Tuesday, April 27, 2010

April 27 2010: Blankfein, Pecora and the blinding limelight

National Photo Co. Hello Lampost 1926
"Auto accident in Washington, D.C., with witnesses"

Ilargi: If today's America's lucky day, we will see some real changes and points of no return come from the Senate hearings involving senior Goldman Sachs staff. We won't necessarily find out right away, some of the things said in the hearings may need time to figure out by specialists, lawyers etc. If the Senate does it s job, and asks questions that are strong and pointedly enough, some of these guys, no matter how they were prepped, are bound to say things they shouldn’t have.

In their eagerness to deny any wrongdoing, or intent of it, they may say things they shouldn't have. If you have someone on the stand who was 28 years old in the time the deals took place, you have a potential weak spot right off the bat. If there is something that needs hiding or "sculpting", that is, of course.

Already, Goldman's official denials of anything and everything thrown at them look to be part of a risky policy with which to respond to various allegations. If only because the firm presumably doesn't, and can't, know what evidence, files, allegations, emails, phone records, are kept hidden in the woodworks by the Senate, the SEC and the lawyers frantically preparing derivative slash class-action suits against it.

Neither the Senate nor the SEC are likely to be the "theaters" where the real sparks will ultimately fly. Still, they can cause some real dents for Wall Street, which could well play a role in the criminal litigation to follow later this year. We should hope Goldman is not the only party to bring its best lawyers to the game, and that their lawyers don't necessarily outshine the government's lawyers every step of the way. Seen in that light, this is as much a test for the US government system as it is for Wall Street. To wit, check this paragraph from a Wall STreet Journal portrait of SEC head enforcer Robert Khuzami:
SEC's Top Cop Oversaw Deutsche CDOs
Before taking his current job at the SEC last year, the 53-year-old Mr. Khuzami spent five years running the U.S. legal division of Deutsche Bank, one of the largest issuers of collateralized debt obligations in 2006 and 2007. As part of that job, he worked with lawyers who advised on the CDOs issued by the German bank and how details about them should be disclosed to investors. The group included more than 100 lawyers who also defended the bank against lawsuits and vetted other financial products [..]

That’s right, over 100 lawyers in one division of just one major bank. How could this fight not get down and dirty and last an eternity? And how will a protracted bout of negative publicity, interspersed with allegations of criminal behavior and unethical conduct influence Goldman's business dealings?

For now, Blankfein et al will be fine, they may just not like all the pesky questioning, but they'll leave confident that they've won the day. That's their default mindset, after all, and an addiction to boot. It could also, however, easily be their undoing. The emails are a weak point, they consist of unrehearsed conversations, and from what's been released so far, it's already clear that there is gloating happening about people on the losing side of deals, some of whom, importantly, were indeed Goldman clients.

In the Senate, the main point at the end of the day would seem to be whether Goldman's behavior was illegal, unlawful or "merely" unethical. And make no mistake, being labeled "unethical" can do serious damage to the company. And in a Catch 22, it may feel for a moment relieved to only carry that label instead of the "illegal" one. Still, the idea that Goldman Sachs always puts its clients first looks forever broken. In sort of another Catch 22, that notion was untenable from the start, whenever it had clients on opposite sides of a deal or a wager, as a CDO clearly is, or can be. And the next issue right behind that one is which side, which client, Goldman put its own money behind.

Which banks, pension funds, governments will still feel at liberty, or receive permission, to close major deals with a company that for all you know could behind your back be betting the deal you just entered into will not go your way? Trust is the prime concern when push comes to shove. It's just that in the recent mad dash for profits it was temporarily put on hold.

Papers appearing the past few days on Goldman's dealings and ethics with respect to Washington Mutual, or many more Abacus-like CDO-style financial instruments it was involved with, will provide plenty fodder for the Senate today. And if Robert Khuzami is as smart and tenacious as we're made to believe (he certainly has the knowledge from his time at Deutsche Bank), the SEC may turn out to be a real pain for Blankfein (provided he lasts long enough as CEO). But it won't be until criminal cases open that the real hard hitting begins. Ironically, by that time Goldman may already be a dead man walking.

Then again, don't be surprised if Lloyd and his boys soon start pointing fingers at JPMorgan and Morgan Stanley or other major players, just to get out of the blinding limelight, thereby spreading the toxicity all around Lower Manhattan.

The finance reform bill got filibustered even before it could be filibustered yesterday. And that's fine, it's a half-ass piece of crap law anyway. It's time to get serious. If that was possible nearly 80 years ago, it can be done now as well. it just takes leadership, guts and ethics. Anyone? Khuzami? Spitzer? Blll Black?

All it takes is a few decent and determined men. An Elliot Ness or a Ferdinand Pecora. If a society has no such people left, what's it worth to begin with?

While there were differences back then with today, they are far outnumbered by similarities. Take a look:

Pecora Commission: Wikipedia
The Pecora Investigation was an inquiry begun on March 4, 1932 by the United States Senate Committee on Banking and Currency to investigate the causes of the Wall Street Crash of 1929. The name refers to the fourth and final chief counsel for the investigation, Ferdinand Pecora.

The investigation was launched by a majority-Republican Senate, under the Banking Committee's chairman, Senator Peter Norbeck. Hearings began on April 11, 1932, but were criticized by Democratic Party members and their supporters as being little more than an attempt by the Republicans to appease the growing demands of an angry American public suffering through the Great Depression. Two chief counsels were fired for ineffectiveness, and a third resigned after the committee refused to give him broad subpoena power.

In January 1933, Ferdinand Pecora, an assistant district attorney for New York County was hired to write the final report. Discovering that the investigation was incomplete, Pecora requested permission to hold an additional month of hearings. His exposé of the National City Bank (now Citibank) made banner headlines and caused the bank's president to resign. Democrats had won the majority in the Senate, and the new President, Franklin D. Roosevelt, urged the new Democratic chairman of the Banking Committee, Senator Duncan U. Fletcher, to let Pecora continue the probe. So actively did Pecora pursue the investigation that his name became publicly identified with it, rather than the committee's chairman.

Following the Wall Street Crash, the U.S. economy had gone into a depression, and a large number of banks failed. The Pecora Investigation sought to uncover the causes of the financial collapse. As chief counsel, Ferdinand Pecora personally examined many high-profile witnesses, who included some of the nation's most influential bankers and stockbrokers. Among these witnesses were Richard Whitney, president of the New York Stock Exchange, investment bankers Otto H. Kahn, Charles E. Mitchell, Thomas W. Lamont, and Albert H. Wiggin, plus celebrated commodity market speculators such as Arthur W. Cutten.

Given wide media coverage, the testimony of the powerful banker J.P. Morgan, Jr. caused a public outcry after he admitted under examination that he and many of his partners had not paid any income taxes in 1931 and 1932.

As reiterated by U.S. Securities and Exchange Commission (SEC) Chairman Arthur Levitt during his 1995 testimony before the United States House of Representatives, the Pecora Investigation uncovered a wide range of abusive practices on the part of banks and bank affiliates. These included a variety of conflicts of interest such as the underwriting of unsound securities in order to pay off bad bank loans as well as "pool operations" to support the price of bank stocks. The hearings galvanized broad public support for new banking and securities laws.

As a result of the Pecora Commission's findings, the United States Congress passed the Glass-Steagall Banking Act of 1933 to separate commercial and investment banking, the Securities Act of 1933 to set penalties for filing false information about stock offerings, and the Securities Exchange Act of 1934, which formed the SEC, to regulate the stock exchanges. Some argue that thanks to the legacy of Pecora Commission's hearings and subsequent regulatory legislation, American economy had a sound financial system for roughly half a century.

The Importance of Getting Wall Street Out of Washington, and Washington Out of Wall Street
by Robert Reich

Washington’s relationship with Wall Street is growing more schizophrenic by the day. On the one hand, Congress is trying to show how tough it can be on the financial sector by enacting a law ostensibly designed to prevent another near-meltdown and taxpayer-supported bail-out. As the mid-term election looms, a staggering number of Americans remain unemployed or underemployed, and most Americans blame Wall Street (whose top bankers are raking in almost as much money as they did before the crisis). The lawsuit launched by the Securities and Exchange Commission against Goldman Sachs for alleged fraud only confirms the view held by many that the economic game is rigged.

On the other hand, both parties are going to Wall Street seeking campaign donations to fund critically important television advertising in the months ahead. After all, the Street is where the money is, and TV ads demand huge amounts of it. In recent years, the financial industry has become the second-biggest source of campaign contributions in America – just behind the healthcare industry.

Even as Congress debates legislation to tame it, Wall Street is conducting a bidding war between the parties for its continued beneficence. More than 60 per cent of the $34m given by the financial industry to fund the 2010 elections has so far gone to Democrats, but since January the Street has switched its allegiance to the Republican camp. In the first quarter of this year, Citigroup, Goldman, JPMorgan Chase and Morgan Stanley donated twice as much to Republicans as to Democrats.

It is hard to bite the hands that feed you, especially when you are competing for food. The finance reform bill emerging from Senate Democrats takes a hard line in many respects – requiring that most derivatives be traded on open exchanges where buyers can see what they are getting and sellers have adequate capital, establishing an agency to protect unwary consumers from predatory lending, and giving the government authority to wind down the activities of banks that get themselves into trouble. Democrats point to these and other features as evidence of their willingness to be strict with the Street, despite their dependence on its generosity.

But the American public has no independent means of judging how tough the bill really is. Most people do not understand the intricacies of finance, and still do not know exactly what Wall Street did to bring the economy to the brink. The dependence of both parties on the financial industry for political support inevitably feeds suspicions that the bill is not nearly tough enough. Why, for example, are so-called "customised" derivatives exempted from the exchanges? Does this not create a big loophole? Why does the bill not limit the size of banks so none can again become "too big to fail"? Why is the Glass-Steagall Act – which once separated commercial from investment banking – not being fully restored? Why does the bill not separate investment banking from the private banking and wealth management activities that got Goldman into trouble?

It does not help that in recent months both parties have held at least three-dozen fundraising events with Wall Street bankers and their lobbyists. Harry Reid, the Democratic Senate majority leader, has trekked to Wall Street cup in hand, while in February and March the National Republican Senatorial Campaign Committee invited financial industry executives to pony up $10,000 each for the chance to confer with Republican senators.

Tight connections between Washington and Wall Street are nothing new, of course, especially when it comes to Goldman. Hank Paulson ran the bank before becoming George W. Bush’s Treasury secretary. Robert Rubin followed the same trajectory under Bill Clinton, then returned to Wall Street to head Citigroup’s executive committee. Dick Gephardt, the former Democratic House leader, lobbies for Goldman. Some 250 former members of Congress are now lobbying on behalf of the financial industry. President Barack Obama himself received nearly $15m from Wall Street during his 2008 campaign, of which almost $1m came from Goldman employees and their families.

But politicians cannot continue to have it both ways. Given the Street’s excesses, Washington’s continued financial dependence on it is eroding trust in government. The distrust has already helped spawn the so-called "Tea Party movement" of disaffected Republicans. Many Democrats and Independents are no less cynical.

If Washington knew what was good for it and the nation, it would sever its financial connections with the Street. Better yet, it would enact legislation seeking to limit the impact of private and corporate money in politics. That goal is made more difficult to achieve by the grotesque recent Supreme Court decision (Citizens United vs. Federal Election Commission) holding that corporations, including financial firms, have the right to spend unlimited amounts on political campaigns. But there are ways around this, such as more generous public funding for candidates that choose not to take private contributions. Hopefully as well, the president will nominate Supreme Court justices who understand the importance of public trust in democratic institutions, and the difference between companies and people.

Judgment day for Goldman Sachs?
by Dylan Ratigan

Dylan with Gregory Zuckerman, writer of "The Greatest Trade Ever".

Senate Readies Goldman Assault
by John D. Mckinnon, Susanne Craig and Fawn Johnson

Goldman Sachs Group Inc. had a clear strategy of shorting the collapsing mortgage market and made $3.7 billion through the tactic, Senate investigators said, setting up a showdown with Goldman executives testifying before a Senate subcommittee Tuesday. The testimony was poised to highlight the fundamental split between Washington lawmakers-who see Goldman as an archetype of the problems that drove the financial system into crisis—and the Wall Street firm, which says it was merely managing risk and didn't make big profits from housing's decline.

Goldman Chief Executive Lloyd Blankfein was set to tell the Permanent Subcommittee on Investigations that Goldman acted "as our shareholders and our regulators would expect." In prepared testimony, Mr. Blankfein said: "We didn't have a massive short against the housing market and we certainly did not bet against our clients." In a briefing Monday, the subcommittee's chairman, Sen. Carl Levin (D., Mich.) made the opposite case. The subcommittee said Goldman's strategy of "shorting" the mortgage market—betting on its decline—was so extensive that, at one point in mid-2007, its mortgage business made up more than half its value at risk, a measure of the firm's overall exposure. "By early 2007 the company blew right past a neutral position and began betting heavily on [the market's] decline," Mr. Levin said.

Goldman was "not hedging but betting heavily against the market," he added, accusing the firm of being "misleading to the country...and not fair to their customers." Senators will also hear testimony from Fabrice Tourre, the Goldman trader at the center of a deal targeted in a Securities and Exchange Commission civil suit. The SEC says Goldman and Mr. Tourre failed to tell customers making a bet on mortgage-backed securities that a hedge fund taking the opposite bet had helped choose the securities in the deal. Goldman denies the charge.

Mr. Blankfein was set to say that April 16, the day of the SEC suit, was "one of the worst days in my professional life." While reiterating that Goldman doesn't think it did anything wrong in the case, he offered a somewhat more contrite note in his prepared testimony. "I recognize, however, that many Americans are skeptical about the contribution of investment banking to our economy and understandably angry about how Wall Street contributed to the financial crisis," the testimony said. "What we and other banks, rating agencies and regulators failed to do was sound the alarm that there was too much lending and too much leverage in the system—that credit had become too cheap."

The subcommittee released excerpts from a raft of internal Goldman emails and other materials providing further insight into what some Goldman executives called a "big short" strategy. "I concluded that we should not only get flat, but get VERY short," executive Joshua Birnbaum wrote in reviewing his own performance in 2007. "Much of the plan began working by February ...and our very profitable year was underway." The subcommittee and Goldman highlighted different numbers on the mortgage business. Mr. Blankfein said Goldman lost $1.2 billion from its activities in the residential housing market in 2007 and 2008. In 2007, Goldman posted an overall profit of $11.6 billion. The shorting strategy often came at the expense of the firm's clients, subcommittee investigators said.

One transaction called Timberwolf was a $1 billion package of complex securities rated AAA. The head of Goldman's mortgage department sent a mass email promising the sales force "ginormous credits" for selling it. The package was downgraded to junk status in just over a year. "[B]oy, that timberwo[l]f was one s— deal," an unnamed Goldman official wrote in June 2007, according to documents released by the subcommittee. Goldman "sold to its clients products that it clearly no longer believed in," said Mr. Levin.

In early 2007, Mr. Blankfein referred dismissively to Goldman products being readied for sale. "[Y]ou refer to losses stemming from residual positions in old deals," he wrote in an email. "Could/should we have cleaned up these books before and are we doing enough right now to sell off cats and dogs in other books throughout the division." The subcommittee released excerpts of emails and performance reviews where executives boasted about their prowess in making money on short positions, and overriding customer objections when Goldman allowed some securities to sink in value without pumping in more cash.

One, Michael Swenson, described 2007 as the year "that I am most proud of to date" because of his efforts to steer the firm off the subprime rocks through "efficient shorts." Mr. Swenson also noted that he "said 'no' to clients" who wanted Goldman to shore up some of the failing securities it had marketed. Another message from an unnamed executive says that some of Goldman's aggressive shorting left hard feelings among clients in October 2007. "Real bad feeling across European sales about some of the trades we did with clients," the email says. "The damage this has done to our franchise is very significant. Aggregate loss of our clients on just these 5 trades along [sic] is 1bln+."

Spitzer & Black: Questions from the Goldman Scandal
by Eliot Spitzer and William Black

For those who have spent years investigating fraud, it was no surprise to hear that Goldman Sachs, the (self-described) jewel of Wall Street, is the latest firm to emerge from the financial crisis with tarnished reputation. According to a lawsuit brought by the Securities and Exchange Commission, Goldman misrepresented to its customers the quality of the toxic assets underlying a complex financial derivative known as a “synthetic collateralized debt obligation (CDO).”

As you may now have heard, the story involves a pair of Paulsons. As CEO of Goldman, Hank Paulson oversaw the buying of large amounts of CDOs backed by largely fraudulent “liar’s loans.” When he became U.S. Treasury Secretary, he went on to launch a successful war against securities and banking regulation. Hank Paulson’s successors at Goldman saw the writing on the wall and began to “short” CDOs. They realized that they had an unusual, brief window of opportunity to unload their losers on their customers. Being the very model of a modern investment banking firm, they thought that blowing up their customers would be fine sport.

John Paulson (unrelated), who controls a large hedge fund, also wanted to short CDOs and he, too, recognized that there was a narrow window for doing so. The reason there was a profit opportunity was that the “market” for toxic mortgages only appeared to be a functioning market. It was, in reality, a massive bubble in which ratings and “market” prices were grotesquely inflated. The inflated prices were continuing only because the huge players knew that the prices and races were fictional and were covering it up through the financial equivalent of “don’t ask; don’t tell.” According to the SEC complaint:

In January 2007, a Paulson employee explained the company’s view, saying that “rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytical tools nor the institutional framework to take action.”

We know from Bankruptcy Examiner Valukas’ report on Lehman that the Federal Reserve knew that the “market” prices were delusional and refused to require entities like Lehman to recognize their losses on “liar’s loans” for fear that it would expose the cover up of the losses. Valukas reports that Geithner explained to him when interviewed (p. 1502) that:

The challenge for the Government, and for troubled firms like Lehman, was to reduce risk exposure, and the act of reducing risk by selling assets could result in “collateral damage” by demonstrating weakness and exposing “air” in the marks.

Goldman and John Paulson worked together. One of the key things to understand about shorting is that it is extremely valuable if other major players short similar targets at the same time. By helping Paulson take advantage of Goldman’s customers (the ones that lacked “the analytical tools” to avoid being hosed), Goldman not only earned a substantial fee, but also aided its overall strategy of shorting the toxic paper.

Goldman created a deal in which John Paulson played a major role in selecting the toxic paper that would underlie the investment. He picked assets “most likely to fail - quickly” and studies show that he was particularly good at picking the losers. At this juncture, there is some dispute as to whether ACA was complicit with John Paulson and Goldman in picking losers (ACA initially invested in the synthetic CDO, but then transferred the risk of loss to German and English taxpayers).

What isn’t in dispute is that Goldman, ACA, and Paulson all failed to disclose to purchasers of the synthetic CDO that it was designed to be most likely to fail. The representation was the opposite: that the assets were picked by an independent entity with their interests at heart (ACA). Goldman claims it’s a victim because while it intended to sell its entire position in the synthetic CDO to its customers, it was unable to sell a chunk. One feels the firm’s pain. Goldman tried to blow up its customers to the tune of over $1 billion, but were unable to sell them the last $90 million in exposure.

The Goldman scandal raises several important questions: Did John Paulson and ACA know that Goldman was making these false disclosures to the CDO purchasers? Did they “aid and abet” what the SEC alleges was Goldman’s fraud? Why have there been no criminal charges? Why did the SEC only name a relatively low-level Goldman officer in its complaint? Where are the prosecutors?

In a December New York Times op ed, we, along with Frank Partnoy, asked for the public disclosure of AIG emails and key documents so that we can investigate the deceptive practices exposed by the Goldman case. Goldman used AIG to provide the CDS on most of these synthetic CDO deals (though not the particular one that is the subject of the SEC complaint), and Hank Paulson used tax payer money to secretly bail out Goldman when AIG’s deceptive practices drove it to failure.

The SEC’s Goldman fraud complaint points to fundamental problem in the financial sector that has been at the root of the financial crisis — one that still exists today. The market is not transparent. It has been fraudulently manipulated to enrich managers. Investors lack clear information to make decisions about what they are buying. A continuing absence of real consumer protections makes people like those trying to obtain mortgages before the crash understand that they were, in many cases, being ripped off.

According to internal Goldman Sachs e-mails, the company vice president, 31-year old Fabrice Tourre, did not really understand the complex deals he was making. And yet we note that many of these Goldman-style deals were “insured” by AIG. Without transparency, regulators cannot properly see all these kinds of deals in the aggregate. So they can neither stop the fraud nor prevent catastrophic results.

We applaud the SEC lawsuit, but it will not solve the problem. Unless our financial system is reformed to put adequate protections and checks and balances in place, we can expect this kind of fraud to continue. Financial executives will continue to take risks they do not understand. Those who control the flow of capital will continue to churn out profits with socially disastrous consequences.

Why Derivatives?
by Dylan Ratigan

Dylan talks to Gary Gensler, chairman of the CFTC, former Asst. Treasury Secretary, and former Goldman Sachs partner (really, that’s your man?). The 5 biggest US banks are engaged in 97% of derivatives trading.

Goldman Said to Have Been in Other Mortgage Deals
by Louise Story

The legal storm buffeting Goldman Sachs intensified on Monday as Senate investigators claimed the Wall Street giant had devised not one but a series of complex deals to profit from the collapse of the home mortgage market. The claims suggested for the first time that the inquiries into Goldman were stretching beyond the sole mortgage deal singled out by the Securities and Exchange Commission. S.E.C. accusations that Goldman defrauded investors in that single transaction, Abacus 2007-AC1, have thrust the bank into a legal whirlwind.

The latest claims came on the eve of what is expected to be a contentious Senate hearing on Tuesday, at which Goldman Sachs executives plan to defend their actions. The stage for that hearing was set with a flurry of new documents from the panel, the Permanent Senate Subcommittee on Investigations. That was preceded by a press briefing in Washington, where the accusations against Goldman have transformed the politics of financial reform.

In the midst of this storm, Lloyd C. Blankfein, Goldman’s chairman and chief executive, plans to sound a conciliatory note on Tuesday. In a statement prepared for the hearing and released on Monday, Mr. Blankfein said the news 10 days ago that the S.E.C. had filed a civil fraud suit against Goldman had shaken the bank’s employees. "It was one of the worst days of my professional life, as I know it was for every person at our firm," Mr. Blankfein said. "We have been a client-centered firm for 140 years, and if our clients believe that we don’t deserve their trust we cannot survive." Mr. Blankfein will also testify that Goldman did not have a substantial, consistent short position in the mortgage market.

But at the press briefing in Washington, Carl Levin, the Democrat of Michigan who heads the Senate committee, insisted that Goldman had bet against its clients repeatedly. He held up a binder the size of two breadboxes that he said contained copies of e-mail messages and other documents that showed Goldman had put its own interests first. "The evidence shows that Goldman repeatedly put its own interests and profits ahead of the interests of its clients," Mr. Levin said.

Mr. Levin’s investigative staff released a summary of those documents, which are to be released in full on Tuesday. The summary included information on Abacus as well as new details about other complex mortgage deals. On a page titled "The Goldman Sachs Conveyor Belt," the subcommittee described five other transactions beyond the Abacus investment. One, called Hudson Mezzanine, was put together in the fall of 2006 expressly as a way to create more short positions for Goldman, the subcommittee claims. The $2 billion deal was one of the first for which Goldman sales staff began to face dubious clients, according to former Goldman employees. "Here we are selling this, but we think the market is going the other way," a former Goldman salesman told The New York Times in December.

Hudson, like Goldman’s 25 Abacus deals, was a synthetic collateralized debt obligation, which is a bundle of insurance contracts on mortgage bonds. Like other banks, Goldman turned to synthetic C.D.O.’s to allow it to complete deals faster than the sort of mortgage securities that required actual mortgage bonds. These deals also created a new avenue for Goldman and some of its hedge fund clients to make negative bets on housing.

Goldman also had an unusual and powerful role in the Hudson deal that the Senate committee did not highlight: According to Hudson marketing documents, which were reviewed on Monday by The Times, Goldman was also the liquidation agent in the deal, which is the party that took it apart when it hit trouble. The Senate subcommittee also studied two deals from early 2007 called Anderson Mezzanine 2007-1 and Timberwolf I. In total, these two deals were worth $1.3 billion, and Goldman held about $380 million of the negative bets associated with the two deals.

The subcommittee pointed to these deals as examples of how Goldman put its own interests ahead of clients. Mr. Levin read from several Goldman documents on Monday to underscore the point, including one in October 2007 that said, "Real bad feeling across European sales about some of the trades we did with clients. The damage this has done to our franchise is very significant." As the mortgage market collapsed, Goldman turned its back on clients who came knocking with older Goldman-issued bonds they had bought. One example was a series of mortgage bonds known as Gsamp.

"I said ‘no’ to clients who demanded that GS should ‘support the Gsamp’ program as clients tried to gain leverage over us," a mortgage trader, Michael Swenson, wrote in his self-evaluation at the end of 2007. "Those were unpopular decisions but they saved the firm hundreds of millions of dollars." The Gsamp program was also involved in a dispute in the summer of 2007 that Goldman had with a client, Peleton Partners, a hedge fund founded by former Goldman workers that has since collapsed because of mortgage losses.

According to court documents reviewed by The Times on Monday, in June 2007, Goldman refused to accept a Gsamp bond from Peleton in a dispute over the securities that backed up a mortgage security called Broadwick. A Peleton partner was pointed in his response after Goldman refused the Gsamp bond. "We do appreciate the unintended irony," wrote Peter Howard, a partner at Peleton, in an e-mail message about the Gsamp bond. Bank of America ended up suing Goldman over the Broadwick deal. The parties are awaiting a written ruling in that suit. Broadwick was one of a dozen or so so-called hybrid C.D.O.’s that Goldman created in 2006 and 2007. Such investments were made up of both mortgage bonds and insurance contracts on mortgage bonds.

While such hybrids have received little attention, one mortgage researcher, Gary Kopff of Everest Management, has pointed to a dozen other Goldman C.D.O.’s, including Broadwick, that were mixes of mortgage bonds and insurance policies. Those deals — with names like Fortius I and Altius I — may have been another method for Goldman to obtain negative bets on housing. "It was like an insurance policy that Goldman stuck in the middle of the sandwich with all the other subprime bonds," Mr. Kopff said. "And it was an insurance policy designed to protect them."

Senate panel finds Goldman spread risk through financial system
by Zachary A. Goldfarb

Goldman Sachs sought to protect itself from a collapsing housing market by selling mortgage investments that it knew were likely to fail and taking other steps that helped spread risk throughout the financial system, according to the findings of a Senate investigation released Monday. The investigation by the Senate Permanent Subcommittee on Investigations suggests that Goldman's actions may also have helped fuel the financial crisis by creating risky investments and then ensuring that other parties were exposed when they lost value.

Excerpts of hundreds of internal Goldman documents released by the committee show that Goldman created and sold complex investments backed by risky home loans. Then, Goldman also bet against those investments by buying a type of insurance that would pay out if the underlying home loans went bad. "Goldman Sachs was slicing, dicing, and selling toxic mortgage-related securities on Wall Street like many other investment banks, but its executives continue to downplay the firm's role in the financial engineering that blew up the financial markets and cost millions of Americans their jobs, homes, and livelihoods," said Sen. Carl Levin (D-Mich.), chairman of the subcommittee.

"Goldman Sachs made billions of dollars from betting against the housing market, and it placed those bets in some cases at the same time it was selling mortgage related securities to its clients," Levin said. "They have a lot to answer for." The findings of the Senate probe come as Goldman Sachs chief executive Lloyd Blankfein and several other current and former Goldman officials come to Washington to testify before the subcommittee on Tuesday. The panel is using Goldman as a case study of how investment banks fueled the financial crisis.

In prepared testimony released by Goldman, Blankfein says that the firm must do "a better job of striking the balance between what an informed client believes is important to his or her investing goals and what the public believes is overly complex and risky." He also said "we didn't have a massive short against the housing market and we certainly did not bet against our clients. Rather, we believe that we managed our risk as our shareholders and our regulators would expect."

But internal e-mails show that Goldman did expect to make big profits off the decline in housing. A presentation by the firm's chief risk officer, Craig Broderick, says that "because starting early in '07 our mortgage trading desk started putting on big short positions . . . and did so in enough quantity that were netshort, and made money (substantial $$ in the 3rd quarter) as the subprime market weakened." A summary of a Goldman Sachs board of directors meeting says that "although broader weakness in the mortgage market resulted in significant losses in cash positions, we were overall net short the mortgage market and thus had very strong results."

E-mails also show the bank was rushing to unload its mortgage investments. One e-mail from Blankfein asks his employees "are we doing enough right now to sell off cats and dogs"? An e-mail from a mortgage trader named Fabrice Tourre urges his colleagues not to approach "sophisticated" hedge funds about selling them mortgage investments because "they know exactly how things work." Rather, Tourre suggested that Goldman approach "buy-and-hold ratings-based buyers" who might not do as much research into the investment.

Investors Lost, Goldman Won On WaMu Deal
by Carrick Mollenkamp and Serena Ng

Washington Mutual Inc. and its Long Beach Mortgage Co. subprime-lending unit rang up one of the worst failures in U.S. history. Left in the wake were billions of dollars of soured loans and questionable lending practices. But when times were better, the two companies had a powerful partner on Wall Street: Goldman Sachs Group Inc. Recently released emails and other documents, including securities filings, show how Goldman, considered one of Wall Street's most elite banks, built its mortgage business by closely working with lenders such as Washington Mutual and Long Beach, two firms that "polluted the financial system" with souring loans, according to a Senate review of Washington Mutual on April 13.

"Long Beach…was not a responsible lender," Sen. Carl Levin (D., Mich.), chairman of the Senate Permanent Subcommittee on Investigations, said in his opening remarks April 13. "Its loans and mortgage-backed securities were among the worst performing of the subprime industry." Goldman declined to discuss its business with Washington Mutual or the communications in the emails released by the Senate panel.

Goldman was one of several Wall Street firms that helped sell bonds backed by Washington Mutual loans. Over the weekend, the Senate subcommittee released internal Goldman emails, including one showing that the firm made $5 million trading profit by betting against securities Goldman sold in a Long Beach bond offering that lost money for its investors, raising a potential conflict with its clients. On Tuesday, the panel plans to question Goldman executives in a separate hearing. The emails and others like them highlight "the importance of transparency, the importance of things being in the open, the importance of it being known who is in a position to benefit from what," senior White House adviser Lawrence Summers said Sunday on CBS's "Face the Nation."

Much has been written about Washington Mutual's failure. In September 2008, the Seattle lender was forced to sell itself to J.P. Morgan Chase & Co. at the height of the crisis in the largest-ever U.S. bank failure. But there has been less scrutiny of the ties between Washington Mutual and Goldman, which emerged stronger than rivals after the mortgage market's collapse. J.P. Morgan said the Washington Mutual loans and securities being investigated were issued before J.P. Morgan's purchase of Washington Mutual. A lawyer for former Washington Mutual Chief Executive Kerry Killinger couldn't be reached.

At times, executives at Washington Mutual discussed seeking out Goldman for its reputation for excellence, according to Washington Mutual emails. But Washington Mutual executives also were wary of their partner because of concerns about how the Wall Street firm traded. "We always need to worry a little about Goldman because we need them more than they need us and the firm is run by traders," a Washington Mutual executive wrote in an email released by the Senate panel in its probe of the lender.

Long Beach was founded in 1979 as Long Beach Savings & Loan by Roland Arnall, a Los Angeles developer who got his start in business in Los Angeles selling flowers on a Los Angeles street corner. A unit called Long Beach Financial Corp., based in Orange, Calif., was sold to Washington Mutual in 1999. Aided by mortgage brokers who channeled loans to Long Beach, Washington Mutual and Long Beach ended up bundling subprime home loans into $77 billion worth of securities, according to the Senate inquiry.

Some Long Beach bonds were ultimately used to allow Wall Street firms and hedge funds to bet against the U.S. mortgage market. Long Beach bonds were among those underpinning subprime-mortgage indexes—assembled by Goldman and other Wall Street firms—that allowed those firms and hedge funds to bet against the housing industry, according to data provided by Markit Group Ltd., which helps run the indexes. The Long Beach loans ended up being among the worst performing in the indexes, according to a Nomura Holdings report. Separately, some Long Beach bonds also underpinned the Abacus 2007-AC1 debt pool now at the center of a Securities and Exchange Commission securities-fraud case against Goldman, which the firm is fighting.

By 2005, Long Beach was in trouble. According to the Senate report released April 13, Long Beach had to buy back $875 million of nonperforming loans from investors. Behind one sale of Long Beach securities was Goldman. In 2006, Goldman teamed with a Washington Mutual unit to sell a debt pool called Long Beach Mortgage Loan Trust 2006-A. Both firms agreed to buy some of the securities with the intention of reselling them or making a secondary market for them, according to a prospectus for them. Washington Mutual executives appeared troubled by loans at Long Beach. In an April 2006 email, a Washington Mutual executive told Mr. Killinger that Long Beach's "delinquencies are up 140% and foreclosures close to 70% ... It is ugly."

By early 2007, Goldman bankers also were growing anxious about their business dealings with Washington Mutual and Long Beach, according to emails released as part of the Senate investigation into Washington Mutual. A Goldman banker raised questions about the performance of Long Beach loans that were "performing dramatically worse" than other similar deals in 2006. "As you can imagine, this creates extreme pressure, both economic and reputational, on both organizations," the Goldman banker said.

In May 2007, Goldman executives were discussing problems facing the debt deal it had helped underwrite, according to emails released by the Senate panel. Among the Senate documents is an email from a Goldman executive to Michael Swenson, then a Goldman managing director in the firm's mortgage group, about the 2006-A bond deal. In an 8 a.m. email, Goldman executives circulated a securities report that showed loans inside the pool had soured. Six minutes later, a Goldman executive wrote, "bad news…(the price decline in the bonds) costs us about 2.5 mm," adding, "good news…we make $5mm" on a derivatives bet against the bonds.

The Senate panel, in a statement over the weekend, said the email showed how the soured Long Beach bonds "would bring [Goldman] $5 million from a bet it had placed against the very securities it had assembled and sold." Mr. Swenson declined to comment through a Goldman spokesman. He is among the Goldman executives set to appear at Tuesday's hearing. A Goldman spokesman said in a statement: "It's our standard, prudent practice to hedge exposures."

Despite the close relationship between Washington Mutual and Goldman, Washington Mutual wondered which side Goldman was on. In October 2007, Mr. Killinger wrote in an email about a situation with Goldman: "I don't trust Goldy on this. They are smart, but this is swimming with the sharks. They were shorting mortgages big time."

Goldman Sachs Bet Against Its Own Deals, Senate’s Levin Says
by Christine Harper

Goldman Sachs Group Inc., the most profitable securities firm in Wall Street history, made an estimated $3.7 billion in 2007 by placing "heavy bets" against mortgage-linked securities, including some it created, a U.S. senator said today. Carl Levin, a Michigan Democrat who leads the Senate’s Permanent Subcommittee on Investigations, released e-mails and other documents that he said show "Goldman repeatedly put its own interest and profit ahead of the interests of its clients."

The documents precede a showdown on Capitol Hill tomorrow between Levin’s panel and seven current and former Goldman Sachs employees. Chief Executive Officer Lloyd Blankfein, 55, and Fabrice Tourre, 31, an executive director who was named in the Securities and Exchange Commission’s April 16 fraud lawsuit against the firm, are among Goldman employees set to answer questions. "To sell to customers at the same time you’re betting against what you’re selling -- we think it’s not uncommon and we think it ought to end," Levin said at a briefing for reporters today on tomorrow’s hearing. "We think there are a number of banks engaged in similar conduct but we had to focus on one."

The subcommittee estimated that Goldman Sachs generated $3.7 billion from its short bets on a declining mortgage market in 2007, Levin said. The figure doesn’t take into account losses they suffered on mortgage-related securities they held, he said. Levin said his committee isn’t responsible for determining whether there was any criminal activity, although he said the panel will decide after the hearing whether to refer the matter to the SEC or the Justice Department.

Blankfein will tell the committee tomorrow that the firm didn’t wager against clients and didn’t make a big bet against the housing market, according to the prepared text of his remarks. "We didn’t have a massive short against the housing market and we certainly did not bet against our clients," Blankfein will say, according to the text. While the firm disagrees with the SEC’s complaint, "I also recognize how such a complicated transaction may look to many people," Blankfein said. "We have to do a better job of striking the balance between what an informed client believes is important to his or her investing goals and what the public believes is overly complex and risky."

Among the evidence Levin presented today was an internal e- mail about a March 2007 presentation to the board of directors that describes how the firm’s mortgage derivatives desk started the quarter with a $6 billion "long" position on BBB- rated mortgages "and shifted the position to net short $10bn notional." An October 2007 internal e-mail sent to Daniel Sparks, who ran the mortgage business at the time and is among those scheduled to testify, includes the comment "real bad feeling across European sales about some of the trades we did with clients. The damage this has done to our franchise is very significant. Aggregate loss of our clients on just these 5 trades along (sic) is 1bln+."

Michael Swenson, a managing director in Goldman Sachs’s structured products group who is also to appear tomorrow, boasted in his 2007 performance review that "I said ‘no’ to clients who demanded that GS should ‘support the GSAMP’ program as clients tried to gain leverage over us," he said, referring to the name for Goldman’s own mortgage-backed deals. "Those were unpopular decisions but they saved the firm hundreds of millions of dollars."

In a September 2007 e-mail to Blankfein, an employee describes having met with 10 or more individual "prospects" and clients and tells Blankfein about how their attitudes differ from institutional clients. "The institutions don’t and I wouldn’t expect them to, make any comments like ur (sic) good at making money for urself (sic) but not us," the e-mail said. "The individuals do sometimes, but while it requires the utmost humility from us in response I feel very strongly it binds clients even closer to the firm, because the alternative of take ur (sic) money to a firm who is an under performer and not the best, just isn’t reasonable. Clients ultimately believe association with the best is good for them in the long run."

Goldman Sachs built a "conveyer belt" of mortgage deals and then bet against them, Levin said, actions that he said contributed to the worst financial crisis since the Great Depression. "In a number of ways they contributed to the collapse of this economy," Levin said. "The toxins that Goldman Sachs and others helped inject into our financial system has done incalculable harm."

While Levin said he is ready to vote on a financial regulation package that is set to be considered by the Senate this week, he said he thinks it could be strengthened. He has proposed an amendment that would help resolve the conflicts of interest among Wall Street firms that he said are embodied in the documents. He also endorsed banning financial firms from engaging in so-called naked credit default swaps, or bets on a decline in creditworthiness by parties that have no exposure to the credit.

After Levin posted internal Goldman Sachs e-mails on his website on April 24 that he said show the firm "made a lot of money by betting against the mortgage market," the firm responded with more than 70 pages of e-mails and other documents that it said showed the firm lost money on mortgages in 2008 and that executives didn’t have any kind of consensus that the market would fall.
$68 Million Bonus Goldman Sachs contests the SEC’s claims that the firm defrauded investors when selling a debt instrument tied to mortgages by failing to inform them of the role played by hedge fund Paulson & Co. The company said on April 24 that Levin’s committee "cherry-picked" the evidence it released and jumped to conclusions "even before holding a hearing."

As other banks struggled throughout the financial crisis, Goldman Sachs posted record earnings in 2007 and then set a new record in 2009. In late 2008, following the collapse of Lehman Brothers Holdings Inc., the firm was allowed to convert to a bank under the oversight of the Federal Reserve and received $10 billion of taxpayer money, which it repaid with interest about eight months later. Blankfein, whose $67.9 million bonus in 2007 was a record for a Wall Street CEO, received no bonus in 2008 and a $9 million all-stock bonus for last year.

While Levin said his committee hasn’t found any evidence that Blankfein was himself aware of the firm’s positions on specific deals, he said the documents show that Blankfein knew the firm was shorting the market in 2007. The interrogation of Goldman Sachs may echo Ferdinand Pecora’s Depression-era investigation of powerful financiers like J.P. Morgan Jr., said some historians. Levin, who has served in the Senate for more than 30 years, and his panel have a reputation for thorough research. "Looking at this crisis, it’s hard not to agree with the conclusion of another congressional committee, which found ‘the result of the unregulated activities of the investment bankers were enormous,’" Levin said in the briefing with journalists.

"That conclusion came in 1934, when the Senate looked into the reasons for the Great Depression."

Goldman internally 'criticised $1 billion Timberwolf CDO'
by Henny Sender, Francesco Guerrera and Stephanie Kirchgaessner

Goldman Sachs officials privately disparaged a complex $1bn mortgage security that the Wall Street bank sold to investors, according to e-mails released by Senate investigators on the eve of hearings on Tuesday on the bank’s role in the financial crisis. The disclosure of the e-mails by the Senate subcommittee on investigations, which is conducting the hearing, opens up a new front in Goldman’s battle to defend itself against accusations that it put its interests ahead of its clients.

The Securities and Exchange Commission earlier this month alleged that Goldman fraudulently failed to disclose that a hedge fund influenced the composition of a complex mortgage-related security, called Abacus, underwritten by the bank. The Goldman communications released on Monday involve Timberwolf, another so-called "collateralised debt obligation", or CDO, which was structured by the bank to give investors a chance to bet on subprime mortgages. Tom Montag, then a senior Goldman executive and now head of corporate and investment banking at Bank of America, was quoted as describing the deal in an e-mail as follows: "Boy that timeberwof (sic) was one shi**y (sic) deal," according to the Senate subcommittee.

The subcommittee said that Matthew Bieber, the Goldman trader responsible for managing the deal, later described the day that the Timberwolf security was issued as "a day that will live in infamy", recalling the language President Franklin Roosevelt used for the Japanese attack against Pearl Harbour. Lawyers for Basis Yield Alpha Fund, a hedge fund that was forced to liquidate after its $100m investment in Timberwolf plummeted in value, have been holding talks with Goldman about the deal, according to a person familiar with the matter.

Within five months of issuance, Timberwolf lost 80 per cent of its value. The security was liquidated in 2008. Among the biggest buyers of Timberwolf was a hedge fund under Bear Stearns Asset Management, which held $300m of the $1bn deal, before the Bear fund collapsed, according to the Senate material.

Jim Chanos Calls For Full DOJ Investigations Of Wall Street’s Collapsed Firms
"I don't know why they're not going after this stuff."

Jim Chanos, Bill Ackman discuss Goldman and more.

Will Goldman Sachs prove greed is God?
by Matt Taibbi

The investment bank's cult of self-interest is on trial against the whole idea of civilisation – the collective decision by all of us not to screw each other over even if we can So Goldman Sachs, the world's greatest and smuggest investment bank, has been sued for fraud by the American Securities and Exchange Commission. Legally, the case hangs on a technicality. Morally, however, the Goldman Sachs case may turn into a final referendum on the greed-is-good ethos that conquered America sometime in the 80s – and in the years since has aped other horrifying American trends such as boybands and reality shows in spreading across the western world like a venereal disease.

When Britain and other countries were engulfed in the flood of defaults and derivative losses that emerged from the collapse of the American housing bubble two years ago, few people understood that the crash had its roots in the lunatic greed-centered objectivist religion, fostered back in the 50s and 60s by ponderous emigre novelist Ayn Rand. While, outside of America, Russian-born Rand is probably best known for being the unfunniest person western civilisation has seen since maybe Goebbels or Jack the Ripper (63 out of 100 colobus monkeys recently forced to read Atlas Shrugged in a laboratory setting died of boredom-induced aneurysms), in America Rand is upheld as an intellectual giant of limitless wisdom. Here in the States, her ideas are roundly worshipped even by people who've never read her books oreven heard of her. The rightwing "Tea Party" movement is just one example of an entire demographic that has been inspired to mass protest by Rand without even knowing it.

Last summer I wrote a brutally negative article about Goldman Sachs for Rolling Stone magazine (I called the bank a "great vampire squid wrapped around the face of humanity") that unexpectedly sparked a heated national debate. On one side of the debate were people like me, who believed that Goldman is little better than a criminal enterprise that earns its billions by bilking the market, the government, and even its own clients in a bewildering variety of complex financial scams. On the other side of the debate were the people who argued Goldman wasn't guilty of anything except being "too smart" and really, really good at making money. This side of the argument was based almost entirely on the Randian belief system, under which the leaders of Goldman Sachs appear not as the cheap swindlers they look like to me, but idealised heroes, the saviours of society.

In the Randian ethos, called objectivism, the only real morality is self-interest, and society is divided into groups who are efficiently self-interested (ie, the rich) and the "parasites" and "moochers" who wish to take their earnings through taxes, which are an unjust use of force in Randian politics. Rand believed government had virtually no natural role in society. She conceded that police were necessary, but was such a fervent believer in laissez-faire capitalism she refused to accept any need for economic regulation – which is a fancy way of saying we only need law enforcement for unsophisticated criminals. Rand's fingerprints are all over the recent Goldman story.

The case in question involves a hedge fund financier, John Paulson, who went to Goldman with the idea of a synthetic derivative package pegged to risky American mortgages, for use in betting against the mortgage market. Paulson would short the package, called Abacus, and Goldman would then sell the deal to suckers who would be told it was a good bet for a long investment. The SEC's contention is that Goldman committed a crime – a "failure to disclose" – when they failed to tell the suckers about the role played by the vulture betting against them on the other side of the deal.

Now, the instruments in question in this deal – collateralised debt obligations and credit default swaps – fall into the category of derivatives, which are virtually unregulated in the US thanks in large part to the effort of gremlinish former Federal Reserve chairman Alan Greenspan, who as a young man was close to Rand and remained a staunch Randian his whole life. In the late 90s, Greenspan lobbied hard for the passage of a law that came to be called the Commodity Futures Modernisation Act of 2000, a monster of a bill that among other things deregulated the sort of interest-rate swaps Goldman used in its now-infamous dealings with Greece. Both the Paulson deal and the Greece deal were examples of Goldman making millions by bending over their own business partners.

In the Paulson deal the suckers were European banks such as ABN-Amro and IKB, which were never told that the stuff Goldman was cheerfully selling to them was, in effect, designed to implode; in the Greece deal, Goldman hilariously used exotic swaps to help the country mask its financial problems, then turned right around and bet against the country by shorting Greece's debt. Now here's the really weird thing. Confronted with the evidence of public outrage over these deals, the leaders of Goldman will often appear to be genuinely confused, scratching their heads and staring quizzically into the camera like they don't know what you're upset about. It's not an act.

There have been a lot of greedy financiers and banks in history, but what makes Goldman stand out is its truly bizarre cultist/religious belief in the rightness of what it does. The point was driven home in England last year, when Goldman's international adviser, sounding exactly like a character in Atlas Shrugged, told an audience at St Paul's Cathedral that "The injunction of Jesus to love others as ourselves is an endorsement of self-interest". A few weeks later, Goldman CEO Lloyd Blankfein told the Times that he was doing "God's work". Even if he stands to make a buck at it, even your average used-car salesman won't sell some working father a car with wobbly brakes, then buy life insurance policies on that customer and his kids. But this is done almost as a matter of routine in the financial services industry, where the attitude after the inevitable pileup would be that that family was dumb for getting into the car in the first place. Caveat emptor, dude!

People have to understand this Randian mindset is now ingrained in the American character. You have to live here to see it. There's a hatred toward "moochers" and "parasites" – the Tea Party movement, which is mainly a bunch of pissed off suburban white people whining about minorities consuming social services, describes the battle as being between "water-carriers" and "water-drinkers". And regulation of any kind is deeply resisted, even after a disaster as sweeping as the 2008 crash. This debate is going to be crystallised in the Goldman case.

Much of America is going to reflexively insist that Goldman's only crime was being smarter and better at making money than IKB and ABN-Amro, and that the intrusive, meddling government (in the American narrative, always the bad guy!) should get off Goldman's Armani-clad back. Another side is going to argue that Goldman winning this case would be a rebuke to the whole idea of civilisation – which, after all, is really just a collective decision by all of us not to screw each other over even when we can. It's an important moment in the history of modern global capitalism: whether or not to move forward into a world of greed without limits.

US States Bristle as Investors Make Wagers on Defaults
by Ianthe Jeanne Dugan

As U.S. cities and towns wrestle with financial problems, investors are finding a new way to profit on their misery: by buying derivatives that essentially bet municipalities will default. These so-called credit default swaps are basically insurance contracts that have long been available to protect holders of corporate bonds against default. They became available a few years ago for municipal debt, allowing investors to short sell—or bet against—countless cities, towns and bridges, and more than a dozen states, including California, Michigan and New York.

The derivatives are still thinly traded, but their existence has the potential to make investors skittish about the issuers of the bonds that underlie them. That has been the case for issuers ranging from Greece to Bear Stearns and Lehman Brothers during the financial crisis. When the price of this insurance goes up, nervous investors have sold off securities issued by these entities. The proliferation of the derivatives is angering treasurers around the country, who say the derivatives are sending a negative message and possibly driving up their costs of borrowing at a time when they need all the help they can get. California planned to send out letters as soon as this week to big Wall Street firms that sell its bonds, seeking in-depth information about their roles in selling derivatives.

"Firms that are underwriting our bond sales are then telling the purchasers maybe they need to buy a CDS reflecting some risk," California Treasurer Bill Lockyer said in an interview. "They are speaking with two tongues, and we want to find out whether that impacts us in an adverse way." In recent weeks, the treasurer received initial information in letters from the banks, but he is probing further to find out who is buying the products and whether the bank is trading in-house for its own profit. The underwriters who have been questioned are J.P. Morgan Chase & Co.; Merrill Lynch and its parent, Bank of America Corp.; Citigroup Inc.; and Barclays PLC. All the banks told California their activity is making it easier for the derivatives to trade without large prices moves and that they aren't driving up the issuers' borrowing costs.

Credit default swaps are the investment products that play a starring role in the federal case against Goldman Sachs Group Inc. and have served as a tool for investors to make money on other investors' misfortunes, such as the collapse of the housing market. Betting on a default creates a perception of risk and could ultimately affect credit ratings, which determine how much it costs debtors to borrow money. Banks that deal in derivatives don't have to disclose who is trading or the prices they are paying. Much like corporate CDS, information isn't available beyond the name of the issuer and the spread—the amount the buyer must pay the seller for protection every year over the life of the contract. Critics say dealers can earn higher profits through this lack of transparency, because buyers and sellers don't have real-time data about prices.

The financial-overhaul bill working its way through Congress aims to change the dynamics. Some lawmakers are proposing dealers publicize the buyers of CDS, similar to the way such information is available for stocks. "Like other states, the Ohio Treasury is concerned about the increase in CDS's and other shorting instruments," Simone Wilkinson, the state's press secretary, said in an email. In Connecticut, Treasurer Denise Nappier has been monitoring whether CDS are affecting the price of the state's bonds.

Some observers say the swaps don't have an impact. Brian Yelvington, a trader at Knight Securities, is among experts who have offered advice to state officials seeking information about whether the instruments are being used for manipulation, which he says isn't happening. "It takes a 10-minute tutorial for them to understand," he says, that the bets aren't nefarious and that they are traded too thinly to affect the market for bonds or a state's bond rating.

The rise in municipal credit-default swaps comes amid growing pessimism about the financial condition of the nation's cities and states. During the recession, local government revenue has declined as people spend and earn less, and raising taxes is becoming harder to do. So bonds, long considered a safe bet, are increasingly regarded as risky. Municipal CDS are documented by the Depository Trust and Clearing Corp., which settles derivatives trades. The contracts are currently trading on California, Illinois, Michigan, Nevada, Florida, New Jersey, Ohio, Massachusetts, Connecticut, Wisconsin, Maryland and Texas. Credit default swaps also are traded for New York City, the Port Authority of New York and New Jersey, and many other taxing districts.

The derivatives also can be traded through an index called the Markit MCDX set up in 2008 by data provider Markit. The index tracks CDS for an underlying basket of 50 issuers of municipal bonds. It is now trading at a spread of about 1.3% of the value of the bonds being insured, but has been as low as 0.40% and as high as 3.5%. The spread is what the buyer must pay to the seller of the protection every year over the life of the contract. This is calculated as a percentage of the value of the contract. California, for example—the state with the widest spread—is now trading at just under 1.9%. That means if a buyer wanted to protect $1 million worth of five-year bonds, it would cost about $19,000 a year for five years.

"The CDS market is allowing people to take a view on the way municipalities will go," says John Jay, an analyst at AITE Group, a market research and advisory firm in Boston. "You can't short California stock, so this is a way to make a bet." Dealers say many of the contracts are being bought by bondholders looking to hedge their investments. Investors, however, don't have to own bonds in order to buy the contracts, and traders say much of the activity is coming from hedge funds speculating that municipalities will default.

"California has never defaulted," says Mr. Lockyer, the treasurer, "and the likelihood is as close to zero as any calculation can be, absent a major thermonuclear war." Ms. Nappier, the Connecticut state treasurer, said in an email that the state launched an initial inquiry after it learned about "potential speculative abuse of CDS in the muni market." She says Connecticut hasn't found evidence that the CDS adversely affected the cost of its debt. But, she says, "there certainly is room for ensuring greater disclosure and stronger collateral requirements."

Chief Executive Interview: Hugh Hendry
by David Stevenson

Hugh Hendry is not one to mince his words. The outspoken hedge fund specialist, formerly a partner at Odey and more recently a co-founder of investment boutique Eclectica, has previously appeared on Newsnight and presented a Channel 4 documentary on the banking crisis. Here he explains why he has been punished for good performance, why China could be the next Japan, and why he would insure you against the UK defaulting on its sovereign debt

Do you think China is a bubble waiting to burst?

I fear it could be, because it has not demonstrated an ability to create wealth. It has demonstrated an ability to create GDP growth, which is a function of spending money. The priority of economic management at the macro level should be to have a high re-occurring level of household disposable income, which manifests itself in a high level of consumption as a percentage of GDP.

The scorecard for China using that metric is really bottom of the class. Over the last 30 years, that ratio has almost halved and we are talking about consumption being 35% of the economy. Now when I say that, people scoff and ask, how can you celebrate the venality of consumption?  Isn’t there nobility to building bridges? However, infrastructure projects and steel plants that are publicly commissioned and have very uncertain economic paybacks ultimately require a subsidy from the household sector. If you build a high-speed rail link and anticipate it improving the productivity of the economy over the next 10 years, but actually it does not, it means you will have to raise Government borrowing or tax the population to sustain the negative cashflow.

But is this all about producing more of everything and increasing their economic footprint?
Well, yes. They are pursuing an Asian model and at the forefront of that model is Japan. My interpretation of all of that is, again at the macro level, profit has been displaced by the notion of sovereign power and accumulation.

If you define success on those criteria, they are clearly top of the class. But then we have witnessed Japan fall from being the unquestioned economic superpower – as it was in the 1980s – and it has now suffered two decades of profound reversal. I think the Chinese have to be concerned about that, because it has a portent their model is so similar.

Turning to specifics, will the distortions in Chinese foreign exchange rates based on the renminbi cause much of the pain to come?
Two precedents seem to describe a situation evident in China today. The experience of the US in the 1920s was one of economic disequilibrium and the economy became the world’s largest creditor nation, but at the same time had the ability and the insistence, that it would run persistent trade surpluses.

That does not wash in the world of equilibrium analysis of economics. Trees do not grow to the sky and the fact everyone owes you money means they require the resources and the ability to repay you your money. They can only find that resource to repay you by trading back with you and earning a trade surplus in return.

It takes the world into conflict and typically liquidity is used as a balm to keep an unstable world together. But that balm of liquidity finds its way into speculative asset prices and therefore makes the society vulnerable to reversal. It found its way into Wall Street, which crashed and the US went from first to last. It took 50 years before we saw the world repeat that folly, and that folly was demonstrated in Japan.

2001 is the fulcrum point where things really started to go right in China – they gained entry into the World Trade Organisation [and this coincided] with America really stepping onto the gas with regard to household debt and financing and mortgage market. And that was very much to the benefit of the Chinese.

Looking specifically at those equity markets – they do not appear enormously overpriced at around 20 times earnings do they? Especially if earnings power ahead in the next few years?
This is back to the silly Slater notion of PEG ratio analysis, which has the flaw that it is not predicated on the accumulation of wealth. This saw Next become a retail empire in the 1980s by having not one but three stores in every high street. The same applied to Starbucks. Again it is this mechanistic notion of generating incremental revenue or earnings growth or GDP growth – at the expense of declining returns on marginal investment, which sows the seeds of its own destruction.

Let’s switch now to some of your own funds and what you are doing with them? We hear a lot about your high profile funds but one of your first was your European unit trust, which has in absolute returns terms been a success, but we do not hear much about it.
I set this up in 2005. In 2007 we made 5.5%, which was nothing to write home about to be honest, as the market was up over 10% that year. But in 2008 in sterling terms, our fund only lost 5% and the stock market lost 25%.

In 2009 our fund made 7% – so we went plus five, minus five, plus seven, which is a remarkably robust performance. Yet the assets invested in that fund have fallen from $80m to £3m. So I have been punished but I am not quite sure why I have been punished. The answer to it reveals the malaise that exists in the investment industry.

What has gone wrong with the investment industry in your view?
It is a malaise and the end of an era. We have leveraged society – in the 1970s total debt to GDP in the US was 1.3. Today it is 4. So leverage has gone up a factor of three.

Equities are a real asset and the subject of a very positive spin on that leverage and therefore it is no surprise stock markets have typically gone up in real terms by a factor of nine. That is without precedent in the 400 years of economic history we have of available.

We have created a hunger just to make money, speculative money and damn the consequences almost – we are either all investing in houses or stocks, soon to be Chinese stocks with Anthony Bolton. But, it has also created a Pavlovian response where every crisis was an opportunity to buy more. I think time is receding, it is passing, it is leaving us behind. My difficulty is that I do not sell dreams. I live in the real world.

How does this enthusiasm for debt and equities relate back to your European fund and its relative neglect?
At best we are agnostic with regard to Europe. In my darker moments when I drop my guard, I am profoundly concerned and troubled by the economic model Europe is pursuing, and that makes me a very good gatekeeper for managing European assets. It means I am very quick to sell things and therefore I can protect capital. It means I have to be convinced – I am sceptical.

I think it provides an edge but it not a marketing edge. In fact you cannot sell the European product clearly by saying Europe sucks.

I am keen to understand how you actually invest. Let’s take the European unit trust as an example. What goes on in the engine room?
In the engine room of the fund we develop a prejudice with regard to the colour and direction of the global macro economy. We think those weather patterns, if you will, actually influence companies.

With this in mind, how do you pick companies?
I am concerned a society that has leveraged three times has therefore created a third presence – debt – within the economy and an inflated sense of the economy. There is a degree to which it has boosted the reputations of perhaps otherwise mediocre businesses.

As we take away this economic module the debt provided, it reveals a more sobering environment where actually it is just tough! So that manifests itself today in the sense we are concerned about the world being profoundly deflationary and therefore are reluctant to take a lot of economic risk. So the businesses we select to buy today are large-cap names, so I can sell them and not be trapped in them. They are businesses that have a lack of economic sensitivity. I have a tremendous amount invested in the tobacco industry. I think it could survive a consumer depression.

Let’s finish by looking again at the bigger, macro, picture. I suppose we could summarise your views thus – deflation is still a very real risk in the West. There is the real chance of asset bubbles, particularly in the East. What about sterling? Should we be selling it because of our indebted state?
There is a hysteria concerning sterling with regard to other currencies, especially the euro, which I do not share. Our economy is troubled and thankfully we have an independent monetary policy that does not avail itself to places like Greece. So when people get very concerned about the sovereign credit risk of the UK, and they compare it to Greece, I think they are horribly wrong.

If you wanted insurance on the UK defaulting on its debt I would write you that insurance. The UK will not default on its debt. I think it is just a preposterous assumption.

You are asking me about currency however, and sterling continues to look as if it will weaken. Clearly, there is uncertainty with regard to politics – sterling will continue to weaken against the dollar and possibly to parity versus the dollar. The dollar will surprise people by being profoundly strong, but in the context of further deflation and further falls in asset prices.

Everyone’s favourite future bogeyman is inflation. Jonathan Ruffer, in an interview recently, suggested over the medium to long term, there is a real chance of inflation picking up sharply, with the RPI [retail prices index] back above 10% or even 15% – back to the 1970s and stagflation. I am guessing you do not think that will happen given your deflationary views on debt?
If you want to create inflation, you will have to do away with free and independent capital markets. It is very hard to create inflation with free and independent capital markets because of people like me and Jonathan.

We have had quantitative easing, what has happened in the UK? Sterling has fallen and the existing stock of Government debt has fallen in price. So rates are going up. That acts as a counter and a check. We now have credit rating agencies, which come in and counter it, so it is very hard.

If you want to create inflation, what you will see is that we will have a ban on short selling. We will have a ban on naked credit default swaps. We will have the re-imposition of exchange controls. I think that could reside in the future.

So, you would put RPI in five years time at 15%?
If all of the things I say come to pass  I anticipate having a lot of inflationary traits. But some of the smartest minds in the marketplace have gone for logic rather than irony… what I am saying is you have to respect policy makers. They are wise, educated, hard working, and diligent. None of them wants to be the person who goes down in history as being the architect of hyper inflation. They do not want that. To get them to do it, to go nuclear, you have to press them to the edge and I think the place closest to the edge is Japan.

Japan? Are the risks of hyper-inflation really that great in an economy rocked by deflation?
Japan features prominently in a lot of the positions we are adopting today. Japan will of course reject the notion of overseas finance and therefore likewise could pursue fiscal austerity.

In that environment you would find Japan could print -5%, -6% nominal GDP very, very quickly. In that environment there is a paradox – the yen would appreciate, which runs very counter to most people’s logic. So I think you could have a coincidence of -5%, -6% Japanese GDP, you could have dollar/yen in the low 70s if not in the 60s. That would be an environment in which they would go nuclear.

Credit market risks lurk despite global thaw
by Dena Aubin and John Parry

The global credit crisis may have eased, but the hangover is still punishing some of the largest U.S. borrowers in the credit derivatives market.Credit default swaps, contracts that insure against debt defaults, are treating debt-laden borrowers ranging from Citigroup to MetLife Inc as though they were rated at junk status, a sign of lingering fears of the risks of heavy debt. One key cause: in a post-credit crisis world, investors can no longer trust that companies can always refinance debt at affordable rates. That fear is heightened by trillions of dollars of bank and corporate debt coming due over the next three years, threatening to push interest rates higher as borrowers scramble for funds.

"If you were to look at what the stock market is doing, you would assume we are in some sort of bull market," said Gary Kelly, head of research at Tradition Asiel Securities in New York. "That's not being echoed from the credit perspective." Credit insurance costs on major U.S. banks have risen by about 17 percent overall this week, according to data from Tradition Asiel Securities. JPMorgan Chase's swaps are up nearly 20 percent, while swaps on the finance arm of General Electric Co are up 11 percent, according to Markit Intraday. That contrasts with a more bullish view in stocks, where strong first-quarter earnings have lifted the KBW banks index .BKX by more than 6 percent this week.

The disparity is not limited to U.S. financial firms. Aggregate CDS spreads for companies across the board in both the United States and Europe remain elevated compared to historical levels, indicating latent concerns, Kelly said. A debt crisis in Greece and the threat of stricter U.S. bank regulations are adding to worries about credit risk. Among the chief concerns is that increased momentum in the U.S. Congress for financial reform will end bailouts of financial institutions with government funds.

Credit rating agencies have warned that financial firms' could be downgraded if they can no longer count on government support. Any banks downgraded to A-minus or below could lose their all-important Tier 1 short-term rating and access to financing in the short-term market, Bank of America Merrill Lynch warned in a recent report. Banks that have to refinance debt will be competing with a huge wave of government debt. The International Monetary Fund warned this week that mounting government debt is a risk to global financial stability and could strain the funding markets as banks face nearly $5 trillion in debt coming due over the next three years.

Market concerns about Greece, if unchecked, could even ignite a full-blown sovereign debt crisis if they spill over to other euro zone members, the IMF warned. "That's something we have been predicting and talking about," said Scott Mather, head of global portfolio management for Pacific Investment Management Co in Newport Beach, California, which oversees more than $1 trillion in assets. "The private sector cannot totally escape the sovereign issues." Greece on Friday appealed to its European partners and the IMF for emergency loans, yet global markets remained wary that the rescue would bring only short-term relief.

One sign of the market's caution is the extraordinary deterioration in credit default swaps of highly indebted euro zone countries since the global credit crisis erupted in the summer of 2007. Swaps on Spain, Portugal and Greece have all traded down to junk-like levels from the top triple-A category just before the crisis, according to data from Moody's Market Implied Ratings Service. "The sovereign issuer is supposed to be the risk-free benchmark," Mather said. "If you have a rising risk premium of the sovereign, (private sector debt) should be a multiple of that."

While short-term speculators may be behind some of the swap moves, many investors still see them as a good barometer of credit risk. "You would ignore a high CDS at your own peril," said Howard Simons, strategist with Bianco Research in Chicago. "The one thing I have always pointed out to people about the CDS market is to remember what 'D' stands for. It stands for default."

Deficits and Private Sector Credit
by Doug Noland

The bullish contingent is these days increasingly confident that there is much more to the recovery than a mere stimulus-induced "sugar high." The marketplace now comfortably disregards bearish developments – and becomes further emboldened by "market resiliency". The market this week brushed aside issues with Greece, China, Goldman and financial reform.

Complacency abounds, in true Bubble fashion. The U.S. stock market dismisses that there could be meaningful ramifications from the unfolding Greek debt crisis. Chinese authorities’ recent determination to restrict mortgage Credit barely garners a headline. And while the Goldman allegations generate great interest and discussion, few believe they will have much general market impact. Financial reform, well, it’s an afterthought when the market is open. Market participants are enamored with the notion that the securities markets and real economy are now conjoined in the initial phase of a big bull cycle.

Count me a subscriber of the "sugar high" thesis. The combination of double-digit (to GDP) deficits, protracted near-zero rates, and the Fed’s unprecedented Trillion-plus monetization has worked wonders. Government stimulus stabilized the Credit system, asset prices, system incomes and economic output. The bulls today believe that a new expansionary cycle has commenced, and fundamentals and prospects couldn’t be much more encouraging from their point of view. Surging stock prices have the optimists disregarding the possibility of a systemic addiction to massive government spending, ultra-low rates, and overabundant marketplace liquidity. Potential issues in the area of risk intermediation are not on the radar screen.

Yet, the sustainability of this recovery will be determined by private sector Credit – eventually.  The markets assume private Credit growth will snap back after its long recuperation – as it always has in the past.  But, mostly, analysts expend little energy pondering this issue.  Deficits of about 10% of GDP, rapid expansion of government-backed Credit (MBS, "build America bonds," student loans, bank deposits, etc.), and near-zero rates have created a recovery backdrop where minimal private-sector growth has sufficed.  This won’t always be the case.

Greek Credit default protection began December at 176 bps. Not many months ago there was little fear of a debt Crisis and no worry of default. Yet here we are today with Greece 2-year debt yielding 11% and annual default protection priced at about 600 bps. Markets fear insolvency and debt restructuring.

The U.S. Treasury borrows these days for three months at 15 bps and for two years at 1.02%.  No one dares contemplate how dramatically the world would change if fear injected itself into the equation. While there is certainly more recognition of the structural debt issues confronting our government borrowers (local, state and federal), there is no concern for short-term funding issues. There was an important aspect of the Wall Street/mortgage finance Bubble that receives little attention: The explosion of Credit provided an enormous boost to governmental receipts.  Especially in the case of federal debt ratios, boom-related revenues reduced borrowing requirements and distorted debt-to-GDP ratios.

At about 70% of GDP, outstanding Treasury debt is not on the surface overly alarming.  Obviously, if one throws in GSE liabilities and the massive future spending obligations related to social security, healthcare, pensions, etc., things are much worse. Yet it is conventional wisdom that the U.S. has the luxury of several years to get its fiscal house in order. And there is today great faith that economic recovery will, as it always does, lead a revival of government receipts and ensure rapidly declining deficits. Count me skeptical. The previous Bubble helped disguise underlying structural debt issues at the state, local and federal levels. Going forward it’s payback time. [..]

Over the years, I’ve emphasized the prominent role "Wall Street alchemy" played in fueling Credit Bubble excess.  The Street’s astounding capacity to transform risky loans into perceived safe and liquid securities was absolutely fundamental to the Credit Bubble.  The OTC derivatives markets – including collateralized debt obligations, asset-backed securities, Credit default swaps, auction-rate securities, etc. – were critical for the intermediation of risky, high-yielding loans into "money"-like securities.  This brand of risk intermediation and distortion was instrumental to the historic boom and bust – and this week it returned to the regulation spotlight.

As I’ve attempted to explain over the years, risk intermediation invariably becomes a central issue inherent to protracted Credit Bubbles and their resulting Bubble Economies.  The amount of Credit necessary to sustain the Bubbles rises each year.  And each passing year requires an increasing (exponentially-rising) amount of riskier Credit.  Our government’s massive injection of Credit/purchasing power coupled with interest rate and market liquidity intervention sustained the existing economic structure.  As they say, "that’s the good news." [..]

The unfolding Greek debt crisis, China Bubble vulnerability, and more intense scrutiny of Wall Street risk intermediation now work in confluence to increase the probability for a negative surprise in our risk markets. Sure, the equities bulls have become intoxicated by some incredible stock and sector performance. But equity market reflation must be approaching the point of unnerving the bond market. And it can’t help sentiment that, as reported today by CNBC’s Steve Liesman, a rising number of FOMC members support a timely sale of assets and a removal of the Fed’s extraordinary liquidity measures. More bearish fundamentals for the private-sector Credit mechanism gladly ignored by a stock market Bubble.

Brutal choices over British deficit
by Chris Giles, Alex Barker and Nicholas Timmins

The next government will have to cut public sector pay, freeze benefits, slash jobs, abolish a range of welfare entitlements and take the axe to programmes such as school building and road maintenance – or make a set of equally politically perilous choices, according to an analysis by the Financial Times. Packages of measures such as these are already under consideration in the Treasury and will be needed if further big tax rises are to be avoided as the next chancellor seeks, at a minimum, to halve the deficit by 2014 – a goal to which all the main parties are signed up to.

The spending choices are so difficult that senior officials believe that an incoming chancellor may be forced to resort to additional tax increases. One senior Whitehall official pointed out that the tax burden rose almost 5 percentage points in both the 1980s and the 1990s when Britain last reduced budget deficits that were large, but much smaller than the £163bn of borrowing the government has had to resort to this year. Without similar increases, it might be difficult to reduce borrowing sufficiently over the coming years, the official said. Under current plans, which include the national insurance increase that the Conservatives say they would largely reverse, a rise in the tax burden of less than half of that is envisaged.

At the very least, Treasury officials believe that the next government must bring down the cost of social security benefits to prevent drastic cuts in the areas of government activity that the parties have said they will not protect. "If you take 25 per cent out of defence, you would not have much of an army left," one official said. FT costings of a range of the choices that the next chancellor will face show that almost the whole population would be hit as the new government makes £30bn-£40bn of cuts in real terms to halve the deficit.

An online simulator, developed by the FT using government figures, suggests a saving of that scale would require all of the following: a 5 per cent cut in public sector pay; freezing benefits for a year; means-testing child benefit; abolishing winter fuel payments and free television licences; reducing prison numbers by a quarter; axing the two planned aircraft carriers; withdrawing free bus passes for pensioners; delaying Crossrail for three years; halving roads maintenance; stopping school building; halving the spending on teaching assistants and NHS dentistry; and cutting funding to Scotland and Wales by 10 per cent.

The public is braced for this looming era of fiscal austerity, but the case for spending cuts is yet to win over the public sector workers likely to be among the worst affected, an FT poll suggests. A Harris Interactive survey of people in battleground marginal seats found that most expected tax rises and spending cuts, irrespective of which party wins the election. More than two-thirds said it was likely that public services would be cut by the next government. But only half agreed with this approach, with 45 per cent of public sector workers backing an actual increase in spending by the state.

Maastricht madhouse fuels EMU-wide contagion from Greece
by Ambrose Evans-Pritchard

If the chief purpose behind the EU-IMF bail-out for Greece – or for banks exposed to Greece – is to prevent a "full-blown and contagious sovereign debt crisis", the market verdict must be a sobering surprise. The relief rally fizzled shortly after Greece folded its bad poker hand and invoked aid. Bond risk as measured by Markit's 5-year credit default swaps jumped to fresh records of 280 for Portugal and 177 for Spain. Irish CDS contracts rose 13 points to 185.

This was an entirely logical response to the twisted events that are unfolding. The rescue obliges countries in trouble to go deeper into trouble. Portugal must come up with €774m as its share of the EU's initial €30bn package. Ireland must find €491m, Spain €3.7bn. Yields on 10-year Portuguese bonds hit 4.94pc, a whisker shy of the 5pc rate that Lisbon must relend to Greece. Meanwhile, safe-haven Germany can borrow at just over 3pc. The bail-out cost falls hardest on those that can least afford it. It deepens the North-South divide that lies at the root of Europe's crisis.

In a rational world, Brussels would tap the EU's AAA rating to issue cheap "Barroso Bunds" to cover rescue costs. But we are not in a such a world. We are in the Maastricht madhouse, a currency union without a treasury, ruled by the "no bail-out" clause of Article 125 of the EU Treaties. Europe is at last paying the price for fudging the true implications of EMU 19 years ago in that Medieval city on the Maas, gambling that it would one day be able to lead Germany by the nose into a debt union. Chancellor Angela Merkel continues to equivocate, demanding "very strict conditions". Dissent is growing louder in her coalition ranks.

Both Free Democrats and Bavarian Social Christians have said it is time to break the taboo and ask whether Greece should "step outside" EMU. Werner Langen, the leader of Christian Democrat MEPs, said the bail-out appears to breach Germany's constitution. If so, we will find out soon. Four professors will launch a legal challenge in early May at the Verfassungsgericht (high court). Should they secure an injunction, EMU may fly apart. The Court ruled in 1993 that Maastricht was constitutional only as long as EMU remains an area of monetary order. "A 'transfer union' is a bottomless pit and is bound to threaten currency stability. That is what we are going to file," said Tübingen Professor Joachim Starbatty.

When accused of consigning Greece to ruin, he told the Frankfurter Allgemeine that EMU exit and default is Greece's only salvation. "The truth has to come out into the open. Greece is in no position to pay it debts," he said. The EU-IMF "therapy" of deflation for Greece repeats the catastrophic errors of Chancellor Heinrich Bruning in the early 1930s and must lead to a depression, he said. Yet that is what IMF chief Dominique Strauss-Kahn is preparing for Greece, against the better judgment of his own experts. "Greek citizens shouldn't fear the IMF; we are there to try to help them," he said over the weekend. Yet a week ago he told Greece that devaluation and default are non-starters.

"The only effective remedy that remains is deflation. That will be painful. That means falling wages, and falling prices. There is no other way." Actually, the IMF pursues other ways often, last year in Jamaica. What Mr Strauss-Kahn means is that the EU will not tolerate any other way. The Greek people must be sacrificed for the Project and to hold the EMU line, like the Spartans of Thermopylae who perished to gain time for the Alliance. They are to squeeze fiscal policy by 6pc of GDP this year in a slump – a "death spiral", warns George Soros. They are to do this without the IMF's devaluation cure. If they do stabilise the debt – to hit 130pc of GDP this year after Eurostat's revelations – they will be left paying 6pc to 8pc of GDP to foreign creditors for ever. Will Greeks comply meekly, or turn their Spartan blades on Europe?

No country in Western Europe has defaulted since the Second World War. More than €7 trillion has been lent to Club Med states, banks and homeowners in the belief that it cannot happen. EMU shut the warning signals, disguising risk. What investors overlooked is that currency risk mutates into default risk in a monetary union. It makes default more likely, not less. The bond markets have suddenly twigged. In barely two weeks, the City mood has shifted from ruling out a Greek default as absurd, to accepting that it could happen, to now fearing that restructuring is highly likely. A country such as Portugal with total debt of 300pc of GDP, a current account deficit of 11.2pc, and a budget deficit of 9.4pc should not think it has the luxury to trim spending at a leisurely pace. Portugal has an ugly choice. If it tightens hard to soothe bond markets, it too risks depression. EMU's Faustian Pact is closing in.

Follow the money
by James Hamilton

What happened to housing and financial markets over the last decade? To find out, follow the money.

According to Yale Professor Robert Shiller's data, the run-up and collapse of U.S. home prices over the last decade were without precedent over the previous century. Where did U.S. households get the money they needed to bid up house prices so high?

Shiller's real home price index, 1890-2009. Source:
Irrational Exuberance
, Princeton, 2005, by Robert Shiller.

The answer is, they borrowed it, with household mortgage debt growing more than twice as fast as GDP between 1999 and 2006.

Mortgage debt as a percent of GDP. Calculated as one hundred times the level of home mortgage debt (taken from Flow of Funds, Table B100, row 33) divided by nominal GDP (taken from Bureau of Economic Analysis, Table 1.1.5).

And where did the money come from that the institutions lent to U.S. households? The loan originators, who provided the initial mortgage loans, quickly sold them off to loan aggregators. In the 1980s these loan aggregators were primarily the government-sponsored enterprises Fannie Mae and Freddie Mac. But by the final days of the housing boom, the loan aggregators were more often private institutions who bundled the mortgages into asset-backed securities.

Assets held by GSEs, GSE and agency pools, and ABS as a percent of GDP. ABS: total credit market assets held by ABS issuers, from Flow of Funds,Table L1, row 53. GSE & agency pools: total credit market assets held by agency- and GSE-backed mortgage pools, from Flow of Funds, Table L1, row 52. GSE: total credit market assets held by government-sponsored enterprises, from Flow of Funds, Table L1, row 51. Each series multiplied by 100 and divided by seasonally adjusted nominal GDP (taken from Bureau of Economic Analysis, Table 1.1.5).

OK, so where did the loan aggregators get the money with which they bought the mortgages from the loan originators? The GSEs took the majority of loans they purchased and collected them into securitized pools that were sold off to banks, pension funds, mutual funds, state and local governments, and buyers all around the world. What made these attractive to the buyers was the fact that the GSEs guaranteed the securities. Although Fannie and Freddie did not themselves remotely have sufficient capital to make such guarantees credible, investors thought-- correctly, as events turned out-- that if Fannie and Freddie ran out of cash, the federal government would step in to honor the guarantees.

Another good chunk of the loans that the GSEs purchased they ended up holding themselves. And where did the money for that come from? Again, it was borrowed. Investors willingly lent trillions of dollars to the GSEs at rates only slightly above that on U.S. Treasuries because lenders again believed that Uncle Sam would ensure that the GSE debt was repaid.

But most of the later egregious NINJA loans (no income, no job, no assets) were made by private loan aggregators. And where did they get the money? Again, much of it seems to have been borrowed. If you buy a mortgage-backed security (or collateralized debt obligation constructed from assorted MBS), you could then issue commercial paper against it to get most of your money back, essentially making the purchase self-financing. This was the idea behind the notorious off-balance sheet structured investment vehicles or conduits, which basically used money borrowed on the commercial paper market to buy various pieces of the mortgage securities created by the loan aggregators. The dollar value of outstanding asset-backed commercial paper nearly doubled between 2004 and 2007.

Asset-backed commercial paper outstanding, seasonally unadjusted, weekly Jan 3, 2001 to Apr 21, 2010, in billions of dollars, from Federal Reserve.

Yale Professor Gary Gorton has also emphasized the importance of repo operations involving mortgage-related securities. If I buy a security, I can then pledge it as collateral to obtain a repo loan, again getting most of my money back and allowing the purchase to be mostly self-financing as long as I keep rolling over repos. Although I have not been able to find numbers on the volume of such transactions, it appears to have been quite substantial.

The question of how the house price run-up was funded thus has a pretty clear answer: Other People's Money. Because of so much money pouring into house purchases, the price was driven up. And because house prices continued to go up, the shaky quality of many of the underlying loans for a while did not come back to bite anybody. If the buyer makes a capital gain on the home purchase, there is every opportunity to refinance the loan and repay the original lender, no matter how poor the borrower's initial financial condition. But after house prices began declining in 2006, the jig was up. The freeze of assets by BNP Paribas in August 2007 was followed by a sharp increase in the spread between the rate on asset-backed commercial paper and nonfinancial commercial paper.

Yield on 30-day AA asset-backed commercial paper minus that on 30-day AA nonfinancial commercial paper, daily, Feb 1, 2007 to Apr 22, 2010, from
Federal Reserve.

The haircut on structured-debt repo-- the amount by which the value of collateral delivered must exceed the money lent against it-- started to climb dramatically after August 2007, forcing repo positions to be unwound.

Source: Gorton (2009).

To the extent that purchases of mortgages were being ultimately being funded by short-term borrowing through commercial paper or repos, the institution borrowing in this manner was essentially fulfilling the function of a bank-- borrowing short and lending long. If, as happened starting in 2007, those providing the short-run funds choose not to renew the loans, the institution would be forced to liquidate its long positions in a market where the underlying securities could only be sold at a deep loss. In other words, there would be a run on the shadow banking system.

Now, there are two aspects of the situation that began in August 2007 that one might choose to emphasize. The first perspective supposes that self-fulfilling fear itself is the key dynamic that propagates the crisis, as fire-sale prices create ever-spreading losses. When calm and rational valuation return, all will be well. The key problem, according to this perspective, is that would-be short-term lenders were hit in August 2007 with a sudden irrational lack of exuberance that ended up persisting over a year and bringing much of the world economy down with it.

The other perspective of what happened beginning in 2007 is that those Other People-- the ones who ultimately provided the Money that drove all this-- finally started to wise up.

E-mails throw light on murky world of credit
by Gillian Tett

Another week, another bout of e-mail embarrassment. Goldman Sachs shot into the spotlight 10 days ago, after the Securities and Exchange Commission accused the bank of fraud and released e-mails written by Fabrice Tourre, a trader, describing the financial products he created as useless "monstruosities" (sic). A Senate committee released a fresh batch of documents at the weekend, including e-mails from senior Goldman officials crowing that the bank could make "serious money" from America’s mortgage disaster. These will be debated in Washington on Tuesday. But these have not been the only electronic howlers. A Senate committee last week released e-mails from Standard & Poor’s and Moody’s that revealed something long suspected but never proven: that from 2005 the rating agencies faced growing pressure to cut corners in how they rated complex credit instruments in order to win lucrative business from banks.

Hence, in 2007, one Moody’s managing director admitted that its behaviour in terms of handing out triple A ratings for, say, mortgage bonds, made it "either incompetent at credit analysis, or like we sold our soul to the devil for revenue". An S&P official said its mortgage team had "become so beholden to their top issuers for revenue they have developed a kind of Stockholm syndrome which they mistakenly tag as customer value creation". Another Moody’s official told a banker that his colleagues were "looking into some adjustments to his methodology that should be a benefit to your folks". Even more revealing is an e-mail at S&P about the media. In early 2007, at the height of the credit boom, it was easy for the rating agencies to brush off suggestions that their business model might face conflicts of interest. Back then, most policymakers were turning a blind eye.

The noteworthy exception was Michel Prada, then the senior French regulator, who caused a stir by publicly suggesting that rating agencies had so many conflicts they could end up suffering the same fate as Arthur Andersen, the accountants. The agencies dismissed Mr Prada as a crackpot, along with journalists who took a similar line. But in private, it was a different tale. In 2007, an S&P official e-mailed a colleague, in response to a Financial Times inquiry, lamenting that: "We… sound like the Nixon White House. Instead of dismissing [journalists] or assuming some dark motive on their part, we should ask ourselves how we could have so mishandled the answer to such an obvious question?if this company suffers from an Arthur Andersen event, we will not be brought down by a lack of ethics or greed; it will be arrogance."

It is fascinating, almost touching, stuff. Reading these e-mails with the benefit of hindsight, there is little suggestion that rating officials were engaged in any deliberate malfeasance. Many appear conscientious and hard-working. But by 2007 they, like the bankers, had become tiny cogs in a machine that was spinning out of control. Their world was also in a strange, geeky silo, into which few non-bankers ever peered. Indeed, this world was so detached and rarefied it is, perhaps, little wonder that S&P struggled to deal with the press; or that Goldman traders felt free to celebrate the mortgage market collapse. In this world of complex credit, a sense of tunnel vision ruled. Few expected external scrutiny or imagined their e-mails would ever be read.

There are two important lessons. One is that what went wrong in finance was fundamentally structural, as an entire system spun out of control. It might seem tempting to lash out at a few colourful traders but that is a sideshow: what is needed is systemic reform that removes conflicts of interest. The second lesson is that the whole murky credit business must be taken out of the shadows. So few people spotted that finance was spinning out of control because the financial system was so separated into silos that its practitioners lost any common sense. I, for one, welcome the publication of these e-mails. It might help produce more scrutiny, and common sense, in a world that has been in the shadows for too long. In the meantime, keep braced for the next instalment. I suspect that US regulators and politicians have not finished publishing all those damning e-mails yet.

The national debt and Washington's deficit of will
by Joel Achenbach

Bill Gross is used to buying bonds in multibillion-dollar batches. But when it comes to U.S. Treasury bills, he's getting nervous. Gross, a founder of the investment giant Pimco, is so concerned about America's national debt that he has started unloading some of his holdings of U.S. government bonds in favor of bonds from such countries as Germany, Canada and France.

Gross is a bottom-line kind of guy; he doesn't seem to care if the debt is the fault of Republicans or Democrats, the Bush tax cuts or the Obama stimulus. He's simply worried that Washington's habit of spending today the money it hopes to collect tomorrow is getting worse and worse. It even has elements of a Ponzi scheme, Gross told me. "In order to pay the interest and the bill when it comes due, we'll simply have to issue more IOUs. That, to me, is Ponzi-like," Gross said. "It's a game that can never be finished."

The national debt -- which totaled $8,370,635,856,604.98 as of a few days ago, not even counting the trillions owed by the government to Social Security and other pilfered trust funds -- is rapidly becoming a dominant political issue in Washington and across the country, and not just among the "tea party" crowd. President Obama is feeling the pressure, and on Tuesday he will open the first session of a high-level bipartisan commission that will look for ways to reduce deficits and put the country on a sustainable fiscal path.

It's a tough task. The short term looks awful, and the long term looks hideous. Under any likely scenario, the federal debt will continue to balloon in the years to come. The Congressional Budget Office expects it to reach $20 trillion over the next decade -- and that assumes no new recessions, no new wars and no new financial crises. In the doomsday scenario, foreign investors get spooked and demand higher interest rates to continue bankrolling American profligacy. As rates shoot up, the United States has to borrow more and more simply to pay the interest on its debt, and soon the economy is in a downward spiral.

Of course, at least in theory, this problem can be fixed. Unlike a real Ponzi scheme, which collapses when no new suckers offer money that can be used to pay off earlier investors, the government can restore fiscal sanity whenever our leaders decide to do so. But that premise is what has people like Gross worried. In addition to running a budget deficit, Washington for years has had a massive deficit of political will.

Over the past decade, lawmakers have avoided the kind of unpopular decisions -- tax increases, spending cuts or some combination -- needed to keep the debt under control. Federal Reserve Chairman Ben Bernanke testified recently that, for investors, the underlying problem with the debt isn't economic. "At some point, the markets will make a judgment about, really, not our economic capacity but our political ability, our political will, to achieve longer-term sustainability," he said.

The economic recovery has been picking up steam in recent weeks -- "America's Back!" trumpets Newsweek -- but the political recovery has been feeble. Whether on taxes, entitlements, military retooling, financial reform, energy policy or climate change, Washington is mired in a political enmity that makes tough decisions nearly impossible. In the fiscal debate, the default position, as it were, is to do nothing. Debt is the grease of Washington legislation; for short-sighted leaders, it is less a political problem than a political solution. As long as the government can continue borrowing at reasonable rates, citizens can have their tax cuts and government services, and eventually the growing debt becomes someone else's problem.

"This is all an exercise in current generations shifting burdens on future generations," Brookings Institution economist William Gale says. "Future generations don't vote, of course." Many careers in Washington have come to an end as casualties of the long battle to restore fiscal balance. President George H.W. Bush in 1990 went back on his "no new taxes" pledge and lost much of his political base. By the narrowest of margins -- with Vice President Al Gore breaking a tied vote in the Senate -- President Bill Clinton raised taxes again in 1993, and House Democrats were pummeled in the following year's midterm elections, giving up control of the chamber to the GOP for the first time in 40 years.

But then, after two decades of deficits, the fiscal picture brightened unexpectedly. The peace dividend at the end of the Cold War combined with the booming economy of the 1990s (and some tech-bubble tax receipts) to create an unexpected dilemma in 2000: what to do with the budget surpluses that were forecast for years to come? One obvious idea was to pay down the existing publicly held debt, then hovering around $3.4 trillion.

But a decade later, we're back in debt madness. The causes of this reversal are not a mystery: tax cuts, two wars, a new Medicare drug benefit, two recessions, massive bailouts and a huge stimulus package -- very little of it paid for in any conventional sense. Obama never misses a chance to remind the public that he inherited an enormous deficit, but as a purely political matter he still needs to persuade the public that he's a prudent fiscal steward.

To that end, the president has proposed a freeze on most nonmilitary discretionary spending. Obama also insisted that the health-care overhaul not add to the deficit, and it won't, according to the CBO. But no one would confuse the health-care law with a deficit-reduction package. Critics say the law worsens the fiscal outlook because its spending cuts and new taxes could have been used to reduce the deficit -- which may run at about $1.3 trillion for 2010 -- instead of being an offset for an entitlement expansion.

Beyond the simplicity of the problem -- the Treasury spends more than it collects -- is a thorny mess of policy options. Conservatives fear that liberals want to expand government by imposing a European-style value-added tax, in which the government sips revenue at multiple stages in the production and sale of goods and services. But a VAT is regressive, would hit the middle class in the teeth and is probably too politically radical to survive beyond the haven of a few Washington think tanks.

Obama's vow not to raise taxes on the middle class -- meaning he's extending George W. Bush's tax cuts for everyone except the most affluent -- eliminates a lot of revenue options. "The Republican view is no new taxes, and the Democratic view is no new taxes on 95 percent of the population. Both of those are so far from reasonable starting points that it's astonishing," Gale argues.

Obama and his fellow Democrats may also be shy of substantial Pentagon cuts, lest they be pegged as weak-kneed liberals. Some of the easiest Medicare cuts have already been made. That leaves Social Security, and such options as postponing the retirement age or means-testing benefits. But recipients figure they paid into Social Security and it's their money, not to be taken away. And they vote -- and live by the millions in swing states such as Florida.

With so many unpleasant options, everyone is looking to Obama's new bipartisan commission for some kind of miracle solution. The 18-member panel, headed by former Clinton White House chief of staff Erskine Bowles and retired Republican senator Alan Simpson, is charged with producing recommendations by Dec. 1, after the midterm elections. Congressional leaders say they'll vote on the recommendations, but the commission has no real clout. A panel proposed by Senate colleagues Kent Conrad (N.D.), a Democrat, and Judd Gregg (N.H.), a Republican, would have had more teeth, but the idea died in the ideological crossfire early this year.

Even before the commission's first meeting, the body is already in the thick of the political battle, with antitax advocate Grover Norquist suggesting that Simpson has a history as a tax hiker. The retired senator struck back in a statement: "This 'Mr. Tax Hike' business is garbage, and is intended to terrify people and at the same time make money for the groups who babble it." In an interview, Simpson said the capital has an aversion to dealing with debt. "It makes all sorts of sense if you're worshiping the great god hiding behind the screen, which is called reelection," he told me.

The latest news from the Treasury is hopeful: Tax revenues are slightly higher than anticipated so far this year. The TARP program to bail out financial firms has proved far less costly than expected. Investors from around the world still eagerly bid on Treasury notes at auction. During this global recession, the U.S. Treasury has been a safe port in the storm.

When I spoke to Peter Orszag, the director of the Office of Management and Budget, he expressed optimism that the administration can balance the primary budget -- not including interest payments -- by 2015. The longer-term deficits are his bigger worry. Asked if the political process in Washington is broken, he answered: "I think it's too soon to know whether the system's broken. The problem is not what happened last year or this year. The real issue is when we move forward in time, something has to give."

The danger is that what "gives" will be investors' confidence in the United States. Bill Gross told me that Pimco still has $150 billion in Treasuries, but that's seriously "underweight" given that the company controls $1 trillion in assets. "It's becoming immediately apparent that some countries will not do especially well and may not escape the debt trap from the recent financial crisis, Greece and Iceland being the most prominent cases," Gross said. "But now investors are even looking at the best of the best, including the United States."

That's also the concern of Michael Burry, the investment guru who predicted Wall Street's meltdown and made millions by placing bets against (or "shorting") the financial sector. Burry, one of the protagonists in Michael Lewis's account of the financial crisis, "The Big Short," believes the federal government is behaving like the companies that lost billions in mortgage-backed securities. He told me he sees the common mistake of focusing on short-term benefits -- whether quarterly earnings or the next election.

The world doesn't want America to go broke, he points out. Americans are the planet's greatest consumers. But if this is a bubble, it will burst with little warning, Burry said. "Strictly looking at the monthly Treasury statement of receipts and outlays," Burry said, "as an 'investor,' you see a company you might want to short."

U.S. Fiscal Policy
by Doug Elmendorf at the Congressional Budget Office

This afternoon I participated in a panel discussion about “Fiscal Strategies after the Global Crisis” at the International Monetary Fund. My short presentation focused on some familiar themes:

Given current law and certain possible changes to that law that are generally supported by the Administration and many Members of Congress, the budget deficit and debt are on a worrisome path—unsustainable in the long run and posing growing risks even during the next several years.

The following picture shows CBO’s March projections of debt relative to gross domestic product (GDP) under current law (the budget “baseline”) and under an alternative scenario in which the 2001 and 2003 tax cuts are extended and the alternative minimum tax (AMT) is indexed for inflation. The President’s budget would extend most of the 2001 and 2003 tax cuts, index the AMT for inflation, and make a variety of other changes in law. CBO’s projection of the debt under that budget is quite similar to our projection under the alternative scenario shown below. If that debt indeed rises toward 90 percent of GDP, it would be entering territory that is unfamiliar to us and to most developed countries in recent years.

Debt Held by the Public as a Percentage of GDP

 Putting U.S. fiscal policy on a safe path would probably require significant changes in spending, revenue, or both. In thinking about changes that might be made, it’s important to understand where most of the revenue will be coming from and where most of the spending will be going.

CBO’s March projection under current law shows that, in 2020, about one-half of federal revenue will come from individual income taxes, about one-third will be from payroll taxes, and the rest will be from corporate profits taxes and other sources. The same projection shows that roughly three-quarters of spending will go to just five areas—Social Security, Medicare, Medicaid, defense, and net interest—with the remaining one-quarter of spending covering all other federal programs. The following chart provides more details:

Shares of Federal Spending Projected for 2020 in CBO’s March Baseline

Changes of the magnitude required to put U.S. fiscal policy on a safe path could have important economic and social effects. Given the political and substantive difficulties in making significant policy changes, determining what those changes will be is an urgent task for policymakers.

Senate Finance Committee Chairman Max Baucus: A bank tax is coming
by David Rogers

It was a short hallway conversation but spoke volumes about the dilemma facing Democrats, hungry for new revenues after emptying the cupboard on health care reform. "I don’t think there’s much doubt that there will be a bank tax," Senate Finance Committee Chairman Max Baucus told POLITICO. And more than ever, the Montana Democrat signaled that Congress will also crack down on wealthy hedge fund and private equity partners who shelter their income as capital gains — taxed at half the top 35 percent rate.

Three times in recent years, the House has voted to rein in the so-called carried interest provision — only to meet Senate resistance. That’s changing with the pressure to find revenues to pay for other priorities such as a $35 billion measure extending popular tax provisions for businesses and families. "I’ve asked my staff to look at alternatives ... Carried interest will probably be part of the offsets," said Baucus. "We were thinking of putting it on later as part of tax reform. But we’re here; we’re here now."

Wealthy Democratic donors are sure to scream; Baucus concedes he could face opposition from his own party moderates. But isn’t the chairman himself the "very soul of the moderate Democrat?" a reporter asks. "I’m a ‘Do-the-Right-Thing’ Democrat," Baucus grinned. Doing the right thing isn’t easy in today’s tax-writing world — whipsawed by record deficits, new "pay-go" budget rules, restless voters and a legacy of Bush-era tax breaks due to expire in December. Even the giant financial reform bill, facing its first Senate test Monday night, has potential revenue problems. And Baucus was sorely frustrated last December, when the Senate let the estate tax expire — thereby costing Treasury billions.

At least three major tax-related battles are taking shape in the next few months:

• First and most immediate is how to pay for the long-delayed extenders bill, which Democrats want to complete by Memorial Day and which includes a must-pass provision authorizing long-term unemployment benefits past the November elections. Health care picked clean most of the planned revenue offsets in the initial bills, leaving a $35 billion hole and carried interest — worth $24.6 billion over 10 years — standing alone in this game of musical chair offsets.

• Second — and fast closing — is President Barack Obama’s proposed bank tax. Baucus wants to keep the bank levy separate from the current debate over financial reform, thereby having the chance to claim the tax revenues as an offset. But the Congressional Budget Office is raising red flags that the Senate reform package will be $17 billion in the red if Democrats drop a $50 billion industry-financed "orderly liquidation fund" opposed by Republicans.

• Third, but scarcely least, is this summer’s battle over Bush-era income tax cuts due to expire at the end of this year. The Senate Budget Committee last week approved a five-year plan that assumes the most popular middle-class tax breaks will be made permanent. House Democrats say some extension could be a powerful engine for a revenue bill prior to the elections; part of the mix would be some compromise on the estate tax issue, which splits the party in the Senate.

Each of these fights has its own nuances and competing equities.

The Obama bank tax proposal began as a plan to recoup money already spent by Treasury in the 2008-09 bailouts. The reform bill’s "orderly liquidation fund" is a bet on the future, imposing an assessment on the industry now in case big companies again fail and demand resolution. Nonetheless, the two issues have become joined in the reform debate. Treasury officials have hinted they would like to sub the bank tax in and the fund out; House Financial Services Committee Chairman Barney Frank (D-Mass.) says Congress should consider a bigger and more permanent bank tax than Treasury has proposed if the liquidation fund is dropped. "The already strong case for the bank tax gets stronger," Frank told POLITICO. "I think one possible approach is no pre-existing fund but a bigger and longer-lasting bank tax."

How the levy is designed depends on how one sees the financial crisis — another reason Baucus is unlikely to move before late May or June, so as to allow time for hearings. As first proposed in January, the so-called responsibility fee was assumed to raise about $90 billion over 10 years through a 0.15 percent tax on the covered liabilities of the very largest financial institutions. And Treasury has since refined its approach to focus more on risk—measured both by the loans or trading done by banks and how firm the financing is behind them.

In tandem with financial reform the goal is go after what one Treasury official described as "the toxic combination of high levels of risky assets funded by highly unstable sources of funding." "We look at both sides of the coin," he said in an interview. "Someone doing traditional banking — using all deposits to fund even somewhat risky commercial and small-business loans — would be largely shielded from the fee."

Nonetheless, the mechanics can seem so complicated that this message is lost. And lawmakers are clearly spooked by the notion that the tax could still penalize commercial loans and fall more heavily on banks like Wells Fargo than on Wall Street’s high rollers, Goldman Sachs or Morgan Stanley. 

Getting to the bottom of this question means wading into the thicket of Federal Reserve rules governing the weighted risks of commercial loans vs. market activities. The Fed’s capital experts warn against quick, generalized comparisons, but a Joint Taxation Committee report this month said that "because commercial loans are assigned the highest risk-weight of 100 percent, a tax on risk-based assets could prove a disincentive for an institution to make such loans, including loans to small businesses."

"There are pluses and minuses," House Ways and Means Committee Chairman Sander Levin (D-Mich.) told POLITICO. "We’re looking at ways to relate it to risk, but that’s not easy to do because the ‘riskiest’ are commercial loans, and we don’t want to tax those." This invites a Ways and Means option based on income and profits. A bank’s taxable income would be first adjusted upward by adding back some portion of the rich bonuses deducted as compensation, then would come a surtax imposed to raise the required funds. Given the huge profits and bonuses being reported by Wall Street investment banks, this has a clear political appeal. But Treasury would argue that its risk approach is substantively better — in terms of the reform message at home and in partnership with reforms overseas by U.S. allies.

The very different carried interest tax debate has its own nuances — and winners and losers. At issue is whether income paid to wealthy investment fund managers should be taxed at the 15 percent capital gains rate or the upper income bracket, 35 percent and climbing. Proponents of the current system argue that the managers have a "carried interest" in the capital investments they oversee. Critics say it is ordinary income paid in exchange for the performance of services, and the managers often have very little skin in the capital game.

The House permits some leeway: allowing carried interest to be taxed at the capital gains tax rate to the extent that it reflects a reasonable return on invested capital. And after interviewing different coalitions with a stake in the outcome, Senate Finance staff is now looking at compromises that could address some complaints — but still yield much needed tax revenue.

Hedge fund partners make for an easy political target today, but much of their trading is so short term that it doesn’t qualify for the lower capital gains rate that applies to assets held more than six months. Private equity, publicly traded partnerships in the energy field and real estate partnerships are often affected more, especially given the strained state of commercial real estate. To win the needed votes, Baucus will have to look at options that ease the transition by perhaps imposing a midpoint rate — between 15 percent and 35 percent — or grandfather in some deals already made before a fixed date.

These deals mean less revenue, so tax writers are also looking at closing a foreign tax credit loophole — estimated to be worth $9.5 billion over 10 years. But the gap is too big to plug without pain. "There are no easy choices left," said one person familiar with the search for revenues and focus on carried interest. "No final decisions have been made. We’re about a week away, but I won’t argue, it is a leading candidate."

Deficits and Private Sector Credit
by Doug Noland

The bullish contingent is these days increasingly confident that there is much more to the recovery than a mere stimulus-induced "sugar high." The marketplace now comfortably disregards bearish developments – and becomes further emboldened by "market resiliency". The market this week brushed aside issues with Greece, China, Goldman and financial reform.

Complacency abounds, in true Bubble fashion. The U.S. stock market dismisses that there could be meaningful ramifications from the unfolding Greek debt crisis. Chinese authorities’ recent determination to restrict mortgage Credit barely garners a headline. And while the Goldman allegations generate great interest and discussion, few believe they will have much general market impact. Financial reform, well, it’s an afterthought when the market is open. Market participants are enamored with the notion that the securities markets and real economy are now conjoined in the initial phase of a big bull cycle.

Count me a subscriber of the "sugar high" thesis. The combination of double-digit (to GDP) deficits, protracted near-zero rates, and the Fed’s unprecedented Trillion-plus monetization has worked wonders. Government stimulus stabilized the Credit system, asset prices, system incomes and economic output. The bulls today believe that a new expansionary cycle has commenced, and fundamentals and prospects couldn’t be much more encouraging from their point of view. Surging stock prices have the optimists disregarding the possibility of a systemic addiction to massive government spending, ultra-low rates, and overabundant marketplace liquidity. Potential issues in the area of risk intermediation are not on the radar screen.

Yet, the sustainability of this recovery will be determined by private sector Credit – eventually.  The markets assume private Credit growth will snap back after its long recuperation – as it always has in the past.  But, mostly, analysts expend little energy pondering this issue.  Deficits of about 10% of GDP, rapid expansion of government-backed Credit (MBS, "build America bonds," student loans, bank deposits, etc.), and near-zero rates have created a recovery backdrop where minimal private-sector growth has sufficed.  This won’t always be the case.

Greek Credit default protection began December at 176 bps. Not many months ago there was little fear of a debt Crisis and no worry of default. Yet here we are today with Greece 2-year debt yielding 11% and annual default protection priced at about 600 bps. Markets fear insolvency and debt restructuring.

The U.S. Treasury borrows these days for three months at 15 bps and for two years at 1.02%.  No one dares contemplate how dramatically the world would change if fear injected itself into the equation. While there is certainly more recognition of the structural debt issues confronting our government borrowers (local, state and federal), there is no concern for short-term funding issues. There was an important aspect of the Wall Street/mortgage finance Bubble that receives little attention: The explosion of Credit provided an enormous boost to governmental receipts.  Especially in the case of federal debt ratios, boom-related revenues reduced borrowing requirements and distorted debt-to-GDP ratios.

At about 70% of GDP, outstanding Treasury debt is not on the surface overly alarming.  Obviously, if one throws in GSE liabilities and the massive future spending obligations related to social security, healthcare, pensions, etc., things are much worse. Yet it is conventional wisdom that the U.S. has the luxury of several years to get its fiscal house in order. And there is today great faith that economic recovery will, as it always does, lead a revival of government receipts and ensure rapidly declining deficits. Count me skeptical. The previous Bubble helped disguise underlying structural debt issues at the state, local and federal levels. Going forward it’s payback time. [..]

Over the years, I’ve emphasized the prominent role "Wall Street alchemy" played in fueling Credit Bubble excess.  The Street’s astounding capacity to transform risky loans into perceived safe and liquid securities was absolutely fundamental to the Credit Bubble.  The OTC derivatives markets – including collateralized debt obligations, asset-backed securities, Credit default swaps, auction-rate securities, etc. – were critical for the intermediation of risky, high-yielding loans into "money"-like securities.  This brand of risk intermediation and distortion was instrumental to the historic boom and bust – and this week it returned to the regulation spotlight.

As I’ve attempted to explain over the years, risk intermediation invariably becomes a central issue inherent to protracted Credit Bubbles and their resulting Bubble Economies.  The amount of Credit necessary to sustain the Bubbles rises each year.  And each passing year requires an increasing (exponentially-rising) amount of riskier Credit.  Our government’s massive injection of Credit/purchasing power coupled with interest rate and market liquidity intervention sustained the existing economic structure.  As they say, "that’s the good news." [..]

The unfolding Greek debt crisis, China Bubble vulnerability, and more intense scrutiny of Wall Street risk intermediation now work in confluence to increase the probability for a negative surprise in our risk markets. Sure, the equities bulls have become intoxicated by some incredible stock and sector performance. But equity market reflation must be approaching the point of unnerving the bond market. And it can’t help sentiment that, as reported today by CNBC’s Steve Liesman, a rising number of FOMC members support a timely sale of assets and a removal of the Fed’s extraordinary liquidity measures. More bearish fundamentals for the private-sector Credit mechanism gladly ignored by a stock market Bubble.

SEC's Top Cop Oversaw Deutsche CDOs
by Aaron Lucchetti and Kara Scannell

Securities and Exchange Commission enforcement chief Robert Khuzami oversaw a group of lawyers at his old firm, Deutsche Bank AG, that was closely involved in developing collateralized debt obligations, the same product in the agency's fraud lawsuit against Goldman Sachs Group Inc., according to people familiar with the matter.

Before taking his current job at the SEC last year, the 53-year-old Mr. Khuzami spent five years running the U.S. legal division of Deutsche Bank, one of the largest issuers of collateralized debt obligations in 2006 and 2007. As part of that job, he worked with lawyers who advised on the CDOs issued by the German bank and how details about them should be disclosed to investors. The group included more than 100 lawyers who also defended the bank against lawsuits and vetted other financial products, these people said.

Deutsche Bank has faced allegations of inadequate disclosure over its creation of CDOs. It isn't clear if Mr. Khuzami personally reviewed any structured-finance deal documents in his role at the bank, and outside law firms were also involved in CDO work.

Deutsche Bank said its CDOs that were similar to Abacus 2007-AC1, the subject of the SEC's suit against Goldman, didn't rely on outside firms to help choose the underlying portfolio. That "eliminated the potential for deception with respect to the role of such a manager," said Ted Meyer, a spokesman for Deutsche Bank. He declined to comment on Mr. Khuzami.

Because of Mr. Khuzami's old job and his financial interest in the company, he has recused himself from any matters related to Deutsche Bank, according to an SEC spokesman.

The SEC spokesman said Mr. Khuzami also isn't involved in a recent SEC case over alleged insider trading by a hedge-fund manager and Deutsche Bank sales official. The SEC probe began while Mr. Khuzami was at the bank.

SEC officials say Mr. Khuzami's résumé is a nonissue, adding that the agency will go after illegal conduct wherever it occurs. "The Commission's recusal policy prevents even the appearance of a possible conflict of interest by prohibiting employees from working on particular matters that could affect their financial interests," said SEC spokesman John Nester. Mr. Khuzami declined to comment through the spokesman.

Mr. Khuzami has vowed to pursue wrongdoing against Wall Street firms in high-profile areas such as subprime mortgages and CDOs. That mission created shockwaves last week when the SEC accused the world's most profitable securities firm of duping investors in its sale of a CDO called Abacus 2007-AC1.

Goldman denies any wrongdoing, but Wall Street and Washington are buzzing with speculation about whether Mr. Khuzami will bring other cases over CDOs. The SEC has sent requests for information to Deutsche Bank and numerous other firms about CDOs and other structured mortgage products, according to a person familiar with the matter.

Mr. Khuzami is the first SEC enforcement director in recent history to come directly from an investment bank. The agency's tradition has been to promote from within. SEC Chairman Mary Schapiro cited Mr. Khuzami's skills as a former prosecutor when she recruited him to run the SEC's enforcement division, which was reeling from the missed Bernard Madoff fraud.

Some securities lawyers say Mr. Khuzami's high-level position at Deutsche Bank could have given him insight into structured-finance products, an area where the SEC has been criticized for a shortage of expertise.

In his seven years at the German bank, Mr. Khuzami took a hands-on role, including when he was general counsel for the Americas from 2004 to 2009. He hired government lawyers and pushed them to more aggressively audit the bank's activities. His group reminded colleagues that regulators would be watching their emails closely, according to one former Deutsche Bank employee.

His large cases include defending the firm in an ongoing tax-shelter case and a favorable judgment and settlement of litigation related to Deutsche's role in the collapse of Enron Corp. Before joining Deutsche Bank, he was a prosecutor in the U.S. attorney's office in Manhattan for 11 years, most notably handling the landmark trial over the 1993 World Trade Center bombing, as well as Ponzi schemes, insider-trading cases and a prosecution linking organized crime to the stock market.

Deutsche Bank is defending itself from a lawsuit triggered by a CDO created before Mr. Khuzami left. In a New York court lawsuit filed in 2008, M&T Bank Corp., a regional bank based in Buffalo, N.Y., accused Deutsche Bank and one company official of making misleading statements when it allegedly described a 2007 deal as "nearly risk-free," "rock solid" and "like a lay-up." M&T said it lost the entire $82 million it invested in the deal.

The bank declined to comment. In a court filing, lawyers representing Deutsche Bank said the portfolio's risks were adequately disclosed, adding that the company "could not (and did not) foresee the extent of a collapse that no one else foresaw."

Like Goldman, Deutsche Bank also worked with Paulson & Co. to develop the CDOs that helped the hedge-fund manager bet against the securities. The disputed Goldman deal allowed Mr. Paulson to score $1 billion in profits.

One difference: Deutsche Bank is believed to have lost about $500 million on this type of its CDO deal when the housing market cratered in early 2007, sticking the bank with some of the assets that Mr. Paulson had bet against. Goldman says it had losses of more than $100 million on its deal.

Mr. Meyer, the Deutsche Bank spokesman, said that "what distinguishes Deutsche Bank's static CDO transactions is that both long and short investors were given the opportunity to select the specific collateral to which they were seeking exposure and mutually agreed on the CDO portfolio."

The Leading Indicator of Repurchase Risk Losses? Audited By KPMG
by Francine McKenna

January 30, 2010, Wall Street Journal:

Fannie, Freddie Chase Bad Mortgages

Lenders Like BofA, J.P. Morgan Repurchase Billions in Faulty Loans; Just a Drop in the Default Pool

Stuck with about $300 billion in loans to borrowers at least 90 days behind on payments, Fannie and Freddie have unleashed armies of auditors and other employees to sift through mortgage files for proof of underwriting flaws. The two mortgage-finance companies are flexing their muscles to force banks to repurchase loans found to contain improper documentation about a borrower’s income or outright lies.

April 14, 2010, FT Alphaville:

"…these repurchases are something to watch out for as JP Morgan reports Q1 earnings on Wednesday. The bank said in its last (2009) 10-k filing that:

In 2009, the costs of repurchasing mortgage loans that had been sold to government agencies such as Freddie Mac and Fannie Mae increased substantially for JPM, and could continue to increase substantially further. Accordingly, Equity Research 15 repurchase and/or indemnity obligations to government-sponsored enterprises or to private third-party purchasers could materially and adversely affect its results of operations and earnings in the future. It anticipates that its 2010 revenue could be negatively affected by elevated levels of repurchases of mortgages previously sold to GSEs."

If you are a regular reader of this site, you may remember the first time I warned you about the poor disclosure practices surrounding repurchase risk.  It was all the way back in March of 2007 and I was referring to the lack of disclosures surrounding New Century Financial.
In a filing with the Securities and Exchange Commission on Monday, New Century said lenders including Bank of America, Barclays, Citigroup, Credit Suisse, Goldman Sachs and Morgan Stanley had issued letters saying the company was in default. New Century also said its bankers had demanded that it accelerate its obligation to buy back outstanding mortgage loans financed under the lending arrangements. New Century said if its bankers demanded accelerated repurchase of all outstanding mortgages, it would cost the company $8.4bn, which it does not have…

I looked quickly at the 2005 Annual Report for New Century to find out who their auditors are and to see how "rapid" this decline really was. Interestingly, besides noticing that KPMG now has another worry at its doorstep, I didn’t see too much in the way of discussion in the "Risks" section of the risk that is now causing this worldwide financial crisis. There are 17 pages of discussion of general and REIT specific risk associated with this company, but no mention of the specific risk of the potential for their banks to accelerate the repurchase of mortgage loans financed under their significant number of lending arrangements. Although there is a detailed discussion of these lending arrangements later in the report, it does not seem that reserves or capital/liquidity requirements were sufficient to cover the possibility that one of or more lenders could for some reason decide to call the loans…Didn’t someone think that this would be a very big number (US 8.4 billion) if that happened?

New Century failed. There was a very detailed, well-done bankruptcy examiner’s report on that one, too. Mr. Missal pointed the finger at KPMG for not heeding the advice of their own experts, a la Andersen/Enron. Instead of the KPMG partner telling the client that their models for estimating potential losses were flawed, the partner told the staff to shut up and move on.

KPMG is now being sued for $1 billion for its sins at New Century.

Donna Kardos in the WSJ:

The lawsuits filed Wednesday said that specialists at KPMG tried to point out errors in New Century’s financial statements but were silenced by the KPMG partner in charge of the audits "to protect KPMG’s business relationship with, and fees from, New Century."

The claims are among the first to attempt to blame auditors for the subprime-mortgage crisis, which spread beyond lenders such as New Century and engulfed the global financial system.

If the New Century trustee is successful, "it may embolden others to look more closely at the possibility of bringing [accounting] firms to some level of culpability for the things that happened," that led to the credit crisis, Francine McKenna, president of McKenna Partners LLC, a corporate-governance consultancy, said in an interview.

I warned you again seven months ago that another KPMG client, Wachovia/Wells Fargo, has the same poor disclosure of repurchase risk.
Did Wells Fargo’s Auditors Miss Repurchase Risk?

How does the New Century situation and KPMG’s role in it remind me of Wells Fargo now?  Well, in both cases, there’s no disclosure of the quantity and quality of the repurchase risk to the organization…The lack of disclosure of this issue here mirrors the lack of disclosure in New Century and perhaps in other KPMG clients such at Citigroup, Countrywide (now inside Bank of America) and others.

How do I know there could be a pattern? Because the inspections of KPMG by the PCAOB, their regulator, tell us they have been cited for auditing deficiencies just like this.  Do we have to wait for another post-failure lawsuit to bring some sense, and some sunshine, to the system?

The latest announcements of potentially material losses due to forced repurchases of mortgages from Fannie Mae (Deloitte) and Freddie Mac (PwC) were made JP Morgan and Bank of America – both audited by PwC.

The biggest losers are likely to be Bank of America Corp., J.P. Morgan Chase & Co. and other mortgage lenders when the housing bubble burst…

Bank of America repurchased nearly $4.5 billion of loans during the first nine months of 2009, according to data compiled by Barclays. That was triple the $1.5 billion repurchased in all of 2008. Some of the bad mortgages were made by Countrywide Financial Corp., which was acquired by the Charlotte, N.C., bank in 2008. A bank spokeswoman declined to comment.

At J.P. Morgan, total buyback demands surged to $5.3 billion in 2009 from $4 billion in 2008, according to Barclays. The New York company, which bought the failed banking operations of Washington Mutual Inc.(Deloitte) in 2008, reported higher reserves for loan repurchases in the fourth quarter… J.P. Morgan and Bank of America don’t disclose how many loans they repurchased from Fannie and Freddie.

Countrywide, now owned by Bank of America, was a KPMG client.

Maybe ya’ll should kick the tires a little more on Citibank’s big comeback.  Citi is the only big money center bank left that is audited by KPMG. Recent testimony before the Financial Crisis Inquiry Commission says their underwriting standards fell apart between 2005-2007.

Chinese property trading down following new policies
by Zhang Jiawei

China's property market has started to cool down after the government introduced new regulation policies, with the country's four first-tier cities of Beijing, Shenzhen, Shanghai and Guangzhou all seeing their property trading volume go down, the Shanghai Securities News reported Tuesday. Property trading volume went down 64 percent last week from a week earlier in Shenzhen, down 45 percent in Beijing, down 38 percent in Shanghai, and down 2 percent in Guangzhou.

In China's 35 main cities where housing market data was monitored by the newspaper, 21 saw their trading volume of commercial housing area go down last week, with the figure in Hangzhou going down 73 percent. The government's new regulation policies have an obvious effect on curbing speculation in cities where property prices are going up too fast, and China's property market will enter a long wait-and-see period as the new policies take effect, an analyst said.

Bill Ackman and The Short Story on MBIA
Legendary hedge fund manager and activist investor Bill Ackman is the subject of a new book about his six-year battle with MBIA, where he warned investors about the coming financial crisis. Christine Richard, author of 'Confidence Game,' talks to CNBC.

California Pension Bomb Ticks Louder
The time-bomb that is public-pension obligations keeps ticking louder and louder. Eventually someone will have to notice. This month, Stanford's Institute for Economic Policy Research released a study suggesting a more than $500 billion unfunded liability for California's three biggest pension funds—Calpers, Calstrs and the University of California Retirement System. The shortfall is about six times the size of this year's California state budget and seven times more than the outstanding voter-approved general obligations bonds.

The pension funds responsible for the time bombs denounced the report. Calstrs CEO Jack Ehnes declared at a board meeting that "most people would give [this study] a letter grade of 'F' for quality" but "since it bears the brand of Stanford, it clearly ripples out there quite a bit." He called its assumptions "faulty," its research "shoddy" and its conclusions "political." Calpers chief Joseph Dear wrote in the San Francisco Chronicle that the study is "fundamentally flawed" because it "uses a controversial method that is out of step with governmental accounting standards."

Those standards bear some scrutiny. The Stanford study uses what's called a "risk-free" 4.14% discount rate, which is tied to 10-year Treasury bonds. The Government Accounting Standards Board requires corporate pensions to use a risk-free rate, but it allows public pension funds to discount pension liabilities at their expected rate of return, which the pension funds determine. Calstrs assumes a rate of return of 8%, Calpers 7.75% and the UC fund 7.5%. But the CEO of the global investment management firm BlackRock Inc., Laurence Fink, says Calpers would be lucky to earn 6% on its portfolio. A 5% return is more realistic.

Last year the accounting board proposed that the public pensions play by the same rules as corporate pensions. But unions for the public employees balked because the changed standard would likely require employees and employers to contribute more to the pensions, especially in times when interest rates are low. For now, it appears the public employee unions will prevail with the status quo accounting method. Using these higher return rates for their pension portfolios, the pension giants calculate a much smaller, but still significant, $55 billion shortfall. Discounting liabilities at these higher rates, however, ignores the probability that actual returns will fall below expected levels and allows pension funds to paper over the magnitude of their problem.

Instead, the Stanford researchers choose to use a risk-free rate to calculate the unfunded liability because financial economics says that the risk of the investment portfolio should match the risk of pension liabilities. But public pensions carry no liability. They're riskless. That's because public employees will receive their defined benefit pensions regardless of the market's performance or the funds' investment returns. Under California law, public pensions are a vested, contractual right. What this means is that taxpayers are on the hook if the economy falters or the pension portfolios don't perform as well as expected.

As David Crane, California Governor Arnold Schwarzenegger's adviser notes, this year's unfunded pension liability is next year's budget cut—or tax hike. This year $5.5 billion was diverted from other programs such as higher education and parks to cover the shortfall in California's retiree pension and health-care benefits. The Governor's office projects that, absent reform, this figure will balloon to over $15 billion in the next 10 years. What to do? The Stanford study suggests that at the least the state needs to contribute to pensions at a steadier rate and not shortchange the funds when markets are booming. It also recommends shifting investments to more fixed-income assets to reduce risks.

But what the public-pension giants find "political" and "controversial" is the study's recommendation to move away from a defined benefits system to a 401(k)-style system for new hires. Public employee unions oppose this because defined benefits plans are usually more lavish, and someone else is on the hook to make up shortfalls. Calpers and Calstrs are decrying the Stanford study because it has revealed exactly who is on the hook for all of this unfunded obligation—California's taxpayers.

Peter Schiff debates Jams Galbraith on US Debt

Studies reveal Americans’ declining living standards and increasing anger
by Hiram Lee

A series of recent studies conducted by the Pew Research Center shed new light on the scope of the economic crisis in the US and the level of hostility the majority of the American population holds for the US government.

Released in March, before the passage of the Obama administration’s health care legislation, a survey entitled "Health Care Reform—Can’t Live With It, or Without It" indicates that 92 percent of Americans give the national economy a negative rating. No fewer than 70 percent of the respondents report having suffered job-related and financial problems in the past year, an increase from 59 percent the year before. Fifty-four percent report someone in their home has been without a job and looking for work in the past year, up from 39 percent in 2009.

The poll saw an aggravation of conditions in every area of economic life studied the year before. Increasing numbers of people are reporting difficulty receiving or affording medical care (26 percent) or paying their rent or mortgage payments (24 percent). More Americans faced problems with collections and credit agencies (21 percent), or had mortgages, loans or credit card applications denied (19 percent).

As could be expected, the poorest Americans are suffering the most. Some 44 percent of those making $30,000 per year or less report difficulty obtaining medical care, compared to 11 percent of those making $75,000 per year or more. A similar gap can be found in the category of rents and mortgages, with 37 percent of those making $30,000 or less reporting difficulty making rent or mortgage payments, compared to 11 percent of those making $75,000 or more. However, the percentage of those facing difficulties paying rent has increased dramatically for both groups since 2009.

Large numbers of workers polled in the study say they have little confidence in job security and prospects for the future, with almost half (49 percent) saying it is "very or somewhat likely" they will suffer "job-related financial stress" in the next year. Twenty-five percent of workers say they expect to be forced to take a pay cut this year, while 24 percent expect to be laid off.

The Pew survey found that 85 percent of Americans reported difficulty finding jobs in their communities. This and other statistics revealing the increasingly dismal employment opportunities facing millions of Americans are provided context in another study released this month by the Pew Economic Policy Group.

"A Year or More: The High Cost of Long-Term Unemployment" reports that no fewer than 44 percent of unemployed Americans met or exceeded the standard measure of long-term unemployment (six months or more) in March 2010. This marks the highest rate for long-term unemployment levels since World War II.

In addition to this, the Pew study reports that "23 percent of the nearly 15 million Americans who are unemployed have been jobless for a year or more." This translates to 3.4 million people, "roughly equivalent," the study points out, "to the population of the state of Connecticut."

These alarming numbers should be considered along with findings in another recent Pew research study entitled "The People and Their Government," released April 18. This report finds that "by almost every conceivable measure Americans are less positive and more critical of government these days."

Only 22 percent of Americans say their government can be trusted, according to the new survey. The report puts this among the lowest measures of trust in the government in half a century.

The study also shows across-the-board declines in approval ratings for numerous federal agencies, including the Department of Education, the Food and Drug Administration, the Social Security Administration, the Environmental Protection Agency, and the Centers for Disease Control and Prevention. Forty-three percent say the government has a negative effect on their daily life, up from 31 percent in 1997.

While approval ratings for the government are remarkably low, with 65 percent saying the federal government and congress have a negative impact "on the way things are going in the country," the approval ratings for other major institutions are as low or lower. Sixty-nine percent of those surveyed say banks and other financial institutions have a negative impact on the way things are going in the country, while 64 percent say "large corporations" have a negative impact. Some 57 percent say the national news media has a negative impact, while 49 percent say labor unions have such an impact.

The report states that "more than six-in-ten (62%) say it is a major problem that government policies unfairly benefit some groups while nearly as many (56%) say that government does not do enough to help average Americans."

Taken as a whole, the Pew studies from March and April offer additional insight into the growing social misery under conditions of the worst economic crisis since the Great Depression, and the outrage it is generating.

Wide layers of the population, who have seen trillions of dollars funneled from the public treasury into the coffers of Wall Street executives while their own living standards have been assaulted, their jobs slashed, their children’s schools closed, and vital social programs such as Medicare cut by billions of dollars, have no faith in the US government to secure their most basic social needs.

The corporate-controlled news media, along with the major institutions overseeing the nation’s educational needs and basic food and medical resources, are considered corrupt and untrustworthy, contributing to the suffering of millions.

President Barack Obama, continuing to pose as a populist man of the people when he finds it necessary or beneficial, stands exposed as the chief representative of the interests of the American ruling elite and the standard bearer in the assault on the working class.

The restructuring of society taking place, in the direct interests of the corporate-financial elite and at the expense of the working population, is not occurring unnoticed. The American and international working class will inevitably find itself drawn into struggle against the present, untenable form of social organization.


graycat said...

Will GS point the finger at other financial firms or will it point to individuals/institutions in Washington? What would happen then with elections less than a year away?

jal said...

Follow the money
by James Hamilton

OK, so where did the loan aggregators get the money with which they bought the mortgages from the loan originators? The GSEs took the majority of loans they purchased and collected them into securitized pools that were sold off to banks, pension funds, mutual funds, state and local governments, and buyers all around the world. What made these attractive to the buyers was the fact that the GSEs guaranteed the securities.

Why are they afraid to say that those young financial wizards stole granma's money.

Bukko Canukko said...

I think after today's hearings, with all the repetition of "shitty deal," that's going to be the latest buzz-phrase to enter the cultural lexicon.

$$$Dollar$$$ said...


Deninnger is almost there. He has gone from not accepting that a near-catastrophic/catastrophic adjustment is going to have to take place, to at least acknowledging the circumstances that would lead to this result. He just needs to get to the phase where he accepts that this event must in fact come to pass. >50% of GDP is going to disappear. Too much debt has already been accrued and much of "GDP" is tied in with that unpayable debt (I.e. >50% of GDP). Every single citizen in the US is looking at a drastic pay-cut, if they can even keep their jobs. So good on KD, he is almost there.

bluebird said...

@$$$Dollar$$$ - I believe Denninger has said it is only a matter of time when it implodes. He's no longer an 'if', but 'when'. And nobody knows when.

Wyote said...

What a superb piece, Ilargi.
The Khuzami Tsunami.

"Trust is the prime concern when push comes to shove."

If Khuzami gets it right, all he may have to do is tip the confidence domino and the GS investment wing is history. And for this to be a real cleaner it must infect JP Morgan, Morgan Stanley, Wells Fargo, Citi and BoA in it's contagion.

Look for the Lloyd to exit soon as per BOD stipulation. He will take enormous wealth with him of course, but will it be safe from the civil courts?

In the end maybe the pension funds and their legal staffs will fork the SOB's. And if it really begins to accelerate it could take the TBTF mammoths to extinction.

Keeping fingers crossed, Wyote

ogardener said...

I watched some of the Senate hearings today. It made me have an Enron deja-vu.

The tiller's broke, it feels like late winter and the fruit trees are flowering early this year.

VK said...

@ Bluebird,

Indeed. It's just one crazy situation, the FED and the US Govt are juggling hundreds of moving parts while on a high wire with electricity running through which is dangling 100 stories up in the air.

And we all fall down. Laah, laah, laah. Singing kumbaya on the way down!

Saw the movie 2012 again today, dang! Those mayans surely had some fancy calendar, imagine how freaked out people are going to be on Dec 20 2012. Ridiculous!

Anyway, the marginal productivity of debt has collapsed, Europe is about to blow with the PIIGS, Major Eurozone countries have a $1.5 Trillion exposure to those countries, not to mention how will Eastern Europe fare?!

The US stock market is fuelled entirely by sham accounting and mark to hopium. Ex-financials earnings have been dismal as they have been mainly based to cost cuts and job cuts. In the meanwhile people genuinely believe that even if China is a bubble, the Chinese govt will be the first Govt EVER to manage the fallout of a bubble in a proper fashion and it will result in not much harm.

Ofcourse timing is key here, so very key but The market can unravel very, very quickly once all those momentum chasing computer algorithms switch from being long to being short. Momo quants be damned!

$$$Dollar$$$ said...

bluebird - He is still taking the line that if we can just remove the fraud from the system all will be well and he can go back to day trading. Sorry, but we are well past that stage. The horses have already left the barn.

$$$Dollar$$$ said...

VK - Are you in the Ilargi camp on China or the Stonleigh camp?

Ilargi said...

" $$$Dollar$$$ said...
VK - Are you in the Ilargi camp on China or the Stonleigh camp?"

There's different ones?

$$$Dollar$$$ said...


You = China is screwed and will implode (paraphrasing).

Stoneleigh = China will have serious troubles but we will see the onset of a "Chinese Century"

Ilargi said...

"You = China is screwed and will implode (paraphrasing).

Stoneleigh = China will have serious troubles but we will see the onset of a "Chinese Century"

That's not different, it's the same thing, or just about.

Once China goes through its implosion (serious troubles), I myself see no reason to look further, or at least describe it, because I think most people are unlikely to comprehend what that Chinese century means, i.e. they will see China playing what the US plays to date: global champions. And that is not what will happen. China will reign its own region, but not have the resources to execute even that in the way we are accustomed to define power. Hence, the Chinese Century will be nothing like the American Century. If that is understood, along with the fact that we're talking at least decades from now, sure, roll with it. Still, I think that it's mostly a mental masturbation exercise, and we have far bigger fish to fry that lurk much closer.


2question said...

Anyone even considering that GS is the sacrificial lamb? We haven't been giving one yet and considering the mess that has happened and is yet too, GS might just fit the bill?

Peter said...

Just heard a piece about Dorothea Lange on NPR this morning-added appreciation to Ilargi's photos-an amazing women.

Bigelow said...

“The pirate acknowledged that they merged their operations with Goldman in late 2008 to take advantage of the more relaxed regulations governing bankers as opposed to pirates, "plus to get our share of the bailout money."”
Somali Pirates Say They Are Subsidiary of Goldman Sachs

Ed_Gorey said...

Hugh Hendry is my hero.

"My difficulty is that I do not sell dreams. I live in the real world."

Dan said...

@ all...

One of the dynamics about these happenings that never ceases to fascinate me is the 4th-dimensional concept of TIME.

My son has pretty intense special needs. He is 7 years old. He has NO concept of time. None. 1 minute, one hour, one week, one year...every experience for him exists simultaneously in all and none of these frames.

I am convinced, and have been for years, that we are witnessing the collapse of human civilization; at least the collapse of civilization as we have come to recognize it.

But time is an odd duck. As an historian, I have, on many occasions, taught high students about the 'rise and fall' of Rome (if you will). We usually spent about a week or two on the Republic, and maybe a week or two on the Empire. 1000 years in a month of study...and that's not including 3-day weekends and snow days. :)

Each of the events that we are witnessing pummels my consciousness. Yesterday's Goldman-'grilling', and the Greek debt debacle were but two in a myriad of moments that, over the past several years, have left me feeling like THIS is the moment! HERE IT COMES!

But then I sit back and take stock of how many of those 'HERE IT COMES!' moments I have experienced, and I settle down and accept the reality that this massive global shift and collapse is going to take decades, nay centuries, to unfold.

I DO believe that we are witnessing the beginning of the end of such institutions as (a) the nation-state, (b) irredeemable fiat currencies (at least in their current iteration), (c) the geo-political hegemony of The West and in particular of the USA, and (d) the ability of the planet to support the needs of the human population....HOWEVER....

I also believe that these tectonic shifts are going to be fairly subtle and difficult to detect...save for the momentary quakes that have rocked civilization for millennia.


Ilargi said...

"2question said...
Anyone even considering that GS is the sacrificial lamb?"

Yeah, but they're not. There's much more to come, and it'll spread like wildfire. But as I said above, it's not the government institutions that will hit the hardest, it's the lawyers. What the SEC has stated is that you can accuse someone of fraud without necessarily understanding the mathematics and hardware that facilitated that fraud. If a court, a judge, a jury, would be receptive to that approach, thereby establishing jurisprudence, neither barndoors nor floodgates are of much use.


Ilargi said...


Nice theory, but that's all it is. It's your personal perception, your getting tired of your own "this is the moment" experiences.

If you were a physicist instead of a historian, you would likely pay more attention to how systems collapse. Very few do so over along time and quietly.

Moreover, when you use the term "collapse" for human societies, you have to make sure of the definition. What percentage of your income, your wealth, would you have to lose before you call it collapse, how many people around you would have to die or go wholly jolly bananas, that sort of question.

If you'd do a survey among people around you, you'd find huge differences in how they reply to these things. You'd also find they will be very reluctant to reflect on any such matters; it's bitterly threatening for the human mind.

I have used the notion of Bulgaria around here a lot in the past, and I think that's a good example: if US and Western European lifestyles would drop to the level of the average Bulgarian, whether today or decades ago, our societies, or at least our economies, will have collapsed. Which is not to see it can't , or won't, get worse. It's all relative. You could use Rwanda as your measuring point, and it would take a bit longer.

But we won't have decades or centuries to get there.The complexities inherent in the systems are such that taking out one vital part can crumble the whole thing. And that takes you back to physics.


paul said...

Re the issue of loss of trust in GS by its clients: I am amazed at the ignorance the general populace has on such issues. People continue to go about business as usual, despite the idea (albeit, unproven as of yet in a court of law) that a financial institution with its tentacles strangling (I mean "wrapped around") nearly every sector of our economy has been working against its own clients. What will it take for people to wake up and realize that our hyper-complex society will undoubtedly soon descend into entropy?!

I do see a collapse as essentially already underway, and am now shedding the notion that there will ever be one catastrophic event or one "a ha" moment, where we all come to understand that things will change and that we might have an opportunity to soften the landing.

I also wonder how others feel about the use of the word "collapse" when spreading this message. I think people are simultaneously threatened and awed by the idea of collapse. It is something reserved for movies like 2012, or the Day after Tomorrow, etc.

Perhaps the "uninitiated" would be more receptive if we were to describe things in terms of progress, transition, and opportunities. I am not advocating spreading some false sense of security or the idea of growth through a green economy. Rather, what if we examined human psychology and found ways to trigger the positive neurochemicals, while presenting a realistic prediction for the future.

I am inspired by such notions; yet, my gut tells me that greed will always win out. We are hard-wired to hoard for the short term. It seems nearly impossible to convince people en masse to prepare for well into the future.

I guess I am just rehashing lots of old conversations on TAE, but something about this post triggered lots of thoughts.

Dan said...

@ Ilargi,

Excellent points.

Collapse is a nebulous term, and needs further clarification.

When I speak of collapse, I mean a systemic shift that, centuries after, historians will look and say, "...that is the era in which the nation-state dissolved, and we saw the birth of the neo-feudal era of social organization...", or some other iteration.

I agree with you that, when 30% of the so-called "working poor" are unemployed in the USA, that collapse of some measure is upon us; that when public school systems are closing 20-40% of their schools and firing thousands of teachers, that collapse of some measure is upon us; that when government---government that is supposed to serve the public purpose---has become so twisted and corrupt vis-a-vis the world of international finance....well, you get my point.

I also agree that my comment about time is in part precipitated by my having experienced too many 'THIS IS IT!!' moments.

Reality persists...and I will continue to prepare.


VK said...

@ $$$

I'm in the camp that says the Chinese Century will be more regional and that too depends...

The problem with China apart from it's major bubble trouble in real estate, CRE and over everything is that it is a very dry country. Chinese arable land is something like 15% of the total surface area and remember we have hit peak phosphates and oil, which were the basis of the 'green revolution'. We mustn't forget soil erosion and depletion of the mineral contents of the soil etc.

The Chinese popn. is ageing rapidly as well while the current male:female popn. ratio is skewed horribly towards men. While I see China having it's own depression. While we may yet see a Chinese century, I can certainly imagine a different scenario where they simply decline.

Picked this up from Wikipedia;

Although China's agricultural output is the largest in the world, only about 15% of its total land area can be cultivated. China's arable land, which represents 10% of the total arable land in the world, supports over 20% of the world's population. Of this approximately 1.4 million square kilometers of arable land, only about 1.2% (116,580 square kilometers) permanently supports crops and 525,800 square kilometers are irrigated.[14] The land is divided into approximately 200 million households, with an average land allocation of just 0.65 hectares (1.6 acres).

China's limited space for farming has been a problem throughout its history, leading to chronic food shortage. While the production efficiency of farmland has grown over time, efforts to expand to the west and the north have held limited success, as such land is generally colder and drier than traditional farmlands to the east. Since the 1950s, farm space has also been pressured by the increasing land needs of industry and cities.

So population decline is a given, so is civil unrest for a long period of time as well as the likelihood of intra-regional competition within China. China has immense problems but they are used to hardship, much more so then the West. That psychological edge might help them survive much better. Only time will tell, otherwise looking 10-20 years out is really speculation at best.

Ilargi said...


It's indeed not an easy matter to discuss, that collapse thing, because everybody feels free to pick their own parameters. Sort of like with inflation: pretty soon 95% of people have no idea what it is anymore, but they keep on talking anyway.

I was reminded of a silly tune by The Firm called Star Trekkin', do watch the video behind the link, which has 5 or 6 endlessly repeated lines of text, one of which is:

"It's life Jim, but not as we know it, not as we know it, not as we know it."

Maybe that's a good definition of collapse.

As for the financial system collapse, all that stands between it and us now is the promise of potential future tax revenue to be paid by our children and grandchildren. Yeah, well, not with U6 at 17.8% they won't.

Every day we're edging further towards the true, deep and underlying sense of Joe Bageant's "Americans live in a hologram".


jal said...

Dan said...
“... Collapse is a nebulous term, and needs further clarification.”

paul said...
“Perhaps the "uninitiated" would be more receptive if we were to describe things in terms of progress, transition, and opportunities. I am not advocating spreading some false sense of security or the idea of growth through a green economy. Rather, what if we examined human psychology and found ways to trigger the positive neurochemicals, while presenting a realistic prediction for the future.”

I Agree! I stopped using “Collapse”.
I use the term “RESET”.
I advocate living within your income.
Forget about your credit score. If you need to know your credit score, then you are living beyond your means.

People who are giving 20% of their take home pay to the credit card companies by paying only their minimum balances will never be free.
In our area, all the school boards are facing multi million dollar shortfalls and are scrambling to find ways to cut budgets, (proposed expenses). One noteworthy item on the radio, this morning, was that the parents of special need kids, were in tears because THEIR school boards actually cut into the support that would be given to their kids.
My reaction was, “I wonder what happens to special need kids in Africa or other countries that do not have the financial means of giving any financial support. What will Greece be doing in the coming months?”
“... ways to trigger the positive neurochemicals”
You would have to suppress the the inbuilt instinct which I refer to as “Minimizing energy output to be able to obtain you basic energy requirements”.
Other people might refer to this instinct as the cause of GREED.

Starcade, now from Siren said...

$$$Dollar$$$: I've almost seen them (some of Karl's posters) admitting what I know the conservatives have believed (and wanted) for a long time: a significant die-off (maybe not quite to the NWO levels, but a good portion of the US population -- I've heard one basically admit that, not only would we have to go back about two generations in the standard of living, but only about 70-75% of the US population could be around to enjoy it...).

And it's for the reason you state. If anyone is to believe that 70% of the US GDP was consumer spending, then it MUST be concluded that a catastrophic, die-off-forcing event is taking place. Because, then, that same 70% was _abjectly dependent_ on the continued house-as-ATM rollover of mortgages and everything around them (including and especially the quadrillion dollars in derivatives).

We would be looking at, at the VERY LEAST, a 30% contraction in GDP, and, at that point, you can't support 305 million legals. (Much less the illegals.)

Your lives are not yours.

Starcade, now from Siren said...

Wyote: Look for there to be no US Dollar anymore if that contagion happens.

I'm not saying that those banks must survive, but the fact is that those banks dying forces a Jubilee, a sovereign default, and a new currency (much like what is about to happen in Greece).

Starcade, now from Siren said...

I'm in the Stoneleigh camp.

I firmly believe that the Beijing Olympics were the announcement of the new Chinese Century.

That there will be problems is conceded: For there to be a Chinese Century, there can be no United States.

Ilargi said...

" Starcade, now from Siren said...
I'm in the Stoneleigh camp."

That might prove to be a bit of a problem, because there is no such camp. We say the exact same thing in this.

The Chinese will bash each other's heads in for a while, once enough of them figure out "progress has halted", and the countryside they are sent back to is too polluted to survive on any longer. And then however many are left will rule the region. Who else? Vietnam? Cambodia? Not exactly a brain buster.


Stoneleigh said...

I don't see a stoneleigh camp and and Ilargi camp on this either. We agree that China will see the end of its bubble, and the consequences thereof, which will be severe and will last for decades. I think we will see a Chinese century, but not for a long time. I am prepared to look further out than Ilargi, but our basic view of the near term is very much the same.

Being very water limited, and therefore agriculturally limited, China is going to have to look beyond its own shores for lebensraum (living space). If you recognize the German word, you will understand what I am referring to here. Empires in the ascendancy always do this. China has begun with the economic colonization of Africa, but it won't stop there.

The Chinese Century can only be a pale shadow of the American Century, as it will be so energy constrained in comparison. It could easily be regional rather than globally hegemonic, as global hegemonic power is the 'gift' of the fossil fuel era. That would still make it the most significant power of the time though - perhaps comparable to ancient Rome, which is no small feat, historically speaking.

2question said...

On China:

Among the many difficulties china faces on the road to a 'Chinese Century' their population is going to be a big one.

In order to be an 'empire' or to have a century the country must be able to support a large middle class to educate, incorporate etc. and most importantly tax. This takes vast resources and wealth depending on how populous a country is. I'm not sure china has the means nor resources to support that large of a middle class.

An empire will generally use the cheap or slave labor of a foreign land and import the wealth and goods back home. China is a source that labor now. They would need to exploit the whole world in order to bring enough wealth back home to support the infrastructure it would need.

Empires don't use their own slave labor. They may conquer lands and use those resources and people, but that is not their core people.

Look what the US has needed from the world just to support it's people and infrastructure. China would need another earth to fulfill this.

One answer to this could be a break up china (doesn't matter how or see below). A much smaller country within china maybe able to exploit the rest of the people/land, use it's resources and be a much bigger global power. See the 1940's Japan model.

Having a multi-million man army is empowering, threatening and dangerous. If you can't feed that army, they are going to find someone to fight. And I don't see them traveling any great distance to find that fight.

Stoneleigh said...


The Chinese population will indeed be a big problem. I do not see any way forward that lets them all survive, even if they spread out to the far corners of the globe. As you say, I can imagine a smaller core 'China' becoming the political centre on some scale. China in its current form is too large and diverse I think. The coastal cities are really the centre.

The gender ratio is so tilted that very significant consequences will result IMO. Large numbers of excess young males with nothing better to do than cause trouble have been a danger signal in many places before. Europe sent its younger sons (who could not inherit without breaking up the ancestral estates) off to the middle east in the crusades, so they could cause trouble somewhere else. China may do the same.

Ed_Gorey said...

@ Ilargi,

Do you think European banks will be forced to accept a haircut on their Greek bonds? Is it politically possible to sell a Greek and peripheral Euro nation (Spain, Portugal, Ireland etc.) bailout that is 100% financed by German and other Euro-nation citizens?

$$$Dollar$$$ said...

So where will this leave the United States? A regional power in its own right? A weakened global power? A fractured Republic of newly independent states? I am aware of your red/green zone analogy but I want to go beyond it.

Ilargi said...

"$$$Dollar$$$ said...
I am aware of your red/green zone analogy but I want to go beyond it."

No idea what it means, but good luck with that, and see you on the other side.


$$$Dollar$$$ said...

Ilargi - Instead of being rude, why not ask what I mean? Seriously, not a good way to get sponsorship. At any rate, I was referring to Stoneleigh's comments about areas of tight government control and areas "beyond the pale". I wanted more flesh on the bone from Stoneleigh. Instead you had to come with your response.

Stoneleigh said...


If China becomes a hegemonic power down the line, the US would be very much diminished. I think it quite likely that the US could go the way that Spain did after its imperial phase - inward-looking and fascist theocratic. That was the era of the Inquisition, which is a really frightening prospect.

As an old centre becomes decadent and collapses in on itself, power is inherited by its former near-periphery (see the primer Entropy and Empire).

Bigelow said...

Since we are postulating China scenarios how about replicating Britain’s experience with United States ascendancy? So what about USA as China’s errand boy?

VK said...

@ Stoneleigh


As an old centre becomes decadent and collapses in on itself, power is inherited by its former near-periphery

You mean Apple Inc. is going to take over the world?! All hail Steve Jobs! iBow before our iOverlord. All hail our dear iLeader.


BTW, did anyone see the Barca Inter game, Mourinho's men kicked some Spanish a$$!!

Bukko Canukko said...

China managed to build itself a good empire in a lower-energy environment a millennium ago with Genghis Khan and the Mongol hordes. As I recall from the history books, the Mongols were but a small, vigourous part of the overall Chinese population. Not a development model for modern times, of course.

But if it was done by those inventive Chinese one time (they DID invent so much in bygone days, like gunpowder and movable type; it's just that Western cultures developed the Chinese inventions better) perhaps they will invent a new way to have a low-energy, widespread empire. I reckon they could use money like Genghis used mounted horsemen. If the creditmoney system holds together in some form, China could use its built-up financial power to buy the water/food/other concessions it wants.

It's doing that in Africa and Australia (see the ore trade) already. Who's to say China won't do that with Siberian water resources or whatever else is necessary? That's why the Chinese government has a strong interest in propping up the current monetary system (and NOT precipitously dumping the U.S. dollar.) The money is like an army, as long as it's not short-circuited by globo-financial collapse. If that happens, they'd have to get out the real army, which will be more essential for keeping the citizenry in check if/when living conditions for the masses start going downhill.

I'd wager that the Chinese PTB are already calculating ways to use their money on the rest of the world the way they use their military on Tibet. And no doubt the U.S./Russian/European PTB are calculating ways to cooperate or counter. Wouldn't you love to be a bug in the walls of where those tanks are thinking?

thethirdcoast said...

Speaking of sports, congrats to les Habitants for exposing the Washington Capitals as regular season frauds who piled up points feasting on an utterly putrid division of hockey clubs.

ric2 said...

VK -

The only pub in Waikiki that has Champions League games is showing this one in about 4 hours. My brother and I are planning on watching. Even though I know the outcome, it sounds like a great defensive game. (I love watching tenacious D.)


jal said...

Hi Bukko Canukko!

I see that you did a small variation on you handle.

Your expressions of the future for China are inline with what I think.

You could add ... the stock piling of natural resources, of semi finished, of raw material and overcapacity of of infrastructures is what a doomstead would be doing.

Smart move for the upcoming chaos. Getting prepared for the long haul.

pasttense said...

Note this comment by John Michael Greer today:
"Goldman Sachs, to begin with, has been in the business of making complex problems more complex for a very long time. One of the chapters of John Kenneth Galbraith’s excellent The Great Crash 1929, a book which ought to be required reading for all those people who think they understand the stock market, is titled “In Goldman, Sachs We Trust”; it’s an account of the preposterous investment vehicles – it does violence to the English language to call them “securities” – that Goldman Sachs floated in the 1929 stock market bubble. Very little has changed since then, either. In 1929, Goldman Sachs sold shares of investment trusts that speculated in shares of other investment trusts; in 2009, they sold tranches of CDOs composed of tranches of other CDOs, and in both cases they served mostly as a means by which a lot of people lost a lot of money while Goldman Sachs did quite well."

So it is hard to see how GS's behavior will have any consequences for it.

Mugabe said...

Adjacent headlines on CNBC:

# Greek Default Impact 'Incalculable': ECB's Weber
# Cramer on Europe: Prepare for ‘Outright Defaults’

Of course, Cramer's idea of preparing is to limber up your clicking fingers to buy the dips. After a brief spit-take, the US market seems unconcerned.

It reminds me of the summer of '08 when all the officials were assuring that Fan & Fred were fine, no danger etc. Europe is running a desperate bluff right now, hoping that by funding Greece they can inspire the bond market to keep funding Spain, Italy, Portugal, etc. They have those other broke countries borrowing money on their own tabs to lend to Greece, which seems like a plan designed by the Marx Brothers.

If the bond market backs away in fear, the game is up, because Europe does not have the cash to bail out five other countries in the same manner as Greece. Except by QE (ECB buys all the bonds with printed euros).

Ilargi's original theory was: Germany was cleverly using the Greece fiasco to drive the euro down. So far, so good. But now it looks like Germany is not really in control, and never was; and soon they will face a stark choice between massive chain-reaction defaults or massive euro printing. What will they choose?

Ilargi said...

"Ilargi's original theory was: Germany was cleverly using the Greece fiasco to drive the euro down. So far, so good. But now it looks like Germany is not really in control, and never was;[..]"

The stories of Germany flip-flopping were there all along, and still are now. Nothing changed, and the Euro isn't nearly down enough in German eyes. It's a dangerous game, for sure, and the fact that it's played is a solid reminder of the importance of export markets in today's global economy. What you rake in through sales, you don't have to borrow.

Ed_Gorey said...

@ Ilargi,

I'm curious about your argument regarding Germany and it's desire to weaken the Euro at the expense of risking a bond default contagion in peripheral Europe.

Here are some very rough back of the envelope numbers that I've been thinking about.

2009 German Exports were about 850 billion euros.

If the Euro weakens to parity with the dollar, then perhaps exports would increase by about 200 to 300 billion euros.

Under these conditions, to contain the bond default contagion among the PIIGS, Germany would need to offer roughly 200 to 300 billion euros in loan guarantees to temporarily stabilize peripheral Europe.

So, on the plus side, Germany increases exports by 200-300 billion euros. This increase represents cash in hand that avoids some level of tax increases or revenue cuts. On the negative side, Germany needs to offer $200 to $300 billion in loan guarantees. These loan guarantees don't require cash up front and the defaults on the loans would be postponed for a few years. All in all, Germany makes a net gain on the deal.

William T said...

Interesting to hear that the Wall street lobbyists were being given the cold shoulder by congress as it debates the financial reform bill.

That could be the real benefit of this action. What politician wants to be seen to be consorting with those banksters now a few months before the election? Was it planned like that? Or a lucky side effect?

Ilargi said...


The WTO 2009 estimate for German exports is $1.21 trillion, roughly a -quite significant- third more than your number.


Greenpa said...

Bukko Canukko said...

"China managed to build itself a good empire in a lower-energy environment a millennium ago with Genghis Khan and the Mongol hordes. "

I think there's a very high chance most Chinese would be appalled to hear anyone call Genghis Khan "Chinese". The Mongols conquered China, yes; and later Mongol rulers were absorbed by Chinese culture; but Genghis himself was far from it.

I'm having a vaguely related conversation over on Causubon's Book at the moment;


Some are claiming my distinctions are merely semantic, while I maintain they are substantive.

When ethnic Han Chinese persons have ruled China, it has very rarely been expansionist - maybe never? I'm not sure there.

These kinds of uncertainties are part of what makes China-watching so fascinating. :-)

Ruben said...


It is like the ice was sprinkled with pixie dust--everything seemed to go Montreal's way. That was an amazing third period.

@bukko, I had several times wondered at your absence, and then you came back as canukko. Good to see you again.

scandia said...

I spent yesterday at a hospital with my critically ill older sister. Couldn't help noting the care that may not be available in the future, noting the machines/products dependent on oil,
noting with extreme gratitude that she is in a Cdn hospital. Without the social safety net my entire family would be bankrupted in providing her care.

When the BP oil spill occured last week I wondered if it was a significant spill. Sure appears now that it is a major one, perhaps the largest ever. So depressing....I'm wondering how much carbon will enter the atmosphere as they burn the oil?

jal said...

RE.: Germany and it's desire to weaken the Euro

Ilargi said...
“... Euro isn't nearly down enough in German eyes. It's a dangerous game, for sure, and the fact that it's played is a solid reminder of the importance of export markets in today's global economy. What you rake in through sales, you don't have to borrow. ...”
In order to be able to determine the winners, it would be necessary to look at the new cost of IMPORTS from outside of the euro zone vs. the gains from exports outside of the euro zone.
scandia said...
... as they burn the oil? ...”

My latest news is that they have given up on that option.
I sure that the oil companies will find that skimming oil off the surface of the ocean cost more than what they can get from the market.
Its going to get done ... who will pay for the cost?

(best wishes to you and family)

Ed_Gorey said...


My German export number is quoted in euros not dollars.

Ilargi said...


My German export number is quoted in euros not dollars."

I'm looking for a pice of rope as we speak.

Dontonson said...

When do the actual numbers come out for Federal and State Governments income tax collections for 2009? I would think that the revenue is going to be much lower than projected even with the knowledge of the increased unemployment numbers. Many Americans are making little or no income but do not show up on the unemployment statistics. I was wondering if you or anyone you know has looked into this issue.

Stoneleigh said...


Europe is running a desperate bluff right now, hoping that by funding Greece they can inspire the bond market to keep funding Spain, Italy, Portugal, etc.

I agree. Once the haircuts begin, the sovereign debt risk genie will be out of the bottle. We are very likely IMO to see the next phase of the decline marked by many such haircuts. The speculators, like any good predator, will pick on the sickest members of the herd of nations first. Once they have the taste of metaphorical blood, they won't give up though. There are many countries on the verge of exploding debt scenarios and we could see a bloodbath of debt default.

If the bond market backs away in fear, the game is up, because Europe does not have the cash to bail out five other countries in the same manner as Greece. Except by QE (ECB buys all the bonds with printed euros).

Agreed again. The bond market will call the bluff at some point. These bailouts are not going to work. Attempts at QE will only spook the bond market even faster.

But now it looks like Germany is not really in control, and never was; and soon they will face a stark choice between massive chain-reaction defaults or massive euro printing. What will they choose?

I don't think any country ever has control in a floating exchange rate fiat system. They can attempt to influence exchange rates, but they are massively out-gunned by the bond market when push comes to shove.

The chain reaction of defaults in inevitable IMO. Euro printing would just spike interest rates and push many more countries over the edge. The wave of defaults would then follow anyway.

Bukko Canukko said...

Thanks for the good wishes, Reuben and JAL. I've been around, working hard on stuff like changing bandages on the grotesque leg wounds of drug-addicted denizens of Vancouver's Downtown Eastside. When the crunch comes, those will be the first people to go, because they're already on the edge.

I'm still reading the blog, but it's hard to keep up with all the news, to say nothing of the comments. I notice the number of those have fallen off as the atmosphere of crisis subsides. Although the underlying economic, energy and environmental rot has not subsided -- it's just scabbed over, like that festering ulcer on a junkie's shin while they stay in the hospital on IV antibiotics. But eventually, they go AWOL from the restrictive discipline of the ward so they can get another fix, and a few weeks later they're oozing again. Like the financial system, eh?

Stoneleigh said...


Welcome back from me too :)

I followed your suggestion and used a mic for some of my talks (although the accoustics of most venues are better than those of the pub we chatted in in Vancouver anyway).

People are indeed far more complacent now than they were. Humans are either complacent or panicked, with little in between. We might as well enjoy our present lull. We aren't going to enjoy what comes next.

Stoneleigh said...


I second the recommendation of both JK Galbraith's book on the 1929 crash and JM Greer's comment. That kind of behaviour is very much characteristic of a manic expansion. That is the only time people are prepared to suspend disbelief to a great enough extent to swallow that kind of preposterous 'investment'. In manic time people not only swallow it, they demand to be given the opportunity to do so. In doing so they are demanding to become the empty bag holders. 'Twas ever thus.

scandia said...

@Bukko Canukko...re the decline in comments I recall Stoneleigh saying more than a year ago that when the mood goes extreme that the crisis is over the support for the bear/contrarian view evaporates. Seems like that is what is happening just before the next storm.
I am shocked I tell you that the market response is to GO UP!

@el G...hope all is well with you? Noticing your silence. Are you taking a break from the financial news? I know I need one from time to time to restore a balance in my living- have some pleasurable experiences instead of a diet of gloom and doom. Of course if you aren't logging on you won't read this message :)

Rumor said...

Worth reiterating:

"The Canadian Bankers Association are deeply opposed to meddling with [the Canadian] pension system which they say is working just fine. Which is understandable, albeit self-serving, given their dominance of the high fee mutual fund industry and the significant profits earned on spreads between low interest GICs and bank lending.

...They go on to say that, if governments sponsor any new pension plans along the lines suggested by three provincial pension inquiries,” it must be made clear that the government is not providing any guarantees with respect to portfolio balances, rate of return or income stream.”

That is deeply hypocritical, given recent federal government backstops for the banks themselves.
Under the Extraordinary Financing Framework introduced to deal with the global financial crisis, the federal government offered to swap rock solid government bonds for up to $125 Billion of bank held mortgages, and the Bank of Canada allowed the banks to borrow dollar for dollar against risky, hard to sell assets. It is inconceivable that any Canadian government would ever let a major bank fail.

I guess the message is that it is okay for the government to backstop the banks, but not the pension savings of working Canadians."

velobabe said...

that picture is the 1926 version of tiger woods' Cadillac Escalade wreck.

Rototillerman said...

I consider myself an old-time commenter, and although I have been following along faithfully I have found little to disagree with, or even comment on, recently regarding our collective predicament. It's been interesting to watch the sentiment of "OMG, we ARE fcuked!" seep in from the periphery (loony web sites, don't we love 'em) to the establishment (Willem Buiter, I'm looking at you here). It's hard not to conclude that at some point soon the herd will indeed turn, and stampede for the exits. Wish I were in a little better position to sit back with popcorn and watch the fireworks, but it is what it is. In the mean time, there are seeds to plant, ditches to dig, squirrels to catch, and a day job to hold down (barely, I might add).

I still have not seen anyone post a broad dissemination of Stoneleigh's presentation. I thought that there was going to be one coming out of Vancouver? Reuben, is that you? Stoneleigh, can I post the audio we recorded in Portland?


Ric said...

Hi Dan,
Each of the events that we are witnessing pummels my consciousness. Yesterday's Goldman-'grilling', and the Greek debt debacle were but two in a myriad of moments that, over the past several years, have left me feeling like THIS is the moment! HERE IT COMES!

When the moment of collapse comes for individuals, it comes in a microsecond--maybe with death, maybe the recognition nothing is left, when a dream is over--a little like the first moment when you realize the love of your life is interested in someone else. Social awareness of collapse happens in a phase change for a paritcular group, but it happens in a microsecond. Bloomberg today talks about 99 weeks of unemployment will probably be a political limit--this suggests a social phase change approaching.

The point is, collapse divides your life into BEFORE/AFTER. Strangely, the next day the sun rises on a different world and people get up and look for something to eat. I've gone through two collapses where absolutely everything was lost. Some die. Some go insane. Some give up. Some start exploring a new world. The odd thing about collapse is that something always follows--it's a continuum. If death is an absolute end, it's just another day. If death is an absolute end, my wife is right that I'm full of s**t. ;-)

Ilargi said...

New post up.

Pandora's box of toxics


Frédéric said...

This one is just too good to pass:


The question is: how long can they keep it going? Indefinitely I guess...