Regulation

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7
Jun 10

The Responsibility Index

Wall Street seems to manufacture measurement indices at the speed of light. Why not a “Responsibility Index” to track bad behavior?  Having one would force bad behavior into the spotlight, something that has been sadly lacking.

How to Be Responsibly Irresponsible

Unfortunately, irresponsible financial and business behavior is everywhere.  Moreover, offenders in search of exoneration have learned to “spin” their irresponsible actions.   Here is a short tour through a world of irresponsibility:

-          The Oracle of Omaha, Warren Buffet, testified before the Financial Crisis Inquiry Commission.  Buffet followed in a long line of CEOs such as Charles Prince who feigned ignorance about the housing crisis.   Buffet defended Moody’s lavish granting of AAA ratings to virtually all housing related bonds.

In Moody’s defense, Mr. Buffet pointed out that nearly all Americans were caught up in the housing bubble and very few market participants predicted a nationwide crash in housing prices. In addition, Mr. Buffet stated that he personally did not realize the extent of the bubble before it broke. See Was Buffet too easy on Moody’s in FCIC Testimony?.

Paraphrased another way, if no one could see the train wreck coming then no one was responsible.

-          The Deepwater Horizon oil disaster is a veritable case study on shirking responsibility.

a.  First we have the President informing the public that this is entirely BP’s responsibility.

b.  Then we have Ben Stein, a financial commentator and Yale Law School graduate, standing corporate law on its head with the following:

Look, I’m a stockholder of BP through mutual funds. You are, I’m sure, too. I’m sure most of your viewers are in their retirement fund. Why should we be punished? Why shouldn’t it be people who actually were there on the watch and made the mistake be put in prison if they did it criminally negligently? See CNN Transcript

When you buy stock in a corporation, you vote for the board of directors and as an equity holder you risk losing your entire investment.  The fact that BP stock is held in pension funds does not exonerate shareholders from financial responsibility.

c.  Finally,  in an interview with the Financial Times of London, Tony Hayward confessed that BP was ill-prepared for the disaster:

BP did not have all the equipment needed to stop the leak from its Macondo well in the Gulf of Mexico in the aftermath of the explosion on an oil rig six weeks ago, the UK company’s chief executive admitted.

Speaking to the Financial Times in Houston as engineers worked on their latest bid to trap the escaping oil, Hayward said BP was looking for new ways to manage “low-probability, high-impact” risks such as existed on the the Deepwater Horizon oil rig.

“What is undoubtedly true is that we did not have the tools you would want in your tool-kit,” Mr. Hayward said.  He accepted it was “an entirely fair criticism” to say the company had not been fully prepared for a deep-water oil leak. See BP CEO: We Were Unprepared for the Disaster

Thus, if you are BP, you should not be responsible for drilling in 5,000 feet of water through 13,000 feet of rock because a blow out is a low probability event?

-          We can draw an analogy in hometown America.  The New York Times highlighted the Pemberton family who have not paid their mortgage for two years.  However, with the extra money available, the Pembertons have funded their family business, gone out to dinners, fueled their air boat and visited casinos.  Their justification is emblematic of the age we live in:

Any moral qualms are overshadowed by a conviction that the  banks created the crisis by snookering homeowners with loans  that got them in over their heads.  See Owners Stop Paying Mortgages, and Stop Fretting.

The Pembertons therefore consider all the banks to be “crooks,” but not themselves for breaking their bank mortgage contract.

Personal Responsibility

We live in an age of moral relativity where we shirk responsibility as easily as we change shirts. Let’s summarize the shirking of responsibility:

-          Mr. Buffet and Moody’s are not responsible since no one could see the collapse in house prices.   Didn’t John Paulson and Goldman make billions in shorting the housing market?

-          Ben Stein does not want the BP shareholders to be punished.  Didn’t shareholders accept this risk when they purchased BP shares?  What if BP committed antitrust violations? Would Mr. Stein have the same opinion?

-          We should excuse BP since the spill was a low probability event? Haven’t spills occurred in Mexican and Australian off shore sites?  A $200 billion company did not have the proper tools in their “tool-kit”?

-          It is alright to default on a mortgage and live in a house rent free.   Didn’t the Pembertons sign a contract promising to repay all the monies they borrowed?  Is this behavior fair to their neighbors who diligently make their mortgage payments?

The Animal House Defense

In the classic comedy film Animal House, Otter, the fraternity president, argues against college expulsion on the following grounds:

But you can’t hold a whole fraternity responsible for the behavior of a few, sick twisted individuals. For if you do, then shouldn’t we blame the whole fraternity system? And if the whole fraternity system is guilty, then isn’t this an indictment of our educational institutions in general? I put it to you, Greg – isn’t this an indictment of our entire American society?  See Animal House Memorable Quotes.

We are perilously close to the Animal House defense that if we are all responsible, then no one is responsible.  We need to bring back individual responsibility and none too soon.  Otherwise,  seriously irresponsible people will be shorting the Responsibility Index.

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25
May 10

Less Leadership Than Meets the Eye

A ritual occurs yearly in major corporations:   the annual setting of management objectives.   This task has evolved to a high art form, with the goal being an objective that looks difficult to attain, but really isn’t.  A successful executive needs to master this skill to attain status among his peers, impress his superior, and thus earn a generous bonus.  To excel at this process the exec must:

1. Privately identify an objective that everyone else has missed.

2.  Keep that objective his little secret.

3.  Complete the objective singlehandedly.  Avoid teamwork; it gets in the way and diffuses credit.

4.  Trumpet the accomplishment to superiors just before bonuses are determined.

Excellent rewards then flow from this “extraordinary achievement.”   Said more colloquially, “Set the barn on fire surreptitiously, but be the guy who has the fire trucks strategically stationed just outside the barn.  Extinguish the fire.  And make sure you’re standing next to the grateful farmer.”

David Leonhardt, financial columnist for the New York Times, lauds the Obama Administration for its bold financial and health care reforms and economic stimulus legislation:

With the Senate’s passage of financial regulation, Congress and the White House have completed sixteen months of frenetic activity that rivals any other since the New Deal in scope or ambition. Like the Reagan Revolution or Lyndon Johnson’s Great Society, this new period of activity seems to be a paradigm shift in how Washington operates. See A Progressive Agenda to Remake Washington

These efforts are not beneficial to the country and appear like the objective setting exercise by our hypothetical executive.  My cynical suspicion is that in a world of sound bites, the Administration has created a formulaic check list of “reforms” to position the Democrats for the 2010 Congressional and 2012 Presidential elections. We have not “remade” anything.

Financial Reform

Since the final bill is not yet law, we can examine only its proposed parts.  The $5 trillion sink holes of Fannie Mae and Freddie Mac remain unchanged.    Instead of breaking up banks that deserve to disappear, the bill institutionalizes them as “too big to fail.”  Fair pricing remains elusive, as derivatives are not yet moved to the exchanges.  Leverage caps have not been reinstated, so the investment banks can leverage at ratios of 30 to 1 or greater.  The bill does not reinstate mark to market accounting. The Federal Reserve has ducked vigorous audit.   Rating agencies remain largely uncontrolled.

As the markets react to excessive debt in Europe, the collapse of the Euro and the possibility of sovereign debt default, it looks like the President has taken credit for “winning the past war,” instead of addressing the financial problems facing the country now.

Health Care Reform

The Administration has promised universal coverage but at what price?   Premiums for younger people will rise 17%, 4 million individuals will be subject to the $1000 penalty for not purchasing coverage, and small employers will incur at least $1000 of additional costs for employees.  Importantly, 15% of hospitals may be forced to close.  Where will doctors come from to staff this financially squeezed sector of the economy? See Obama’s Health Care Promises Already Busted

Deepwater Horizon Oil Spill

The oil rig explosion and spill occurred on April 20.  The President did not fly to the site until May 2.  This is ironic, as Obama campaigned against the Bush Administration’s lethargic response to Hurricane Katrina’s devastating impact on New Orleans and the Gulf region. The original estimate of a 5000 barrel per day spill is now believed by scientists to be 10 times as great.  BP and the government are blaming each other for misinformation about the original estimates, and we now have a bipartisan commission to examine it all.  What we do not have is expeditious candor from the beginning of this tragedy:  about its size, its scope, the ways to remedy it, what role the government will play and its potential effect on the Gulf and the Atlantic.  The Administration seems intent on avoiding responsibility and shifting any solution to BP.

Checking the Boxes

Robert Reich, former Clinton Labor Department Secretary, is scathingly critical of the timidity and lack of resolve in restructuring the finance and health care industries. He maintains that monster “regulatory” bills with huge loopholes favor these industries rather than reform them.  Worse, he predicts that these loopholes will result in later payoffs to those who benefited from them.  His damning conclusion:

So why has Obama consistently chosen regulation over restructuring? Because restructuring Wall Street or health care would surely elicit firestorms from these industries. Both are politically powerful, and Obama does not want to take them on directly. [emphasis in original article]

“A regulatory approach allows for more bargaining, not only in the legislative process but also, over time, in the rule-making process as legislation is put into effect. It’s always possible to placate an industry with a carefully-chosen loophole or vague legislative language that will allow the industry to continue as before.

And that’s precisely the problem.” See Robert Reich:  Why the Finance Bill Won’t Do Anything

Where is the Leadership?

There is an old saying that managers do things right, but leaders do the right thing.   The Obama Administration is checking all the correct political boxes: health care, financial reform, economic stimulus and crisis management.   Maybe they are doing things right politically, but I am not sure they are doing the right thing for the country.

Sudden crises like the Euro mishap and the Deepwater Horizon have a way of recurring and demanding true leadership.    What Obama may not realize is that the American public is skeptical and can see through his merely expedient responses to all these crises.  And if that is true, the recent primaries and special elections raise questions on the political longevity of this Administration.

Triumphant Rose Garden speeches will just not make up for lack of leadership.

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16
May 10

Surfing the Financial Crisis

I’ve been watching the financial crisis since it began in 2007.  Every so often it is good to step back and consider some of the anomalies. Thus, some disconnected thoughts:

-          The time between crises gets shorter.  It was seven years from the dot.com to the sub-prime crash.  It has taken us only one year from TARP and other alphabet soup US-based federal bailout programs to the European Commission trillion dollar bailout.  With the Euro plunging after the bailout, how long will it be to the next crisis?

-          If everything is really improving why have short-term US interest rates not risen? I am amazed that for over 2-years of regular Treasury auctions, 3 month bill rates have ranged between .1 – .2%.  Why does the Federal Reserve keep stating in its guidance that it intends to keep rates at zero for an extended period of time?

-          Why would anyone invest in the US equity markets?  The most active stocks each day are severely troubled, probably insolvent companies:  Citicorp, Fannie Mae, AIG, and Bank of America. More than sixty percent of every day’s volume is non-human, computerized, automated trading.  And what is worse, computers doing this trading are shaving cents off each transaction to the detriment of institutions and retail investors.   No one believes in long term investment value any more. Respected analysts believe the market is severely overvalued and should probably trade at the 850 S&P level.

-          How do Goldman Sachs and JP Morgan have perfect trading performance, that is, making money every day of the first quarter?  Karl Denninger has calculated the odds of achieving this feat at one in many trillions.  Have the SEC and other government regulators taken an extended holiday during the financial crisis? It sure seems that way.

-           The 1987 version of the SEC portrayed in the movie Wall Street was able to detect illegal activity in the fictional Blue Star Airlines and arrest the hapless Bud Fox.  Mary Schapiro and the current SEC staff can’t seem to find water with two hands if they fell out of a rowboat in the middle of the Atlantic.

-          Why do things keep getting more complicated and less clear? Yes, we live in a complex world.  But I have a deep suspicion that complexity is being used as a subterfuge to mask true intent.  Why do we need multi-thousand page financial and health reform legislation, customized credit default swap instruments and impenetrable corporate proxy statements? The answer: complexity is designed to disguise the essence of each issue.

-           Why is the Federal Reserve afraid of a full-fledged audit?   As taxpayers, we are the ultimate financiers for the various government bailout programs. What happened to sunshine as the best disinfectant in public matters?  This is an economic, not a national security matter. Or in the minds of the government, has everything become a national security matter, even the Fed’s purchase of the Red Roof Inn?

-          Why is Senator Chris Dodd, himself compromised with a Countrywide below market loan, allowed to lead financial reform?

-          With a Justice Department of 100,000 employees, why haven’t we indicted a major financial institution?

We live in dangerous times.  Perhaps some of our leaders should be thinking about some of these questions and issues.

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13
May 10

Lack of Skepticism and Imagination Can Be Harmful to Your Financial Health

Ron Geffner, a lawyer and hedge fund expert, was a recent guest on Bloomberg’s Hays Advantage.  He commented that one of the causes of the financial crisis was that investors were lulled into a false sense of security.  (See A False Sense of Security).  My corollary observation is the striking lack of investor imagination, skepticism or integrated thinking.

We have become a task focused society.  Much of the work in large corporations is task- or project-based.  Common business phrases reinforce this short sighted focus on immediate outcomes: “singular focus,” “eyes on the prize,” “mission critical” “pedal to the metal” and “full court press.”  These idioms reveal a true but unspoken agenda:  put blinders on and accomplish the task at hand.  Thus, in the interest of efficiency and rapid results, do not prioritize the long term, which takes much more imagination and thoughtfulness.  Let’s look at how a lack of imagination can be harmful not only to our personal net worth, but also to any notion of greater or societal good.

What Were They Thinking?

Group think can be a tourniquet around one’s mind, or if you will, intellectual tunnel vision.  Focused on outcome, we brush aside unintended or negative consequences, or worse we don’t even consider them. Let’s look at some of the group think that ushered in the current state of economic distress:

Exotic Securities – Without understanding what they were buying, why were investors involved with collateralized debt obligations, interest rate swaps, auction rate securities and other exotica?  Why were brokers and bankers selling these securities when even they did not understand them?  See e.g., Fabulous Fab’s s emails.

Counterparty Risk – When making a large bet, one wants to make sure the bookie can make good on the bet.  In the financial world, investors did not consider that counter parties (the bookie in the analogy) could be a bankrupt Northern Rock, Bear Stearns or Lehman.

Credit Agencies –When banks paid credit rating agencies and often worked with them to improve ratings, why were investors surprised that those ratings (AAA no less) were in fact false?  Today, NY Attorney General, Andrew Cuomo opened an investigation of bank fraud in obtaining ratings. Prosecutors Ask if 8 Banks Duped Rating Agencies.

Housing – When agencies pay mortgage brokers on the basis of dollar volume, why are we surprised that those brokers colluded with homeowners to qualify the unqualified?  When we created exotic mortgages such as interest only, no documentation loans, and option ARMs is it surprising that homeowners default in droves?  Why didn’t investors, brokers or homeowners ever question the prevailing assumption spouted by leading bankers and public figures that house prices always increase?

The FIRE Economy and Outsourced Jobs – Why did leading economists not question the viability of an economy based heavily on Finance, Insurance, and Real Estate?   Our economy has always been at its most prosperous based on strong domestic production of goods and services.  As we were outsourcing jobs and freezing wages for workers why did no economist raise the question of why a recession would not result from the decline in good paying US jobs?

Katrina and the Regulatory Environment – Katrina was a wakeup call that the laissez faire Bush Administration could lead to disastrous consequences.  Why did investment analysts, Congress and the media not question the ineffectiveness of key government regulators such as the Securities and Exchange Commission, Federal Deposit Insurance Corporation, the Federal Reserve and others?   Failure to enforce the laws and regulations on the books has had disastrous consequences for investors.

Private Equity – Corporations such as Chrysler and GMAC were deeply flawed before their failures.   Why did we not question how a private equity firm could improve on existing managements?

Programmed Trading – Why are we not surprised when 25 year olds put in charge of computer trading programs that trade against other computer programs can crash the market 1000 Dow points in several minutes?

Sovereign Debt – Why are we surprised that we now question the creditworthiness of nations such as Portugal, Ireland, Italy, and Greece, Spain and even the UK and US, when governments respond to the financial crisis by absorbing the private debt problems of the banks?

Human Nature

It is human nature to dislike hearing bad news.  Sometimes it takes a little imagination to conjure up negative consequences.  Maybe it is my legal training, but I tend to look at my downside risk before I look at the upside.  The public should have been a lot less trusting in some very flawed institutions: banks, brokers, mutual funds, traders, real estate agents, the SEC, the Federal Reserve and others.  Unfortunately, one consequence of an uncritical financial media is that presenting a cavalcade of financial “experts” without harsh questioning only reinforces misplaced trust and zero imagination.

We need to encourage some imagination and a whole lot of skepticism before we reach the other side of the Great Financial Crisis and try to stay there.

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25
Mar 10

Living in the Land of Pretend

I rarely have the radio on in the middle of the day. But yesterday on the Bloomberg Radio Hays Advantage, Kathleen’s guest was David M. Jones Sr.  Dr. Jones is a professional economist and consultant and the principal in DMJ Advisors. He holds a Masters and a PhD (presumably in economics) from the esteemed University of Pennsylvania.  He was speaking with Ms. Hays on the subject of financial reform and the role of the Federal Reserve.

Departures from Reality

Dr. Jones argued for the centrality of the Fed as chief financial regulator since they had garnered enormous expertise in banking practices in the current crisis. That is a pretty remarkable statement, as the Fed purportedly had a major bank regulatory role BEFORE the crisis. When events exploded, the Fed was clearly part of the problem.  They in fact had condoned shoddy lending practices and therefore contributed to the consequences we face now. (As examples, the Bear Stearns-J.P Morgan forced merger, the Lehman and AIG insolvencies).  On this issue, I guess we should all be glad if the Fed at least has learned that lesson.  But have they? Dr. Jones then lauded the government for the 2009 “stress tests” of the nineteen major banks.  These tests have purportedly restored confidence in our financial system.  Jones maintains that these “rigorous” tests demonstrate the reaffirmed solvency of the banks.

Stress Tests and Public Relations

Dr. Jones is wrong because the stress tests were not valid, but in fact were a public relations stunt.  Independent economists and bloggers such as Michael Shedlock, Karl Denninger and Martin Weiss felt the tests were at best deceptive and at worst fraudulent.  Instead of demonstrating the financial worthiness of the banks, the terms of the “stress tests” exposed fundamental weaknesses in these banks’ financial health.  Let’s look at some of the criteria, assumptions and methodologies the government utilized to assess solvency.

-          Worst case scenario too optimistic – The government assumed that at worst losses would not exceed $950b by the end of 2010. Projected bank losses far exceeded that worst case. The IMF projects a range of loss of 2.4 – $4.1 trillion; Karl Denninger projects residential mortgage losses at 2.5 trillion, and Nouriel Roubini’s loss estimates are in excess of $1.8 trillion.

-          The “Take Home Test” – Using two alternative macroeconomic scenarios, the government required the banks to estimate their potential losses on loans, securities and trading positions, as well as pre-provision net revenue and the resources available from the allowance for loan and lease losses.  Karl Denninger in The Scam of the “Stress Test” commented:

They asked the banks, they did not send in a team of examiners to look at the books independently.  So the base data that was ingested into this process in fact came from the banks themselves, not from independent, outside examination.  As a consequence it is fair to ask where the valuations came from and how they are supported, including the models and other information used to develop these figures.

This data is not disclosed.

Second, some of the data points and “expected losses” are comical.  For example, the banks are expected under the “more adverse” situation to believe that prime mortgage losses will not exceed 4%, and ALT-A (liar loans and Option ARMs) will not exceed 13%.  HELOC loss (most of which is unsecured!) is expected not to exceed 11%.

-          Bank Permission to Massage and Change Results – Some banks did not like the results, so they lobbied for methodology and outcome changes.  Karl Denninger again reports:

Some major banks managed to wrest concessions from the government in closed-door negotiations over their “stress tests” that helped them put the best face on their results, financial analysts, industry officials and sources said.

So in essence the entities being examined became the architects of their own examination.  In what universe do we do that?  Do we allow school students to write their own tests?  The resulting continued wave of residential delinquencies, foreclosures, losses on second mortgages (home equity lines) and commercial real estate demonstrate that the stress tests were flawed.  In fact, utilizing 2010 data from FDIC losses in bank seizures, Mr. Denninger estimated losses at just 4 major banks (Bank America, Wells Fargo, Citicorp and JP Morgan Chase) to be in the range of $1.5 to $3 trillion. See All You Need to Know About Bank Balance -Sheet Fraud

Sometimes the Truth Appears

Yesterday, Thomas Hoenig, President of the Federal Reserve Bank of Kansas City, blasted the current large bank regulatory regime.  See Kansas City Fed’s Hoenig Endorses Volcker. The top 20 banks have a grossly unfair economic advantage by way of explicit government loan guarantees.  Without these guarantees the top 20 would need $210 billion more in new equity, or would need to shrink their lending activities by $3 trillion. How does this need for capital square with the confidence building stress tests?

Dr. Jones is a sad example of economists who slavishly follow the government line of thought.  Dr. Jones should be asking some tough questions: why do we need $23 trillion of government guarantees for our financial system to be solvent? Why are short term interest rates still set at zero for our top banks?  Why have we been in a state of financial emergency since 2008 if the economy is recovering?  Were the stress tests a scam to help the banks raise cheap capital? Given the Fed’s past poor regulatory performance why give them more plaudits and power?

Perhaps the Administration and the Federal Reserve have done a better job at capturing prominent economists and our news media than regulating the banks -  of course, all to the taxpayer’s detriment.

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2
Mar 10

Goldman and the Winner Take All Society

Finally, Goldman Sachs has gone too far.  In A Reputation as Good as Goldman?  Part I, we discussed Goldman’s selling of mortgage backed securities, and its role in the current Greek budget crisis.  These activities clearly contributed to its self-inflicted reputational damage.

Perhaps the hubris went further.   Does Goldman believe that its status as a favored Federal Reserve “too big to fail” firm will insulate it from government investigation? Last week Ben Bernanke put a dent in Goldman’s Teflon shield:

Ben S. Bernanke, the Federal Reserve chairman, told Congress Thursday that the Fed was ‘looking into a number of questions relating to Goldman Sachs and other companies and their derivatives arrangements with Greece.’

Mr. Bernanke said the Securities and Exchange Commission was also concerned about how derivatives — financial instruments that are largely unregulated and do not trade on public exchanges — have contributed to Greece’s problems. ‘Obviously, using these instruments in a way that intentionally destabilizes a company or a country is counterproductive,’ he said. See In Greece’s Crisis, Fed Studies Wall St.’s Activities.

In Is Goldman Finally About to Be Leashed and Collared? Yves Smith observes and analyzes Goldman’s corporate culture.  As a former employee, she reports on colleagues’ piggish and overly aggressive behavior. But in an otherwise excellent post, I believe she overlooks the role of current compensation systems.

Pay Practices and Reputation

In previously discussing the banking crisis, we pointed out a fundamental principal: you get what you incent.

Banks were interested in generating upfront fees. Incentives were predicated on “making the deal.”  The best way to make a deal was to ignore the creditworthiness of the borrower.  The banker who made the bad loan suffered no personal financial penalty.  There was no “skin in the game.” Why not write as many loans to poor credits as possible? See Hard Truths from the Banking Crisis.

The Goldman culture incents a “winner take all” mentality.  Since it is a public corporation rather than a partnership everyone is an employee.    A highly mobile employee rather than an owner is far less concerned about the firm’s long term reputation.  That employee wants to maximize current compensation; worrying about future consequences is for suckers.  Drawing on this paradigm, we are not shocked by headlines excoriating the firm for trading against its clients’ interests, shorting the municipal bonds it helped underwrite, skirting EU rules, or tanking the housing market.

Goldman operates in a larger Wall Street and indeed general culture that encourages greed at the expense of overall civic good:

  • Successful hedge funds report individual earnings in the hundreds of million dollars per employee.
  • Loyalty is dead.  Employees change firms. Highly paid athletes change teams without a second thought.
  • The media treats great wealth as reason for great celebrity.
  • Compensation validates individual worth.
  • Government backstops losses and allows gains to remain private.
  • The zeitgeist promotes: “I better grab as much as I can now before the economy implodes.”

Does It Have To Be This Way?

Any alert Board of Directors should be asking some difficult questions.  Why aren’t we concerned about the long-term firm reputation?  What do we want the corporate culture to be? Just because we can legally do a transaction should we be doing it?  How do we blend partnership-based personal accountability with a public corporation structure?   How do we get employees to care about the long-term view?  How do we meet the competitive threat of hedge funds and private equity without damaging corporate reputation? How does our compensation system comport with these concerns?

Yves Smith noted that it was as dangerous for anyone to get in the way of a Goldman employee and a profit making opportunity as it was to get between a predatory animal and its kill.  Goldman has managed to get itself between a very worried Obama Administration and a very angry public.  How ironic if the Goldman predatory lion becomes the Administration sacrificial lamb.

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18
Feb 10

A Reputation as Good as Goldman? Part I

Part I of II in a series. Part II here.

“It takes 20 years to build a reputation and five minutes to ruin it. If you think about that, you’ll do things differently.”

Warren Buffett

Arguably the greatest living investor, Warren Buffet, clearly valued a person’s or an organization’s reputation.   In 2008 Buffet was the “white knight” investor for a struggling Goldman Sachs, investing $5b in the firm.  A mentor of mine had wise complementary counsel to Buffet’s:  when providing legal advice, be sure that you would be comfortable if that advice were to appear in a New York Times, Washington Post or Wall Street Journal front page article.

We live in  an age of greed, and indeed supreme irony.   Perhaps Mr. Buffet never shared his wise advice with the senior management of Goldman Sachs.  Worse, maybe he did and they ignored him.  In any event, how has Goldman’s reputation fared?  Let’s examine three separate front page New York Times articles.

Banks Bundled Bad Debt, Bet Against It And Won (NY Times, December 24, 2009)

Goldman Sachs sold mortgage-backed debt securities to pension funds and insurance companies. To hedge their position and to profit from a decline in the housing market, Goldman created a synthetic derivative security called Abacus. This second security was a direct bet against the position of their institutional clients. The mortgage-backed debt securities sold to the institutional clients performed poorly, with losses in the billions. Some of the original securities were of such poor quality that losses occurred within months of issue. Goldman created these synthetic securities well in excess of any hedging needs, permitting it to profit handsomely at the expense of its institutional clients.  The obvious ethical problem was succinctly stated:

“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

The SEC and other governmental agencies are investigating Goldman and other firms to determine whether or not they violated “fair dealing” rules.

Testy Conflict with Goldman Helped Push A.I.G. to Edge (NY Times, February 7, 2010)

AIG insured some of Goldman’s complex mortgage securities.  When the housing crisis deepened, AIG paid Goldman $2b to cover potential losses. AIG later asserted that Goldman had inflated the potential losses and sought monies back. Goldman countered that it was due even more money.  The SEC is now looking into whether or not Goldman’s demands for loss coverage depressed the mortgage market and hastened AIG’s demise.

In another supreme irony, after the government took over AIG, Goldman received an additional $12.9b from taxpayers, one hundred percent of expected losses.

Wall St. Helped to Mask Debt Fueling Europe’s Crisis (NY Times, February 14, 2010)

Goldman’s questionable financial maneuvers were not confined to the United States.

As worries over Greece rattle world markets, records and interviews show that with Wall Street’s help, the nation engaged in a decade-long effort to skirt European debt limits. One deal created by Goldman Sachs helped obscure billions in debt from the budget overseers in Brussels.

Even as the crisis was nearing the flashpoint, banks were searching for ways to help Greece forestall the day of reckoning. In early November — three months before Athens became the epicenter of global financial anxiety — a team from Goldman Sachs arrived in the ancient city with a very modern proposition for a government struggling to pay its bills, according to two people who were briefed on the meeting.

The bankers, led by Goldman’s president, Gary D. Cohn, held out a financing instrument that would have pushed debt from Greece’s health care system far into the future, much as when strapped homeowners take out second mortgages to pay off their credit cards.

European authorities are looking into the role of Goldman and others in skirting EU rules.

Is There Another Way?

Has the American public been lulled into believing that this is an acceptable way of doing business, or do we require the people involved to be publicly excoriated, tried, convicted and jailed before we acknowledge their tactics were shabby?  Is Goldman Sachs an institution now synonymous with crafty machinations and greedy outcomes? Are its tactics symptomatic of a Wall Street “disease?”  Is there an alternative way of doing things?  Does reputation matter?  Part II will examine these issues and possibilities.

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9
Feb 10

Ask Your Congressional Representative to Do Nothing

Every 12-step program has an initial confession, a moment of recognition.  Here’s one: I am a lawyer and I do not know the law.  I have practiced law for more than 35 years, fulfilled continuing legal education requirements and kept up with the daily reporters.  Yet I do not know the law and would venture there is no lawyer who completely knows the law.  Shocking!

Why No One Knows the Law

The law has made itself unknowable.  How did we get to such a place?  There are 50 titles in the United States Code, the official compilation of federal law.  Each title has coordinate regulations compiled in the Code of Federal Regulations.  The tax laws are in Title 26:

If you go to the US Government Printing Office (www.gpo.gov ), you can order a complete set of Title 26 of the US Code of Federal Regulations (that’s the part written by the IRS), all twenty volumes of it, at the bargain price of $974, shipping included.

According to the US Government Printing Office, it’s 13,458 pages in total. The full text of Title 26 of the United States Code (the part written by Congress–available for an additional $179) is a mere 3,387 printed pages, bringing the adjusted gross page count to 16,845. [Statistics as of 2006].

Remember this is one title among 49 others.

An attorney can master small sections or even subsections of the law, but never all the law. Since we live in a federal system, such an aspiring attorney would have to master not only federal law, but also state statutes and regulations.

From day one of law school, a basic principle is hammered home: ignorance of the law is not a defense to a criminal offense.  Thus, we live with the ultimate paradox:  the least schooled of our citizens are charged with complete knowledge of the law, a task that is unattainable even by the most skilled legal practitioners.

Where Laws Come From

Laws emanate from the talented quills of our elected representatives.  Taft and Hartley (labor laws), Sarbanes and Oxley (corporate governance), Glass and Steagall (banking), Smoot and Hawley (tariffs) were all elected representatives.  Congressional representatives demonstrate their worth by identifying a societal wrong that cries for redress. Then they form a coalition to pass legislation.  Often campaign contributions from interested parties find their way to the sponsoring legislator. Immortality awaits these legislators.

Once a law is passed, administrative agencies create regulations to interpret.   Regulations can run many times the length of the law.  Moreover, they have the force of law and in some instances carry criminal penalties for an infraction.

Laws Have a Cost

A law is a hidden tax.  When passed, the simplest of laws require legal analysis, interpretive regulations and a compliance program.  These functions are performed by highly paid professionals. Following the momentary drama and satisfaction of bill passage, these long term costs begin.  Newly passed laws may conflict with existing laws, leading to uncertainty and then an inevitable clarifying court challenge.  Ultimately, these costs are passed along to the consuming citizenry.

What to Do

A modest proposal: we should elect Congressional representatives who promise NOT to pass laws.  Even better would be elected representatives who promise to repeal the most harmful ones.

More seriously, we need   to overhaul and simplify our legal codes.  Society needs basic safeguards, but we have far exceeded that standard. Every problem in society does not require the passage of a law.  Perhaps what we really need is greater trust and a renewed sense of shared responsibility and sacrifice.   Then we would need fewer laws.

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2
Feb 10

Timothy Geithner and Plausible Deniability

Congressional hearings often make wonderful theater.  Last week at the House Oversight and Government Reform Committee, the American public heard testimony from Timothy Geithner, former head of the Federal Reserve Bank of New York and now US Treasury Secretary and Henry Paulson, former US Treasury Secretary.  Both men’s testimony relied on one premise: if we did not bail out AIG and pay its counterparties 100 cents on the dollar, the financial world as we know it would have ended,  i.e., the US would have plunged into a second Great Depression.  By written statement, Fed Reserve chair Ben Bernanke informed the Committee of his full support for this decision.  In person, Henry Paulson agreed.  However, both men said they had nothing to do with the decision.  Further, Mr. Geithner testified that he had relied on his staff or details of the bailout.  And even further than that, he later distanced himself from the decision whether nor not to disclose the details of the bailout. America was treated to the concept of “plausible deniability.”

Plausible Deniability

Working in a corporation one gets a firsthand look at the concept of “plausible deniability.”  Plausible deniability works something like this: a crisis starts; an important decision must be made; a senior executive is charged with making a decision; the senior executive delegates much of the preparatory work to  staff or a trusted lieutenant; the staff or trusted lieutenant ultimately makes a recommendation which later becomes “The Decision. “  If or when something goes wrong in the future, the senior executive denies involvement and places the blame on the staff or the trusted lieutenant.  Almost every time, the superiors of the senior executive accept this scenario.  The senior executive survives.

Let’s Get Real

Harry Truman said “the buck stops here,” meaning that the most senior executive has ultimate responsibility for a decision.  Perhaps with President Clinton or at some time it became fashionable for the senior person to distance himself from the decision so that he would have plausible deniability.  Further, it was expected that subordinates would “throw themselves on their swords” to preserve their boss.

It stretches credulity that the three most senior financial executives in government, The Chairman of the Federal Reserve, the President of the New York Federal Reserve and the Treasury Secretary did not know the intimate details of the AIG bailout.  At stake at the time was $62b of taxpayer money to effect this phase of the bailout.  All three men agree that if the bailout did not take place financial Armageddon would have ensued.

More is expected of our public servants. We appointed these individuals because of their unique skills, judgment and character. Apparently, these individuals were unavailable in the AIG crisis to make critical decisions.  Based on these stated actions, I deplore the confirmation of Ben Bernanke.  Moreover, I would ask for the resignation of Timothy Geithner.

It is time that high level government officials took responsibility and become the watchdog of the public purse. Trying to blame subordinates should elicit the response from the public: “that dog won’t hunt!”

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1
Dec 09

Uncomfortable Questions

By nature Americans are optimistic people.  But, optimism should not be an excuse to suspend critical thinking.  There are uncomfortable questions which should be asked:

To Congress:

  1. Is this financial crisis different from past recessions?
  2. If this crisis is different why are we continuing to employ the same failed policies of the past?
  3. Ben Bernanke and Tim Geithner were in positions of responsibility at the inception of the financial crisis. Why should they continue in their positions?
  4. If easy monetary policies have gotten us into past financial trouble, why will easier monetary policies not cause further financial trouble?
  5. How is a jobless recovery a genuine recovery?
  6. After passing the TARP and a stimulus program, have Americans received value for money spent?

To the Federal Reserve Chairman:

  1. You have been a student of the Great Depression; explain how and why current circumstances differ from the 1929 Depression?
  2. Your zero interest rate policy created the housing bubble and much of the current financial crisis.  Why continue this zero interest rate policy and cause further financial damage?
  3. Under what authority did the Federal Reserve have the right to purchase mortgages, equity stakes in private entities?
  4. If you believe a recovery is in progress, why are you not removing government guarantees and selling the mortgage backed securities the Federal Reserve purchased?
  5. Isn’t a zero interest rate policy antithetical to a strong dollar?  And might not a weak dollar actually hurt the US economic recovery?
  6. Won’t a zero interest rate policy lead to dangerous speculative excess and misallocation of capital?
  7. Given the scope and nature of guarantees and expansion in the Fed balance sheet with securities of dubious quality, what is the chance of a US default on its debt?
  8. Did the Federal Reserve buy private mortgage backed securities at face value? If so, why?
  9. Why are you afraid of an audit of the Fed’s balance sheet?

To the Executive Branch and Treasury Secretary:

  1. Given the massive amount of public and private debt (almost 400% of GDP) should government policy be encouraging businesses and individuals to go further into debt to spur a recovery?
  2. Why are record bonuses being paid to Wall Street executives when these entities caused the financial crisis and needed public support to avoid bankruptcy?
  3. Has China directly threatened the Administration with boycotting the purchase of US debt?
  4. With meager internal savings and the potential for a threatened foreign boycott of US debt purchases, how does the Administration intend to fund the rapidly growing federal deficit?
  5. How many banks are actually insolvent?
  6. Why have we not promptly closed problem banks?
  7. Is the FDIC insolvent?
  8. How much more public money will be required to continue to fund the losses at Fannie and Freddie?
  9. Is massive federal assistance to select private companies like GE, American Express or AIG constitutional?
  10. With ever growing deficits, why is the Administration proposing costly health care proposals and expanded troop levels in Afghanistan?
  11. Is the government secretly intervening in the public debt and equity markets?  If so, why?
  12. You have current regulatory power to reform the financial system. Why are you not:

a. Forbidding the creation and trading of private, customized credit derivatives?

b.Imposing windfall profit taxes on Wall Street that received any form of federal assistance?

c. Breaking up the “too big to fail banks?”

    General Questions for Economists:

    1. How is the constant tampering with interest rates and providing taxpayer supported financial guarantees consistent with capitalism?
    2. How does a zero interest rate policy affect pension funds and the elderly population living on a fixed income?
    3. Why is the market incapable of determining an appropriate level of interest rates?
    4. Does our level of national income support our current projected debt levels?
    5. Does FDIC insurance lead to reckless lending?
    6. What is the long-term effect of government meddling in supposedly free capital markets?
    7. Many of you did not predict the last financial crisis. What did you learn which would help you predict the next crisis?

    To the Judiciary:

    1. Has the US Constitution been violated in favoring select private entities with public support, backdoor “make whole” schemes at the expense of competitors and at the expense of taxpayers?
    2. What theory of preemption permitted the Treasury and the Federal Reserve to effectively take over AIG when insurance companies are state regulated enterprises?

    Conclusion

    We are in uncharted waters.  When a real estate enterprise in Dubai dominates the financial headlines and shakes the world financial markets we are far from putting the financial crisis behind us.  Right now, I think we are in the “extend and pretend” phase of the crisis, wherein markets and government collectively believe that ignoring current problems will permit the economy to heal over time.  That is Plan A.

    The real question looms in front of us:  What is Plan B, if all government efforts fail?

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