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Archive for April 17th, 2010

Janet Tavakoli:  Did Goldman Sachs Commit Fraud?

Highlights:

Yes. The only thing that was surprising how long the SEC took to do it.

The complaint does not go quite far enough. It was a blatant fraud, more than just a failure to disclose information.

And this may be the beginning of a lot of questions about a lot of investment banks. It has massive implications IF the SEC does its job right, which they have not done in the past.>

Tavakoli Structured Finance

Numerous Derivative Swap Deals Blow Sky High In Europe

Lost in the turbulence of a market focused on fraud charges against Goldman Sachs (see Rant of the Day: No Ethics, No Fiduciary Responsibility, No Separation of Duty; Complete Ethics Overhaul Needed), there are some interesting derivatives blowups in Europe to consider, similar in nature to swaps that blew up Jefferson County, Alabama.

Please consider Saint-Etienne Swaps Explode as Financial Weapons Ambush Europe

The worst global financial crisis in 70 years arrived in Saint-Etienne this month, as embedded financial obligations began to blow up.

A bill came due for 1.18 million euros ($1.61 million) owed to Deutsche Bank AG under a contract that initially saved the French city money. The 800-year-old town refused to pay, dodging for now one of 10 derivatives so speculative no bank will buy them back, said Cedric Grail, the municipal finance director. They would cost about 100 million euros to cancel today, he said.

Saint-Etienne is one of thousands of public authorities across Europe that tried to shave borrowing expenses by accepting derivatives deals whose risks they couldn’t measure. They may be liable for billions of euros, according to the Bank of Italy and consulting and law firms in France and Germany. As global economies climb out of recession, the crisis is hitting Saint-Etienne in central France, Pforzheim in western Germany and Apulia, an Italian regional government on the Adriatic. They may pay for their bets into the next generation.

From the Mediterranean Sea to the Pacific coast of the U.S., governments, public agencies and nonprofit institutions have lost billions of dollars because of transactions officials didn’t grasp. Harvard University in Cambridge, Massachusetts, agreed last year to pay more than $900 million to terminate swaps that assumed interest rates would rise.

Under the interest-rate swap deals popular with European municipalities, a bank would agree to cover a locality’s fixed debt payment and the government or agency would pay a variable rate gambling its costs would be lower — and taking on the risk that they could be many times higher.

Use of swaps in Europe soared in the late 1990s and early 2000s because banks pitched them as the easiest way to reduce costs on fixed-rate loans, according to Patrice Chatard, general manager of Finance Active, which helps more than 1,000 localities across Western Europe manage their debt.

The financial institutions that sold the derivatives were many of the same ones that received government bailouts to weather the worst global credit crisis since the 1930s.

“These municipal swaps are the same thing as Greece,” said Fruchard, a former banker at Credit Lyonnais, now a unit of Credit Agricole SA, who designed swaps in the early 1990s. “It’s all trying to dress up your accounts.”

Germany, Italy, Poland and Belgium also used derivatives to manage fiscal deficits, Walter Radermacher, the head of Eurostat told EU lawmakers in Brussels yesterday without being specific.

Municipalities are having to rewrite their budgets. Saint-Etienne raised taxes twice, slashed by three-fourths a plan to renovate a museum commemorating the region’s extinct coal mining industry and sparked the cancellation of a tram line. Pforzheim, on the edge of the Black Forest in Germany, is scrimping on roads, schools and building renovations.

The town followed the advice of Deutsche Bank in taking out bets on interest rates in 2004 and 2005, according to Susanne Weishaar, Pforzheim’s budget director until March.

For cities like Saint-Etienne, the risks from buying swaps were out of proportion to the potential savings.

“This isn’t traditional asset management,” Fruchard said in reference to swaps based on currency moves in general. “It’s speculative, like a hedge fund. And it’s done in bad faith. An elected official who takes the benefit from the guaranteed low rates without understanding what happens after his mandate ends is acting in bad faith.”

Accounting rules in Europe help keep derivatives deals hidden. Most local governments have no obligation to set aside cash against potential losses, and reflect only current-year cash flows in balance sheets.

“It’s only transparency that will make elected officials scared to invest in dangerous products,” said Jean-Christophe Boyer, deputy mayor of Laval, in western France, which has swaps covering about 25 percent of its total debt of 86 million euros. “Even if we banned them today, the impact is coming now, tomorrow and 10 years from now,” he said, because of the number of derivatives contracts still in force.

For more on how swaps recommended by JPMorgan destroyed Jefferson County, please see Jefferson County Alabama Considering Bankruptcy.

This is a huge story with many participants, and one of longest articles I have ever seen on Bloomberg. It’s well worth a closer look.

Also take another look at the actions required by two of the many cities mentioned.

Saint-Etienne raised taxes twice, slashed by three-fourths a plan to renovate a museum and sparked the cancellation of a tram line. Pforzheim, on the edge of the Black Forest in Germany, is scrimping on roads, schools and building renovations.

Those who think derivative blowups will be inflationary need to think again.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

Rant of the Day: No Ethics, No Fiduciary Responsibility, No Separation of Duty; Complete Ethics Overhaul Needed

Goldman Sachs Shares Drop After Goldman Sachs Accused of Fraud in Mortgage Deals

Goldman Sachs, which emerged relatively unscathed from the financial crisis, was accused of securities fraud in a civil suit filed Friday by the Securities and Exchange Commission, which claims the bank created and sold a mortgage investment that was secretly devised to fail.

The move marks the first time that regulators have taken action against a Wall Street deal that helped investors capitalize on the collapse of the housing market. Goldman itself profited by betting against the very mortgage investments that it sold to its customers.

The suit also named Fabrice Tourre, a vice president at Goldman who helped create and sell the investment.

The instrument in the S.E.C. case, called Abacus 2007-AC1, was one of 25 deals that Goldman created so the bank and select clients could bet against the housing market. As the Abacus deals plunged in value, Goldman and certain hedge funds made money on their negative bets, while the Goldman clients who bought the $10.9 billion in investments lost billions of dollars.

“The product was new and complex, but the deception and conflicts are old and simple,” Robert Khuzami, the director of the S.E.C.’s division of enforcement, said in a statement. “Goldman wrongly permitted a client that was betting against the mortgage market to heavily influence which mortgage securities to include in an investment portfolio, while telling other investors that the securities were selected by an independent, objective third party.”

In recent months, Goldman has repeatedly defended its actions in the mortgage market, including its own bets against it. “We certainly did not know the future of the residential housing market in the first half of 2007 anymore than we can predict the future of markets today,” Goldman wrote. “We also did not know whether the value of the instruments we sold would increase or decrease.”

No One “Knows” Anything

While Goldman can claim it did not “know” anything, the statement rings as hollow as saying we do not “know” if the sun will come up tomorrow.

Goldman is nothing more than a giant hedge fund that front runs trades and bets against advice it gives clients, with one important exception. Goldman is a bank holding company deemed “too big to fail” with the explicit backing of the Fed.

There is no fiduciary responsibility in any of the large corporations in my opinion.

I gave an example a while back where fund managers at two large broker dealers told me they do not collect fees if client positions are in cash.

Thus, whether or not those managers I spoke with thought that being invested was the correct thing to do, there was intense pressure to invest client money not only from the manager holding cash, but also from upper management at these firms.

That my friends is the origin of “you can’t time the market, so be 100% in 100% of the time, for the long haul.” Over the long haul, Wall Street wants you all in all the time so it can collect fees.

Worse yet, clients are steered to speculative products because those are the ones that make the broker dealers the most money.

Corruption, Greed, Lack of Ethics

The corruption, greed, and lack of ethics in the industry is appalling. I still want to know Where is The Indictment of Ex-CEO Dick Fuld? over fraudulent action Lehman made.

Here is a list of some of the things the SEC has ignored.

March 2, 2010: Geithner’s Illegal Money-Laundering Scheme Exposed; Harry Markopolos Says “Don’t Trust Your Government”

January 31, 2010: 77 Fraud, Money Laundering, Insider Trading, and Tax Evasion Investigations Underway Regarding TARP

January 28, 2010: Secret Deals Involving No One; AIG Coverup Conspiracy Unravels

January 26, 2010: Questions Geithner Cannot Escape

January 07, 2010: Time To Indict Geithner For Securities Fraud

October 20, 2009: Bernanke Guilty of Coercion and Market Manipulation

July 17, 2009: Paulson Admits Coercion; Where are the Indictments?

June 26, 2009: Bernanke Suffers From Selective Memory Loss; Paulson Calls Bank of America “Turd in the Punchbowl”

April 24, 2009: Let the Criminal Indictments Begin: Paulson, Bernanke, Lewis

Where is the Fiduciary Responsibility?

I am tired of ethics (or lack thereof) that allows front running and betting against clients whether legal or not. I am tired of corporations talking about “walls” between their proprietary trading units and their investment groups. In practice the walls are invisible, if they exist at all.

Moreover, I am tired of accounting rules that allow hundreds of billions of dollars of assets to be held off balance sheets (Citigroup had $1 trillion in off balance sheet assets at one point), and I am tired of mark-to-fantasy pricing (Goldman has more level 3 assets than anyone else).

In client relationships, the first and most important thing is to never do or advise a client in any way that is not in their best interest. Instead, we have ethics that allow (even encourage), making profits at client expense.

Don’t expect anything to come from this SEC investigation. If there is a fine it will be with a nudge and a wink and trivial to the amount of money Goldman Sachs clients lost.

Complete Ethics Overhaul Needed

We need a complete ethics overhaul but we will not see it until people are thrown into prison and corporations have to choose which business they want to be in as opposed to the current state of affairs where anything for a profit is acceptable.

• Firms give advice based on how much profit the firms will make on it
• Firms trade their own books to the detriment of clients
• Firms make upgrades and downgrades after they take positions themselves
• Firms front-run trades
• Firms engage in dark pools
• Firms deemed too big to fail take advantage by upping leverage
• Firms like Goldman Sachs (which is nothing more than a giant hedge fund with no ethics) have access to Fed funds at low interest rates to do whatever the hell they please

Sadly, this business screws the client for a fee time and time again because there is no ethics, no sense of fiduciary responsibility, and no walls on separation of duty to prevent fraud.

Some misguided souls will blame the free market for this.

Nothing could be further from the truth. One of the legitimate roles of government is to protect property rights, prevent fraud, and level the playing field so that everyone has an equal chance and equal protection under the law.

Instead, we have rules, procedures, and taxpayer bailouts specifically designed to make sure the playing field is not level. This is not a free-market concept and desperately needs to change.

Mike “Mish” Shedlock
http://globaleconomicanalysis.blogspot.com
Click Here To Scroll Thru My Recent Post List

The Great American Bank Heist – On the Day we Reach a Monthly Foreclosure Filing Record Banks Announce Record Profits and the Stock Market is up 80 Percent.

Posted by mybudget360

It is rather fitting that on the day we hear about banks reaching record profits once again, because after all it is so difficult to borrow at zero percent and gamble in the stock market and make a gain, that we also find out that March was the highest month of foreclosure filings ever (and we’ve had some bad months).  If there was ever a more clear indication between the split from Main Street and Wall Street this is probably the strongest indicator so far.  I’ll include the charts below but being blunt about the situation, the bailouts worked.  If we define “worked” as boosting banking profits once again while 40,000,000 Americans are on food stamps and 17 percent remain underemployed then all is well again in the economy.  Yet this isn’t what the American people bargained for in the bailouts.  In fact, they didn’t want the bailouts if you remember the massive anger from both aisles calling their representatives.  But the cronies didn’t listen since they receive millions in lobbying dollars and $13 trillion went to Wall Street in the biggest wealth transfer witnessed by the disgruntled American public.

It should be obvious the real economy is still a mess.  The latest foreclosure data is merely a reflection of failed government programs but more importantly, the absolute greed and robbery committed by Wall Street:

Just look at that chart.  We’ve had an 80 percent stock market rally in one year and today, we are at the peak of foreclosure filings.  That is, Americans getting kicked out of their homes because they are unable to pay their mortgages.  So much for banks using that money to help people stay in their homes and keeping the credit markets open as they preached.  JP Morgan announced stunning profits for the first quarter.  How did they make their money?

“(Yahoo!) NEW YORK – JPMorgan Chase & Co. reported a $3.3 billion first-quarter profit on big gains in the financial markets even as the Obama administration pressed for limits on banks’ trading of risky but lucrative investments.”

$3.3 billion is fantastic.  But how did they make that money?

“Investment banking, especially bond trading, generated the bulk of JPMorgan’s profits. The bank said that division earned $2.5 billion, up 50 percent from a year earlier.”

So their gambling division made up the bulk of their profits.  How are they helping out consumers with those billions in taxpayer dollars?

“JPMorgan said it lost $1.3 billion on its real estate portfolios, slightly more than the $1.1 billion it lost the previous year. Signaling that it expects further credit weakness, the bank set aside $3.3 billion for real estate loan losses, up from $3.1 billion a year earlier.

The bank’s losses in its credit card business fell to $303 million, while provision for future credit card losses also dropped to $3.5 billion.”

The formula is simple for these banks.  Use the taxpayer money to enrich their elite class under the guise of helping average Americans.  They have robbed the American people and much of this was all legal.  Yet we all know that there is something royally flawed in the financial system since it is the legislature that develops the laws and many are bought by the Wall Street crowd.  So this 80 percent stock market rally if we dissect it is being propelled by banks gambling:

Source:  Bloomberg

Notice how non-financials (i.e., the real economy) is only seeing a slight uptick in profits?  This probably has to do with 15 million unemployed Americans and another 9 million working part-time looking for full-time work.  But given there are 6 workers for every 1 job opening, things will be slow going.  Unless you are the corrupt banking sector.  In that case, you can borrow at zero percent and buy Treasuries, foreign currencies, stocks, or whatever it is and make money hand over fist while the real economy remains in the trough.  Why would you expect anything to be different?  We have yet to have one single piece of serious legislation hit the table for financial reform.  These banks are back to their same antics.

So what should be done?  Break the banks up.  Commercial banking should become more boring and what it once was, the lubricant to get the real economy going.  Right now it is merely a vampire sucking the blood out of the productive sectors.  Investment banking will be pushed to the edges and if banks want to gamble their own money then that is fine.  But right now they are gambling taxpayer money trying to get back to even while shifting all the toxic credit out of their books.  Privatize gains and socialize losses.  With a system like that, is it any wonder the banks are back to record profits?

And you have to ask yourself how is it that banks while pushing a record number of foreclosure filings are back to record gains?  It is actually very simple.  They can shift the crap to taxpayers as they have through the FDIC, HAMP, suspension of mark to market, and other absurd gimmicks.  Then, they can use taxpayer money primarily funded through the Federal Reserve and U.S. Treasury and then gamble on the stock market.  But don’t be surprised when the market falls through again.  And why wouldn’t it?  The real economy isn’t really improving.  For $13 trillion we sure got bunk but add up the Wall Street market cap and profits and you can see what occurred.

It is a simple formula to understand.  And with no rules being changed, things are back to normal for the banks.  Too bad the other 95 percent of Americans are still dealing with the repercussions of the actual economy.

Weekend Corruption Roundup

Posted by Karl Denninger

2. Empowered to elect or designate.3. Authorized to make or amend a constitution: a constituent assembly.

2. A resident of a district or member of a group represented by an elected official.3. One that authorizes another to act as a representative; a client.

Regulation is supposed to be an adversarial process.  The OTS’ – and indeed every other government agency – has we the people as constituents!

But there is hope.  Specifically, as I wrote about Wednesday, Senator Lincoln has filed a bill in The Senate that would actually stop essentially all of the derivatives abuse.

If you recall I have said for three years that all derivatives must be forced onto an exchange so as to stop the games and BS.  This is necessary to both bring margin and open interest transparency.  Well, guess what – this bill does that.

It also absolutely bars any federal backstop of any sort, including access to the Fed’s discount window or FDIC insurance, for any entity that trades, writes, or holds swaps.

You can bet there will be much push-back on this account.  But let’s be straight here – these swaps are poisonous, just as are the synthetic CDOs that Goldman is now accused of fraudulently peddling.

Goldman, by the way, while a convenient whipping boy, is not alone.  The real problem is with these so-called “complex securities” that are in fact nothing more than a gambling contract designed and constructed in such a fashion as to make proper due diligence impossible.  Some of these synthetics had literally 100,000 pages of referenced documentation related to them – how can anyone reasonably expect to read and understand that sort of paperwork?

Further, as I have written previously, these “Synthetics” are an inherently abusive construct in the first instance.  They come into existence only because someone believes that the reference security or securities in question will decline in value to the point that a “credit event” will occur.  In addition, under the claims made by the “intermediaries” the buyer of these synthetics is not entitled to know who the real party at interest is on the other side of the transaction.

This claim comes from the general view in the options and futures market.  If I buy a PUT contract (betting that a stock will decline in price) I do not know who sold me that contract; ditto for futures (e.g. if I am long or short corn or oil, for example.) 

But in these cases the security in question does not come into existence only because someone wanted to place a bet on the destruction of the underlying collateral. 

In the case of these “synthetics” this in fact is very likely the case!

When a company goes public or issues a bond, thereby creating a security, the real party at interest and their intentions are known to everyone.  When GE issues a bond for 10 years, as an example, we all know that the real party at interest is General Electric and they intend to use the money to fund their operations.  You, as a buyer of that security at original issue, know that GE intends to pay and are acquiring to the capital for their operations.

Likewise, when a company issues an IPO, at original issue the securities are issued into the market (and sold to market participants) for the purpose of general working capital to further the enterprise.

Note that in both cases the real party at interest, and what their interest is, has been identified to the buyer of those securities.

We should not tolerate anything less for these so-called “synthetics”!

There is a huge difference between the secondary trading of a security once issued and its creation.  Knowing who sold me the 5,000 shares of IBM I bought is not material to the transaction – we simply have a difference of opinion on the future of the company.  I think the stock will be worth more tomorrow, the seller thinks it will be worth less.  That’s all.

But when a security is created the real parties at interest and their economic position – that is, who they are and their motivation in getting involved in the transaction – is not only material to the transaction it is part of the essence of the transaction!

Hiding such information thus must always be prohibited as the only reason to hide such information is to commit a fraud upon the buyer or seller on the other side.

The reason the banks don’t like such rules is that if the real party at interest (in this case alleged to be the John Paulson hedge fund) and the essential purpose of the creation of the synthetic CDO (to place a bet on the detonation of the reference securities) were disclosed nobody would have bought it.

If that’s not the definition of fraud I don’t know what is.  Let’s review – for there to be a fraud the following elements must occur (this is a condensation of the “nine points” in the legal definitions):

• A party must make a representation that is false (intentional omission is often good enough, in some contexts) and know that they’re doing so (if you are truly and not intentionally ignorant, you didn’t commit a fraud) with the specific intent of inducing the other party to rely on what has been said.
• That representation has to be material to the transaction – that is, if the other party knew about it, they would have not engaged in the transaction on the original terms (or at all).
• The person relying on the representation has to be ignorant of the falsehood (if I lie to you about some element of a transaction and you know I’m lying at the time, then you can’t later use the false claim.  That is, you must actually rely on the false statement.)
• The person relying on the representation has to have the right to do so.  In the case of a security this is simple – the offering documents are considered “inherently part of and material to the transaction.”
• Finally, you have to be victimized (that is, suffer an economic loss) as a consequence.  It is not enough that someone lied – that lie has to cost you something of value (in this case, money.)

These sorts of synthetics are not at all similar to a “PUT”, a “CALL” or a futures contract – or, for that matter, a naked CDS!  In all such cases the real intent of the person buying or selling is clear. 

If I offer a short position in the S&P 500 futures, identifying me with specificity isn’t material – but the fact that I by doing so believe that the S&P 500 will decline in price is.

But with these synthetics what was not known was who led to the creation?  Was Goldman Sachs, for example, creating the Abacus deals because they believed that the reference material would perform, or did they create them because someone wanted to bet against them – that is, they believed they would not perform?

We always know this when someone goes on a roadshow to sell an IPO or (real, not synthetic) bond deal.  It is inherent in the capital structure being created – the seller has a real economic interest in success.  Indeed, if they do not – if they IPO a company they know has no material value simply to loot the public I’ve committed securities fraud.  In doing so I will have met all of the definitions above, in that I will have made (false) representations about my expectation for success, when I had no such expectation.

But when it comes to synthetic CDOs this is not clear.  The entity at who’s behest the security was created may be on either side – that is, they may either hold the opinion that the reference securities will perform or that they will default.  Unlike “real” (non-synthetic) CDOs, bond and stock offerings, one cannot infer the intent of the creator, and yet this is THE most material fact in the entire transaction – what the fundamental, underlying belief was of the entity that caused the security to come into existence!

In the 1990s investment banks brought literally hundreds of IPOs to market in which they had no reasonable expectation of business success, relying on the “brand integrity” – that is, the “good name” of the particular book-runners and offering managers, to get people to buy. Millions of investors bought predicated on ridiculous and outrageously-inflated expectations, all based on the imprimatur of these “investment banks”, and ultimately lost everything.  These scams were uncovered during the .COM blowup when it came to light that the investment banks knew they were pumping garbage securities – emails and other communications came to light where the bankers were calling particular companies they were representing “trash”, “vomit” and other similar adjectives.

Yet very few went to prison.

That refusal to prosecute after the 2000 crash - a uniquely government failing – was in large part responsible for why we got into trouble this time.  The bubble in housing and the markets, both stock and credit generally could not have inflated without these very same bankers creating all this “liquidity” by creating and selling securities that were once again, in many cases, described as “vomit” – in private.

If the SEC action taken yesterday remains a solely civil one, then we will not fix a damn thing.  Fines will be paid and chuckles will ensue around the boardroom table.

These acts demand, as they did in 2000, criminal investigation and prosecution, including where appropriate charging the company, not just specific actors within the firm.  Such charges should, if proved, result in the effective dissolution of the firms involved via the revocation of banking and securities licenses.

We cannot have a fair and free market economy, most particularly in the securities realm, unless those who invest and trade have good cause to believe they’re not being swindled.  This confidence has been lost, and the blatant and outrageous refusal to clamp down after the debacle in 2000 was directly responsible for the depths of the latest collapse.

Ironically, it is also related to the huge stock market rally, as was demonstrated yesterday.  When Goldman Sachs has their stock decline by $23.00, a 13% drop in one day, as a consequence of being potentially tagged for unlawful behavior in a civil venue, it tells you that much of the rise that has occurred in these firms’ stock prices happened because investors believe that their conduct would not be exposed and stopped.

That’s the sort of “market” that one has in a Banana Republic, not a nation governed by the rule of law.