions at the end of the quarter to mask how levered it truly was:Lehman regularly increased its use of Repo 105 transactions in the days prior to reporting periods to reduce its publicly reported net leverage and balance sheet.2850 Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105 transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in these transactions, Lehman did not disclose the known obligation to repay the debt.2851 Lehman used the cash from the Repo 105 transaction to pay down other liabilities, thereby reducing both the total liabilities and the total assets reported on its balance sheet and lowering its leverage ratios.
Yves here. The stunning bit is these “repos” were actually a conventional type of repo, despite the name, but Lehman was engaging in blatant misreporting, treating these “repos” (in which a bank still shows them on its balance sheet as sold with the obligation to repurchase) as sales. Note that at the time (as the report notes) analysts and others kept probing at the seeming miracle of Lehman’s deleveraging in a difficult market. This ruse may also square the circle on a Lehman leak we broke in 2007. A former Lehman MD had reported that most of the deleveraging that had occurred at the end of 2Q 2008 had resulted from the placement of $55 billion of assets with newly-formed entities in which Lehman retained a 45% ownership interest and were operated by former Lehman employees. To put it mildly, these were off balance sheet entities that strained the idea of independence. Bloomberg got hold of the story, and Lehman asserted that only $5 billion of assets had actually been transferred. I am now wondering whether the $55 billion were indeed transferred precisely as the source had said originally (he in turn had been told this by several people at Lehman) but that most of it was via this type of repo, and then re-materialized on Lehman’s balance sheet once the quarter end had passed (the Examiner’s report notes that the amount that Lehman moves off its balance sheet at the end of 2Q 2008 was $50.38 billion, which tallies with the difference between what the Lehman MD said had been moved off balance sheet versus what they fessed up to when asked by Bloomberg) .
Denninger raises one question: were other banks engaging in this type of accounting chicanery? But there is another question: did some of Lehman’s counterparties must have suspected what was going on, given that this took place on a large scale basis at the end of every quarter? How many had an idea that Lehman was engaging in massive window dressing and chose to play along?
But here is the part of the report that discussed how the Fed aided and abetted Lehman misconduct:the Examiner questioned Lehman executives and other witnesses about Lehman’s financial health and reporting, a recurrent theme in their responses was that Lehman gave full and complete financial information to Government agencies, and that the Government never raised significant objections or directed that Lehman take any corrective action.
Yves here. So get this: even though Lehman dressed up its accounts for the great unwashed public, it did not try to fool the authorities. Its games playing was in full view to those charted with protecting investors and the financial system.
So what transpired? The SEC (which in all fairness, has never had much expertise in credit markets, this is a major regulatory problem) handed assessing Lehman over to the Fed, which bent over backwards to give it a clean bill of health:After March 2008 when the SEC and FRBNY began onsite daily monitoring of Lehman, the SEC deferred to the FRBNY to devise more rigorous stress?testing scenarios to test Lehman’s ability to withstand a run or potential run on the bank.5753 The FRBNY developed two new stress scenarios: “Bear Stearns” and “Bear Stearns Light.”5754 Lehman failed both tests.5755 The FRBNY then developed a new set of assumptions for an additional round of stress tests, which Lehman also failed.5756 However, Lehman ran stress tests of its own, modeled on similar assumptions, and passed.5757 It does not appear that any agency required any action of Lehman in response to the results of the stress testing.
Yves here. So get this: the stress tests were a sham. Only one outcome was permissible: that Lehman pass. So after the Fed was unable to come up with an objective-looking stress test that Lehman could satisfy, they permitted Lehman to devise a test with low enough standards to give itself a clean bill of health.
So why should we trust ANY government designed stress test, particularly when the same permissive grader, Timothy Geithner, was the moving force behind the ones dreamed up last year, which have been widely decried by banking experts, including Bill Black, Chris Whalen, and Josh Rosner? We linked to a simple analysis by Mike Konczal that demonstrates that for the biggest four banks alone, merely on their second mortgage portfolios, the stress tests of 2009 were too permissive to the tune of at least $150 billion.
Lehman type accounting, in other words, is being institutionalized, with the active support from senior government officials.
It is time for Geithner to go. He is not fit to serve as Treasury secretary.
And the time is overdue for a full audit of the Fed, and in particular the New York Fed, from the start of the Bear crisis through and including all the retrades of the AIG bailout.
Update 12:00 AM, 3/12/10. Oh, boy, the spin is in in the US. Bloomberg focuses on an interesting revelation in the report, but which strikes me as secondary, that JP Morgan and Citi delivered the fatal blow to Lehman by withholding collateral. That JP Morgan seized $17 billion of collateral has been reported elsewhere; the only new elements are Citi’s role and that its and JPM’s actions could serve as grounds for legal action:"There are a limited number of colorable claims for avoidance actions against JPMorgan and Citibank," Valukas said in the report. He defined a colorable claim as sufficient credible evidence to persuade a jury to award damages at trial.
The Times pointed ignores the Fed’s lapses, as does the Journal and the major report at the Huffington Post.
Update 3:00 AM. Have now read the germane section a bit (over 300 pages, please do not bust my chops). Every page is stunning (the law firm did a great job, this is one case where big fees are associated with big time value). The nonsense is mile high. Lehman had been doing this sort of thing since 2001. No US law firm would give them cover via an opinion letter for their phony repo accounting, they managed to get the opinion they sought in the UK and accordingly shuffled assets through the UK for the repo 105 transactions. Frankly, if you don’t need colorful characters or glam settings, this is as attention-capturing as Too Big To Fail.
How Bad Is the Lehman Bankruptcy Report for Geithner?
If you're looking for a reader's guide to attorney Anton R. Valukas' report [pdf] on the bankruptcy of Lehman Brothers in September 2008, Yves Smith at Naked Capitalism has a quirky, erudite take that calls the cops on Secretary of the Treasury (then president of the Federal Reserve Bank of New York) Tim Geithner.And most important, it says that the NY Fed, and likely Geithner himself, undermined, perhaps even violated, laws designed to protect investors and markets. If so, he is not fit to be Treasury secretary or hold any office related to financial supervision and should resign immediately.So much depends upon a likely. Speaking as somebody who believes Geithner must not only be removed from office but be imprisoned like Magneto in a metals-free environment where there will be no conductivity for his brain waves of pure bamboozlement, I'm not sure the court report makes a very strong case against him. Smith calls for more evidence gathering, and huzzah to that.
But in his brief appearances in the 336-page report, Geithner's main concern seems to be with preventing a panic over the diseased state of Lehman. Geithner not only acknowledges his efforts at concealment, but seems to believe they were the right thing to do:In addition to the losses Lehman would incur by selling "sticky" assets at firesale prices, deleveraging also raised the additional problems of market perception and valuation.3187 As Secretary Timothy Geithner explained to the Examiner, selling "sticky" assets at discounts could hurt Lehman by revealing to the market that Lehman "had a lot of air in [its] marks" and thereby further draining confidence in the valuation of the assets that remained on Lehman's balance sheet.3188The first sentence is drawn from a November interview between Geithner and Valukas, the second from "Reducing Systemic Risk In A Dynamic Financial System," a speech Geithner delivered in June 2008. To say dressing up Lehman's bleeding sores was wrong, you need to acknowledge that a central bank should not engage in the suppression of information, and I'm pretty surewe lost that argument a long time ago.
Smith suspects (not without reason) that this mission to regulate the market'sfeelings toward Lehmanled Geithner to connive at what certainly looks to have been a fraud: the erroneous counting of "501 Repos" -- assets Lehman sold with an agreement to repurchase --as straightforward sales. That is, the outside world thought these toxic assets were gone from Lehman's books, when in fact they were merely festering. Smith has some interesting words about whether, and why, Lehman counterparties went along with this charade. (Likeliest answer: They were all betting on the come like the rest of America.) Geithner, typically, says he would have caught the problem if only we'd given him more power:From 2003 to 2009, Treasury Secretary Timothy Geithner served as President of the Federal Reserve Bank of New York ("FRBNY"). The Examiner described to Secretary Geithner how Lehman used Repo 105 transactions to remove approximately $50 billion of liquid assets from the balance sheet at quarter?end in 2008 and explained that this practice reduced Lehman's net leverage. Secretary Geithner "did not recall being aware of" Lehman's Repo 105 program, but stated: "If this had been a bank we were supervising, that [i.e., Lehman's Repo 105 program] would have been a huge issue for the New York Fed."3489"That's somebody else's department" being the first order of government, I suspect this will be enough to get the catlike Treasury Secretary off the hook. But we live in interesting times.
New round of foreclosures threatens US housing market
The housing market is facing swelling ranks of homeowners who are seriously delinquent but have yet to lose their homes, and this is threatening a new wave of foreclosures that could hit just as the real estate market has begun to stabilize. About 5 million to 7 million properties are potentially eligible for foreclosure but have not yet been repossessed and put up for sale. Some economists project it could take nearly three years before all these homes have been put on the market and purchased by new owners. And the number of pending foreclosures could grow much bigger over the coming year as more distressed borrowers become delinquent and then, if they can't obtain mortgage relief, wade through the foreclosure process, which often takes more than a year to complete.
As these foreclosed properties add to the supply of homes for sale, they could undercut housing prices, which have increased modestly through December, according to the most recent figures in the S&P/Case-Shiller home prices index. That rise partly reflected a slowdown in the flow of foreclosed homes onto the market. The rate at which J.P. Morgan Chase seized properties, for example, peaked in the middle of 2008 and fell steadily last year, according to a February investor report. But the bank expects repossessions to increase this year, nearly doubling to 45,000 by the fourth quarter.
"Some of the positive housing data may not be signaling a true turning point, as many servicers are holding back on foreclosures and the related houses are not yet being offered for sale," said Diane Westerback, a managing director at Standard & Poor's. Westerback said it could take 33 months to clear the backlog. Data released Thursday by RealtyTrac illustrate the dynamic. While banks repossessed fewer homes in February than a month earlier, borrowers continued to fall behind on their payments, adding to the inventory of properties headed toward foreclosure that have yet to be put on the market, said Daren Blomquist, RealtyTrac's spokesman.
"Just looking at the numbers, we would expect there to be a bigger percentage of properties" repossessed by banks by now, he said. This "shadow market" reflects the increasing lag between defaults and foreclosures. Many lenders are struggling to keep up with the overwhelming number of borrowers who can't make their payments, and they're reluctant to rush repossessed homes onto the market when prices are depressed.
Today's delinquent borrowers, for the most part, differ in a key regard from those who were caught up in the surge of defaults in 2008. That earlier wave, which precipitated the financial crisis, consisted largely of subprime borrowers who defaulted when their risky loans became unaffordable. The borrowers in trouble now are, for the most part, people who have better credit and safer loans and have become delinquent because they've lost their jobs or are dealing with other economic setbacks, economists said. More than 75 percent of the borrowers who are now seriously delinquent -- meaning they have missed at least three monthly payments -- have traditional prime loans, according to First American CoreLogic. Most of these borrowers have not made a mortgage payment in six months.
These borrowers are among the most difficult to help. Homeowners with economic troubles such as extended unemployment often cannot make even reduced mortgage payments. And the longer borrowers stay delinquent, the more difficult it is to fashion a mortgage relief plan for them. Some lenders are giving distressed borrowers more time to see whether they can modify the terms of their loans. It can take a borrower six to seven months to find out whether he or she qualifies for a permanent loan modification under the federal foreclosure relief program, Making Home Affordable, according to Barclays Capital.
In Maryland, for example, lawmakers extended the foreclosure process from 15 days to 135 days in 2008 and are considering emergency legislation to force lenders into mediation with a borrower before foreclosing on a property. But other states and jurisdictions have even more drastic measures to slow down the foreclosure process. "There were cases where sheriffs were refusing to file foreclosure notices," said Jay Brinkmann, chief economist for the Mortgage Bankers Association.
After a temporary foreclosure moratorium in 2008, the backlog of homeowners facing foreclosure in Maryland has surged. The number of Maryland homeowners who are seriously delinquent or in the midst of the foreclosure process nearly doubled during the fourth quarter of 2009 compared with the same period a year earlier, according to data from the Mortgage Bankers Association. "Lenders are deluged by late-stage delinquencies. The pent-up foreclosure inventory is there," said Massoud Ahmadi, director of research for the Maryland Department of Housing and Community Development.
The uptick in foreclosure sales is helping depress Maryland home prices, he said. "We have seen that home sales are on an upswing, but prices are on a downswing. That is the impact of the shadow inventory. It is keeping prices down," Ahmadi said. In addition to those already in default are 11 million more U.S. borrowers who owe more on their mortgage than their home is worth -- known as being underwater -- and are in danger of becoming delinquent, said Sam Khater, chief economist for First American CoreLogic.
Over the past year, the number of foreclosed homes going up for sale has declined. Distressed properties made up just 38 percent of purchases in January, compared with the 49 percent peak in March 2009, according to the National Association of Realtors. That helped the inventory of homes on the market fall to a 7.8-month supply, close to the figure during normal times and down from more than 11 months in July 2008. But as prices continue to stabilize, lenders are likely to take advantage of the situation by putting more of these distressed properties on the market, economists said. "Banks have remained in foreclosure paralysis, allowing that backlog to get larger and larger. You can't do that indefinitely," said Sandeep Bordia, head of U.S. residential credit strategy at Barclays Capital.
That impact could be muted if enough buyers emerge to snap up properties or efforts to enroll borrowers in mortgage relief programs improve. Some lenders are looking for ways to ease delinquent borrowers out of their homes without a foreclosure. For example, lenders are allowing more short sales, in which the home is sold for less than the outstanding loan balance. Citigroup is testing a program that allows delinquent borrowers to stay in their home for six months free if they leave the property in good condition, making it easier to sell afterward. "We are anticipating a foreclosure glut that is likely to come up in next 16 to 18 months. We are trying to stay ahead of this," said Sanjiv Das, chief executive of CitiMortgage. These types of programs are "protecting house prices and consumer sentiment from going down further," he said.
The impact of the coming foreclosure wave will vary by region. The Washington area has a "shadow inventory" of about 67,000 properties that could go into foreclosure this year, an 11-month supply at the current sales rates, according to research by John Burns Real Estate Consulting in Irvine, Calif. That is slightly higher than the national average but far less than the hardest-hit communities, such as Orlando and Miami, where there is two-year backlog. And the backlog will hang over some communities for years. By the end of 2012, 39 percent to 50 percent of home purchases in Phoenix will still be foreclosed properties, J.P. Morgan Chase has estimated. In Los Angeles, they'll account for 28 percent of home sales.
It's Time to Stand Up to the Supreme Court
by John C. Bogle
In January the U.S. Supreme Court ruled that laws limiting corporate political contributions were a violation of constitutional free speech principles. "The First Amendment confirms the freedom to think for ourselves," wrote Justice Anthony M. Kennedy in his 5-4 majority opinion, which is sure to unleash a flood of corporate spending on ads for and against political candidates. But public companies aren't people. As Justice John Paul Stevens, writing for the minority, observed, the court committed a grave error in treating corporate speech the same as that of human beings.
The notion that the same freedoms should apply when a public company, often with tens of thousands of owners, speaks in matters beyond the scope of its business affairs offends common sense. We can justifiably suppose that the individuals holding shares in these giant corporations hold a broad spectrum of opinions, and corporate political contributors can hardly honor them all. Past experience also suggests that corporate managers are likely to try to shape government policy in a way that serves their own interests over that of their shareholders. (For example, managers have opposed most attempts to limit executive compensation.)
Common sense and experience also suggest that, given the enormous revenues of today's giant corporations, these companies will make their political contributions generously. (Disclosure might help allay this generosity somewhat.) The tenet that "nothing seems expensive when you can pay for it with other people's money" comes to mind. Those investors who share my concerns aren't powerless against the Supreme Court's decision. Their first order of business is the submission of a resolution such as this for inclusion in the next proxy statement for each corporation in which they've invested:RESOLVED: that the corporation shall make no political contributions without the approval of the holders of at least 75% of its shares outstanding.
I recommend a supermajority requirement because of the inevitably wide range of views in any shareholder base. As it happens, 75% is halfway between a simple majority and the standard (under Delaware corporate law) requiring a unanimous shareholder vote to ratify a gift of corporate assets. Such a check on unfettered political contributions is essential now that our corporations are no longer controlled by "persons" (i.e., individual shareholders). Some 70% of the shares of big publicly held corporations are held by "agents"—the institutional investors who manage our mutual funds, pension funds, insurance and trust companies, and endowment funds.
These agents—who together hold working control of Corporate America—have all too often failed to honor their responsibilities of corporate stewardship, and they actively vote their proxies far too rarely. The record, as far as I know, is bereft of a single proxy proposal submitted by a mutual fund or pension fund investor in opposition to a corporation's management. The temptation for agents to take advantage of their agency position for their own benefit is too great. Large institutional investors, for instance, routinely manage the retirement plans and thrift plan portfolios of the very corporations whose shares they own. As the saying goes: "There are only two types of clients we do not want to offend: actual and potential."
Most institutional money managers today are owned by giant U.S. and global financial conglomerates with their own shareholders. Of America's 40 largest, 23 are owned by conglomerates, 8 are publicly held, and only 9 remain privately owned. Money managers who share my fears about unlimited corporate contributions to politicians must enter the arena with clean hands. Before they stand up against political contributions by the companies whose shares are held in their portfolios, they must publicly pledge a no-political-contribution policy of their own. This may sound like a tall order, but it's the only avenue that presents itself for, in effect, overriding the Supreme Court's unwise decision.
John C. "Jack" Bogle is founder and former chief executive of Vanguard. His latest book is Common Sense on Mutual Funds, 10th Anniversary Edition.
Regulators shut banks in NY, Florida, Louisiana
Regulators on Friday shut down banks in New York, Florida and Louisiana, raising to 30 the number of failures this year of federally insured banks. The Federal Deposit Insurance Corp. was appointed receiver of Park Avenue Bank in New York, Old Southern Bank in Orlando, Fla. and Statewide Bank in Covington, La. Park Avenue Bank had $520.1 million in assets and $494.5 million in deposits as of Dec. 31. The FDIC said the bank's deposits will be assumed by Valley National Bank, based in Wayne, N.J. Valley National agreed to pay a small premium to assume all of the deposits. It also agreed to purchase essentially all of Park Avenue Bank's assets. Park Avenue Bank's four branches will reopen beginning Saturday as offices of Valley National Bank.
It was the second New York bank to be shuttered this week. On Thursday, the FDIC closed LibertyPointe Bank, which catered largely to the Orthodox Jewish community in Manhattan and Brooklyn. Valley National is also taking on LibertyPointe's assets and deposits. Old Southern Bank had $315.6 million in assets and $319.7 million in deposits, as of Dec. 31. Centennial Bank in Conway, Ark. agreed to acquire the deposits for a premium and purchase virtually all of Old Southern's assets. The seven branches of Old Southern will be reopened Monday as branches of Centennial Bank. Statewide Bank had $243.2 million in assets and $208.8 million in deposits, as of Dec. 31. Home Bank in Lafayette, La. is assuming Statewide Bank's deposits, but will not pay a premium. Home Bank is also purchasing nearly all of Statewide Bank's assets. Statewide Bank's six branches are reopening Saturday as branches of Home Bank.
The pace of bank seizures this year is likely to accelerate in coming months, FDIC officials have said. As the economy has weakened, bank failures have mounted, sapping billions of dollars out of the deposit insurance fund. It fell into the red last year, hitting a $20.9 billion deficit as of Dec. 31. Park Avenue Bank's failure is expected to cost the FDIC's insurance fund $50.7 million. Old Southern Bank's failure will cost the fund $94.6 million, while Statewide Bank's failure will cost the fund $38.1 million.
The number of banks on the FDIC's confidential "problem" list jumped to 702 in the fourth quarter from 552 three months earlier, even as the industry squeezed out a small profit. Banks earned $914 million, compared with a $37.8 billion loss in the fourth quarter of 2008, at the height of the financial crisis. Still, nearly one in every three banks reported a net loss for the latest quarter. Last year, 140 bank failed. That was the highest annual tally since the height of the savings and loan crisis in 1992. Last year's bank closures cost the insurance fund more than $30 billion. There were 25 bank failures in 2008 and just three in 2007.
The FDIC expects the cost of resolving failed banks to grow to about $100 billion over the next four years. The agency mandated last year that banks prepay about $45 billion in premiums, for 2010 through 2012, to replenish the insurance fund. Depositors' money—insured up to $250,000 per account—is not at risk, with the FDIC backed by the government. Apart from the fund, the FDIC has about $66 billion in cash and securities available in reserve to cover losses at failed banks.
China Hits Back at Obama on Yuan
China responded sharply to U.S. criticism of its currency and human-rights practices, in the latest sign that relations between the two powers remain testy. A senior Chinese central banker, responding to U.S. President Barack Obama's remarks urging China to move toward a more market-based exchange rate for its currency, suggesting the president was trying to divert attention from America's own economic mismanagement.
"We don't agree with politicizing the…exchange rate issue," People's Bank of China Vice Governor Su Ning said when asked about Mr. Obama's remarks Friday on the sidelines of China's legislative meetings in Beijing. "We also don't agree with a country taking its own problems and having another country solve them." Mr. Obama's remarks Thursday were relatively mild, compared to statements from some U.S. lawmakers and economists criticizing China for suppressing the value of Chinese yuan.
The critics say the practice makes China's exports artificially inexpensive. In a speech at the Export-Import Bank's annual conference, Mr. Obama argued that liberalizing China's exchange rate would help increase consumption in countries like China that have external surpluses, and boost savings and exports in countries like the U.S. that have external deficits. "As I've said before, China moving to a more market-oriented exchange rate would make an essential contribution to that global rebalancing effort," he said.
China's currency has been effectively pegged to the dollar since China halted the gradual appreciation of the yuan in mid-2008. Last weekend, People's Bank of China Governor Zhou Xiaochuan suggested that the de facto peg was a temporary measure, but also indicated that it may remain in place for some time yet. Mr. Su said liberalizing exchange rates doesn't necessarily resolve trade imbalances. "We believe the yuan exchange-rate issue will not help shrink or increase our trade surpluses and deficits [in the U.S. or China]," he said. The U.S. and Chinese statements were consistent with their often-stated positions, but the direct and forceful rebuttal to the U.S. president was unusual. The spat comes amid broader tension in U.S.-China relations over issues ranging from trade to Internet censorship to China's refusal to back sanctions on Iran for its nuclear program.
Meanwhile, in what has become an annual ritual, China's cabinet Friday responded to a U.S. State Department report criticizing China's human rights record by publishing its own report alleging human rights abuses in the U.S. China began issuing such reports in 2000 in response to the State Department's annual human rights report, which has been published for the past 34 years. This year's State Department report, released Thursday, once again highlighted problems in China. Beijing's human rights record "remained poor and worsened in some areas," the U.S. report said, using identical language to last year's report to describe the overall situation. The report cited incidents including "severe cultural and religious repression" in Xinjiang, harassment of rights activists and lawyers, and controls on the Internet and free speech.
China's report lambasted America for "posing as 'the world judge of human rights' again." "At a time when the world is suffering a serious human rights disaster caused by the U.S. subprime crisis-induced global financial crisis, the U.S. government still ignores its own serious human rights problems but revels in accusing other countries. It is really a pity," said the report, issued by China's State Council Information Office. As in previous years, it said, the U.S. report is "full of accusations" against countries, including China, but its contents "turn a blind eye to, or dodge and even cover up rampant human rights abuses on its own territory."
Japan Wants to Weaken Yen
Japanese Prime Minister Yukio Hatoyama said Friday the government needs to take steps against the yen's recent strength, which doesn't reflect Japan's weak economic and industrial conditions. Because of overseas factors, "there has emerged a strong yen that we can hardly believe reflects the fact that Japan's economy and industries aren't necessarily strong," Hatoyama said in a parliamentary session. "I think we need to take firm steps against such yen strength." Hatoyama even suggested he wants joint international action to push the yen lower, saying, there is a need to "politically cooperate on the world stage."
Also, Bank of Japan Gov. Masaaki Shirakawa said Friday the central bank aims to stimulate demand by maintaining a low interest-rate environment, but declined to comment on whether the central bank will take additional easing steps next week. "The BOJ is trying to stimulate demand by keeping low interest rates," Shirakawa said in a parliamentary committee session. Asked about the need to take additional easing steps at its two-day policy board meeting ending next week, Shirakawa declined to answer. The BOJ meeting will be held Tuesday and Wednesday.
Europe's banks brace for UK debt crisis
by Ambrose Evans-Pritchard
UniCredit has alerted investors in a client note that Britain is at serious risk of a bond market and sterling debacle and faces even more intractable budget woes than Greece. The Italian-German group, Europe's second largest bank, said Britain's tax structure will make it hard to raise fresh revenue quickly enough to restore confidence in UK public finances. "I am becoming convinced that Great Britain is the next country that is going to be pummelled by investors," said Kornelius Purps, Unicredit 's fixed income director and a leading analyst in Germany.
Mr Purps said the UK had been cushioned at first by low debt levels but the pace of deterioration has been so extreme that the country can no longer count on market tolerance. "Britain's AAA-rating is highly at risk. The budget deficit is huge at 13pc of GDP and investors are not happy. The outgoing government is inactive due to the election. There will have to be absolute cuts in public salaries or pay, but nobody is talking about that," he told The Daily Telegraph. "Sterling is going to fall further over coming months. I am not expecting a crash of the gilts market but we may see a further rise in spreads of 30 to 50 basis points."
Yields on 10-year gilts have already crept up to 4.14pc, compared to 3.94pc for Italian bonds, 3.48pc for French bonds, and 3.19pc for German Bunds, though part of this reflects worries about higher inflation in Britain. Ian Stannard, currency strategist at BNP Paribas, said markets are fretting over how the UK will cover its deficit following the pause in quantitative easing by the Bank of England. The Bank has absorbed £200bn of debt, more than total Treasury issuance over the last year. "The UK may have difficulty in attracting extra investors to fill the gap. We think they will have to do more QE as recovery falters," he said.
BNP Paribas expects sterling to drop to $1.31 against the dollar this year and reach parity against the euro despite troubles in Club Med. "We're very bearish on the UK," he said. Big global banks are divided over Britain's economic prospects . Goldman Sachs is betting on a turbo-charged recovery as the delayed effects of sterling devaluation kick in. Britain's trump card is an average debt maturity of 14.1 years, nearly three times US maturities and double those of France. This greatly reduces the risk of a "roll-over" crisis.
UniCredit said Greece is better placed than the UK in coming months even if deficits look comparable. "The polls point to a minority government in the UK, while Greece's government can count on a majority to push austerity measures through parliament. Secondly, the British tax system offers less leverage for a rise in revenue," he said. Paradoxically, Greek tax evasion creates scope for a surge in revenues from tougher enforcement. "It is not out of the question that we will see a positive surprise in Greece: is there any such hope for Britain?" said Mr Purps.
Still, while it is arguable whether a hung Parliament in Britain will lead to policy drift, analysts said Greece was in trouble already. The country was brought to a standstill on Thursday by the second general strike in weeks. Police clashed with rioters , again reducing Athens to a fog of tear gas. Observers said that did not augur well for a nation that has hardly begun its three-year ordeal of draconian cuts.
Washington Must Ban U.S. Credit Derivatives: Games and Gold (Part 2)
by Janet Tavakoli
In an earlier post, I wrote that Congress should act immediately to abolish credit default swaps on the United States, because these derivatives will foment distortions in global currencies and gold. Credit defaults swaps on the United States currently settle in euros, but there is talk of creating new contracts calling for settlement in gold. This is just a trial balloon discussion at the moment, but it is one that Congress should immediately deflate along with all credit derivatives on the United States.
Most traders in U.S. credit default swaps don't think the U.S. will default as long as we have money printing presses, so they are speculating on price movements. If speculators manage to get contracts to settle in gold, speculators on the winning side of a price move will demand collateral paid in gold.
Gold is Collateral on the London CME
Presenting gold to satisfy demands for Performance Bond Collateral is already allowed on the London CME in a limited way since October 2009. [Hat tip to Hilary Till, co-founder of Premia Capital.] This is an excerpt from the announcement:CME Clearing is introducing an enhancement to the existing Performance Bond Collateral schedule. Effective October 19, 2009, firms will be able to post physical gold to CME Clearing to cover non-segregated (NSEG) Performance Bond requirements. Initially, gold will be able to be posted to JPMorgan Chase Bank in London, England. In the near future, we hope to add additional depositories.
There will be a firm asset limit of $200 million. These guidelines are subject to change and will be evaluated on a regular basis.
Sovereign Credit Default Swap Contracts: Tower of Babble
The credit default swap market has a history of conflicts, and the worst of them occur when it is time to settle up. For example, hedge funds Eternity Global Master Fund Ltd. and HBK Master Fund LP thought they purchased protection against an Argentina default and sued when J.P. Morgan refused to pay off on Argentina credit protection contracts Eternity had purchased.
J.P. Morgan's posture was different when it wanted to collect on the protection it bought from Daehon, a South Korean Bank. J.P. Morgan claimed the slightly different contract language met the definition of restructuring under the credit default protection contract it had with the South Korean Bank.
Regulators "Can't Find" Evidence of Market Manipulation
European regulators said they saw no evidence of manipulation in the Greek credit default swap market because they examined DTCC data. DTCC doesn't capture all trades. Regulators would have found evidence of the rampant manipulation in the U.S. mortgage backed securities market, either, since those trades were not captured on any clearing exchange. Moreover, already flawed "ISDA standard" documentation does not have to be used for opaque credit derivatives, including those that may reference sovereign debt. Allan Sloan at the Washington Post asked the right questions:How much of this stuff do the Street people own? Where is it? What kind of securities has it been pushed into? No one knows. The one thing you can bet on, though, is that unraveling it all is going to be horribly complicated. Why? Because for Wall Street, complexity equals profitability.
I am not against covered short selling or puts, and some short sellers have done better work than main stream media in uncovering accounting manipulation and over-borrowing. (Click here to see David Einhorn's early warnings about Lehman Brothers.) But the credit default swap market has a history of manipulation, and we are in the middle of a global financial crisis. Speculators can potentially destabilize a country or a company that's already in trouble.
Time for Reform is Overdue
More than a year has passed since former Treasury Secretary Henry Paulson went to Congress in September 2008 to plead for special powers and TARP money to bail out U.S. financial institutions. Yet there has been no meaningful financial reform.*
Lehman was not alone in fudging its accounting and over-borrowing. All of our legacy investment banks: Lehman Brothers, Goldman Sachs, Morgan Stanley, Bear Stearns, and Merrill Lynch had borrowed too much money, all of them used gimmicks to disguise debt, and all of them--including Goldman Sachs--would have gone under in 2008 without the bailouts.
World leaders should not be surprised that many countries also disguise debt and fudge their accounting. A good first step to reform of the financial system is to take away financial instruments that are ripe for abuse, starting with a ban on all sovereign credit default swaps.
*This video explains how cheap money, wide-spread bad (often predatory) lending, phony securities, credit derivatives, and Wall Street banks' massive over-borrowing led to our current financial crisis. Yet there is still no meaningful reform. Explanation of credit derivatives begins at 8:00.
No Need for Greek Bailout Now, France's Lagarde Says
Credible efforts by Greece's government to clean up its finances have so far negated the need for any bailout from the European Union, French Finance Minister Christine Lagarde said Friday. In offering a strong vote of confidence in the new Greek government, Ms. Lagarde said in a Wall Street Journal interview that Greece had "for once, over-delivered from what was expected" in terms of legislation intended to cut spending. Whereas she had expected cuts worth 1.5% of gross domestic product, the government had come up with 2%, she said.
She cited the Greek government's stringent budget cuts as the key reason for the stabilization in its debt prices, rather than any talk of a bailout plan. Focusing on the bailout speculation to explain the market's improvement is "narrowing the debate," Ms. Lagarde said. "The Greek authorities understood that it was in the interest of everybody, not just themselves but also members of the euro zone and the EU at large to come up with a solid plan and not something that was half-baked," she said. "And for the first time for as long as I've been on the Ecofin (the EU finance ministers group), they over-delivered compared with what we had expected." Greece's leaders, she added, "have demonstrated that they are credible and the market responded that way."
In contrast with reports out of Europe Friday that suggested the announcement of a bailout plan for Greece was imminent, Ms. Lagarde said no such plan would emerge if Greece doesn't default on its debt. "There is no such thing as a bailout plan which would have been approved, agreed or otherwise, because there is no need for such a thing," she said. Nonetheless, Ms. Lagarde said that "technical experts" at the EU have been working on a contingency plan, so that if the need arose, "all we would have to do is press the button." Echoing remarks made by many European leaders, she said "the members of the EU would take whatever measures necessary to make sure the currency is stable."
Asked about lessons to take away from the crisis, she returned to the theme of "misrepresented or undisclosed" debt numbers and called for greater and more powers at Eurostat, the EU's statistical agency. "Eurostat needs to be more intrusive, it needs to be better informed," she said Yet, despite her criticisms of the quality of data in the EU, Ms. Lagarde was unconcerned about the fiscal health of other heavily indebted euro-zone nations. Asked whether other countries faced financial risks, Ms. Lagarde said, "I have no idea and no suspicions."
In recent months, observers have warned that other euro-zone countries with high fiscal deficits and debt levels, in particular Portugal, Spain, Ireland and Italy, could run into problems similar to Greece's. Ms. Lagarde gave only guarded support for the creation of a European Monetary Fund, a new project currently under debate within the European Commission. "The European Monetary Fund is one of many options that we should explore [and] examine to see whether there is virtue and value in having it," she said. "I am not sure it is the ultimate answer to the issues we are dealing with at the moment."
The EMF would make a large pool of money available for the euro zone to provide financial aid to struggling countries under strict rules that would tie disbursements to compliance with fiscal goals. It would be modeled on the International Monetary Fund. Asked why the E.U. is so opposed to having the IMF simply fill such a role now and come to the aid of one of the euro zone's members, Ms. Lagarde said it is complicated by the presence of a monetary union. Whereas the E.U. worked with the IMF to provide support to Hungary and Latvia, both members of the broader European Union but not part of the euro zone, having the IMF involved in the euro zone "is a bit different."
"It is as if California were in terrible shape and you were to call the IMF to rescue California. That's a bit odd within the same monetary zone," she said. In reference to the euro's slide against the dollar since the Greek crisis erupted, Ms. Lagarde said she was "kind of pleased that it has come down a bit" because it means that French exporters are "not knocking on my door" and pressuring her to do something about the high exchange rate. Asked about the U.S. authorities' decision to let Lehman Brothers' fail in September 2008—which sent shock waves through the global financial system—Ms. Lagarde reiterated that she considered this decision at the root of the global turmoil. Had the decision not been made, she said, "the trauma might have existed but would have been tempered over time without the brutality and depth of the recession that we've experience around the world."
Eurozone could risk 'sovereign debt explosion'
by Ambrose Evans-Pritchard
Europe's governments are at increasing risk of an interest rate shock this year as the lingering effects of the Great Recession drive debt issuance to record levels and saturate bond markets, according to Standard & Poor's. "Debt-related sovereign vulnerabilities have increased, particularly in the Eurozone, where we expect government borrowing will rise to further new peaks," said Kai Stukenbrock, the ratings agency's European credit analyst. "The resulting fiscal pressure from a sustained increase in financing cost could be significant in our view."
The warning comes as bond giant PIMCO spoke of a "sovereign debt explosion" that has taken the world into uncharted waters and poses a major threat to economic stability. "Our sense is that the importance of the shock to public finances in advanced economies is not yet sufficiently appreciated and understood," said Mohamed El-Erian, the group's chief executive. Mr El-Erian said most analysts are still using "backward-looking models" that fail to grasp the full magnitude of what has taken place in world affairs since the crisis. Some 40pc of the global economy is in countries where governments are running deficits above 10pc of GDP, with no easy way out.
Standard & Poor's said Europe's states need to raise €1,446bn (£1,313bn) this year as the full damage inflicted by the credit collapse – masked last year by emergency stimulus measures – becomes ever clearer. This will become harder to fund cheaply as central banks start to tighten. "We believe that benchmark yields have benefited from liquidity injections into the financial sector and quantitative easing measures by the Bank of England and the Federal Reserve. As that support could eventually be withdrawn from 2010, excess supply in government bond markets could start driving benchmark yields back up. Such a development could add to fiscal pressure in a number of sovereigns with high deficits," it said.
Several states have come to rely on cheap short-term funding, storing up "roll-over risk" that will come to a head in coming months. Italy has to refinance 20pc of its entire debt – the world's third largest after Japan and the US – tapping the bond markets for a total €259bn this year. Belgium has to roll over 22pc of its substantial debt. "This implies dependence on more or less constant access to financial markets," said the report. Weaker states risk a double effect of rising yields on benchmark bonds as well as higher spreads as investors demand a greater risk premium in the harsher climate now facing heavily-indebted countries.
Greece has already seen a surge of 300 basis points in its long-term funding costs since the new Pasok government of George Papandreou revealed that the country's true budget deficit was 12.7pc, double the previous estimate. The agency estimates that a sustained rise in yields of 300 basis points would raise the burden of interest costs each year by 3.9pc of GDP for Greece, 2.6pc for Portugal, and 2.5pc for Italy and Britain by the middle of the decade.
A jump of this kind would amount to an extra £35bn or so in annual interest costs, roughly equal to the UK defence budget. This would play havoc with UK public finances and force the Government to squeeze fiscal policy even further. S&P's warning clearly underscores the risk of waiting too long before restoring the deficit to a sustainable path. The report said there had been a notable increase in "alternative channels of borrowing" that "embellish" the true debt picture. France's Société de Financement de l'Economie (SFEF) has issued €77bn of state-backed bonds since 2008 and the Caisse d'Amortissement de la Dette Sociale has amassed liabilities of €103bn. Austria's infrastructure financing companies, used to buttress state stimulus programmes, have €23bn in debts.
This hidden iceberg of debt kept off balance sheet is likely to be the next focus of bond vigilantes.
Euro-zone industrial production posts record rise
A record monthly rise in industrial output across the 16-nation euro zone in January tempered pessimism about the outlook for the region's economy in the first quarter, economists said Friday.nIndustrial production rose 1.7% from December, the strongest rise since the statistical series began in 1990, the European Union statistics agency Eurostat reported. Compared to the same month last year, production was up 1.4%.
A survey of economists conducted last week had forecast a 0.7% monthly rise and a 1.3% annual fall. But expectations for the figure had risen this week after stronger-than-expected national data from Italy and France. Read earlier story about national industrial production data. nEven if February and March production came in unchanged, first-quarter output would show a rise of 2.5%, which would add 0.1 percentage point to first-quarter gross domestic product growth, said Ben May, European economist at Capital Economics.
Moreover, business surveys point to further improvement in the sector, he noted. But expectations for a slowdown in the global recovery later this year and the still relatively strong euro will weigh on the sector later in the year, May said, underlining the need for growth in other sectors to pick up in order to ensure a sustained recovery. nThe euro rose to a three-week high versus the dollar and changed hands at $1.3785, a gain of 0.8% on the day. Eurostat also revised up its December production data from an initial estimate of a 1.7% monthly decline to show a 0.6% rise. The December annual growth rate was revised to show a 4.1% fall from an initial estimate of a 5% decline.
Patchwork Pension Plan Adds to Greek Debt Woes
Vasia Veremi may be only 28, but as a hairdresser in Athens, she is keenly aware that, under a current law that treats her job as hazardous to her health, she has the right to retire with a full pension at age 50. "I use a hundred different chemicals every day — dyes, ammonia, you name it," she said. "You think there’s no risk in that?" "People should be able to retire at a decent age," Ms. Veremi added. "We are not made to live 150 years."
Perhaps not, but that still makes it difficult to explain to outsiders why the Greek government has identified at least 580 job categories that are deemed to be hazardous enough to merit retiring early — at age 50 for women and 55 for men. The law includes some predictably dangerous jobs like coal mining and bomb disposal. But it also covers positions like radio and television presenters who are thought to be at risk from the bacteria on their microphones and musicians playing wind instruments who must contend with gastric reflux as they puff and blow.
As a consequence of decades of bargains struck between strong unions and weak governments, Greece has promised early retirement to about 700,000 employees, or 14 percent of its work force, giving it one the lowest average retirement ages in Europe at 61. Greece’s patchwork system of early retirement has contributed to the out-of-control state spending that has led to Europe’s sovereign debt crisis. What’s more, the government’s promises to pay pension benefits will grow sharply in coming years, and investors can see that the country has not set aside enough money to cover those costs.
The predicament has emerged as a divisive topic within Europe, especially because Germany, Greece’s most stubborn taskmaster on fiscal matters, has already taken politically difficult steps to increase its retirement age to 67 and reduce benefits. Indeed, the problem with Greek pensions far outweighs the troubles caused by finagling with its accounts in the early 1990s to get its official deficit figures low enough to qualify to join the euro club. A recent report by the European Commission found that Greek spending on pensions and health care for its aging population, if left unchecked, would soar from just over 20 percent of G.D.P. today to about 37 percent of G.D.P. by 2060, the highest level in Europe.
Greece is an early indicator of troubles to come. Bigger countries like Germany, France, Spain and Italy have relied for decades on a munificent state financed by a range of stiff taxes to keep the political peace. Now, governments across Europe are being pressed to re-examine their commitments to providing generous pensions over extended retirements because the downturn has suddenly pushed at least part of these hidden costs to the surface.
The situation in the United States is different but also dire. The United States government will face its own fiscal reckoning, analysts say, as 78 million baby boomers begin drawing on underfunded Social Security and Medicare programs to support them in retirement. Without some combination of raising taxes, reducing benefits or pushing back the retirement age, both programs will run out of money within the next few decades. And many American states are woefully short of meeting their pension obligations for public employees.
In Europe, the conflict has already erupted on the streets of several major cities, with workers demanding that generous retirement policies be kept while governments press to pare pensions and raise retirement ages because taxpayers cannot bear any additional weight and creditors will no longer finance excessive borrowing. To make matters worse, the unfunded pension liabilities far outweigh the high levels of official sovereign debt that governments owe creditors, which have caught Greece and several other weak European nations in a borrowing vise. According to research by Jagadeesh Gokhale, an economist at the Cato Institute in Washington, bringing Greece’s pension obligations onto its balance sheet would show that the government’s debt is in reality equal to 875 percent of its gross domestic product, which is the broadest measure of a nation’s economic ouput. That would be the highest debt level in the 16-nation euro zone, and far above Greece’s official debt level of 113 percent.
Other countries have obscured their total obligations as well. In France, where the official debt level is 76 percent of economic output, total debt rises to 549 percent once all of its current pension promises are taken into account. Similarly, in Germany, the current debt level of 69 percent would soar to 418 percent. Mr. Gokhale, like many other economists, says he believes that this is a more appropriate way to assess a country’s debt level because it underscores the extent to which the cost of providing for rapidly aging populations, if left unchanged, will add to already troubling debt burdens.
"You have to look ahead and see how pension expenditures are rising in comparison to the revenues needed to finance them," he said. "It’s not just Greece; all major European countries are facing pension shortfalls. It is a very difficult challenge because it involves selling pain to current voters." He estimates that to fully finance future pension obligations, the average European country would need to set aside 8 percent of its economic output each year, a practical impossibility given that raising already high taxes that much would impose a crushing burden on their economies.
Mr. Gokhale has done a similar calculation for the United States and estimates that the truest measure of federal government debt, incorporating Medicare, Medicaid, Social Security and other obligations, is $ 79 trillion, or about 500 percent of the nation’s output. Currently, United States debt owed to the public is equal to about 60 percent of it domestic output. Many of these liabilities will not be coming due for decades. But as most developed countries suffer the worsening dynamic of having fewer workers to cover pensions and health care bills for the elderly, their ability to borrow more is rapidly approaching its limits.
In its 2009 annual report on Greece, the International Monetary Fund warned that the government’s excessive pension and health payments to the elderly would result in a debt level of 800 percent of its ouput by 2050 if left unchecked, similar to the figures Mr. Gokhale calculated. That is a theoretical number, of course: international creditors, who are already balking at lending Greece more money, will force changes in government programs well before Athens borrows that much.
"The pension crisis is the biggest single test of Greece’s willingness to tackle longstanding reform," said Kevin Featherstone, an expert on the Greek political economy at the London School of Economics. "Any meaningful reform must lead to reduced benefits for workers — the government needs to show that it can overcome union pressure." Greece has already proposed to raise its average retirement age to 63, and that may be just a beginning — not just for Athens but for much of Europe as well.
The French president, Nicolas Sarkozy, has met with union leaders and broached the prospect of raising the normal retirement age from 60. Spain has gone further by proposing a retirement-age increase, to 67 from 65. In the face of union opposition, however, the government is wavering on that proposal. "Projected pension expenditures are expected to double," said Manos Matsaganis, a professor at the University of Athens and author of numerous papers on Greece’s pension system. "That is unsustainable." Still, the millions who have come to rely on these payouts see their pensions as an acquired right, one they will not give up easily. "Nobody thinks they have to be the one to sacrifice," Mr. Matsaganis said.
That’s certainly true of Christos Bourdakis, a retired government accountant. Sitting in a dusty union hall in Athens, he who is in no mood to offer any concession on his pension, regardless of the severity of the crisis. He is a full-throated proponent of a system that pays him a yearly pension of 30,000 euros, or $41,000, more than he was making when he retired 13 years ago at the age of 60. He has even written a book in defense of it, "The Guide to Granting Civil Service Pensions in Greece." "We have to protect our standard of living," Mr. Bourdakis said. "The pensioners should not have to pay for the crisis created by the bankers."
Fitch Cites Dong in Putting Vietnam Rating on Watch
Vietnam had its debt rating placed on negative watch by Fitch Ratings, which cited poor sentiment toward the Southeast Asian nation’s currency and a risk of accelerating inflation. The country has had its long-term foreign and local currency issuer default rating of BB- placed on alert for a possible downgrade, Fitch said today. Other countries that Fitch rates BB-, which is three notches below the credit-ratings company’s investment-grade, include Armenia, Lesotho, Nigeria, Serbia, and Uruguay.
Vietnam’s central bank devalued the dong in November and again in February, pushing the exchange rate of the currency to around 19,095 per dollar now from 17,862 four months ago. The dong has been hurt by weakening foreign-exchange reserves and external finances, which have contributed in turn to Vietnamese losing confidence in the nation’s currency, Fitch said. "The ongoing divergence between the black market Vietnamese dong and the market clearing spot rate continues to point to depreciation pressures," Fitch said. "Without a strong policy tightening backed by significant balance of payments support, confidence in the Vietnamese dong is unlikely to be restored."
The dong traded at about 19,330 on the black market today, according to a telephone information service run by Vietnam Posts & Telecommunications. Failed attempts by the government to sell domestic bonds illustrate a lack of confidence in dong-denominated assets, Fitch said. A further devaluation of the dong "is not ruled out," wrote Yong Yin Ng, a Kuala-Lumpur based analyst for Citigroup, Inc., in a note this week on Malaysia’s Gamuda Bhd, which has property projects in Vietnam.
Citigroup also cited "strong economic growth" as driving inflation, while Fitch today said the Vietnamese economy is showing signs of overheating. Vietnam’s economy expanded 6.9 percent in the fourth quarter from a year earlier, the fastest pace of 2009, and the government is targeting 6.5 percent growth this year. "A preference towards Vietnamese dong devaluation to boost exports and the authorities’ pro-growth policy measures in the run-up to the January 2011 national congress of the ruling Communist Party point to risks of further build-up in inflationary pressures and a weak policy response," Fitch said.
Vietnam’s year-on-year inflation rate reached 8.46 percent in February, the highest level reported in 10 months. "Triggers for a rating downgrade include continued lack of significant policy tightening and continuing pressure on the Vietnamese dong and international reserves," Fitch said. Vietnam’s central bank has held its benchmark interest rate at 8 percent since December. Foreign-exchange reserve cover may drop this year to 2.6 months worth of imports, Fitch estimated.
Blame the market
by Mark Hulbert
Gold bulls use curious arguments to excuse gold's weakness
You can learn a lot about the market's prevailing mood by analyzing the rationales and justifications that advisers give when they're wrong. Take the gold market, whose recent decline caught many gold bulls by surprise. After staging a nearly-$100 rally from early February through early March, gold then gave nearly half that rally back. The most common excuse that gold bugs have used to explain why they didn't anticipate gold's recent weakness: Strength in the dollar. And I'm sure they're right that dollar strength does translate into gold weakness.
But I'm cynical about their using this rationale as an excuse. A loss in gold is a loss, regardless of what caused it, isn't it? If dollar strength means that gold's weakness doesn't really count, then -- by the same token -- the dollar's weakness a month ago should have meant that gold's strength didn't count either. But I didn't see any of the gold bulls saying that.
Imagine a bullish stock market timer who, upon failing to anticipate a big decline, excuses his failure by saying that corporations turned out not to be as profitable as anticipated. But, if that timer had been basing his bullish forecast on a certain level of corporate profits, wasn't it his job to get that forecast right? This reminds me of a newsletter editor I tracked in the mid 1980s, who no longer publishes a newsletter and whom I therefore will not mention, in order to spare him any additional ignominy. When asked why the stock market had risen so much, despite his persistent predictions that it would fall, this editor said that it was the market, not he, who had been wrong!
By this logic, of course, an adviser can avoid ever admitting he made a mistake, no matter how much money he has lost for his clients. Back to gold: What we're looking for in a gold timer is someone who can accurately and objectively assess the world as it is, and after taking all relevant factors into account, make a profitable forecast about what is going to happen. Part of that world is possible fluctuations in the dollar.
Another part of that world right now is an unsettling degree of bullish sentiment among gold timers. From a contrarian point of view, of course, such bullishness is a warning sign -- as indeed I pointed out earlier this month, just before gold entered into its recent slide. Unfortunately, the sentiment picture is no better now than it was earlier this month -- and perhaps even worse. The gold timers tracked by the Hulbert Financial Digest have steadfastly refused to build up any cash in the wake of gold's recent slide, which hints at stubbornly-held bullishness.
According to contrarians, the corrections that are most likely to be relatively minor affairs are those accompanied by market timers rushing for the exits. That's not what we're seeing right now. As I have frequently done in prior columns about gold sentiment, let me stress that my analysis only applies to the short-term horizon -- the next couple of months. That's because contrarian theory, to the extent it works, is only a short-term market timing tool. So gold may indeed be headed much, much higher in coming years, as gold's true believers constantly stress. But, if contrarian analysis is right, gold first has more work to do on the downside before it can begin that march to much higher levels.
Likely Fed Picks Back Low Rates
Janet Yellen's expected nomination as Federal Reserve vice chairman would bring a strong advocate of low interest rates into the central bank's leadership just as the Fed weighs how to unwind its extraordinary intervention in the economy. For two other vacancies on the Fed's board, the White House says it is considering Sarah Raskin, Maryland's commissioner of financial regulation, and Massachusetts Institute of Technology economist Peter Diamond, an expert on Social Security, pensions and taxation. The three nominees are being vetted and plans could change before an announcement.
President Barack Obama's unusual opportunity to name three new members to the Fed's seven-member Board of Governors at once would put an important stamp on the central bank as he tries to boost the economy and labor market. The governors vote on interest rates and oversee a wide range of regulatory policies at the Fed. Fed Chairman Ben Bernanke, seeking to pick the appropriate time to tighten policy, is likely to get a set of new governors who support keeping interest rates low to help the economy recover.
The likely nominees are expected to be a key counterweight to the Fed's most "hawkish" policy makers—those who generally place inflation risks as a higher concern over unemployment, compared with "dovish" members who generally prefer lower interest rates for a longer period when joblessness is high. "I expect that the board will eventually appear to be a much more dovish place than it was some time ago," said Allan Meltzer, a Fed historian at Carnegie Mellon University.
Ms. Yellen, already a strong voice at the Fed through her role as San Francisco Fed president, has been one of the central bank's key defenders of low interest rates, a position that could draw sharp questioning from some Senate Republicans during her confirmation process. "Some people worry that sustained federal budget deficits and the huge increase in the Federal Reserve's lending and stimulus programs could eventually lead to high inflation," Ms. Yellen said in a recent speech. "Others take the opposite view, arguing that economic slack and downward pressure on wages and prices are pushing inflation down. I would put myself squarely in the second camp."
Ms. Yellen, 63 years old, also could face tough questioning from lawmakers about the high number of bank failures in California, where the San Francisco Fed is a top regulator. Ms. Yellen was tapped from the University of California, Berkeley faculty in 1994 to become a Fed governor. After almost three years, she moved to the White House as chair of the Council of Economic Advisers under President Bill Clinton. As president of the regional Fed bank since 2004, Ms. Yellen has earned respect from the Fed's hawks as a skilled economist and worthy adversary. She is known inside the Fed as a nonconfrontational consensus builder and could help to smooth tensions among competing factions at the central bank.
Although Ms. Yellen has a reputation for being a dove, that hasn't always been her position. As a Fed governor in September 1996, Ms. Yellen and Laurence Meyer, another governor at the time, visited the Fed's then-chairman, Alan Greenspan, before a policy meeting to convince him that inflation risks were rising, according to Mr. Meyer. Mr. Greenspan believed the U.S. was experiencing a productivity boom that would keep inflation low and favored keeping interest rates low. Ms. Yellen and Mr. Meyer wanted to raise them. She and Mr. Meyer failed to sway Mr. Greenspan to start moving toward higher rates, though Ms. Yellen continued her argument days later when Fed officials gathered formally. Inflation remained in check, as Mr. Greenspan expected. Mr. Meyer, now vice chairman of Macroeconomic Advisers LLC, a consulting firm, calls that case "an example of Janet taking a hawkish position."
The common thread in her positions then and in her positions recently is a strong focus on the interplay between unemployment and inflation. When there is a lot of slack in the economy—represented by unemployment among other measures—Ms. Yellen has tended to believe that inflation risks are low. That view has placed her in the camp of officials now, with the jobless rate at 9.7%, who see little inflation risk. But not all officials ascribe to that view. Some, pointing to the high inflation and high unemployment of the 1970s, don't see such a strong link between unemployment and inflation.
But high unemployment hasn't been her only concern lately. Ms. Yellen also has been wary of the risk that the Fed's extraordinary efforts to pump money into the financial system to stave off an even worse recession could lead to unintended consequences, such as some new asset bubble. "She's pragmatic," says Alfred Broaddus, former president of the Federal Reserve Bank of Richmond, who often disagreed with Ms. Yellen when they served at the Fed in the late 1990s, he being more concerned about inflation. Hawks at the Fed tend to be clustered at its regional banks—in places like Kansas City, Richmond and Dallas. Though Ms. Yellen often disagrees with them, they have tended to work well together. As a vice chairman, one of her roles would be to help the Federal Reserve Board in Washington keep smooth relationships with heads of regional banks.
Ms. Yellen would take a significant pay cut to join the Fed's board. In 2008, she earned $392,600 as president of the San Francisco Fed. The congressionally mandated pay of the Fed vice chair: $179,700. Ms. Yellen's husband is Nobel-winning economist George Akerlof. With the three nominations, Mr. Obama will have named five officials to the Fed's board. Last January, he placed Daniel Tarullo, a lawyer focused on tough regulation, on the board. In August, he offered Mr. Bernanke a second term as Fed chairman that began last month.
It’s Déjà Voodoo Economics... All Over Again
by Eric Sprott & David Franklin
If you’re of a certain age, chances are you remember exactly where you were when JFK was assassinated. Similarly, if you’re from Canada or the United States and have an even remote interest in hockey, it’s highly likely that you remember exactly where you were when ‘Sid the Kid’ scored the winning overtime goal in the Olympic gold medal game. These were both "significant events", albeit for different reasons. We wonder, however, if any of you recall where you were on September 18th, 2008? Do you remember that day? We can’t seem to recall it either, which is strange, because it was one of the most important days of the decade.
October 7, 2008 is another day that should stick out in our memories, but we’re sure you don’t remember that day either – and we’re in the same boat. How is it, then, that we can’t recall where we were or what we were doing on the two days the entire financial system almost collapsed?!? It boggles our mind. These dates should have been emphasized in every "review of the decade" written at the end of 2009, but we’ve been hard pressed to find them mentioned in any mainstream publication. This is troubling to us, and makes us wonder if people are even aware of the incredible events that took place on those fateful days only eighteen months ago.
The financial industry often prides itself on the hindsight principle. We may not predict the future with great accuracy, but when things fall apart we’re very quick to explain why and how it happened with authoritative aplomb. "Hindsight is 20/20", as they say. But is it really? Despite our seemingly thorough analysis of past failures, the financial industry seems to have an uncanny ability to make the same mistakes over and over again. Perhaps this is due to the fact that we don’t properly review events passed. Our obsession with predicting future results impels them away into oblivion.
The fact remains that a cursory look back on the last decade reveals an apparent cycle of asset bubbles that all grew and burst before our eyes, with little effort made to actually address the underlying causes that made them possible. We have written at length about the next asset bubble now forming in government debt and currency. Looking back on the last decade from 2000 to 2009, are there any lessons that can provide some guidance for the next decade? And are there any lessons that can be gleaned from September 18th and October 7th, 2008, when we almost lost the entire financial system? We certainly hope there are.
The seeds of the financial mess we are currently experiencing began in the mid-to-late nineties. As we approached year 2000, the widespread belief developed that new technology would rewrite economic rules. The euphoric years between 1995 and 2000 blew the first asset bubble of the 21st century in the technology-heavy NASDAQ Index. Alan Greenspan first uttered his now famous "irrational exuberance" warning in December 1996 when describing stock valuations at the time.1 It wasn’t until mid-1999, however, that the U.S. Federal Reserve actually increased interest rates in an attempt to quell the overheated stock market.
The Fed actually raised rates six times between June 1999 and January 2000 in an attempt to cool an already overheated economy. The dot-com euphoria burst on March 10, 2000, when the NASDAQ peaked at 5,132, representing more than double its value from only a year before. We were watching the bubble closely at the time, and wrote on March 9th 2000, "In the next few months, if not weeks, we anticipate that the Nasdaq will capitulate to market liquidity. Valuations are screaming at us! Excessive speculation is running rampant! DON’T BE A PART OF IT!!!" It was a timely recommendation.
In many ways, the NASDAQ bubble was somewhat conventional in that it was born out of over- enthusiasm for the prospects of new technology. The fact that the Federal Reserve actually tried to cool the bubble down, however feebly, in the years before its peak, is really what differentiates it from the bubbles that followed. The NASDAQ collapse is well understood now, ‘in hindsight’. This collapse compelled Alan Greenspan and the Federal Reserve to embark on the largest rate cuts in US history in an effort to soften its impact. The inability to face the economic pain of the market crash ultimately set the stage for the second bubble of the decade, this time in housing.
The key point to emphasize here is that the Federal Reserve lowered interest rates thirteen times between January 3, 2001 and June 25, 2003 in order to cushion the economy. These rate cuts allowed for increasingly easy access to credit on a worldwide scale. It didn’t take long for the second bubble to develop, and it wasn’t hard to see the warning signs. Even The Economist magazine noticed, stating on June 16, 2005, that "the worldwide rise in house prices is the biggest bubble in history."2 Home prices rose at an annualized rate of more than 11% from 2000 to the peak on July 31, 2006 -more than doubling in that time period.3
The financial sector became the US economy’s central economic driver, generating up to 41% of all corporate profits and making it the fastest growing sector of the economy.4 In July 2005, Greenspan described certain real estate markets as "frothy" and recommended that the Federal Reserve rein in lending standards.5 We wrote in response at the time that "(Alan Greenspan) should be careful what he wishes for… it may come true. It’s like throwing stones in glass houses. It may all end with the Federal Reserve having to bail out the financial system, as it did with the savings and loan crisis a decade ago." We now know what transpired in the years to follow – we’ve all lived through it, and it ended with the biggest bailout in financial history.
So what’s the point, you ask? In hindsight, it’s very safe to argue that the Fed probably shouldn’t have lowered rates thirteen times between January 3, 2001 and June 25, 2003. It proved to be an extremely damaging policy. Artificially low rates created a lending mania of enormous proportions which dragged consumers along for a debt-fueled buying orgy. In our January 2008 commentary, aptly entitled "Welcome to the 2008 Meltdown", we opined that "There are meltdowns occurring everywhere: commercial real estate… car loans…credit cards.
It was all a massive Ponzi scheme sustained by overleverage. Because this has been one of the most egregious bubbles ever, its impact is likely to linger longer than anyone expects. This is more than just a market failure. It’s a systemic meltdown." And it was. But the meltdown happened so fast that it never seemed to burn into our collective memory. Everyone remembers that we went into a severe recession in late 2008, but do they know the details of what actually transpired? A quick review is needed to appreciate how close we really came to a full shutdown.
It was the Lehman Brothers bankruptcy on Sept. 15th that set everything in motion. Most market participants will remember that date - Bank of America bought Merrill Lynch the very same day, so it was certainly memorable. What many people fail to appreciate, however, is the mayhem that took place during the following days in the US money markets. The day after Lehman’s collapse, the Reserve Fund, one of the oldest and most high profile US money market funds, began to hemorrhage money as investors redeemed in panic.
Large institutional investors soon began pulling money out of other major US money market funds fearing heavy losses from Lehman Brothers debt. Almost $173 billion was pulled from such funds over the next two days, threatening to collapse the entire US financial system.6 Two weeks later, on Sept. 29th, investors sent the Dow Jones plummeting 778 points, representing the largest single-day loss in the history of the index. In hindsight, it was somewhat of a delayed response, because the real damage had by then been averted by the Treasury’s blanket guarantees on all money market funds.
The fact remains that on Thursday, September 18th, the US financial system almost completely collapsed. The details of that day remain frustratingly murky. The imminence of complete disorder seemed to scare Congress into action, but we can only piece the story together through random anecdotes that have been partially revealed through subsequent interviews. In what has been dubbed ‘the Kanjorski meme’, Congressman Paul Kanjorski recounts a meeting that was held between Ben Bernanke, Henry Paulson and certain members of Congress where the conception of the "Troubled Asset Relief Program" (TARP) supposedly took place.
To stem the flow of money out of US-based money market funds, Paulson had to provide an almost instant guarantee on all money market funds held within the US. Kanjorski recounts, "If they had not done that, their estimation was that by 2pm that afternoon (September 18th), $5.5 trillion would have been drawn out of the money market system of the United States, [which] would have collapsed the entire economy of the United States, and within 24 hours the world economy would have collapsed. We talked at that time about what would happen if that happened. It would have been the end of our economic system and our political system as we know it."7 Further details of these meetings have been provided by Senator James Inhofe, who recounted that Paulson had warned of martial law and civil unrest if the TARP bill failed.8 It is interesting to note that while Henry Paulson mentions several meetings that took place on September 19th in his book, the discussion of ‘imminent financial collapse’ and ‘martial law’ was noticeably absent.
How I Got the Goods on Madoff, and Why No One Would Listen
by Harry Markopolos
"I'm a quant," writes Harry Markopolos. "I look at numbers the way other people read books." That ability allowed him to smell a rat in 1999 when he encountered the remarkable returns claimed for a secretive hedge fund run by Bernard Madoff, a renowned Wall Street broker-dealer. Markopolos and two colleagues at asset manager Rampart Investment began looking into Madoff's operation. They soon concluded he couldn't produce those results legally.
The following excerpt describes Markopolos' 2002 trip to Europe with Thierry de la Villehuchet, a French aristocrat who ran Access International, a New York firm that funneled money to Madoff. Markopolos already suspected Madoff was running a giant Ponzi scheme. As he and de la Villehuchet try to market an options-based trading product, Markopolos begins to understand the true dimension of Madoff's crime. On Dec. 23, 2008, less than two weeks after Madoff confessed to FBI agents, de la Villehuchet committed suicide.
We had 20 meetings in three countries in 10 days. It was a whirlwind tour of Europe. We met with various hedge funds and funds of funds. The meetings eventually ran together in my memory, but it seemed like each office or conference room was more luxurious than the previous one. The floors were covered with plush Persian carpets; the walls were done in rich walnut and cherry woods, and hung on many of them were oil paintings; we were served only with sterling silver, and the fixtures were gold. These rooms had been decorated to impress clients, to show them that money didn't matter—which they apparently believed was an effective means of convincing clients to give them their money.
We met with many of the leading investment banks and private banks of Europe. The system there is quite different than here, as wealthy investors use private banks to conduct their business. I went to a meeting with members of the L'Oréal family. At JPMorgan I met with a member of the Givenchy family, who spent considerable time complaining about the Hermès family, who apparently were suing his family over an investment that had soured. At lunch one day with Prince Michel of Yugoslavia we sat at a table near Marc Rich, the disgraced financier whom Bill Clinton had so controversially pardoned. All these people knew each other. In Geneva, we were supposed to meet with Philippe Junot, the playboy who had been married to Princess Caroline of Monaco, but he canceled, I was told, because he thought my strategy was too risky, and he preferred to stay with Madoff.
Thierry began every one of our 20 meetings the same way: "Harry is just like Madoff. It's an option-based derivative strategy, only he offers a higher risk and a higher return. But it's different enough from Madoff that you should have him in your portfolio. If you have Madoff and you want some diversification, this will do it." And every time he said it I got furious. What I wanted to shout out loud was that I was offering higher returns than Madoff because my returns were real and his were not. And I was a lot lower risk, because at most I was going to lose only 50% of their money while with Bernie they were going down a full load.
But I didn't. Instead I smiled and explained how this strategy worked. After that we would drill down to the details. I'd go through my pitch book. Then they would ask the usual range of questions: What are your risk controls? What are your trading rules? What is the frequency of the bad events that can hurt you? It was the potential risk that scared them. I told them that way less than 1 percent of events could hurt the product, although admittedly should it happen it could be catastrophic. I was honest: "You could lose half your money very quickly."
The only fund that asked what I thought were the right questions about my due diligence was Société Générale. The people I met with there knew their derivative math. They told me, "We like your risk controls. You're the only guy who's ever come in here and specified what we can lose. But that risk is too high for us." Ironically, we found out in January 2008 that they actually weren't such good risk managers, as an employee named Jérôme Kerviel defrauded them of more than $7 billion by executing a series of elaborate, off-the-books transactions that circumvented the bank's internal controls.
These meetings generally lasted about 90 minutes, and Thierry would end each one the same way: "When can I have your answer? When shall I call you to find out how much you'd like to invest?" It was never "if you want to invest," always "how much." He was a master salesman. While the objective of this trip was to introduce my product to these fund managers, it also turned out to be an extremely educational trip for me. I came back with a lot more knowledge about Bernie Madoff than I had expected—and what I learned changed my life.
My team had absolutely no concept of how big Madoff was in Europe. We assumed several European funds and funds of funds had invested with him, but we never appreciated the number of funds or the size of their investments. It became clear to me during this trip for the first time that Madoff presented a clear and present danger to the American capital markets—and to the reputation of the Securities & Exchange Commission (SEC). While obviously I had lost confidence in the SEC, I also knew that investors around the world believed that it offered them a great level of protection and that their money was safe. That was one reason they invested here. When they discovered that wasn't true, that confidence in the integrity of the American markets that led people to invest in them was going to be badly shaken. When Madoff went down, and that was inevitable, the American financial system was going to take a worldwide beating to its reputation. A primary reason to invest in the United States would have disappeared.
Of the 20 meetings we had, the managers from 14 of those funds told me they believed in Bernie. Listening to them, I got the feeling it wasn't so much an investment as it was some sort of financial cult. What was almost frightening was the fact that every one of those 14 funds thought that they had a special relationship with him and theirs was the only fund from which he was continuing to take new money. At first I thought the only reason they would admit to me, someone they didn't know at all, that Madoff was managing their money was because they trusted Thierry, but then I began to understand that they were telling me this to impress me. The message was practically the same in every one of those 14 meetings: "We have a special relationship with Mr. Madoff. He's closed to new investors and he takes money only from us."
When I heard that said the first time I accepted it. When I heard it the second time I began to get suspicious. And when I heard it 14 times in less than two weeks, I knew it was a Ponzi scheme. I didn't say anything about the fact that I heard the same claim of exclusivity from several other funds. If I had, or if I had tried to warn anyone, they would have responded by dumping on me. Who was I to attack their god?
"HE'S NOT A FRAUD"
What I did wonder about was what was going on in Thierry's mind. He heard these 14 fund managers bragging, literally bragging about this special access, just like I did, and he knew it was a lie just like I did. But we never discussed it. Like Frank [Frank Casey, one of Markopolos' colleagues], I had previously tried to warn him. Before we'd left for Europe I'd told him, in these precise words, "You know Madoff is a fraud, don't you?" And just as he had done when Frank told him, Thierry became extremely defensive. "Oh no, that's not possible," he'd replied. "He's one of the most respected financiers in the world. We check every trade ticket. We have them faxed. We put them in a journal. He's not a fraud."
I had considered asking to see those trade tickets, knowing I could use them to prove to Thierry I was right, but I didn't. I was afraid that if I asked to see them he would think I was using them to reverse engineer Madoff, and I knew he wouldn't let me kill his golden goose. I cared about Thierry and I wanted to save him. After it had become clear that Thierry wouldn't listen to me, I called Access's director of research, who was a bright guy and understood derivative math, and told him that I had compiled a substantial amount of evidence proving Madoff was a fraud. "I get into the office at 6:30 in the morning," I'd told him. "If you'll come over half an hour early before tomorrow's scheduled meeting, I can prove to you mathematically that Madoff is a fraud."
He never showed up. And then I got it. He didn't want to know. Thierry didn't want to know. They were committed to Madoff; without him they didn't exist. It was their access to Bernie Madoff that allowed Access International to prosper. So when Thierry heard each of these funds claim an exclusive relationship, there was nothing he could do about it. It changed nothing. I also felt absolutely no obligation to tell any of the 14 asset managers that Madoff was a fraud. I had no personal relationship with any of them, and I certainly didn't want Bernie Madoff to know we were tracking him. Like Access, these funds needed Bernie to survive; they didn't need me. Where would their loyalty be? And what would happen to me when Madoff found out I had warned them?
I did appreciate the fact that they were trapped. They had to have Madoff to compete. No one had a risk-return ratio like Bernie. If you didn't have him in your portfolio, your returns paled in comparison to those competitors who did. If you were a private banker and a client told you someone he knew had invested with Madoff and was getting 12% annually with ultralow volatility, what choice do you have? You're going to either get Madoff for that client or lose the client to a banker who has him. And Madoff not only made it easy; he made it lucrative. He allowed the feeder funds to earn higher fees than anyone else and always returned a profit.
That was the reason so many European funds gave their millions to him. It was after these meetings that I strongly suspected Madoff was even bigger in Europe than he was in the U.S. I estimated the minimum amount of money Bernie had taken out of Europe was $10 billion and in retrospect even that probably was low. Once I realized how much money he had taken out of Europe—and was continuing to take—there was no longer any doubt in my mind that he wasn't front-running [that is, using his knowledge of transactions moving through his brokerage to trade ahead of them for his hedge fund clients]. This was a Ponzi scheme.
FEEDING THE MONSTER
For a Ponzi scheme to continue to survive you have to bring in new money faster than it is flowing out, because you're robbing Peter to pay Paul. The more Pauls you have to pay, the more Peters you need to find. It's a ravenous monster that needs to be continuously fed. It never stops devouring cash.
But it became clear to me that the Europeans believed he was front-running—and they took great comfort in it. They thought it was phenomenal because it meant the returns were real and high and consistent and that they were the beneficiaries of it. They certainly didn't object to it; there was a real sense of entitlement on this level. To them, the fact that he had a seemingly successful broker-dealer arm was tremendously reassuring, because it gave him plenty of opportunity to steal from his brokerage clients and pass the returns on to them. They never bothered to look a little deeper to see if he was cheating other clients—like them, for example. What they didn't understand was that a great crook cheats everybody. They thought they were too respectable, too important to be cheated. Madoff was useful to them, so they used him.
They were attracted to Bernie like moths to a flame. Just like the Americans, they knew. They knew. Several people admitted to me, "Well, of course we don't believe he is really using split-strike conversions. We think he has access to order flow." It was said with a proverbial wink and a nod—we know what he's doing. And if the American Madoff got caught, well, c'est la vie. They believed that the worst that could happen was that he could get caught and go to prison for a long, long time; but they would get to keep their ill-gotten returns and would get their principals back because they were offshore investors and the U.S. courts have no legal hold on them.
But for me, the most chilling discovery of this trip was the fact that many of these funds were operating offshore. It was not something that was spoken about; it was just something I picked up in conversation. Offshore funds are known as tax havens, places for people to quietly hide money so governments won't know about it. They're particularly popular in nations with high tax brackets, like France. While offshore funds certainly can be legitimate, to me it indicated that at least some of these funds were handling dirty money.
An offshore fund allows investors from a high-tax jurisdiction to pretend their income is coming from a low- or no-tax jurisdiction. While I have no direct knowledge, I definitely don't believe that all income from offshore tax havens is eventually declared to the proper government. But what was more frightening to me was the fact that offshore investments are used by some very dangerous people to launder a lot of money. It is common knowledge that offshore funds are used by members of organized crime and the drug cartels that have billions of dollars and no legitimate place to invest them.
For me, that suddenly added a frightening new perspective. It wasn't just the people in these luxurious offices who were going to be destroyed when Madoff went down; it also was some of the worst people in the world. I was pretty certain the Russian mafia had to be investing through one of those funds. I didn't know about the Latin American drug cartels, but I knew they went offshore and were probably into Madoff in a big way. Obviously Bernie had to be worried about a lot more than going to jail. These were men who had their own way of dealing with people who zero out their accounts. Maybe Bernie was close to being a billionaire—we had no idea how much of the money he was keeping for himself—but we knew that even he couldn't afford that.