Current Commentary

Friday, April 30, 2010

Goldman fraud case explained in 50 words

Question #1: Did Goldman represent to the long party Abacus was assembled by an independent, uninterested 3^rd party?

Question #2: Did Paulson have influence or control over the assembly of Abacus?

Question #3: Did Goldman know the answers to 1 and 2 at the time it sold Abacus?

Yes to 1 + 2 = civil fraud

Yes to 1 + 2 + 3 = criminal fraud

Thursday, April 29, 2010

Financial derivatives must be banned

There is a huge difference between agricultural/commodities derivatives, which serve a legitimate purpose, and financial derivatives, which should be outright banned as they were from 1907-1999.

Almost every argument about derivatives mentions the benefits of the agricultural/commodities/currency type: A farmer bringing grain to market who wants to guarantee a delivery price. A manufacturer buying components across multiple currencies who wants to lock in an exchange rate. Airlines that want to be able to sell tickets in advance based on a specific price of jet fuel. All of these serve legitimate purposes. All also have one thing in common: one party to the "bet" has a bona fide vested interest in the asset being bet on.

A financial derivative, on the other hand, is a financial instrument whose value is determined by the value of another financial instrument, often times with neither party having any actual ownership in the underlying, determining financial instrument. The natural question that comes to mind is "why not directly buy ownership in the underlying/determining instrument?" The purported reason is such buys increase price discovery and allow investors to fine tune their risk exposure, thereby improving the efficiency of capital markets, thus improving how capital is allocated throughout the real economy.

The truth is that financial derivatives were a primary, proximate cause of the meltdown we just witnessed. Financial derivatives as we know them are an invention of the last 10 years having been effectively banned from 1907 to 1999. Is anything being done to undo the recent laws that created this? No, and we are kidding ourselves to think that they can be regulated.

Two guys bet against each other over the outcome of football game: illegal.

Two investment bankers bet against each other over the outcome of a pool of loans: perfectly legal.

We built the transcontinental railroad, the interstate highway system, the national telecom network, the electrical grid, cured multiple diseases, and sent a man to the moon all without the widespread use of financial derivatives. Within less than 10 years of their widespread use, the entire system nearly imploded, and all we got to show for it were some new homes that we'll be disputing the ownership of for some time.

Tuesday, April 27, 2010

Financial reform must-haves not now on the table

You can pin the entire debacle of the last couple of years on two very bad pieces of legislation at the start of the decade -- both of which had HUGE bi-partisan support (thus the reason neither party can point the finger without implicating themselves) that rested on top of failure to apply common sense anti-trust law and a corrupt ratings system that gave AAA ratings to bundled garbage made possible by the SEC that brought you Bernie Madoff.  The following are 5 ideas that must be included in any financial reform serious about preventing a Bailout Nation Part Deux:

The list:

1. Restore Glass-Steagall (undo Gramm-Leach-Bliley from 1999).
2. Outlaw credit default swaps (undo the Commodity Futures Modernization Act of 2000).
3. Reform the ratings agencies so they are paid by the purchasers of securities, not the issuers.
4. Reform the SEC that turned the ratings agencies into a government sponsored oligopoly with a 1973 rule change, and increased permissible leverage from 15:1 to 30-40:1 with a 2004 rule change.
5. Enforce existing antitrust law from 1994 prohibiting any one bank from owning more than 10% of the nation's deposits. Banks routinely are either exempted from this or exploit loopholes.

The list explained:

FIRST:  Even the Volker Rule in its purest form stops short of outright prohibiting FDIC insured depositories from engaging in securitization, and the watered down version places limits only on investment banking activity.  A little history is in order:  FDIC and Glass-Steagall's firebreak between commercial banking and investment banking were created in unison, to work together.  You can't have FDIC insurance without the break, or you are subsidizing risk, and if you subsidize something, you get more of it.  Securitized loans perform worse than portfolioed loans. This should come as no surprise because the belief that you are "spreading" risk, or more appropriately unloading risk, degrades underwriting scrutiny.  The 1968 bystander apathy experiment is a good explanation of the psychology behind it: essentially, you feel only fractionally responsible for the outcome.  

SECOND: Credit Default Swaps (CDS's) are legalized, institutional gambling that is specifically exempted from state and federal gaming laws. CDS's were were illegal for the 93 years leading up to the Commodities Futures Modernization Act of 2000.  Trying to regulate them or trade them on an exchange is laughable.  It is akin to saying bankers can bet on sports as long as it is transparent.  CDS's were instrumental in gaming the ratings agencies into AAA ratings and adding fuel to the fire of shirked risk responsibility from securitization.  CDS's allowed MIT physicists and Harvard MBA's to mathematically engineer theoretically risk free investments built atop 580 credit scores with no equity and stretched income.

THIRD:  As it is now, the ratings agencies' pay structure is a huge conflict of interest.  They are paid by the companies who design and issue the securities getting rated.  Naturally, the investment banks issuing these securities shop for the highest rating. And as the AAA ratings on bundled 580 credit scores with no equity and stretched income attest, the agencies were recklessly eager to earn their business. Prohibit payment by the issuer so that the PURCHASER of securities pays for the rating.  That will change the motivation from shopping for the loosest rater into shopping for the most realistic.

FOURTH: With a 1973 rule change, the SEC turned the 5 ratings agencies existing at the time (since consolidated into 3) into a government-sponsored oligopoly.  Moody's, Fitch and S&P enjoy average profit margins of 50%; you don't find that in a competitive market place.  The 1973 rule change required broker-dealers who dealt in securities to get those securities rated or face a higher reserve requirement.  The caveat was that it had to be a rating from a "qualified" ratings agency and then went on to anoint 5 lucky companies the government-sponsored oligopoly status.  Open up the ratings agencies to real competition paid for by the PURCHASER of securities.  Those tasked with keeping the state teachers' pension fund safe and solvent will find the good agencies.  I cannot over-emphasize how important the bogus AAA ratings were.  Most wealth on this planet is governed by covenants prohibiting the investment in any security less than AAA. Without the AAA ratings on these mortgage-backed securities and all the various financial derivatives and CDS's layered over them, there simply would not have been enough money involved to make this a "bring the world to its knees" event.  Front page news for a while, yes. Financial Armageddon, no.

FIFTH: Just about every major bank in the US (and every one of the big 4) is either exempted from or exploits loopholes through a 1994 anti-trust law prohibiting any one bank from holding more than 10% of the nation's deposits.  There has been some too-big-to-fail talk addressing capping deposit size as a percent of GDP, but there's no need to re-invent the wheel when we already have a good law on the books -- a law that is being flagrantly ignored (albeit silently and without public awareness). Limiting the size to 10% of total deposits ends too-bit-to-fail. 

The framework of what is currently on the table is a public placebo to give politicians the ability to run for re-election as being "tough on Wall Street" while substantially leaving intact the casino rules created over the last decade.

Thursday, April 22, 2010

GM loan repayment:
Mischaracterization at best, lie at worst

GM received $52 billion from the US government in bailout money but has paid back only $6.7 billion. How then is this being reported as "repayment in full 5 years ahead of schedule"? Answer: Only $6.7 billion was technically considered to be a loan. The rest of it was the government buying GM stock when it was falling like a rock and no one else would buy it. The government's decision to ignore contract law and blowout the bondholders that GM owed money to also helped.

The new GM would have to IPO at a market cap greater than presently profitable Ford in order for the government to no longer be a majority shareholder, a highly unlikely scenario within the foreseeable future.

Reporting this as repayment in full without explaining these crucial details is mischaracterization at best and a bold-faced lie at worst.

For COMMENTS, CLICK HERE.

Friday, April 2, 2010

5 years to fix unemployment,
even under best possible scenario

Today's news:  The US economy created 162,000 jobs in the month of March, the most in 3 years.

Now for the sobering news:

1.  Every month an average of 100,000 new people enter the workforce. This means the economy must create 100,000 new jobs every month just to break even or to hold the unemployment rate steady.
2.  Of the remaining 62,000 jobs created last month that actually did go to reducing unemployment, 48,000 of them were temporary census jobs.
3.  The greatest average number of jobs the US has ever created for a sustained period was only 242,000/month during the Clinton years. This period represents the strongest post-war growth ever, even accounting for population changes.
4.  Even if the US started growing at that rate right now (a BIG and doubtful if), it would take almost 5 years to bring the unemployment rate back down to where it was before the recession started.

States must repeal and unwind small business regulations. (For example, did you know that in Maryland you can go to jail for cutting someone's hair without a cosmetology license, or that the reason the ice cream man never has soft serve is because it comes with an additional level of regulation?) Also, the Feds must reform and exempt small employers from having to comply with the cumbersome employer-contributed payroll tax system if we have any hope of real recovery before the later years of this decade.