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I've been writing about this now over a year in regard to the mess that became of AIG, their "financial products" unit, and what I believe is culpability not only of certain financial parties but more importantly our regulators of these firms.
Now The NY Times has published a new article that makes clear that my clarion call for major changes in these areas of the market were not only spot-on, but are even more necessary today than they were back then.
A.I.G. had long insured complex mortgage securities owned by Goldman and other firms against possible defaults. With the housing crisis deepening, A.I.G., once the world’s biggest insurer, had already paid Goldman $2 billion to cover losses the bank said it might suffer.
A.I.G. executives wanted some of its money back, insisting that Goldman — like a homeowner overestimating the damages in a storm to get a bigger insurance payment — had inflated the potential losses. Goldman countered that it was owed even more, while also resisting consulting with third parties to help estimate a value for the securities.
Read that carefully. The NY Times is making this sound like AIG had insured losses against securities Goldman was holding. That's what insurance is, right?
Here's the problem: Goldman didn't own the securities.
In addition to offering to cancel its own contracts, Goldman offered to buy all of the insurance A.I.G. had written for several other banks at severely distressed prices, according to three people briefed on the discussions.
Negotiating with Goldman to void the A.I.G. insurance was especially difficult, Federal Reserve Board documents show, because the firm did not own the underlying bonds. As a result, Goldman had little incentive to compromise.
Now do you see the outrage in these so-called "protection devices"?
They aren't. They were raw bets. Very highly-leveraged gambling instruments that had a very low cost at origination - a cost all out of proportion to their eventual potential return.
We do not let "just anyone" buy insurance. You must have an insurable interest. That is, I can't buy fire insurance on your house. If I could, I might - and so might 20 of my best friends. We might even target those homes we think might have fires. We could even bribe the folks doing a controlled burn nearby to be a little less careful than they ordinarily would. Or, in the extreme case, one of us might just set a fire on purpose!
None of this is allowed in the insurance marketplace because it creates too many incentives for people to set fires and otherwise cause calamities, whether through outright unlawful conduct or helping along "a series of unfortunate events."
In the regulated options, futures and stock markets we have controls on this sort of thing as well. To short a stock (legally) you have to be able to borrow it. That is, someone who owns it must lend it to you first (perhaps in exchange for money.) As more people short the cache of people willing to lend out that stock for free will evaporate, and you'll have to start paying up for the privilege of borrowing it. This is a natural check and balance on placing negative bets via shorting.
Buying PUTs or transacting in the futures market has costs too. Those regulated markets have defined margin requirements and they are enforced - nightly. The cost of buying a PUT includes something for the guy who sells it to you, as he is going to hedge his bet by being short the stock. Thus, as the number of PUT buyers increases the premium demanded rises - precipitously so as the demand for those PUTs goes up. Finally, buying a PUT doesn't come with the right to demand anything more from the seller - his margin requirements are enforced by the exchange and you don't get to hold the money.
These OTC CDS contracts had another insidious feature: They apparently included a clause that not only would a downgrade of the security trigger margin requirements but so would a downgrade of AIG.
The terms, described by several A.I.G. trading partners, stated that A.I.G. would post payments under two or three circumstances: if mortgage bonds were downgraded, if they were deemed to have lost value, or if A.I.G.’s own credit rating was downgraded.
The perversity of incentives here is that if you can demand that your counterparty hand over more and more "margin" to you it is possible to actually force a downgrade by your actions and thus cause even more margin to have to be posted! This, of course, harms the firm's liquidity and makes a further downgrade more likely.
Rinse and repeat to destruction - which, incidentally, is exactly what happened.
This is dramatically different than the regulated markets, where valuations are determined by the market, not by one of the parties at interest and the margin requirement is fixed by the deficiency (if any) against the final strike price and the market's price - the person who happens to be short gets no benefit (or harm) due to his or her credit rating. If you're underwater, you post margin. If not, you don't, but in neither case does the person on the other side of the trade get to hold the margin funds! He gets your money only when he closes his position or the option expires (if it's in the money.)
These "synthetics" (such as the Abacus CDOs) are an outrage on their face. These are not created from the purchase of actual physical asset (e.g. a mortgage security) but rather by someone writing a credit-default swap against a reference. These are then bundled up and sold. When a credit-default swap is then written against a synthetic CDO it is equivalent to writing a gambling contract on a gambling contract as nobody in the chain owns an actual physical asset (such as a loan)!
The simple fact of the matter is that "naked" CDS exposures need to be prohibited right now. They never should have been allowed and not a damn thing has changed. Purely synthetic instruments need to be traded on an exchange in each and every case as a means of preventing chicanery, where margin can be enforced transparently on a nightly basis by a neutral third party in the middle of all transactions - the nominal buyer for every seller, and seller for every buyer. This third party (the exchange), having no skin in the game either way, will not permit the abuses that are too easily committed when you have over-the-counter transactions of this type.
The article referenced makes a decent case that AIG didn't fall off the cliff, it was pushed. There are even allegations raised of collusive conduct which, if true, add an even more serious angle to this entire story.
But at the end of the day the problem boils down to the same basic facts I have been harping on since the beginning:
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Writing "insurance" on something the purchaser doesn't own isn't insurance, it's a gambling contract.
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When such gambling contracts stack up to a great degree there are huge incentives for someone to commit financial arson. Whether they did or did not is a matter for debate, but that the incentives exist to structure deals in a way that are easily detonated so you can profit from them as exposure increases is not open to debate. Such incentive does absolutely exist - and we must eradicate it.
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To prevent fraud and gaming of the system, such contracts must be on a regulated exchange where each buyer and seller deals with a neutral third party (the exchange itself) that is responsible for nightly margining, trade reporting, open interest and bid/offer maintenance. These facts must be exposed at all times to the public so that the market operates in a transparent fashion and neither side of the transaction can be "pushed".
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The exposure of these contracts on said exchange will also prevent disasters like AIG from occurring, as the fact that they are short "X" will become instantly visible to everyone, including their regulators. The precise exposure they are taking on will thus be known at all times.
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We must bar backstopped entities (such as banks and insurance companies) from trading in or creating synthetic instruments such as this in the first place. These are not hedges as by definition there are no actual hard assets behind them. The argument that they are created to fill a demand from the market is true but irrelevant - the fact remains that with no actual hard asset acquisition behind them they serve no fundamental credit intermediation purpose which is the purview of banks and insurance companies - they are, instead, pure speculative instruments. Let the hedge funds, operating without any sort of financial backstop, create these all they want - and trade them on a regulated exchange - but keep the banks and insurance companies out of it.
We have not neutered this monster in the slightest. Indeed, the latest rabble in the market with regard to Greece, Spain and Portugal is, not surprisingly, about (once again) credit default swaps blowing out.
And again I ask - who wrote those CDS naked on these nations to people who didn't actually hold underlying positions in the bonds without them being traded on a central exchange, and why, after 2008 and 2009, do we still let that crap go on?
So we got our "Bernanke" reconfirmation on two votes, the first the "real" one and the second the one that everyone is trying to "count."
Let's first look at the real vote - the vote for Cloture, without which there would have been no confirmation vote at all.
The following Senators voted YEA on Cloture and stand for election this November.
AK:Murkowski (R)
AR:Lincoln (D)
CA:Boxer (D)
CT:Dodd (D)
GA:Isakson (R)
HI:Inouye (D)
IN:Bayh (D)
MD:Mikulski (D)
NC:Burr (R) YEA
ND:Dorgan (D) YEA
NH:Gregg (R) YEA (Retiring - to a Goldman affiliate!)
NV:Reid (D) YEA
NY:Schumer (D) YEA (Wall Street's Chief Whore)
OK:Coburn (R) YEA
OR:Wyden (D) YEA
UT:Bennett (R) YEA
VT:Leahy (D) YEA
WA:Murray (D) YEA
Ignore the actual confirmation vote. Some of the clowns in the Senate, like Babs Boxer, tried to obfuscate reality by voting for Cloture and then voting "Nay" on the final vote itself, in an attempt to play "I voted against it before I voted for it." This sort of symbolic malarkey must not be allowed to stand.
More importantly though is that Bernanke is now officially President Obama's child. He put him up for renomination, he did not pull that nomination, and he personally lobbied for his reconfirmation. He owns it.
There are many who believe that Bernanke "saved us from another Depression." I will note that there were many in 1930 who thought we had been "saved" as well. They were wrong.
They were wrong for the same reason they're wrong this time. From SIGTARP's latest report:
It is hard to see how any of the fundamental problems in the system have been addressed to date.
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To the extent that huge, interconnected, “too big to fail” institutions contributed to the crisis, those institutions are now even larger, in part because of the substantial subsidies provided by TARP and other bailout programs.
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To the extent that institutions were previously incentivized to take reckless risks through a “heads, I win; tails, the Government will bail me out” mentality, the market is more convinced than ever that the Government will step in as necessary to save systemically significant institutions. This perception was reinforced when TARP was extended until October 3, 2010, thus permitting Treasury to maintain a war chest of potential rescue funding at the same time that banks that have shown questionable ability to return to profitability (and in some cases are posting multi-billion-dollar losses) are exiting TARP programs.
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To the extent that large institutions’ risky behavior resulted from the desire to justify ever-greater bonuses — and indeed, the race appears to be on for TARP recipients to exit the program in order to avoid its pay restrictions — the current bonus season demonstrates that although there have been some improvements in the form that bonus compensation takes for some executives, there has been little fundamental change in the excessive compensation culture on Wall Street.
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To the extent that the crisis was fueled by a “bubble” in the housing market, the Federal Government’s concerted efforts to support home prices — as discussed more fully in Section 3 of this report — risk re-inflating that bubble in light of the Government’s effective takeover of the housing market through purchases and guarantees, either direct or implicit, of nearly all of the residential mortgage market.
Stated another way, even if TARP saved our financial system from driving off a cliff back in 2008, absent meaningful reform, we are still driving on the same winding mountain road, but this time in a faster car.
Yep.
That report is 224 pages, and ought to be required reading. But the executive summary above that I have excerpted is the base of it all.
There is one place that I disagree with Barofsky - that is the "reinflation" of the housing bubble. That's simply not going to happen, because the bubble itself was (as are all bubbles) predicated on false credit quality claims.
Bubbles all depend on credulity. That is, they rely on the ability to find more and more suckers upon which one can offload over-rated securities, each of which is worth less than claimed (and in some cases literally "worthless"!) They pop when the number of suckers is exhausted and the mad scramble for chairs begins as the music suddenly stops. Those left holding a bag with no sucker to offload it to go bankrupt and since the essence of bubble economics is the overuse of leverage the bagholders inevitably are geared and those who lent them their money are imperiled as well.
The natural check and balance on such behavior is the risk of bankruptcy. That fear prompts underwriting and proper margin supervision, thereby limiting the impact to those who actually speculated.
But we have failed on two accounts: We first allowed regulated banks and insurance companies to speculate, effectively allowing private parties to gamble with the credit of The United States, where they keep the winnings but pass on the losses to the taxpayer. Then, when the bust came, instead of punishing those who gambled and lost by forcing them through bankruptcy (even if it meant the taxpayer would take a huge hit) we instead took the hit but left those who did the evil things with operating businesses!
Bernanke is one of the chief architects of this structure. He has repeatedly engaged in "bubble economics" with scant regard for the common taxpayer - the citizens of this nation. Instead, his focus is on the few thousand brigands found in New York, who are plundering our society to the limit of their ability.
The last two weeks have treated us to a few ugly realities in regard to where the markets are and what Bernanke has done. By pumping a literal trillion dollars into the markets via his above-market-price purchase of mortgage and treasury securities along with a zero interest rate for short-term fed borrowing he has engendered a monstrous stock market bubble. This has come about due to the inherent disconnect between real valuations and yields in markets where he has interfered (when you overpay for something you drive its yield down.)
But that stock bubble has in turn been predicated on growth numbers that simply cannot arrive in the real world. The realization that "we've been had" may be coming now - but whether it is now, a month from now or six months from now, it will come, and instead of producing a flattening of the market (which would be the likely outcome were we trading in the 800s or even low 900s now on the S&P) the potential for an outright crash instead exists as people run for the door.
We should know better - after all, the same dynamic took hold in the housing market. But that sort of dynamic was ignored then ("subprime is contained") and is being ignored now ("I don't see any asset bubbles") by Bernanke, and will continue to be - right up until the market implodes.
Perhaps this is his (and President Obama's) intent. After all, our dear President intends to send a nearly $4 trillion Federal Budget to Congress in the coming days, while we are running a deficit of nearly half that. With China increasingly unwilling (or unable) to continue to recycle hundreds of billions annually back to US Debt (a losing strategy for them in the longer term as they'll never be paid off) and both Japan and England drowning under their own debt issuance one has to wonder exactly where Obama and Bernanke think they can source the over $1.5 trillion in net issuance they need to continue the charade.
Perhaps the answer is nothing more complex than intentionally cranking the stock market one more time, then crashing it again, scaring everyone into Treasuries. Recent changes in money-market fund rules to permit them to throw up gates without prior approval of the SEC may be part of this, as may the rumblings about "annuitizing" people's retirement accounts. Anyone care to take a bet on there being some sort of "conversion to something safe" option being thrown about if and when the stock market dives once more?
In any event the key items here are that we now have a "hit list" of Senators that must go from their seats come November, and a reminder that President Obama can no longer blame what I believe is an upcoming collapse of the stock market - a multi-year affair that will be much worse than what we suffered in 2008 and early 2009 - on President Bush. He had the opportunity to name either Volcker or John Taylor (to name two) to the position that Bernanke has, and decided instead to go with the guy who has been a chief architect of the "Brigand-and-Loot-Em" society - for better or worse, it's all his now.
Bonne chance mes amis.
Out from the IRA is an interesting piece taking a shot at Volcker's reform proposals:
If you accept that situations such as AIG and other cases where Buy Side investors (and, indirectly, the US taxpayer) were defrauded through the use of OTC derivatives and/or structured assets as the archetype "problems" that require a public policy response, then the Volcker Rule does not address the problem. The basic issue that still has not been addressed by Congress and most federal regulators (other than the FDIC with its proposed rule on bank securitizations) is how to fix the markets for OTC derivatives and structured finance vehicles that caused losses to AIG and other investors.
Well, actually it does partly fix the problem.
IRA gets the cause correct: we got into this mess as a consequence of intentionally-opaque financial instruments that were less-than-honest in both their intentions and disclosures.
But where IRA misses the market is that they have not discussed who was it that came up with these structured financial instruments, who assembled them, who wrote the prospectuses, and who bought ratings for them from the ratings agencies?
Why that would be "the big banks", right?
Remember, Wachovia wrote off-balance-sheet swaps against their own securitized mortgage deals when they found them unmarketable "as written."
Goldman, Merrill, Morgan, Bank of America, Lehman, Bear and others created the securitized mortgage conduits and structures for non-agency paper and in fact stuffed into Fannie and Freddie securitized loans that did not meet the GSE's actual mandate in terms of disclosure and underwriting - that is, they sold them purely on the basis of a rating.
Despite warnings from the FBI in 2004, Comscore in 2006 and HUD in 2007, all of which warned of extraordinary levels of fraud in these instruments and two of them - Comscore and HUD - making the claim that as many as nine in ten ALT-A loans were made to people who did not have the income and/or assets they represented, there was no disclosure of these facts in the offering prospectuses for the securitized debt generated from these "loans."
IRA points out:
A decade since the Enron-WorldCom scandals, we still have the same basic problems, namely the use of OBS vehicles and OTC structured securities and derivatives to commit securities fraud via deceptive instruments and poor or no disclosure. Author Martin Mayer teaches us that another name for OTC markets is "bucket shop," thus the focus on prop trading today in the Volcker Rule seems entirely off target -- and deliberately so. The Volcker Rule, at least as articulated so far, does not solve the problem nor is it intended to. And what is the problem?
Not a single major securities firm or bank failed due to prop trading during the past several years. Instead, it was the securities origination and sales process, that is, the customer side of the business of originating and selling securities that was the real source of systemic risk. The Volcker Rule conveniently ignores the securities sales and underwriting side of the business and instead talks about hedge funds and proprietary trading desks operated inside large dealer banks. But this is no surprise. Note that former SEC chairman Bill Donaldson was standing next to President Obama on the dais last week when the President unveiled his reform, along with Paul Volcker and Treasury Secretary Tim Geithner.
The argument that we have not solved these issues is a good one, but again misses the mark in that one must ask: why would an institution create these things unless they were able to force someone else to eat them when they go bad?
I would argue that while IRA certainly has the "long view" correct (and in fact it is almost exactly what I've been arguing for since I began publishing The Market Ticker) in point of fact separating securities businesses from deposit and loan -making in all of its forms is in fact a positive change, in that it will remove the backstop that these firms otherwise immediately run to whenever someone proposes to do something (like make them eat their fraudulently-created securities) that might threaten their survival.
As such while "The Volcker Rule" certainly won't fix the world, it will in fact change the landscape in a fashion that will make possible the imposition of strict liability for the creation of fraudulent securities in all their forms, including the "corporate death penalty" sanction that, at present, we are told cannot be applied without destroying both the banking system and economy.
Oh oh.
Remember, Blankfein testified in front of the FCIC at 10:12 AM on 1/13 that he never got a request to take less than 100 cents on the dollar for AIG credit default swap contracts.
Well then what's this that Zerohedge dug up?
As everybody knows, AIG got a huge government bailout in September 2008 to help make payments on derivatives contracts with banks, including Goldman. Yet in the previous month, Goldman approached AIG about "tearing up" its contracts, according to a November 2008 analysis by BlackRock, then an adviser to the New York Fed.
WHAT?
Oh yeah. Here's the link to the Zerohedge article, and the paper in question is right here:
Thanks and noted on the tear up stand down.
We should get back with Goldman. I will talk with Bill.
Date: 10/31/2008 6:57 PM.
Which followed:
Also, I spoke to Manzari this morning. He asked me to stand down on tearing up / unwinding CDS trades on the CDO portfolio.
That appears to be a smoking gun in that it documents that there was an active negotiation on "tearing up" - that is, unwinding CDS trades at less than 100 cents on the dollar and that negotiation was intentionally terminated.
Will we next be entertained by a discussion of what the word "is" means, or can we take the above at its obvious face value - that GOLDMAN ITSELF APPEARS TO HAVE OFFERED TO TEAR UP THE CDS ON AIG'S PORTFOLIO!
If there indeed was such an offer - as is all but stated here - and if indeed there was an order given to "stand down" on such negotiations then those persons responsible must be summoned to the dock and compelled to provide testimony, as it appears that one or more individuals who have already stated that no such negotiation was possible may have committed perjury, never mind dispensing more than $10 billion of taxpayer money to Goldman Sachs unnecessarily - at best.
NOW IS YOUR OPPORTUNITY.
GET ON THE PHONE NOW and call your Senators. Tell them:
VOTE NO ON BERNANKE OR YOU'RE FIRED; INSTEAD, BRING BACK PAUL VOLCKER!
This is Janet Tavakoli's take:
What has the financial crisis taught us? Among other things, we should show Bernanke and Geithner, enablers from the previous administration, the door. Paul Volcker is right to ask for a return to Glass-Steagall. It worked until it was eroded over several decades by bank lobbying. Banking and speculative trading activities--even when done for "customers"--don't mix.
"Financial innovation" must be limited, since much of it in recent years was the financial equivalent of card cheating. Banks should not be allowed to sponsor hedge funds and private equity funds, and furthermore, they should not be allowed to lend to them through prime brokerage units or other means. Financial institutions must be allowed to fail. Hedge funds require regulation. Malfeasance should be investigated and prosecuted. Credit derivatives should be traded and cleared through exchanges and made transparent. Compensation and financial incentives at banks must change. Bank employees cannot continue to reap huge rewards at no personal risk while shoving risk into the global financial system.
President Obama promised us change, and he should seize this opportunity to demand sweeping financial reform.
Support is literally crumbling across the board - and it should.
This is not about whether Bernanke "saved the system" - I argue that he did not, in point of fact, in that everything he said wouldn't happen, including the market crash from fall 2008 to spring of 2009, happened anyway even though Congress gave him everything he demanded and more! Further, the only "success" Bernanke's policy has shown is that he blew another asset bubble - this time in stocks where a huge number of issues in the S&P 500 are trading with P/Es over 60 - in clear bubble territory having no relationship of any sort to fundamental value or forward earnings potential. Employment is still in the tank, spending ex-government has not recovered and real-time indicators of forward demand continue to be extremely weak - two years after Bernanke said "he could and would save us."
No, the real reason he cannot be reconfirmed is that he has continued to refuse responsibility for anything related to the mess in the first place, and yet Ben Bernanke has the lion's share of individual responsibility for what has happened.
He has refused to regulate the banks.
He has refused to protect consumers against predatory acts.
He has intentionally grown credit aggregates at a rate dramatically faster than GDP over the space of his entire term and in fact influenced Greenspan doing the same, which is the root cause of the last two bubbles and market crashes.
He has dogmatically stuck to his doctoral thesis even after it has been proved wrong by the passage of time and the market.
He has intentionally concealed the terms of bailouts and handouts that were funneled through the banks on his watch, including but not limited to AIG's bailout that was funneled to Goldman Sachs among others.
He has not supported the market - he in fact became the market for Fannie and Freddie securities, putting himself into a box from which he has failed to explain how he will exit (likely because he now realizes he can't!)
He has been dead wrong in virtually every public pronouncement related to the economy over the last five years, including his repeated claims that there was no housing bubble, that subprime would be contained, that the economy would avoid a recession and that his monetary policies were "supportive" of sustainable growth in the economy. Not one of those claims from 2003-2007 was in fact true.
For all these reasons and more Bernanke cannot be reconfirmed.
We need an adult in the room. While there are others who could do the job, Paul Volcker is the obvious choice. He has proved his willingness and ability to take steps unpopular with the banking cartel when it is necessary, despite the heat that reflects back upon him. He understands the need for separation between the subsidized and protected lending function and speculative activity by financial institutions. And finally, and perhaps most importantly, he understands the difference between sound lending and fraudulent asset stripping and value destruction.
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